Classifying costs is an important job for business managers, especially Production managers and Marketing managers who need to make product-related decisions. The operations department is more interested in the costs of producing products, while the marketing department is responsible for setting prices and selling products to customers to generate sales revenue.
Both operations management and marketing management require correct and current costs data. That is why appropriately managing costs is such a crucial job:
- Different types of costs need to be correctly identified.
- A proper costing method needs to be chosen for making crucial decisions.
- Various costs must be accurately assigned to Cost Centers and Profit Centers.
All of the above tasks are based on quantitative factors. However, relying on using only numbers in the decision-making process would lead to poor decisions in many instances.
Therefore, business managers need to also consider qualitative factors to avoid typical problems with classifying costs.
1. It is difficult to clearly classify costs into different categories.
It is not easy to classify all of the business costs into Fixed Costs (FC) and Variable Costs (VC) as well as Direct Costs and Indirect Costs (Overheads). Because not all costs can be conveniently classified into different types. And the introduction of Semi-Variable Costs (SVC) makes classifying costs even much more complicated. For example, let’s take a look at labor costs. The cost of labor can belong to both Fixed Costs (FC), Variable Costs (VC), Direct Costs and Indirect Costs (Overheads) depending on circumstances.
- Labor as a Fixed Cost (FC) when a business TV anchor is employed on a fixed-contract salary of USD$4,000 per month which will not be related to the amount of work done every month.
- Labor as a Variable Cost (VC) when factory workers who manufacture products are paid hourly wages or per piece produced. The more products they produce, the higher their wages are going to be. In this case, the cost of labor is directly related to the firm’s output.
- Labor as Direct Cost when a flight attendant earns a certain amount of wages per piece per flight. The cost of labor is directly allocated to each flight, and accurate and reliable records are kept for the purpose of calculating the cost of each flight.
- Labor as Indirect Cost when workers are unoccupied because of a lack of orders. The business will continue to employ workers in the short run, however these costs cannot be directly allocated to any particular output produced because nothing is being produced. Also, the salaries of administration workers are always considered to be an Indirect Costs (Overheads) because they cannot be identified with any one of the firm’s products.
Sometimes, especially for smaller unincorporated businesses such as sole traders and partnerships, it may not be even worthwhile to waste time on classifying every cost into the categories explained above.
2. The exact same cost can be classified differently by different businesses.
Certain costs can be classified as a Variable Cost (VC) for one business, but as a Direct Cost for another business, even when both operate in the same industry of the economy. For example, let’s take a look catering costs of airlines.
- Catering costs as Variable Costs (VC) when catering costs are for a flight on a mainstream airline carrier where food and drinks are included in the ticket price. The more passengers are on the airplane, the more food and drinks are required.
- Catering costs as Direct Costs when catering costs are for a flight on a budget airline carrier where food and drinks are not included in the ticket price. The catering costs are considered to be directly related to the flight, but paid individually by passengers.
Another example can be telephone charges.
- Telephone charges as a Direct Cost in the marketing department where telephone charges for cold calling potential customers could be directly allocated to each range of products. All records regarding to the number of phone calls and the duration are kept within the business.
- Telephone charges as an Indirect Cost (Overhead) in a business where the phone bill is just paid at the end of the month regardless of who or which department made those phone calls.
3. Every cost can change unexpectedly any time.
The graphs depicting costs usually show that all cost functions are linear. However, in reality, cost curves are very unlikely to be linear at all. It is because both internal and external business environment is very dynamic and constantly changeable.
- Fixed Costs (FC) can change when the greedy landlord increases rent.
- Variable Costs (VC) can change because not all Variable Costs (VC) change directly with output. And production costs can change at very short notice. For example, labour costs may increase as output reaches maximum due to the need of overtime payments to workers. And, the cost of imported raw materials might change due to fluctuating exchange rates on daily basis.
- Average Cost (AC) can change depending on the level of output because of economics of scale. The Average Cost (AC) when operating on a larger scale will be lower than when the number of products produced is fairly small.
As we can see, the assumption that costs are always represented by straight lines, even the curve of Fixed Costs (FC), is unrealistic.
4. Direct Costs do not equal Variable Costs (VC).
Many people assume that Direct Costs are the same as Variable Costs (VC). However, this is not actually correct. When a pizza restaurant buys a new oven for the kitchen department, this is a Direct Cost to that department. However, the cost of the new oven will not vary with the number of pizzas being baked and sold. The cost of the over will remain the same regardless of how many pizzas are produced.
5. Some costs belong to one type, but behave like another type.
When administrative Direct Costs related to different transactions are the same with each transaction, they will behave more like constant Fixed Costs (FC). For example, the Direct Costs of purchasing a commercial building will most likely always be the same regardless of the building, including consulting costs, notary public fees, postage, photocopying costs, mortgage fees and bank charges.
Understanding costs data, choosing the right method of classifying costs and deciding upon the right costing method is very significant for any business organization. Hence, successful business managers need to consider both quantitative as well as non-financial factors when making all costing decisions.
