By John Seasholtz, Seasholtz Consulting

Budgeting plays an increasingly important role in today's challenging and complex business environment. During the budgeting process, you need to make decisions about company goals, operational tactics to achieve those goals, potential changes in market dynamics, and the associated financial implications. Understanding types of costs and cost behavior is important to support the budgeting process and to execute your company's strategy.

What are some different kinds of costs?

Your company probably has a variety of costs. The behavior of these costs varies depending on a number of factors, including the time frame you are using for analysis, what the cost drivers (activities that incur cost) are, and market conditions.

Here are some of the more common types of costs that you may find in your organization:

• Variable costs increase and decrease depending on changes in the activity level of the relevant cost driver. An example of a variable cost is direct materials, such as disposable cups for a coffee shop. In this case, the cost driver is the number of "to go" coffee unit sales. Another example of variable costs is sales commissions paid to employees as a percentage of overall store sales. The cost driver for these sales commissions is store sales.
• Fixed costs do not change in response to activity levels over the time frame in which you are conducting the analysis. Some fixed costs, such as advertising, can be altered by management. Other fixed costs, such as depreciation on equipment, can't be altered. Additional examples of fixed costs include rent, executive salaries, and insurance premiums.
• Step costs stay the same for a certain level of activity. When you exceed that level of activity, step costs jump. Examples of step costs include compensation for customer service representatives who can handle only a certain number of customer calls per year before another representative must be added; and servers in an e-commerce company that can receive only a certain number of hits before another server must be added.
• Mixed costs exhibit characteristics of both fixed and variable costs. An example of a mixed cost is your telephone bill, in which you are charged a fixed fee for a baseline level of service. If you exceed the volume of service included in your telephone plan, you are charged an additional variable fee.

Why is understanding cost behavior important?

Understanding how different types of costs behave provides critical information for a variety of activities that support the budgeting process. Some of these activities are:

• Forecasting   To forecast future costs, you must understand the breakdown between fixed and variable costs, as well as understand the cost drivers. For example, if unit sales are a driver of variable costs, such as direct materials and direct labor, then those costs can be estimated based on the unit sales forecast and the expected unit costs of materials and labor.
• Breakeven analysis   Breakeven analysis helps you determine when your business will be able to cover all of its expenses and begin to make a profit. This analysis uses a simple mathematical equation, but you need to understand your fixed costs and variable costs before you solve the equation.
• Operating leverage   Operating leverage reflects the level of risk in your cost structure. If your company has relatively low levels of fixed costs in your cost structure, it has a low operating leverage. Your business is at lower risk, meaning that your profitability will remain more consistent during fluctuating economic times. But if your company has relatively high levels of fixed costs, it has a higher operating leverage. That means that your company is at higher risk and will likely see bigger swings in profitability as business conditions change.
• Cost control   During the budgeting process, you might be asked to cut costs in order to increase profitability. By understanding the nature of your fixed costs, you can identify those that can be reduced in the short term, such as advertising and promotional spending (although the impact to sales should be carefully evaluated). You might also seek to control costs by increasing the level of activity that step costs can handle in order to postpone the next jump in costs. For instance, instead of hiring another customer service representative to handle the increasing volume of customer calls, devise a plan that enables your existing customer service representatives to handle more calls.
• Variance analysis   By understanding how costs behave, you can more accurately describe why costs might not have met budgeted amounts. For example, if customer service representative costs were higher than budgeted, you can focus on several components: the overall number of customer calls that the company received, the number of calls that each representative handled, and the compensation for each representative.

Why companies fail to understand cost behavior

Many companies have only a limited understanding of cost behavior and how cost behavior affects decisions related to the budgeting process. Your company might have the following problems:

• Lack of technology   You might lack the appropriate tools to collect and analyze cost information. These tools can be as basic as a standard worksheet program or as advanced as statistical analysis programs and advanced financial systems.
• Large percentage of step costs   Step costs might be posing a problem when you conduct certain kinds of analyses. For example, when conducting a breakeven analysis, a company with a large percentage of step costs must decide whether they behave more like variable costs or fixed costs.
• Inaccurate data   You might have a difficult time collecting high-quality cost data. This could be a reflection of your accounting system (or lack thereof), human input error, or data loss during a merger or data migration.
• Lack of accountability   Employees or even managers might not be knowledgeable about how cost behavior information relates to day-to-day activities. Frequently, spending decisions might be made without considering cost data.
• Lack of time   Although you might understand the importance of determining cost behavior in your company, you lack the time to account for it in your budgeting process.

What can you do?

You can overcome these obstacles and gain a better understanding of how your costs behave. Here are some recommendations:

• Rely on management expertise   Talk to department managers who have the best knowledge of costs and cost drivers in their respective areas. Ask them to identify variable costs, fixed costs, and step costs. Also ask them whether step costs should be treated as fixed or variable costs for financial analysis purposes.
• Conduct statistical analyses   If you are having a difficult time understanding how to split fixed and variable costs, use statistical analysis tools, which are often included in standard spreadsheet programs.
• Treat cost behavior as a tool   Make understanding cost behavior and using cost behavior and the budget a meaningful part of ongoing activities in the company. Create an environment where workers and managers use cost data routinely in decision-making.
• Train employees   Ask the head of your finance department to set up training for financial staff and department managers. The training should include the importance of cost behavior in budgeting and in effective decision-making.
• Bring in a third party   Sometimes a professional from outside your company, such as a certified public accountant or a business consultant, can give you an objective assessment of your cost behavior.

Understanding cost behavior is a critical foundation for your budgeting process. By developing this understanding, managers and employees will begin to think about relevant cost-behavior issues in their day-to-day jobs. And they will learn how the information can be used for more effective budgeting and decision-making.

About the author   John Seasholtz is the founder and principal consultant of Seasholtz Consulting, Inc., in Seattle, Washington. Seasholtz Consulting provides strategic and operational planning services to clients in the consumer products, high-tech, financial services, and retail industries.