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When is a company allowed to eliminate costs?

If a manager decides to fire an inefficient worker, collective bargaining will inhibit his will; if economic outlook shows that a business line doesn’t provide goods for a relevant market share, managers won’t be allowed to eliminate the relative machineries, because strategic decisions are unchangeable in the short term: these all are clear examples of sunk costs.

Sunk costs are often related to evaluation of external costs due to purchases for outsourcing policy (http://www.questidenari.com/?p=218), and everybody understands easily that manufacturing a product is cheaper than buying (“make or buy” decisions). So, what about increasing external variable costs after having cut (a minimal percentage of) internal fixed and variable costs?

No written rules for all these questions. A clever controller, before creating an effective cost accounting system (http://www.questidenari.com/?p=611), must be a good communicator, because he has to talk to every person working in his company, blue collar or white collar: that’s the only way to know and assess costs, and the first step for an accurate analysis.

An effective cost accounting system requires variability of costs to be known very well.

Everyone remembers that costs can be considered fixed or variable depending on the link with the number of products. If costs grow with increasing in size of an operating unit, they’ll be considered “variable” (energy for motive power, seasonal workers, raw materials); if costs remain equal, they’ll be considered “fixed” (salaries & wages for direct labor, advertising, depreciation).

This is an easy theorical example referring to fiscal year, because no costs are constant in the long run. Every cost is always going to change because of increasing production – when a very strong demand suggests managers increasing production volume, they’ll probably decide to purchase another machinery in order to have multiple production facilities: fixed expenditures will have been made double.

Moreover, some costs are fixed and variable at the same time, so we talk about semi-fixed costs or semi-variable costs according to their greater portion (lubrificant for machinery, maintenance, tools).

The second argument regards direct or indirect costs.

We consider costs “direct” when they can be easily allocated to a particular product through a cause-effect relationship, and controllers are able to measure the consumption of input in financial terms of money.

On the other side, the lack of the same relationship, or difficulties in measuring the input’s cost, make us consider the expense as “overhead”.

Raw materials are the classical example for direct costs, while amortization is often considered an indirect cost.

Be careful: ancillary materials are overheads, but machinery dedicated to a particular business line refers to direct costs. Basic operational manuals consider direct variable costs and indirect fixed costs: you must evaluate chance by chance and make sure to do the best choice.

(to be continued)

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Communication and cost classification – 2

Communication and cost classification – 1