and either fixed or variable. Let’s go through the examples one at a time.
Say you manage a factory. You pay wages to hourly workers based on a union contract. The contract states the number of hours each employee works and their pay rate per hour. The total wages paid is a fixed cost. The cost is also a direct cost. That’s because the only reason to have hourly workers is because you’re producing a product. No production, no hourly workers — and no cost.
In the section “Kicking around fixed costs,” you work with an equipment lease. Because the equipment is used to make a product, the lease is a fixed, indirect cost. You allocate the indirect cost based on the number of units (desks) created.
Material and direct labor costs are addressed in the section “Comparing direct and indirect costs.” Those are variable costs that change (in total) with your level of production.
If you manage a factory, you incur utility costs to heat, cool, and provide power to the factory. The more products you produce, the more utility costs you incur. So utility costs can vary with the level of activity.
Utility costs are also indirect costs. Because you can’t trace the costs directly to a product, you have to allocate them. Utility costs are often allocated using labor hours for a particular time period.
Covering Costs in Different Industries
In the Introduction, I note that this book covers both products and services. A product is a physical item that your customer can touch, see, and feel. When a customer pays you for doing something — such as cleaning an office or driving a product from point A to point B — that’s a service. The way customers interact with your business also determines the type of costs you incur. Do you have a physical store or site location, sell online, or both?
Reviewing manufacturing costs
Manufacturers make products. They incur material and labor costs, as well as overhead.
No manufacturer can produce a product instantly. When you close the factory doors for the night, you have partially completed goods on hand. Those products are called work-in-process (WIP).
Assume you make blue jeans. The jean production moves from one department to another. Say that the denim material has been cut for 100 pairs of jeans. The next step is to sew the denim and then dye the material. You close your factory doors before the jeans move to the sewing department.
Consider the cost you’ve incurred on the jeans. You purchased the denim, a material cost. You paid your workers to run machines to cut the denim (labor costs). So the work-in-process jeans have incurred some costs, but not all the costs required.
When work-in-process goods are completed, they are defined as finished goods. Finished goods are ready for sale to a customer. They incurred all manufacturing costs.
Considering costs for retailers
A retailer doesn’t make a product. Instead, it buys inventory and sells it to customers. The largest cost for most retailers is inventory. (See Chapter 9 for more on inventory.) Retailers don’t create work-in-process or finished goods. Those terms apply only to manufacturers.
Retailers incur ordering costs to order inventory and carrying costs to store inventory. Check out Chapter 18 for the details. The risk for a retailer is carrying too much inventory — or running out of inventory when a customer wants to buy more product.
This is a delicate balance. The more inventory you own, the more cash you spend (and that gives you less cash to use for other things). You don’t recover the cash until the customer pays for the product. Likewise, if you run out of inventory, and there’s more demand for your product, you lose sales.
Adding up costs for e-commerce firms
E-commerce refers to selling products and services online, rather than through a physical store location. Online sales continue to grow, as technical innovations make it easier to find and compare products and make purchases over the web. As technology improves, so does the customer experience when buying online. The result? The percentage of retail sales placed online increases each year.
This industry has a different cost structure to a traditional retail or manufacturing company. The good news is that e-commerce firms don’t need physical locations. However, online businesses have other costs that must be managed.
As an example, let’s say you own Treeline Outdoor, an e-commerce company that sells hiking and camping gear. Your buyers shop online and compare prices, and you compete against a number of competitors.
Maintaining a website
Every business has a website these days, but e-commerce firms make a much larger investment in this area. Treeline’s website represents that first interaction that a prospect has with the business. How often have you visited a site, and left after 10 seconds? Yeah, me too. That’s what Treeline is trying to avoid.
The site must be attractive, particularly the homepage, and website navigation has to be easy for shoppers. E-commerce firms make a big investment in website design, including product images and graphics. Ready to check out? These sellers also need a smooth process for selecting items, updating their shopping basket, entering a shipping address, and for processing payments.
Ensuring product fulfillment
It’s frustrating to order a product, and receive the wrong merchandise. E-commerce businesses understand that an error during fulfillment can result in a lost client (been there, done that).
Treeline has several options here. The company could warehouse inventory and ship items using company employees. However, this choice requires Treeline to pay for a warehouse and extra staff, regardless of sales levels. If sales are declining, those costs may keep you up at night.
For many sellers, a better choice is dropshipping, in which a supplier maintains inventory and ships products when the seller receives an order. The pros and cons of dropshipping are discussed in Chapter 9.
Getting buyers interested
Nothing happens until a prospect visits the website, so it’s not surprising that sellers invest heavily in marketing. Here are two common marketing strategies:
Online ads: Pay for ads on websites and social media platforms where your target audience is spending time.
Content marketing: Create blog posts and videos that solve problems for your target market. For example, Treeline might write an article called: “10 Items You Must Have for a Winter Camping Trip” (not my thing, but you get the idea).
E-commerce firms spend big on websites, product fulfillment, and marketing. You won’t spend money on a brick-and-mortar store, but you have a number of other costs to manage.
Finding costs most companies incur
Most companies incur costs for human resources, marketing, lawyers, accountants (hey, that’s good!), and other experts. The costs might be salary and benefits for experts inside your company. You also might pay outside experts to perform the work.
Most companies incur costs for insurance, utilities, supplies, and depreciation expense on assets. So keep in mind that there are costs that apply to companies