1.3 Categorizing Costs

The example shown above is quite simple and only provides summary values, hiding many of the details underlying the values shown (e.g. the number of servers, their associated working hours and hourly wages are likely used to estimate the total “servers” payroll cost.) Real-world budgets can get very complex, thus it is useful to organize and categorize activities, materials, costs, etc. in a logical manner to both help ensure that the budget is comprehensive and thoroughly considers all factors involved with the overall endeavour, and to help accurately and transparently communicate the budget to others. There are several different ways costs can be categorized, as discussed in the following sections.

1.3.1 Fixed, Variable, and Mixed Costs

One way to group costs within a budget is to look at fixed costs versus variable costs. Variable costs will increase proportionally with the output volume of a project (thus they vary) while fixed costs will remain constant regardless of output volume. Consider the cash flows for a grain bin manufacturer; in order to sell more bins, the company must produce more bins, and therefore spend more on raw materials. However, regardless of how many bins it produces, the company will still spend the same amount each month to lease its production building and storage yard. Thus, we can say that the raw materials represent a variable cost, and the lease represents a fixed cost.

Suppose that the same manufacturer has a salesperson who markets the grain bins to local farmers. The salesperson is paid a base salary for the year, but to incentivize them to sell more bins they also make a small commission from each sale they make. Since the cost to pay this salesperson is partially fixed, and partially variable based on their output, we say that it is a mixed cost. Other common mixed costs include water and electricity costs, which often include both delivery costs, which are fixed, and usage costs, which vary based on consumption.

These cost categories are commonly used when projecting costs as they enable comparison between different production levels.  For example, the grain bin manufacturer could compare expected profits for normal production versus a 10% increase, and so on.

It should be noted that many fixed costs are only truly fixed for a certain range of activity and dramatic changes may alter these as well. If the grain bin manufacturer decided to double production, their storage yard may not have adequate capacity and they may have to lease additional storage area to accommodate the increased volume of units in inventory, thus the fixed cost of their lease would also increase. In general, though, if altering production by one unit (either an increase or a decrease) would not affect a cost, we would consider it fixed. If it would affect a cost, we would consider it variable.

1.3.2 Direct Costs, Indirect Costs, and Overhead

Another way to categorize costs is distinguish between direct costs and overhead costs. A direct cost is any cost which can be completely and directly assigned to a specific cost object. For example, in a manufacturing context, the two major sources of direct costs are materials and labour; the direct cost for a manufactured product would therefore be the cost of its material components plus the labour cost to assemble it. Since these costs can be directly traced to the cost object being produced, they can be assigned accurately without additional effort. However, even in basic manufacturing situations, not all costs can be directly assigned to a cost object.

Suppose you are managing the budget of a small local brewery. You might find that several of the major cash flows are straightforward to identify: the brewery gets its revenue from selling beer, and pays direct costs for its raw ingredients. However, there are many other unrelated expenses which must be considered, including heat and lighting, equipment maintenance costs, marketing, rental costs or property taxes for the facility, among others. All these costs must be taken into account in the selling price of the brewery’s products. As they affect the company’s profitability, they cannot be ignored. As such, we refer to any cost which is not directly related to a specific product as an indirect cost. Even the salaries of the brewery employees may be indirect costs: the wages for people on the production line are direct costs, whereas the wages for administrative staff (among others) are indirect costs.

To make this more complicated, there is a third category of costs known as overhead, which is often a subset of indirect costs. You can think of overhead costs are costs which would be incurred regardless of whether any product is produced, and typically are long term costs (i.e. they continue for as long as a product is in production). Other indirect costs may be incurred only once during the life of a product; these are typically indirect, but not overhead, costs.

For example, a direct cost of a pharmaceutical drug would be the chemicals that go into making a pill. An overhead cost of the drug would be the utilities to run the company’s production lab. An indirect, but not overhead, cost may be the cost of the clinical trial for that pill.

The lines between overhead and indirect costs are fuzzy. Some sources consider the two terms to be synonymous, and some draw slightly different distinctions than the one given above. Due to the lack of distinction, we may at times use these terms interchangeably in this text.


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Engineering Economics Copyright © by Schmid, B., Vanderby, S. is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.