Cost components

Before you can identify opportunities to reduce costs you need to know the way companies track and allocate costs and then use this information to make business decisions.
A company cost structure usually includes three types of costs – variable, overhead and mixed costs – which are explained below.

Variable costs

These are the costs of doing business. These costs increase with increases in business activity, ie the more you make, the more costs you incur and the more return you can expect.
These are also referred to as direct costs.
It is important to understand the relationship between efficient use of resources and variable costs.

• Labour costs rise if people are not used effectively.
• Raw material costs rise if raw materials are not used properly, such as if they are damaged or not stored properly.
• Energy costs rise if people waste these precious resources.

All variable costs are interrelated. For example, if a machine breaks down due to poor maintenance, this results in a loss of production which, if it is a continuous issue, will impact the overall running of the organisation as labour costs will rise and sales may fall.

Overhead costs

These are the costs of being in business. These costs remain fairly constant, regardless of the volume of product or services being delivered.
These are sometimes referred to as fixed costs, administration costs or core costs. Examples of overhead costs are:

• monthly salaries
• rent on property
• insurance premiums
• lease agreements
• depreciation of assets.

These costs are fixed over a period of time.

Mixed costs

This type of cost contains elements of both variable and fixed costs. Mixed costs change in total but not proportionately with changes in the activity level. An example would be the rental of a truck, where the daily rental rate is fixed while the cost per kilometer and fuel is variable. Electricity, gas and phone are examples of mixed costs as there is a fixed service fee and a usage fee.
To determine the cost to manufacture a product, the direct costs in making it (materials, labour, etc) and a proportion or percentage of the overhead costs are added together to give the final cost of manufacture. The problem with this calculation is that different products consume different amounts of overheads. Activity based costing, which is a relatively new accounting approach, looks at ways to apportion the overhead costs to each product giving it a much more accurate cost.