Learn about direct variable costs, with examples of how they relate to products.
- [Man] Businesses that have only one product, if those actually exist, should not have any problem with determining their profitability at a product level. At the end of the day, that one product needs to cover all the costs no matter what. Once we introduce a second product to our company, maybe an orangeade to our lemonade stand, then there's a whole new level of complexity that is added to calculating product profitability. Not so much on the product-related costs, since it's easy enough to know that lemons are for lemonade and orange are for orangeades, but more on all the costs that are not specific to one product.
For example, the cost of putting a stand together. How do you determine how to add it to your lemonade and orangeade costs and profitability? And because there are different types of costs in a company, some directly related to your products, others somewhat related to it, and others not related to it at all, it can be a complex endeavor. That's where you need to decide if you're just going to evenly split those unrelated costs on all your products or choose a more scientific method.
In fact, it's the nature of the cost that will determine how you're going to handle it. And common sense is all that's needed to decide what to do. All it really takes is a good understanding of your company and your business. All the costs of a company can be broken down into four main categories. Direct fixed costs, which are costs that are directly related to your product but are fixed whatever the number of products you build or sell. For example, in your lemonade stand, that could be your knife and cutting board.
You'll need them to make the lemonade, and the cost of it will remain the same whether you sell one lemonade or 100. Direct variable costs are directly related to your product but vary with the number of lemonades you produce. That could be your lemons, for example. You'll consume just enough for your production, and the more you produce, and the more you'll have to buy. Then, we have indirect fixed costs, which are this time costs not directly related to your product and that stay the same whether or not you produce anything, and whether or not you sell anything.
That could be the cost of your stand. You'll need a stand even if you don't sell any lemonades. And the last one is indirect variable costs, which are costs not related to your products but that vary with your production. Your time, for example, is an indirect variable cost. The more time you spend working in your lemonade business and the more it costs your company, even though it is not directly related to your products. And if you think your time is not worth anything, then think again. Think about everything else you could be doing to make money and see that your time is worth something and needs to be taken into consideration.
Each of those cost categories will influence how we will allocate costs by product and how we will determine the profitability of each product.
- Identify the purpose of cost-accounting.
- Define product profitability.
- Determine your baseline.
- Gather revenue and cost information for your analysis.
- Connect targets with profitability.
- Build your target baseline.
- Analyze pricing.
- Calculate probable product profitability.