Introduction

On becoming the owner of a startup or small business, there are crucial aspects you should
understand to put your business on the path to success. One of those aspects is understanding the
distinction between direct and indirect costs when pricing your products or services.

When you know the true costs involved with producing and providing your goods or services to
consumers, you can price both competitively and accurately. There's another benefit as well: Certain
costs, both direct and indirect, are tax-deductible. And if you ever apply for and receive a grant, there are
several rules around the types of indirect costs – and the maximum amount – you can claim. Therefore,
this module will help you to understand the distinction of different types of cost and importance of cost
management.
Take note, “NOTHING IS FREE. And EVERYTHING you need for your production is MORE THAN A
GUESSTIMATE”.

Learning Objectives

After studying this topic, the students should be able to:

1. Explain what is cost
2. Distinguish different types of cost
3. Describe the nature of cost
4. Understand the importance of cost management

Pre-test

1. what is cost?
2. What are the different types of cost?
3. What is the importance of cost management?

Key Concepts

 WHAT IS COST

Cost is an amount that has to be paid or given up in order to get something. In business, cost is
usually a monetary valuation of;
(1) effort
(2) Material
(3) Resources
(4) time and utilities consumed
(5) risks incurred
(6) opportunity forgone in production and delivery of
a good or service.

What Is Costing?

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 Costing is the way the entrepreneur calculates or works out how much each individual product
(goods or service) costs to produce or sell.

Why Is It Important to Cost Before Pricing?

To be able to set the price of the product fairly and competitively.

How to Use Costing

Costing is used for two purposes:
a. Internal reporting. Management uses costing to learn about the cost of operations, so that it can
work on refining operations to improve profitability. This information can also be used as the
basis for developing product prices.

b. External reporting. The various accounting frameworks require that costs be allocated to the
inventory recorded in a company's balance sheet at the end of a reporting period. This calls for
the use of a cost allocation system, consistently applied.

 TYPES OF COST
1. Direct Cost
A direct cost is the material, labor, expense or distribution cost associated with producing a
product.
2. Indirect
Expense unrelated to producing a good or service
Example….
A semiconductor company rents office space in a building and produces microchips. The wages
paid to the workers and the material used to produce the microchips are direct costs. However, the
electricity used to power the entire building is considered an indirect cost because it appears on one bill
and is difficult to trace back to the semiconductor company.
3. Fixed Cost
Does not vary with the number of goods or services a company produces.
Fixed costs are costs that are independent of output. These remain constant throughout the relevant
range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed
costs often include rent, buildings, machinery, etc.

4. Variable Cost
This type of cost varies depending on the number of products a company produces. A variable cost
increases as the production volume increases, and it falls as the production volume decreases.
Variable costs are costs that vary with output. Generally variable costs increase at a constant rate
relative to labor and capital. Variable costs may include wages, utilities, materials used in production,
etc.

In accounting they also often refer to mixed costs. These are simply costs that are part fixed and part
variable. An example could be electricity--electricity usage may increase with production but if nothing is
produced a factory still may require a certain amount of power just to maintain itself.

Below is an example of a firm's cost schedule and a graph of the fixed and variable costs. Noticed that
the fixed cost curve is flat and the variable cost curve has a constant upward slope.

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 A graph of MC, ATC and MR curves

 NATURE OF COST

 COMPONENTS OF DIRECT AND INDIRECT, FIXED AND VARIABLE COST

What are direct costs?

Direct costs are expenses that a company can easily connect to a specific "cost object," which may be a
product, department or project. This can include software, equipment and raw materials. It can also
include labor, assuming the labor is specific to the product, department or project.
Direct or Variable Costs: Vary directly with the number of items made or sold. This includes all money
spent for supplies and materials to make the product or to provide the service. For example, the cost of
raw materials, packaging and labor.

For example, if an employee is hired to work on a project, either exclusively or for an assigned number
of hours, their labor on that project is a direct cost. If your company develops software and needs specific
assets, such as purchased frameworks or development applications, those are direct costs.

Labor and direct materials constitute the majority of direct costs. For example, to create its product, an
appliance maker requires steel, electronic components and other raw materials. Two popular ways of
tracking these costs, depending on when your company uses materials in production, include last-in,
first-out (LIFO) or first-in, first-out (FIFO). This can be helpful if the costs of your materials fluctuate in
the course of production.

Usually, most direct costs are variable. Smartphone hardware, for example, is a direct, variable cost
because its production depends on the number of units ordered. A notable exception is direct labor costs,
which usually remain constant throughout the year. Typically, an employee's wages do not increase or
decrease in direct relation to the number of products produced.

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What are indirect costs?
Indirect costs extend beyond the expenses you incur creating a product to include the costs involved
with maintaining and running a company. These overhead costs are the ones left over after direct costs
have been computed.

The materials and supplies needed for a company's day-to-day operations are examples of indirect costs.
While these items contribute to the company as a whole, they are not assigned to the creation of any
one service.

Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones.
Much like direct costs, indirect costs can be both fixed and variable. Fixed indirect costs include things
like rent. Variable costs include the fluctuating costs of electricity and gas.

Indirect or Fixed Costs: Are the business expenses or overheads that must be paid whether or not its
products are sold. Indirect costs include items such as rent, electricity, telephone, salaries, insurance and
depreciation.

 Importance of Costing/Cost Management

Cost Management is defined as the process of planning and controlling the budget of the business. It
helps in predicting the expenses of the business so that one can avoid going over budget, thereby being
an integral part of business management.

1. It helps in controlling the project specific cost, in turn also the overall business cost.
2. One can predict the future expenses and costs and accordingly work towards the expected
revenues.
3. Predefined costs can be maintained as records for the business.
4. It helps in taking those actions that are necessary to assure that the resources and business
operations aim at attaining the chalked objectives and goals.
5. It helps in analysing the long term trends of the business.
6. The actual cost incurred can be compared to the budgeted to see if any component of the
business is spending more than expected.
7. It helps in analysing the business positioning in terms of making an acquisition factoring the cost
component involved.

Post-test

1. Why is it important to a business owner to know the difference between both types of cost?
2. Compare and Explain the graph below by providing an example of a certain product.

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References

A. Online References

 Ethan Spielman. Business News Daily Contributing Writer Updated Jun 12, 2020.
https://www.businessnewsdaily.com/5498-direct-costs-indirect-
costs.html#:~:text=Indirect%20costs%20include%20supplies%2C%20utilities,costs%20of%20
electricity%20and%20gas.
 Cost Management: Meaning, Techniques & Advantages. November 25 2015 Written By:
EduPristine. https://www.edupristine.com/blog/cost-management-in-detail

B. Book References
 Kuratko, Donald F. (2017). Entrepreneurship. Cengage Learning.
 Barringger, Bruce R. & R. Duane Ireland (2013). Entrepreneurship Successfully Launching New
Ventures, Fourth Edition, Pearson Education Limited, Edinburg Gate, Harlow, Essex, England,
 Medina, Roberto G. (2015), Entrepreneurship and Small Business Management, Rex Bookstore,
Manila, Philippines
 Scarborough, Norman M.(2013). Essentials of Entrepreneurship and Small Business
Management, Sixth Edition, Pearson Education Limited, Edinburg Gate, Harlow, Essex, England.
 Principles of Marketing by Young & Pagoso

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