Types of Costs Explained
How to easily unravel the large variety of cost types & behaviours!
If you aren’t interested in more profits, stop reading… but, if you want to really start to work on your business and see some improvements in your returns then understanding what is going to happen, when it will happen, and why it will happen is vital.
(and it is OK if up to now you thought understanding this stuff was boring, it might sometimes be a bit techy, but to quote a local annoying TV advert at the moment “saving money is NEVER boring!”)
Definition of a Cost: An amount that has to be paid or given up in order to get something. In business this relates to production and delivery of a goods or services.
Costs can be confused, and confusing:
* are they fixed?
* are they direct?
* are they variable?
* are they indirect?
* what is the difference?
* why does it matter?
Because costs are half your profit equation, and as the more profit you have means the richer you are, I’m sure you can now see why understanding all about your costs suddenly becomes pretty important.
I am talking about costs here, not expenses…
Expenses are costs allocated to the business activities undertaken within a reporting period.
What that actually means is a cost turns into an expense when it is reported on your Profit and Loss (Income Statement)
Costs may not be monetary but Expenses always are – because in-order to be reported it has to be allocated a monetary value.
For more about expenses see Income Statements Explained – Elements Mastered[/box] One of the main reasons costs become confusing is because there are:
* Types of costs and
* Behaviours of costs
Often people, even accountants, will use the types of costs interchangeably with their behaviours, this is kind of like mixing up colors and flavours… If I say “this is a caramel desert” does it mean it tastes like a caramel or it is brown? It could be brown but taste of chocolate – see what I mean? Often I discover clients’ decide not to think about costs because it is “all too hard”, but they are robbing themselves of the ability to manage their business really profitably.
No more excuses: Types of Costs Explained
A. Direct Costs (Cost of Goods Sold or COGS)
The term “direct” describes the relationship of these costs to goods produced and/or sales made – the concept is that there is a “direct” correlation between a sales and this cost. This may not be on an exact 1:1 relationship (1 more unit sold = 1 more unit of cost). Consider a tele-sales business re-selling steak-knives for a profit. For every sale there is the direct cost of the steak knives and the cost of the shipping.
Direct Expenses usually only appear in Income Statements of businesses which are manufactures or retailers – supplying stock – and refers to expenses such as raw materials, inventory, delivery etc. Service businesses generally do not allocate any specific costs to Direct Expenses as the cannot hold, nor sell, their staff as “stock”.
B. Indirect Costs (Operating Costs, General Costs, Overhead costs, Overheads)
Indirect Costs are incurred to keep the business running; all the overheads and support functions that need to be paid for regardless of whether you have customers or not. This typically includes salaries and wages of staff, marketing and advertising, stationery, rents, electricity etc. There is no exact correlation between an increase in sales and an increase in these expenses – i.e. for every extra unit sold, there is not an obviously corresponding extra unit of cost in this area.
C. Other Costs
Apart from the Direct and Indirect Costs seen on most Income Statements above, there are several other types of costs that can be also classified as Indirect Costs, but often appear under their own headings when it comes to reporting.
Income statement should not regularly contain extraordinary items since these items are called “extraordinary” for a specific reason — they do not occur as a frequent, or regular, part of operations. Examples include; unexpected natural disaster, prohibitions under new regulations. They are usually stated at the end of the Income Statement as a separate note; since they cannot be simply ignored, but are generally outside Management’s control.
Taxes
Taxes are, from the point of view of management, mandatory and the amounts paid are set by various State and Federal Governments. Regardless Taxes are an amount “given up” in order to continue operating the business.
Opportunity Costs
Opportunity costs are the lost value forgone when you choose to do one thing over another – this cost almost never appear in financial Reports, but are still very real. If you have to choose between a holiday in New Delhi or New York each offer a different experience and if you choose New Delhi, then your opportunity cost was missing out on the New York experiences, the clearest example of an opportunity cost is when gambling, what is the cost of backing one horse instead of another that won?
So that covers off the various types of costs, and now we know what the costs belong to:
* Direct: costs related directly to manufacturing and stocking goods/services for sale or
or
* Indirect: costs of operating the business as a whole
– it is also important to understand how the costs behave, because understanding these two aspect together, cost type and cost behaviour, enables you to know what your costs will look like in the future; will this cost stay the same next month or will it increase as sales increase? And that helps you plan, in a profitable way.
Curious to know more about costs – especially how they behave??? – See
Part 2 – Behaviours of Costs Explained
Have a Cost that you aren’t quite sure what it is and how it fits in, feel free to add it to the comments below and I will unravel that cost specifically…
