It is essential that business owners categorize their costs, not only for accounting accuracy, but also for tax purposes. Some costs are easily recognized and measured. The cost of labor and benefits for employees, the cost of materials used in production, and capital expenditures for machinery are all good examples of these kinds of expenditures. However, some costs are more difficult to quantify, particularly for businesses that provide services rather than goods, and must be estimated or allocated.
Below you will find seven basic cost categories that business owners need to know in order to correctly calculate (or estimate) all the costs of running their business.
Fixed costs remain the same no matter how much business your small business does. They are sometimes called overhead costs, and often include rent, depreciation of capital investments, management salaries, property taxes, and insurance payments. Whether a factory produces 100 or 1,000 t-shirts, these costs remain the same.
Conversely, variable costs fluctuate depending on the amount produced. It costs more in labor and materials to produce 1,000 t-shirts than it does 100, and those increased costs are classified as variable costs.
For many service industry companies, categorization into fixed and variable costs doesn’t work as clearly. Variable costs usually apply to labor and materials, but the cost for labor in service businesses may be salaried or contracted out, and not fluctuate. So, service business owners need to consider each cost individually and decide whether it is in fact fixed or variable.
Direct costs are similar to variable costs in that they can be directly attributed to the amount of goods produced. For example, the direct cost of those 1,000 t-shirts is the sum of the costs of material and labor, plus all the fixed manufacturing costs.
Indirect costs are not tied to the volume of output. Indirect costs in a manufacturing plant may include management salaries, supplies used, taxes, utilities, depreciation on building and equipment, factory rent, tool expenses, and patent expenses. These indirect costs are also referred to as “overhead.” When determining the cost of inventory, full costing or absorption costing is often utilized—that is, adding together all of the indirect costs in manufacturing overhead as well as the direct costs.
Product and Period Costs
Product costs are associated directly with the amount of goods produced and are used to value inventory.
Period costs are charged as expenses to the current period. Under direct costing, period costs are not viewed as part of the cost of the products being manufactured, so they are not associated with valuing inventories. Under full costing, however, all fixed, overhead, and variable costs are charged against inventory.
Out of Pocket and Sunk Costs
Out of pocket costs require the use of current business resources, usually cash. Sunk costs are costs that have already been incurred. So, if a business manager were deciding whether or not to increase t-shirt production from 100 to 1,000, she would consider the sunk cost of the machinery as well as the out of pocket costs for material and labor.
Incremental and Opportunity Costs
Incremental costs are those costs that result from increasing production. Suppose you want to buy a new sewing machine for your t-shirt factory. The incremental costs of buying the machine include its actual price plus any insurance or accessories.
An opportunity cost is a cost you pay for making one decision instead of another. For example, say you choose to take the day off from work to go sewing machine shopping, losing $500 in income. That lost income is an opportunity cost. These costs are not deductible but may influence your decision to choose to do or not do something for the business.
Imputed costs are not actually incurred but are due to internal transactions. For example, if you own the building that houses your t-shirt factory, but rent it back to your company instead of renting to or from someone else, that rent is an imputed cost.
Put simply, controllable costs can be influenced by the actions of a manager, while uncontrollable costs cannot. For example, the sales manager has control over the salary and commissions of sales personnel. Uncontrollable costs, which cannot be influenced by the decisions or actions of a manager, include depreciation, insurance, rent, etc.
The Bottom Line
Knowing these cost categories is more than a lesson in business vocabulary. Entrepreneurs need to measure day-to-day operation costs with accuracy. And organizing these costs into categories will help business owners track and manage both accounting and tax expenses, as well as business investments and development decisions.