Understanding costs

With the economic forecasts oscillating between bad and awful, many organisations are taking a long, hard look at their costs. With this in mind, I thought now might be a good time to explore some of the different types of cost and what we can do about them.

Firstly, let’s think about what a cost is. In financial terms, which is what we are interested here, a cost is simply something that we have to pay. And when we incur a cost, we generally – but not always – get something in return, such as a new car, a few hours of someone’s time or a year’s insurance.

There are various ways of categorising costs, but we shall look here at three of the main ones:

• direct and indirect costs;
• fixed and variable costs; and
• controllable and uncontrollable costs.

Direct and indirect costs

When we think about costs, we often think about the cost of something. For example, we might refer to the cost of making a particular product, the cost of putting on a seminar or the cost of running a department.

Direct costs are costs that relate directly to the thing that we are interested in. So the direct cost of making a new product, for example, would include the materials we use, the labour involved in making the product and any other specific costs relating to it, such as licenses or special tools that we need to buy.

Indirect costs are costs that cannot be attributed directly to the thing we are interested in, but are still connected to it in some way. This includes things like the cost of running the building, management, administration and the sales team. Indirect costs are often referred to as overheads. Direct costs plus overheads give us the ‘full cost’ of something, though the process of calculating this full cost can be complicated and probably merits an article of its own at some point.

Fixed and variable costs

When we make products or deliver services, some costs depend on the volume of activity that we do. These are known as variable costs and can include things like raw materials, venue hire and sessional workers. If we do more, then our variable costs go up. If we do less, then they go down.

Fixed costs, as the name suggests, remain fixed regardless of the level of activity. These include things like staff salaries, rent, business rates and insurance. In general, direct costs are variable and overhead costs are fixed. Of course, even fixed costs are not completely inflexible over a long enough time period. We can reduce our rent costs, for example, by moving to different premises and can cut our insurance costs by shopping around or reviewing the level of cover.

Somewhere between variable and fixed costs are ‘semi-fixed’ or ‘stepped’ costs, which remain fixed at a certain level of activity but increase or decrease when particular points are reached. For example, if we use a fifteen-seat minibus to transport service users, then we will need a second minibus (and driver) when we have sixteen or more people to transport. So the cost of the service will be fixed for up to fifteen participants, but will increase once we have sixteen or more. Understanding these ‘step points’ can be very helpful in managing costs effectively.

Controllable and uncontrollable costs

Controllable costs can be controlled – or at least influenced – by the people who are responsible for them. So if you are in charge of delivering a particular service, you may be able to control things like the materials you use, the hourly paid staff that you employ and the level of advertising or promotion that you arrange. These are, for you, controllable costs. Though to one of your team, they may not be controllable – as that person is not able to influence them in the way that you are.

You will probably not, however, be able to control or influence the Chief Executive’s salary, the rental or lease payments on the office in which you work or the business rates that you pay. These are uncontrollable costs for you. Although they may be controllable for senior management, who can perhaps influence these costs to some degree.

An understanding of controllable and uncontrollable costs is vital when holding people accountable for budgets and when seeking to reduce expenditure. People should only be held accountable for costs that they can control. And if you want to reduce costs, you need to find out who can actually control them.