If you’ve not heard the term “cost behavior” before, you’re not alone.
Janet M., APRN, hadn’t either, not once in the four years since starting her practice. That is until one day, late last summer…
She had almost clicked the “ORDER NOW” button when it dawned on her. She was about to order three times more flu vaccine then she had ordered in the past!
- Where would she store all that vaccine; would she need to buy a bigger refrigerator?
- Would she have enough staff to handle the flow of patients or would she need to hire extra help?
- Would there be enough space and furnishings to handle her growing flu clinic?
- … and, would the extra income offset any new expenses?
These were some of the questions that popped into her mind. But after a few minutes of thinking and debating, she clicked the submit button and placed her order.
She Began to Understand…
She knew she would have to buy a few more chairs and re-allocate space in her practice. But if she scheduled the flu clinic just right, she wouldn’t need to bring on additional staff.
For the past five years, her office held flu clinics; attendance was reliable, and the clinics had been steadily growing every year.
Without a doubt, she was pleased with the growth. But the thing she hadn’t thought about was having to buy new equipment or perhaps having to hire extra staff to handle the increase; it was her introduction to the concept of cost behavior.
And that’s what cost behavior is all about; it’s about understanding how specific costs in your business are affected by changes in your level of activity or output.
Knowing how your costs are affected by changes in business activity allows you to better plan and budget. But if you’re unaware of the potential impact, you could find yourself running into trouble.
While the term “cost behavior” is most often associated with product businesses, the above example shows that it also applies to a service business. Janet M’s growing flu clinic could burden her practice with additional, yet unexpected costs.
Types of Cost Behavior
Just about anything we do in life has an expense associated with it. I guess the old saying “Nothing in Life is Free,” is true after all. Some costs are obvious, while others are not; it applies to personal and business life alike.
Essentially there are two main patterns of cost behavior. You’re probably familiar with them as fixed costs and variable costs. Let’s take a closer look at each of them.
What are fixed costs, and what are they in your business?
Fixed costs in business are said to be unchanging regardless of the level of products produced and sold, or the level of services offered and sold. Consider fixed costs to be expenses a business must absorb irrespective of the level of income generated.
Of course, this definition only applies to a certain point. No business can sustain fixed expenses without generating income.
And as we’ve seen in the case of the flu clinic, fixed costs may be affected by a change in business activity. However, it would be a one-time change creating a new level of fixed costs for the business.
Essential fixed costs for a practice might include the following:
- Rent or mortgage for practice space
- Salaries paid regardless of hours worked
- Equipment and software leases
- Utilities, such as electric, phone, internet. While payments may fluctuate between billing cycles, most utilities stay at predictable levels and are necessary to operate the business
- Insurance: malpractice, slip and fall, workers compensation
Depending on the individual practice, there may be other fixed costs.
Since most service businesses generate their revenue solely by providing services to their customers, they shoulder higher fixed costs, relative to income.
These are the costs that fluctuate with the level of output in the business. For example, when a widget manufacturer secures a big order for widgets, the variable costs for the company are guaranteed to go up.
Compared to service businesses, product businesses carry significant higher variable expenses as part of their overall cost structure.
Most service businesses have few variable expenses to pay. For a small practice variable costs may include some of the following:
- Hourly employee wages paid for the number of hours worked
- Medical supplies and tests: tied to the number of patients seen
- Credit card processing fees
To round out our discussion of cost behavior, let me mention there are also mixed costs. Here, a cost has a fixed and a variable component.
A car is an excellent example of a mixed cost item. Things like lease payments and insurance are fixed, whereas wear and tear, tires, gas, etc. vary depending on how frequently the vehicle is driven.
Another example of a mixed cost might be your internet access plan. Some internet service providers only sell flat plans, whereas other plans feature a fixed base price with additional fees based on usage.
Understanding that the costs in business may change based on the growth or decline in business activity allows you to better plan and be prepared to carry additional expenses.
Ignoring cost behavior may result in unpleasant surprises, that could have a negative impact on your business.
In full disclosure, I am not an accountant and don’t play one on TV…
The article is strictly informational; it’s my attempt to underscore the importance of understanding financial concepts, regardless of the type of business you own.
Cost behavior, fixed or variable costs… Whatever you may call it in your business, do you pay attention to it? Let us know and share your thoughts below.
By Johanna Hofmann, MBA, LAc; regular contributor to the NPBusiness blog and author of “Smart Business Planning for Clinicians.“