Why Should I Care About the Different Forms of Cost?
In order to understand your current budget and how cost affects that budget, it is important to know the details of what costs are and how they vary. This post provides a detailed analysis of the various types of "cost" and their potential impact on your business.
Fixed costs are constant expenses that do not change relative to business or change. One example of a fixed cost would be a lease payment on an apartment or studio. Normally, there is a fixed monthly payment for rent. This price is constant throughout the term of the lease and does not change regardless of how well or poor the business is running. Despite changes or other outside factors that may be involved, this particular cost is fixed based on the fact that there was a signed contract which enforces payment on a specific location for a specific sum of money each month.
Variable costs are costs that may change or vary as conditions change. One example of a variable cost would be payments on electricity usage. Businesses will use up a certain amount of electricity each month and that bill may appear to be a constant, fixed cost. The usage of electricity, however, will many times increase relative to an increase in business. This bill, subsequently, becomes a variable cost based on the fact that it is subject to change as conditions change. Another example comes in the way of transportation. Flight tickets and other methods of transportation are variable costs in that they are subject to change as the activities of businesses change. Normally there is no firm, predictable method of knowing how much travel will be needed in business and as the techniques of businesses change, so does their cost of transportation.
Semi-variable costs are a somewhat mixture of both fixed and variable costs. Costs are fixed for a set level of production or consumption, and then become variable after that level is exceeded, whatever it may be. One example of this would come from something such as employee pay. Hourly employees have a fixed cost which is based upon the hours in which they work in a day. This cost is constant and does not change unless the employee is promoted or receives a raise in pay. In many cases, however, this cost will change when an employee works more than 40 hours in one week. The cost is fixed for a set level of production and then becomes a variable after the level is surpassed. When an employee works more that 40 hours per week, his or her fixed income becomes variable and they are subject to more money for less work.
A direct cost is a cost that can be specifically traced to the production of a good or service. It is something that can be physically identified as a source for how the product was produced or what was used to produce it. Building a home provides the best example of direct costs because we are able to see what went into its construction. The direct costs would include such things as the materials used to build the home, fees coming from its design, and the cost to have it built.
Indirect costs are somewhat different from direct costs in that they are more difficult to identify. Sticking with the home building example, an indirect cost of its construction would be something such as real estate fees or the various forms of insurance that were needed to protect the home builder from liability and loss. Other utilities that were needed throughout the construction process would also be identified as indirect costs.
A sunk cost is something most everyone is familiar with because it is a price already paid. It is something that cannot be reversed and a historic transaction or activity that cannot be undone. One example is the purchase of a lawn mower. Aside from the fact that the lawn mower was bought ten years ago and no longer functions, the cost of the lawn mower is a sunk cost and its purchase cannot be undone. Businesses must decide whether or not to cut their losses and move on, or maintain use of the cost in some alternative form.
An incremental cost another cost that comes by businesses deciding to produce one additional product or service. The best example of this which explains it more clearly is a law firm deciding whether or not to add an additional client. This new expense will require that much more out of the firm itself and additional resources which may or may not be available.