Classification of costs

Anything a business spends money on is a cost. There is almost no end to the

list of things businesses need to buy in order to produce goods and services.
These range from large, one-off costs, such as buying land for a new factory,
to everyday expenditure like purchasing fuel for delivery vehicles. This
section will classify the vast array of business costs into simple, identifiable
groups. If this can be done successfully, then costs can be tracked and
hopefully minimized.

Costs can be split using two different methods:

● Fixed costs and variable costs

● Direct costs and indirect costs.

Fixed and variable costs

 Figure 1. A coffee shop has both fixed and variable costs.

The first method of classifying costs simply asks the question: 'Does the cost
increase directly with production?' If the answer is yes, then we have found a
variable cost. If no, then it is a fixed cost. To explore the differences between
fixed and variable costs, we are going to use the example of a simple coffee
shop.

Variable costs
 Figure 2. Some examples of variable costs.

As we have said, variable costs vary directly with production. If the coffee
shop sells one more cup of coffee, which costs will increase? Well, to start
with, all of the things that go into the drink. So variable costs will include the
coffee beans, milk and any sugar or additional flavorings. But that is not all.
If the shop sells one more drink, it will have to buy one more paper cup, so
packaging is also a variable cost.
Commission is a method of paying sales staff. It encourages staff to focus on
increasing revenue by paying them a small amount (often a percentage) for
every item they sell. For example, a member of staff may receive an
additional payment every time they sell a customer some food. The nature of
the variable costs will depend on the business, but normally includes things
like:

● materials
● packaging
● delivery
● piece rate labor and sales commission
● cleaning (in the case of something like a hotel).

Our definition of variable costs uses the word 'directly', which should not be
overlooked. A variable cost is defined by its cause and effect relationship
with output. Some students make the mistake of classifying advertising as a
variable cost, arguing that if advertising increases then so does output. This is
incorrect because the relationship is the wrong way around. When there is an
increase in advertising costs, there is no guarantee that demand and therefore
output will rise. To be a truly variable cost, an increase in output must lead to
increased costs.

Be aware
Variable costs per unit vs. total variable costs. It is important to make a distinction
between these two similar-sounding terms. Variable costs per unit are the costs
of making one product. Total variable costs are the sum of all variable costs.

Using the example of a coffee shop again, if it costs £0.50 to make a single cup
of coffee and in one day the shop only sells 12 cups, what are its variable costs?
Obviously, the variable cost per unit is £0.50, which makes the total variable cost
£6.00 (£0.50 x 12 cups sold).

Fixed costs
 Figure 3. Some examples of fixed costs.

Fixed costs are those that do not vary directly with production. In the short
run (the period during which it is difficult to change things), there are items
that need to be paid for no matter the level of output. These will not change
quickly over time. For example, rent and rental agreements are set out in
contracts that stipulate the amount of rent (e.g. $500/month) needing to be
paid for a specified period of time.
Consider our coffee shop once more. The variable costs included all the
things that go directly into a drink, as well as the packaging. But ingredients
alone are not enough to make a hot cup of coffee. Other things are needed
too. For example, we need a coffee machine and someone who actually
makes the drink. These are examples of fixed costs. Other examples include:

● salaries of staff
● rent and mortgage payments
● machines and other capital equipment
● fixtures and fittings
● insurance.

Semi-variable costs

Figure 4. Some examples of semi-variable costs.

Some costs could be seen as having both variable and fixed elements.
Electricity is a good example. A little bit of extra electricity will be needed to
power the espresso machine and make an additional cup of coffee. This is
obviously a variable cost. However, electricity will also be used to power the
lights and keep the fridges cool and these do not vary with output. If more
customers come into a shop they do not consume more light. This element of
the electricity bill is therefore fixed. For this reason, we classify electricity as
a semi-variable cost. Other examples include:

● mobile phone bills, which feature a monthly fixed fee plus a charge for
any additional units that are used
● production staff, who are paid a basic salary plus a bonus for any
additional output.

Direct and indirect costs

This method of classifying costs relates to the parts of the business that deal
with budgets. Some costs relate directly to the sale of the goods while some
relate to other parts of the business. Complex businesses will have a huge
number of costs. In order for them to be tracked, they need to be allocated to
the correct department.
 Figure 5. National chains have both direct and indirect costs.

Take the example of a nationwide clothing retailer with branches in 15

different cities, plus a head office that deals with things like marketing and
operations. Each store will have direct costs associated with it. This will
include the wages of people who work in that store, the goods they sell and
the electricity to keep the shop lights on.

This is simple enough, but what about the wages of the marketing staff at
head office? And the CEO's salary? How should they be allocated? As these
relate to all stores and not just one, they are referred to as indirect costs.
These costs are not directly related to sales of the goods in the 15 retail
locations either.

Direct costs

Figure 6. Some examples of direct costs.

Firms divide themselves into parts so they can keep track of what is being
spent in the company. Each section will have a budget attached to it and must
take care to stay within those allocated amounts. Direct costs are those that
can only be attributed to a single part – that is, directly linked to the sale of
the goods or the provision of the service. Examples include:

● staffing cost of employees in that particular section of the business

● utility costs of a single branch of a chain store
● material costs for a product line
● running costs of a single store.

Indirect costs
 Figure 7. Some examples of indirect costs.

Indirect costs are more difficult to allocate. Using the example of the clothing
retailer from before, all costs from the head office would be referred to as an
indirect cost for the 15 retail branches. The activities carried out in the head
office will affect all the branches, so it makes sense to split the costs of the
head office between them. Indirect costs will be different in each company,
but examples may include:
 ● nationwide advertising campaigns
● accountancy and auditors' fees
● salaries of the board of directors
● expenses of running a central human resources department
● ICT and infrastructure costs.

Case study

Indian startups and the problem of costs

Many Indian companies in Mumbai and New Delhi, faced with a decrease in
funds available for investment, have had to resort to cutting costs. Investment
funds allowed startups to keep running even when they were not experiencing
increasing revenues. These funds also served as a stopgap measure to allow
businesses to meet their variable costs (the costs to run the business monthly –
their cash flow). More than a half a dozen mid-sized companies – such as online
marketplace Snapdeal, online retailer Craftsvilla and fashion portals such as
YepMe and Tolexo – have had to lay off workers.

Craftsvilla laid off over 100 staffers, including all of its product and tech teams as
well of most of its marketing and operations teams. But this is just the beginning.
Many startups are now going to cut their largest fixed cost – management. It is
estimated by research firm Xeler8 that over 9,000 jobs in e-commerce, food tech
and logistics have been cut. And many startups have followed. The results have
been that many startups have had to restructure, causing job loss. The other
effect has been that Indian companies have now outsourced other parts of their
business, like marketing and operations.

According to Harminder Sahni of Wazir Advisors, the model that Indian

companies followed was not sustainable. Fundamental metrics like cash flow
and working capital (you will learn more about these in sections 3.5-3.7) were
ignored, while companies focused upon ‘vanity’ metrics that make companies
look good but may misrepresent their financial health. Sahni goes further and
says not paying attention to cost fundamentals is irresponsible behavior. The
results were job layoffs.

Adapted from: Economic Times

1. What reasons can you think of that may have caused a decrease in investment
funding in India?

Investment funding in India may decrease due to economic downturns, which make
investors hesitant to invest. If certain sectors or industries become overcrowded with
startups, there will be increased competition for limited investment funds, causing some
companies to receive less funding. Investors may also withdraw funding if startups
perform poorly financially or fail to meet growth targets, as they seek profitable returns.
Changes in regulations or government policies can create uncertainties, leading investors
to hold back their funding until the situation stabilizes.

2. Explain how the lowering of a company’s fixed costs can make it more profitable.

When a company reduces its fixed costs, it can make its operations more efficient by
eliminating unnecessary expenses. This helps the company become more productive and
cost-effective, allowing it to make more money from the resources it already has.Lower
fixed costs also lead to higher profit margins for the company. Even if the overall revenue
remains the same, the company can generate more profit from its sales. This can improve
the company's financial health and provide a safety net for unexpected challenges. By
lowering fixed costs, a company becomes more flexible and adaptable to changes in the
market. It can adjust its pricing strategies, invest in growth opportunities, or allocate
resources to areas that offer higher returns. This flexibility helps the company respond
effectively to market trends and take advantage of new opportunities.Reducing fixed
costs also improves the company's cash flow because It lowers the point at which the
company needs to cover its expenses, meaning it requires less revenue to break even.
This leads to better cash flow, as the company needs to make fewer sales to be profitable.
Improved cash flow provides stability and allows the company to reinvest in the business
or allocate funds for expansion. However, it's crucial to balance cost-cutting with
maintaining essential capabilities and ensuring that the company's long-term growth
potential and ability to deliver value to customers are not compromised.