Seeing the Total Cost Picture - Part 2 of 2

The top level of cost allocation is fixed and variable costs. Fixed costs are things your business has to pay for regardless of how much you sell. Variable costs on the other hand are costs associated with creating your products or delivering your services to the market.

For new managers and middle managers one of the best management tips you will ever learn is to start with the variable costs. Variable costs are everywhere, they are often the biggest business expense, and it is possible for managers at every level to influence spending in this area.

So when you launch into your variable cost control initiative, make sure you understand the different types of variable costs, and talk about them using the same terms as your accountants and your executive leaders.

At the top and middle levels of business variable costs are broken down into direct and indirect costs.

Direct Costs

Direct costs are costs that can be easily and directly related to a specific project, activity, or production piece with a high degree of accuracy. For example, if your business was selling hamburgers your direct costs would include the hamburger patty, the bun, the pickles, and the wrapper you put it in. Direct costs could also include the 5 minutes it takes someone to grill each burger and put it together. The direct cost of a hamburger is whatever it cost you to provide one hamburger to a customer. The direct cost of 100 hamburgers is 100 times that number.

Indirect Costs

Indirect costs on the other hand are costs related to the production of whatever you sell, but are not easily allocated per piece. Let's look at our hamburger stand example again. We understand what goes into each hamburger, but what about the cost of fuel for our gas grill, and lighting for the kitchen? We need these to produce hamburgers, but we don’t really know how much lighting goes into making each hamburger, or how much fuel it took cook one burger on our great big grill. We could try to average out the cost of fuel and lighting and divide it by the number of hamburgers sold, but what if we sell zero hamburgers tomorrow? Our lighting and fuel costs are not going to be zero. We can't accurately predict these costs based on how many hamburgers we sell. We also know that if we stopped selling hamburgers, we could stop paying these costs. Costs related to production, or to providing a service, that cannot easily be measured per order are known as indirect costs.

So let's go back to our example one more time and look at the cost of labor. In our original example we said that the labor time associated with making one burger was a direct cost. We'll what if our hamburger store only has 3 employees? Are we only going to pay the cook for 5 minutes if we only sell one burger between 2:00 and 3:00 pm? Not likely. So in this case it would make more sense to say the cook's salary is really an indirect cost, not a direct cost. It's related to production, but we still need to pay him even if sales are slow.

Now imagine you supply all the hamburgers for a football stadium. Whenever there's a professional football game you need 100 cooks. Whenever there's a high school game you need 20 cooks. Now the number of cooks is related directly to the number of burgers you will sell, and you only need to pay as many of them on any given day as you will need to provide the burgers. This sounds like a direct cost again. The fact is that different businesses categorize different things as direct or indirect costs depending on their size and how they like to manage things.

The thing to remember is this. Over all, variable costs are the costs that go up or down depending on how many orders you are trying to fulfill. The direct cost portion are things directly related to how many orders you take, and the cost goes up or down immediately depending on the number of orders you have. Indirect costs are things that contribute to overall production, but are hard to assign to each order or small group of orders. Indirect costs can be managed up or down depending on how many orders you have, but it doesn't necessarily happen automatically.

Summary

Understanding your cost structure is the first step in learning to control your costs. The first level of breakdown is into fixed and variable costs. Variable costs are the things that vary based on how business is going. Fixed costs are the things that remain the same.

Variable costs can be further broken down in direct costs and indirect costs. Direct costs vary based on how many orders you are trying to fill. Indirect costs are the things required to be able to fulfill orders, but are not easily assignable to individual orders.

Each type of cost requires a different type of cost management. Understanding the types of costs you have is the first step in learning to manage them effectively.