the cost of the lease to any particular pair of gloves. The cost belongs to all the gloves, yet the cost does need to be included in the cost of a single unit of your product. That way, you can determine the price and profit for one unit (one glove).
One way to allocate overhead is to base it on some level of activity. As you see later in Chapter 5, activities in your business cause you to incur costs. Assume you run a machine for 1,000 hours a year and pay $2,000 for the repair and maintenance on the machine. You could allocate the repair cost to each hour of machine time as $2,000 ÷ 1,000 hours, or $2 per machine hour.
Deciding on direct versus indirect costs
As a business owner, you need to analyze all your costs and decide which ones are direct and which ones are indirect. One way to do that is to visualize your product. Look at that pair of gloves one more time. You can certainly picture the materials (cotton, yarn, and leather) used in a pair of gloves. Also, you can visualize a worker cutting the cotton and sewing it together.
That exercise should convince you that material and labor are direct costs. You can imagine those costs “traveling along” with the gloves as they are produced, packaged, and shipped to a customer. Okay, direct costs. Got it.
Working with direct costs in cost planning is preferable because direct costs are known. In the previous example, you defined material and labor costs as direct, because you can attach the costs directly to the product. If the costs are known, your planning is more precise. Actual costs are likely close to your planned amounts. Because indirect costs are based on estimates, your budgeted costs are less precise.
Next, you review your checkbook to find other costs. You find checks for vehicle insurance for a truck. Consider what you just read in the previous section. Insurance costs can’t be traced directly to the gloves, so you need to decide on an activity level to allocate the costs.
The truck’s insurance cost can be allocated based on the number of miles you drive the truck. Assume you compute an insurance allocation of $0.10 per mile. You now need to get the cost allocated to your product.
Instead of allocating the cost to individual pairs of gloves, you allocate costs to each shipment of gloves. When a customer orders gloves, they are packed up and shipped, using the truck. Based on the number of miles driven to a client, you can allocate the truck insurance cost.
Mulling over fixed and variable costs
Total fixed costs don’t change when your level of production or sales changes. On the other hand, total variable costs do change with the level of production or sales.
Kicking around fixed costs
Consider a lease payment for a piece of equipment. Whether your production increases or decreases, the check you write for the lease stays the same. The cost is fixed in your lease agreement.
Say the lease payment is $500 per month, and that you manufacture office desks. You can’t directly trace the lease payment to the product you produce — the cost is indirect. So you allocate the lease payment cost to each desk you produce. In March you produce 1,000 desks. The equipment lease is $500 ÷ 1,000 desks, or $0.50 per desk.
In April, you make 800 desks. The April equipment lease is $500 ÷ 800 desks, or $0.63 per desk. Because you produce fewer desks in April but the lease payment doesn’t change, you allocate a larger cost per unit (desk).
There’s a difference between total fixed costs and the fixed costs per unit. The total fixed costs don’t change with your activity level. Fixed costs per unit do change as your production level goes up or down. As a strategy, businesses aim to produce and sell as much as they can for the same amount of fixed costs. That strategy generates the lowest possible fixed cost per unit.
Computing variable costs
Total variable costs change in total with your level of production. Say you use plywood to make each office desk. Each desk requires $4 of plywood. The $4 cost per desk does not change with production.
If you produced 1,000 desks in March, your total variable plywood cost is 1,000 desks × $4, or $4,000. The 800 desks produced in April generate $3,200 in variable plywood costs. The total variable costs do change, but the $4 variable cost per unit stays the same.
Table 2-1 summarizes fixed and variable costs.
TABLE 2-1: Fixed and Variable Costs
| Change with Level of Production? | |
|---|---|
| Fixed Costs | |
| Total fixed costs | No |
| Fixed cost per unit | Yes |
| Variable costs | |
| Total variable costs | Yes |
| Variable cost per unit | No |
Fitting the costs together
This section explains how direct costs, indirect costs, fixed costs, and variable costs all fit together. One simple way to explain the relationship is to go over some examples. Table 2-2 shows you an example of four types of costs.
TABLE 2-2: Fixed and Variable Costs, Direct and Indirect Costs — Examples
| Direct Cost | Indirect Cost | |
|---|---|---|
| Fixed costs | Hourly union wages | Equipment lease |
| Variable costs | Material and labor cost | Factory utility costs |
Table 2-2 is a new territory.