Direct costs are those that vary with the level of production; another name for them is variable costs. If you make no craft widgets, you incur no direct costs. This happens when you are on vacation or at a show. Once you set foot in your studio, though, the meter starts running on direct costs. They include your materials used in the production process, supplies consumed in production, energy (if that's a significant component) and wear and tear on your tools and equipment. Cheerful but clumsy production helpers in the form of contract workers or employees are considered direct costs. Direct costs, since they vary with the level of production, are also known as product costs -- they attach themselves to the widgets you're producing -- and are generally shown above the gross profit line on your financial statements. In our continuing example of Crafts R Us direct costs are fifty per cent of revenue. It's easy to calculate or forecast direct costs: fifty per cent of nothing is still nothing, while fifty per cent of a million bucks is half a million bucks. As long as you focus on keeping that fifty per cent margin intact, direct costs will take care of themselves.
The next kind of costs to consider are fixed costs. They tend to be recurring costs that have nothing to do with production. They are also referred to as period costs, or overheads. Whether you're on the beach or at the show, these kinds of costs continue to pile up and consume your gross profit margin. They require constant vigilance to keep them in line -- see the FACQ on Cost Reductions. You can't avoid them, but you can control them. Examples include rent on your studio, office workers, telephone and utilities, office supplies, insurance, etc.
A hybrid kind of cost is the step variable cost. In the typical studio situation these are almost always people costs. They arise when you move your production level to a new plateau, either higher or lower. Let's say that you score bigtime at the show -- Coldwater Creek wants your craft widgets on the cover of their catalog. Not only are you going to be hiring more production workers to make those widgets (direct costs), but you are probably going to have to hire more staff to handle the warehousing and shipping of those widgets. And when the catalog hits, you'll need more folks in the office to handle the huge number of calls from customers who saw your widgets in the catalog, but want one in a different color. And don't forget the incremental changes in your toilet paper consumption when budgeting these step variable costs! Shows, retail fairs or trade shows, are another example of step variable costs. You decide how many and which shows at which to exhibit. Hopefully they provide incremental revenues to grow your business.
So why do you need to know about the different flavors of costs that go into the makeup of your profit and loss statement? So that you can plan and budget more effectively, making you that much more efficient as a manager or business person. With this understanding, you now have the tools to make your move up or down the mountain that much more manageable and profitable -- both of which will help make that next trip to the beach more enjoyable.
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