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 o