Six Categories of Cost

Six Categories of Cost


A supply professional knows that Price = Cost + Profit. He or she also must understand variable, fixed, semi-variable, total, direct, and indirect costs and how those costs influence prices.


            Variable Manufacturing Costs


These are items of cots that vary directly and proportionally with the production quantity of a particular product. Variable manufacturing costs include direct labor, direct materials, and variable manufacturing overhead. For example, if a specific cutting tool costs $10 and lasts for 100 cuttings, each cut represents a variable cost of 10 cents. If three cuts are required in machining a specific item, the variable cost for cutting would be 30 cents. Variable costs may decrease as a result of economies of scale and increase as a result of dis-economics. Variable costs exist only in the manufacturing environment but also in the selling, general, and administrative areas. In summary, variable costs are fixed per unit but vary in total as the activity level changes.


Fixed Manufacturing Costs


Fixed costs do not vary with volume but change over time. Fixed costs are costs sellers must pay simply because they are in business. They are a function of time and are not influenced by the volume of production. Fixed costs generally represent either money the seller already has spent for buildings and equipment or money the seller will have to spend for unavoidable expenses regardless of the plant’s volume of production. For example, if the lathe that held the cutting tool in the preceding example depreciates at a rate of $250 a month, this is a fixed cost. The seller has this $250 expense every month whether or not any turnings are made during that period. Fixed selling, general, and administrative costs may include advertising and research and development; these are classified as nonmanufacturing costs. Fixed costs may be increased or decreased from one time period to another regardless of production volume. Fixed costs are fixed in total but vary per unit as the activity level changes.


Semi-Variable or Mixed Manufacturing Costs    


Generally, it is not possible to classify all production costs as being completely fixed or completely variable. Many others, termed semi-variable or mixed costs, fall somewhere between those extremes. Costs such as maintenance, utilities, and postage are partly variable and partly fixed. Each is like a fixed cost because its total cannot be tied directly to a particular unit of production, yet it is possible to sort out specific elements in each of these costs that are fixed as soon as the plant begins to operate. When the fixed portion is removed, the remaining elements frequently vary closely in proportion to the production volume. For example,  if a plant is producing and average of 5,000 items a month, it may have an average light bill of $700 a month. If the number units produced is increased to 8,000, the light bill may increase by $100 to $800. The $100 increase is not proportional to the production increase because a certain segment of the light bill is fixed whether any production occurs or not. Above this fixed segment, however, light costs may vary in a fairly consistent relationship with production volume. Mixed selling, general, and administrative costs may include selling salary and commission, telephone service and metered local and long distance calls, and so on.


            Total Production Costs


The sum of variable, fixed, and semi-variable costs constitutes total costs. As the volume of production increases, total costs increase. However, the cost to produce each unit of product decreases. This is the case because the fixed costs do not increase; they are spread over a larger number of units of product.


            Direct Costs


Direct Costs are specifically traceable to or caused by a specific project or production operation. Two major direct costs are direct labor and direct materials. Although most direct costs are variable, conceptually, direct costs should not be confused with variable costs; the two terms are rooted in different concepts. Direct costs relate to the traceability of costs to specific operation, while variable costs relate to the behavior of costs as volume fluctuates. The salary of a production supervisor, for example, can be directly traceable to a product even though the supervisor is paid a fixed salary regardless of the volume produced. Returning to the illustration of the cutting tool, if a firm pays a worker 15 cents for making the three cuts required for each item, direct labor costs are 15 cents. If the value of the piece of metal being cut is 85 cents, direct costs for the item are $1.00.


            Indirect Costs (Overhead)


Indirect costs are associated with or caused by two or more operating activities “jointly” but are not traced to each of them individually. The nature of an indirect cost is such that it is either not possible or not practical to measure directly how much of the cost is attributable to a single operating activity. Indirect costs can be fixed or variable, depending on their behavior. Therefore, it is important that the reader not confuse indirect costs with fixed costs.