Understanding costs: The foundation of effective financial planning
For any organisation, the number one financial question that should be asked is: "What is the most impactful way that our limited resources can be invested?" While this is a straightforward enough principle, in reality, an organisation's costs are complex, and almost always you aren't starting with a blank piece of paper but rather have activities already committed and ways of working established that define your "cost base."
Understanding your costs is critical to putting yourself in a position to plan and optimise the most impactful way to invest your limited resources.
Broadly speaking, there are two categories of costs:
Costs of Sale (aka Costs of Goods Sold or Operating Costs) - the costs you incur in the delivery of your principal organisational activity, e.g., making and selling a product/service.
Overheads - the administrative costs and critical infrastructure that support the organisation's smooth running. The most typical overheads are things like office rent, finance, legal, and HR costs.
Why is this distinction so important?
Management of your costs of sale goes hand-in-hand with your pricing and sales strategy to ensure that your product/service makes a surplus, aka a gross profit.
Overheads can be optimised, but ultimately need to be funded out of your gross profit, and a key part of strategic financial planning is determining how this will be done through one or a mix of volume (how many things you sell), increasing profitability (price increase/costs of sale reduction), and expansion (introducing new products/services, opening a new store, trading overseas).
Regardless of category, there are broadly three types of cost:
Fixed - Do not vary with a change in the scale of your business (e.g., increase in the number of products sold or number of people employed).
Stepped - Increases when a threshold is hit, e.g., office costs will be fixed until you exceed the capacity of your office and need to open another one or move to a bigger office when it will once again be fixed until that capacity is hit and so on.
Variable - These vary either exactly or approximately in line with another variable, e.g., the cost of components for a product will directly vary with the volume of products.
Analysing and understanding both your existing costs and any new costs through this lens is essential for effective financial modelling as it ensures that you create the appropriate relationships between business activities/decisions and costs.
Fixed costs may be significant when they are first incurred but may be quickly paid for as revenue increases.
Stepped costs may mean your cost base significantly alters at key points in your organisation's growth, e.g., an additional production line or machine being required once volume exceeds a certain amount, or an additional person needing to be hired to ensure you can service your clients to the standard you want.
Variable costs will directly influence the price of your product/service and therefore your positioning in the market and the types of customer you target.
Understanding the two categories and three types of cost is the foundation from which you can map your cost base to identify how it can be optimised or a lens through which you can evaluate both short-term decisions and long-term strategic plans. These categories are also the fundamentals with which to build an effective financial model.
