The mathematical formula for making money is simple: Sales – Costs = Profits. The real-world reality, is a little more complicated. But it need not be a mystery.
Your cost structure
In this post, I’d like to explore one element of the equation: costs. And I’d like to begin with the premise: “All costs are not created equal”. There are different characteristics of costs, and different ways to evaluate costs, that if you can master, go a long way to helping that simple equation up above.
The first step is to realize that every business has a “cost structure”—basically, the particular arrangement of different types of costs that flow from the business’ strategy. For example, one business may decide to outsource IT, and another may choose to manage it in-house. Neither of these options is right or wrong per se, but each of them results in particular benefits and limitations. When looking at your cost structure, some traditional ways of describing them can be helpful:
Types of costs
- Fixed vs. Variable — “Fixed” costs, are costs that don’t change with volume. So for example, regardless of whether you sell 1 or 1,000 flowers, your rent this month won’t change—it’s a fixed cost. “Variable” costs, however, do change with volume. So using our florist example again, the more flowers we sell, the more money we’re spending on flower inventory—it’s a variable cost.
- Direct vs. Indirect — “Direct” costs are those that are closely connected to our end product. So if I’m a contractor, my job materials are easily linked to the construction project—they’re a direct cost. “Indirect” costs are those that are not closely connected to our end product. For a contractor, as an example, general liability insurance is typically not associated with a particular construction project—it’s an indirect cost.
- Pecuniary vs. Non-pecuniary — “Pecuniary” is just a fancy word for “relating to money”. These are the most obvious costs: you actually have to go to your bank account, and take some money out. “Non-pecuniary” costs are less obvious, but no less important. They don’t directly involve your bank account, but include things like your business’ environmental impact. (As an aside, I would argue that non-pecuniary costs eventually surface as pecuniary, but that is a topic for a future post.)
- Opportunity cost — Each door you walk through, means you didn’t walk through the other. If you chose “A”, you didn’t chose “B”—it’s your opportunity cost (or perhaps better stated, opportunity lost). So if you decide to sell men’s haircuts, you’ve decided to forgo website design services.
- Sunk cost — Sunk costs are costs that are already spent, that you’ve already “sunk” into a particular project or situation, and are unable to retrieve. So if you’re developing a piece of land to resell, and you’ve put in permitting, water testing, and grading costs, these are all sunk costs.
And cost characteristics are not mutually exclusive either: For example, a printing company could be evaluating whether to buy a piece of printing equipment from a new manufacturer with great promise. This decision involves a cost that is “fixed” (the machine’s cost won’t change based on the number of cards she prints), “direct” (the cost is directly linked to the printing of cards), and involves “pecuniary” elements (the actual price of the machine), “opportunity” cost (not developing a relationship with a potentially promising manufacturer), and “sunk” cost (her current familiarity and investment in the machines of the existing manufacturer).
The types of costs listed above are in no way comprehensive, but simply having a basic vocabulary to talk about costs, gives us an ability to understand them better and thereby make better decisions. In a future post, I’ll focus on how this understanding can then inform our decision-making process. But for now, I hope the above was helpful to you, and please feel free to connect if we can be of assistance.