Direct, Indirect, Fixed and Variable Costs
This nomenclature is interrelated and can be confusing. You may have to read through this section a couple of times to refresh and clarify these concepts. It may be a bit confusing at first, but will become clear with use.
All types of businesses track their activities with cost accounting techniques. Managers need to understand the costs of running the business. If you don’t know your costs accurately, you don’t know if you are making money. You need to sell things for more than they cost to make to have a sustainable business.
Cost accounting developed with the industrial revolution. As the scale of enterprises increased so did their complexity. Operating complex enterprises led to the development of systems for recording and tracking costs. Understanding costs help managers make better decisions. We now have 300 years of cost accounting experience to draw upon.
In the beginning of the industrial age costs were primarily variable costs. Labor, raw materials, and power varied directly with the level of production. The total variable costs were a rough guide for decision-making.
Variable costs go up and down according to the volume of work. Other costs tend to remain the same whether a factory is busy or idle. Manufacturing has become more mechanized and automated. As a result, fixed costs have become more important in management.
Fixed costs include factories, equipment, and maintenance. They also include overhead costs like quality control, storage, plant supervision and engineering. These costs were not part of businesses in the early days of industrialization. With the growth of industrial scale enterprises like railroads, fixed costs became important. You can’t move freight on a railroad without first putting down tracks and buying locomotives. These are fixed costs.
Not understanding how to allocate fixed costs to products initially lead to poor decision making. Today we know that understanding fixed costs is crucial to making informed decisions about products and pricing.
Direct costs such as labor and raw materials are variable costs. Total variable costs increase as more units are manufactured. For example, every pizza made in a pizzeria uses a certain amount of dough. That dough, the raw material, is a variable cost.
Direct costs can be variable or fixed. A supervisor is a direct cost. Her salary is the same each week no matter how many products are manufactured. Her salary is a fixed cost. By contrast, raw materials are a direct cost, and a variable cost. The amount of supplies used increases as the volume or activity increases. Got it?
Fuel used operating a machine is an indirect cost. The cost of the fuel is variable because more is used when the machine runs longer and more products are made. Depreciation is also an indirect cost. It is a fixed cost since the machine’s depreciation expense is the same each year and not tied to its amount of use.
Costs are categorized as direct or indirect. The cost is fixed if the total amount of the cost does not change as production volume changes. If the cost changes as a function of activity or volume, it is a variable cost.
Classifying costs in these ways help managers understand the dynamics of their operations. It helps them use data about the past, in the present, to make better decisions about the future. A deep understanding of costs and their dynamics is a competitive advantage.