In this post we’re going to cover a foundational aspect of cost analysis: the cost structure, and the different types of costs. Boring as it may sound, it’s an important concept to master for anyone wanting to optimize their business decisions, since it's needed to make:
Note that I’m not talking about keeping track of costs for tax and compliance reasons. This video is about keeping track of your costs, so that you can make proper strategic business decisions.
But to start...
What is a cost structure? A cost structure is the classification of a business' costs according to whether they are fixed or variable, and direct or indirect.
That means that we will have 4 types of costs according to the previous classification. So, in this post we're going to see:
Throughout the post we’ll be using the example of a bakery.
One of the bakery’s employees is a baker. He bakes everything there: bread, pastries, pies, cakes… everything.
But the bakery also has a specialised cake decorator, whose only job consists of decorating wedding cakes.
What are direct, variable costs
When we think about the costs that go into making one of these wedding cakes, some are quite obvious: every cake needs flour, milk, sugar, eggs, and butter, among other ingredients.
And obviously, if you want to make one more cake, you need to use the same amount of ingredients. In fact, whenever you make one more cake, you need more ingredients.
So, the overall ingredients’ cost increases as more cakes are made. These costs that increase as production volume increases, are variable costs. In this case, the flour, milk, sugar, eggs, and butter are examples of variable costs.
What are variable costs? Variable costs are those that increase whenever one more unit of a product or service is produced.
And, since we can easily link the use of ingredients to a wedding cake’s production, we say that these are direct costs. In this case, the flour, milk, sugar, eggs, and butter are also examples of direct costs.
What are direct costs? Direct costs are those that can be linked to a cost object in a relatively easy way (that is, in an economically viable way).
So the ingredients are examples of direct, variable costs of selling a wedding cake. Another example of direct variable cost would be packaging, since whenever a cake is sold, it needs to be packaged for delivery.
To sum up...
What are direct variable costs? Direct variable costs are those that increase whenever one more unit is produced, and that can be linked to a cost object in an economically viable way.
What are indirect, variable costs
But producing a wedding cake has a lot more costs. For example, the cake also needs to be baked.
And whenever a cake is to be baked, we need to spend some electricity to get the oven going.
The more cakes we bake, the higher our electricity bill will be.
Since the electricity cost increases whenever an additional cake is made, electricity is an example of variable cost.
However, although it’s easy to see how baking more cakes drives costs up, it’s a lot harder to say what part of your electricity bill corresponds to a cake type, since electricity is needed for many other things besides baking the wedding cakes.
So, we can try to allocate the electricity costs to the wedding cakes' prduction, but it’s not so easy, and it requires some judgment.
These types of costs are what we call “indirect costs”. In this particular case, the electricity is an example of indirect cost, since we can't easily know how much electricity is being spent on the wedding cakes' production alone.
What are indirect costs? Indirect costs are those that cannot be directly linked to a cost object in a relatively easy way (that is, in an economically viable way).
So, when costs change with production volume, but can’t be directly linked to a cost object, we say we have indirect, variable costs.
What are indirect, fixed costs
But to run a bakery business selling wedding cakes, there are some other very important costs, which are neither directly related to the wedding cake production, neither vary with production volume.
In other words, they are indirect, and fixed. An example of indirect fixed cost might be the bakery’s rent.
What are fixed costs? Fixed costs are those that do not increase regardless of whether we produce more units or not (within a given range or production, or "relevant range" of production).
If you bake and sell a cake, you need to pay rent. But you always have to pay the same, regardless of how many cakes you produce and sell.
So, since this cost does not increase as more cakes are made, it is fixed.
And, just as in the case of the electricity seen before, you can allocate these costs to the wedding cakes' production, but it’s not so straightforward to find a link; they’re indirect.
What are indirect fixed costs? Indirect fixed costs are those that do not change with production volume (within the relevant range of production), and that cannot be linked to a cost object in an economically viable way.
Another indirect fixed cost example, might be the salary of the person selling the cakes, since the salary is the same every month, regardless of how many cakes are sold, and you cannot link that cost to a specific cake line (such as wedding cakes, or breads, or whichever product lines the bakery may have). Of course, how fixed salaries are will depend a lot on your local labour laws.
What is the relevant range of production
Now, one important thing: fixed costs are only fixed within a RELEVANT RANGE of production. Meaning, they are fixed as long as production level stays within an interval.
For example, if suddenly demand for the bakery’s products doubles, in case it’s not working close to its capacity limit, it might be possible to double production and sales without hiring another seller, nor expanding the bakery area.
However, if demand increases 10 times, the bakery may need to hire more sellers, and expand the whole bakery, thus increasing the costs with rent and salaries. So, although these costs were fixed within a production interval, once we need to step outside that interval, the fixed costs may need to change too.
What is the relevant range of production? When it comes to the cost structure, the relevant range of production is the production capacity within which some costs (fixed costs) do not change.
Finally, note that fixed costs are usually also fixed in the short term. Meaning, that even if you can eventually change the production capacity, you cannot do it from one day to the next.
What are direct, fixed costs
And finally, let’s talk about that wedding cake decorator that I mentioned in the beginning, whose only job is to decorate wedding cakes.
Since we have to pay her salary, regardless of whether she decorates 1 cake, 2 cakes, or 20 cakes, employing her is an example of fixed cost. Because sure, she spends time whenever she decorates a cake, but since she earns a fixed salary, it does not cost us more money for her to decorate extra cakes (of course, as seen previously, within the production volume limit imposed by the hours she works per day - her relevant range of production).
So, if what we are analyzing is the cost of producing the wedding cakes, her salary is an example of direct cost. If we produce wedding cakes, we need to employ her, if we don’t produce those cakes, we won’t have this cost.
That means that, in the case of the wedding cake decorator, when we are analyzing the costs of the wedding cakes, the costs of employing her are an example of direct fixed costs.
The first thing we need to do to understand our cost structure, is to ask the question: Does the cost change has a number of produced units changes?
If the answer is "yes", we have a variable cost. If the answer is "no", we have a fixed cost.
And the second question we would need to ask, is: can the cost be easily linked to a cost object?
If the answer is "yes", we have a direct cost. If the answer is "no" we have an indirect cost.
Important detail: the cost object
But note here that I say “cost object”.
This is a very important detail. The same cost can be direct or indirect, depending on the analysis we’re doing. Let me clarify this:
In our example, although I never mentioned it, throughout the post, the cost object I was considering was the wedding cakes production line.
In that case, the ingredients were examples of direct variable costs, the wedding cake decorator was an example of direct fixed cost, the electricity to bake the cakes was an example of indirect variable cost, and the bakery’s rent was an example of indirect, fixed cost.
But, this analysis would be interesting if we were trying to make business decisions about the future of the wedding cake decoration business.
If what we had was a chain of bakeries, and our goal was to determine whether to close a specific store, then we should be analyzing the costs per store, and the entire store would be our cost object under analysis.
What is a cost object? A cost object is the element whose costs we want to analise, and therefore, to which we allocate the costs. The cost object selection is what will determine whether a given cost is direct or indirect.
In that case, all store costs (including rent and electricity), would be direct costs of keeping that store open. The only indirect costs in that case, would be those generated by the central activities related to managing the stores’ network.
Anyway, this post was meant to cover only the basics of the cost structure, so that those of you who weren’t familiar with it can follow the posts on the volume-profit analysis, breakeven, or the “contribution margin” that keeps coming up in pricing posts. So, I hope you found it useful and not too confusing!