Understanding your Period Costs Can Save You Money
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Understanding your Period Costs Can Save You Money
Period costs are a simple concept but many entrepreneurs ignore them because they are not very easy to see. If you want to sell a product online you usually think only of the product cost. If you ignore period costs then you could quickly run out of cash and kill your business
Period costs definition
Period costs are costs that do not fluctuate with output. That sounds nice and fancy but what does it really mean? Well I like to refer to period costs as fixed costs. In other words if you sell 500 products this month or if you sell 1000 products this month it doesn’t affect this cost.
But it’s never that simple. Most period costs will change if you sell more of your product but just not on a one for one basis. So for example if you normally sell 100 pieces of a product per month but your total monthly period cost is $500 which includes the cost of hosting your site.
Hosting is generally a period cost but what if your site goes viral and you start getting millions of pageviews per day? Well your host provider will likely shut your site down. Then you will have to purchase a more expensive hosting plan which would increase your period cost.
Not that simple to define
So this totally breaks our period cost definition. If period costs change with volume then how are they different from variable costs? The answer is not easy.
The viral site hosting period cost example is extreme. Most of the time you can steadily increase your sales and your hosting cost would stay the same.
The most important difference is the rate at which the period costs change with output. Ok so output can mean different things. Most of the time it is represented by something that is closely related to your cost.
Output is usually the resulting product and not the revenue. If you are manufacturing physical products this would be your units produced, if you are selling a service it would be your billable hours.
Period costs might increase with output but not on a 1:1 relationship. It might be more like a 20% increase. This would mean that if your output increased 5x then your period cost would increase only 1%.
Product cost vs Period Costs
Product costs are a more common concept for most entrepreneurs to understand. If you are building a product then the cost it takes to build the product are your product cost. This is mostly the variable costs of continuing to build the products.
If you are building a software product then your product costs would not be the development cost. It would be the cost to product an additional unit, which is usually very close to zero for most software companies.
Period costs as we have discussed are quite the opposite of product costs. Product costs are usually variable and will change with the amount of units you sell. Period cost change only a little as the amount of units produced increase.
Let’s look at a period cost example
In this example you have a consulting business and you charge your clients based on an hourly rate. You have 5 employees that include one secretary and four experts who do the consulting. Your company’s output is billable hours.
Your period costs might include:
- office rent
- monthly car lease
- office internet
- employee phone bill
- secretary salary
- utility bill
- employee training
Your period costs should not include product costs. What are the product costs for your consulting business? They are the cost to produce one more unit of output.
This is the tricky part
So your unit of output is billable hours but your expert consultants get a salary whether or not they are actually at the client’s office consulting. So you would have to split up their time. This can be done with time management software or just by hand but you have to know what they are doing with their time.
So your expert consultants’ salaries will be period cost when they are not actually accruing billable hours. And when they are accruing billable hours their salary would be considered product costs that vary with output.
How does this save you money?
Knowing your period costs exist is the first step. A lot of times young entrepreneurs are looking at how much it costs to make each product and comparing that to how much they can sell that product for. They keep that margin in their mind always.
Once they budget things out in their mind then they forget about the period costs that they have already incurred. They might feel like business is going fine but all of a sudden they have no cash and cannot buy anymore inventory.
On the other hand If you mix period costs into product cost then you will not be able to see how profitable the business really is. You might not realize that your profit margins are higher which causes you told hold off on hiring additional employees that will help your company grow.
Period costs are an accounting concept that all entrepreneurs need to understand. All your costs need to be classified and organized so that you can see how your business is really doing. It is essential to understand what costs are period and what costs are directly related to producing additional units of output.
The main contributor and founder of WiseNumbers.com. Tom enjoys helping small business owners on and offline to understand how accounting can help save time and money. His expertise is in setting up accounting systems for small business owners. He lives with his wife and two sons in Korea.
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