Understanding Costs

2. Understanding costs

The first step in setting prices is to establish your costs. Your price has to be high enough to cover all the costs you incur and to make a profit. You need to understand the different types of costs involved in setting up and running your business.

Business costs fall into 3 main categories:

• fixed costs or overheads
• direct or variable costs
• capital costs

If you've not yet looked at this BOSS course on Understanding your finances, then you may find it useful for understanding your costs.

(BOSS Digital courses created by Business Wales to support starting and running a business. Sign in/Registration is required).

Fixed costs or overheads

These are the costs you have to pay no matter how much or how little you sell. For example, one of the fixed costs for a shop is the rent. This stays the same whether the shop sells one product or thousands.

Fixed costs include:

• office expenses such as supplies, utilities and telephone
• salaries and wages for you, office staff and salespeople
• marketing and sales expenses, including advertising
• insurance
• vehicle and travel costs
• professional fees
• rent

Direct or variable costs

These costs change as sales increase. For example, the costs of raw materials, packaging and delivery charges are variable costs as they change depending on the number of units you are producing.

For businesses providing a service, there are often fewer variable costs, although these may include charges for freelance support or sub-contractors.

Variable costs include:

• raw materials
• direct labour costs for staff involved in producing products or delivering services
• packaging
• delivery charges
• utilities for a manufacturing base or warehouse
• depreciation expense on production equipment and machinery

Capital costs

These are fixed costs that benefit your business for a long time. This includes items such as machinery, equipment and company vehicles. Capital costs are also known as capital assets.

Depreciation

This is the accounting term used to give a value to the amount of wear and tear on your capital assets. The value of things such as machinery, equipment and vehicles falls as they are used or wear out. Depreciation means the cost of these assets are spread and they are written off against the profits of several years rather than just the year in which they are purchased.

The general rule of thumb is that capital items depreciate by approximately 25% each year.
Talk to your accountant or Business Wales business adviser for more information on how to work out depreciation and on which items.

Use this template to identify the different costs in your business. Use the 3 different sections in the document to identify your capital costs, your fixed costs, and your variable costs (MS Word 609kb).

Next: Costing Your Product or Service