Operational costs are those recurring costs incurred in the operation of a business. Seemingly simple in concept, the identification, allocation and control of these costs are complex and have generated a plethora of management practices. This article clarifies what constitutes operational costs, including the distinction between direct, indirect, variable and fixed costs. It then looks at some of the most common practices of accounting allocation, including absorption costing, marginal costing, activity-based costing, throughput accounting and target costing. Finally, it explores lean manufacturing, total quality management and the theory of constraints as methods companies have used to control costs.
Operational costs are the recurring costs incurred by a company in the course of running its business. They encompass virtually all the expenses incurred by a company, except the costs of financing (interest), income tax and depreciation. Thus, on the income statement, operating income is identified as remaining monies after the cost of revenue and other expenses are deducted from revenue.
Categories of Operational Cost
As an example, Dell Inc.'s 2005 income statement is shown below in Table 1 for illustration purposes. The two broad areas of operational costs are the cost of revenue and the operating expenses.
(In thousands) Revenue 55,908,000 Cost of Revenue 45,958,000 Gross Profit 9,950,000 Operating Expenses Research & Development (R&D) 463,000 Selling, General & Administrative Expenses (SG&A) 5,140,000 Nonrecurring Other Operating Expenses Operating Income 4,347,000 Income from Continuing Operations Total Other Income/Expenses Net 255,000 Earnings before Interest & Taxes 4,602,000 Interest Expense 28,000 Income before Tax 4,574,000 Tax Expense 1,002,000 Net Income 3,572,000
Operational costs include direct costs and indirect costs.
- Direct costs are those that can be directly attributable to specific products the company produces, and typically include materials and production labor.
- Indirect costs are not directly allocated to specific products and are not directly impacted by the level of production (at least over a short term).
The cost of revenue is generally comprised of direct costs, though certain manufacturing overhead is generally included through cost allocation, as we'll see later. Operating expenses are indirect costs.
This all seems relatively straight forward, but things get a little more complex beneath the surface. In addition to thinking of costs as direct and indirect, we must also consider whether they are variable or fixed.
- Variable costs vary in direct proportion to the volume of product being produced. For instance, if a widget factory produces 10,000 widgets per day and demand suddenly increases to 5,000 per day, there are correspondingly immediate costs incurred by the factory, including an increase in raw materials being purchased and added production line labor. Variable costs appear on the income statement in the cost of revenue.
- Fixed costs, on the other hand, relate to manufacturing and general overhead costs that cannot easily be allocated to specific production units. These costs are not immediately impacted by increases or decreases in production, and are therefore "fixed." On the income statement, fixed costs are included in both the Cost of Revenue (manufacturing overhead -- a direct cost) and Operating Expenses (indirect costs).
- re two variations of fixed and variable costs worth noting. The first, "step" costs, are those that will change once certain levels of production are reached. For instance, as the production in the factory grows, at some point it will overcome the capacity of the janitorial staff to support it, and will need to add more staff.
Another variation is a cost that includes a mix of direct and indirect costs. An example might be electricity to the factory. While the factory as a whole uses a baseline of electricity, each production unit also uses a portion of electricity to power its own equipment.
This is not simply an exercise in accounting mania, but has real implications for organizations, because fixed costs are very often the larger percentage of overall costs. You can see from Dell's income statement that the cost of revenue (which includes an unknown amount of manufacturing overhead, a direct, fixed cost) consumes a whopping 82% of revenue, and operating expenses consumes another 56%. Once these are paid for, Dell is left with a mere 7.8% of revenue in operating profit. In fact, manufacturers (and many other industries) consider 10% operating profit to be quite good.
This then, is why cost accounting is such an important topic. From pricing product to capacity planning to profitability analysis, an understanding of the true costs of products is vital to a company's financial health.
Identification of Operational Costs in Manufacturing
There is an old adage in business -- "you can't control what you don't measure." The first step in accounting for and controlling costs, then, is to understand what they are. The following provides more detail on the costs involved with manufacturing companies.
Cost of revenue represents the direct costs incurred to produce the products sold by the company. The primary costs include:
- Direct Labor (production line staff)
- Materials (used in producing the products)
- Manufacturing Overhead (e.g. non production line staff, general supplies, heat/light/power, freight)
R&D expenses are the costs associated with developing new products and improving existing products. They include:
- Royalties & Patents
Selling expenses are the costs associated with selling the products offered by the company. They include:
- Labor & Commissions
- Market Research
- Sales Promotions
- Account Management
- Travel & Entertainment
Administration expenses are general overhead costs incurred by every company running a business:
- Financial functions -- accounts payable and receivable, collections, payroll, budgeting, financial reporting, etc.
- Human resources administration -- recruiting, training, compensation and benefits administration, etc.
- Information systems management -- new systems implementations, systems maintenance, etc.
- Facilities Management -- lease management, janitorial functions, landscaping, etc.
In a typical accounting system, accounts are set up that reflect the above categories, and costs are allocated into these accounts as they are incurred. However, reports derived from these accounts are not very helpful in managing operational costs, except for comparing the costs over time and against budget. For instance, they do not tell us anything about how much direct labor is being spent on different products. Which products are contributing the most margin? Which might actually be unprofitable?
With all this, it becomes clear that the company's management is making important decisions for the firm with too little information. We need another way to identify and control costs.
(The entire section is 3351 words.)