Cost is a part of every business, you have to incur them in order to deliver a product.

For most, the extent of cost management is via the Profit and Loss account in the monthly reports, and by the comparison of expenditure to budget.

Both are  by themselves inadequate, and miss three of the generators of cost from which great benefit can be derived by intelligent management. In addition, just cutting costs with no regard to the role the cost incurred plays in the generation of revenue and margin, often results in greater costs in the long term, almost always only indirectly connected to the cost cutting. A former corporate employer engaged in a ‘re-engineering’ exercise which was code for reducing headcount. Short term there was a benefit, but the hidden costs incurred as tasks were not done, and the survivors left as soon as they had another job, incurring recruiting and training costs for the replacement employees,  were considerable.

The nature of the costs vary, but there are 5 classes that occur in every business. To one extent or another, they are a part of the profit equation.

Profit = Revenue – Cost

Direct or marginal cost.

Direct costs, as the name implies, are driven directly by the production process. In most manufacturing environments these are recorded as the Cost of Goods Sold.

Indirect costs, or overhead.

These are the costs incurred to keep the doors open, disconnected directly from revenue generation. Rent, insurance, management wages and salaries, for instance are necessary, but not connected directly  to the generation of revenue.  

Opportunity costs.

Nobody has enough resources to do everything they would like, no matter how big and profitable you may be. Therefore choices must be made, option A instead of option B. Opportunity costs are those benefits forgone as a result of those choices. They are rarely definitive costs, although calculations done that lead to making those choices such as Internal Rate of Return, and discounted cash flow forecasts, make some attempt to do so. 

Transaction costs.

Transaction costs are similarly challenging to identify, as they are generally invisible amongst the general overheads. However, focusing attention on transaction costs can yield considerable savings. For example, a client of mine had 5 suppliers of the key raw material for his operations, each supplying across a wide range of specification variations, and each having about a 20% share of my clients purchases. Each of the 5 relationships consumed time of the purchasing, operations and accounting personnel, as they managed the paperwork, reconciled mistakes, and maintained the human contact. Over a short period we engaged in a process to reduce the number of suppliers, one that would supply most of the required product, and a second as backup. Not only did we get a much better deal on price, but it quickly became evident that the time consumed by staff engaged in the day to day was reduced by a huge amount, leaving them free to undertake more productive and personally satisfying activities.    

Short cut costs

As with transaction costs, short cut costs are hidden, perhaps even more so. Taking short cuts almost always results in longer term higher costs in remediation. You might make the short term budget, or target, but at the expense of the long term. It is a bit like losing weight, take the quick way out by ‘starving’ yourself, and you might get a short term result, but unless you change your eating habits, once the short  term pressure is off, your weight will start to go back on, slowly. In a factory, short cuts usually lead to waste generated elsewhere, which are often just as hidden. Doing a patch up job on a machine to keep it running today, can lead to a major breakdown tomorrow that closes the factory for a week. These costs are rarely attributed to their real cause, and as a result, keep happening. The best cost  is the unproductive one you just eliminated!

There is a 6th cost, only sometimes seen with then benefit of hindsight: Opportunity cost. While your resources were tied up, particularly your strategic attention, an opportunity emerged that was not seen, or for which you did not have the resources.