• Kevin McDonnell

Rule #1 Know Your Costs

Understanding Direct and Indirect Costs is Key to Any Decision Making Process

In order to make effective resource allocation decisions, organizations must understand their costs. On a personal level it is easy understand costs. If you buy a car, it is $30,000 plus tax.

However, organizations have both DIRECT AND INDIRECT COSTS. The cost of something is NOT JUST THE PURCHASE PRICE. There are many INDIRECT COSTS (FIXED OR SEMI-VARIABLE COSTS) of the delivery for any product or service.

A simple example is a restaurant. Let's say dish of Penne Alfredo is listed as $30 on the restaurants menu. The cost of delivering that meal has many layers. The DIRECT cost is simply the cost of ingredients plus maybe the labor to prepare (obviously you pay the cooks by the hour so you have to assume a time to prepare multiplied by a labor rate). But then there are many different INDIRECT COSTS. Examples of INDIRECT COSTS TO DELIVER THE MEAL:

Waiter's Time, Bus Person's Time,Cost of Utensils and Plates (initial costs divided by usage factor)Rent on the Space (rent divided by meals served gives you cost per meal)Cost of Cash Register System (cost of system per month divided by meals) Spoilage of Ingredients (you buy $100 worth of ingredients, but $10 worth goes bad before you use it so ingredients cost you about 10% more than the direct amount) Utilities - electricity, gas, trash, etc. (total cost divided by meals served) Restaurant Management Salaries Etc.

There are many ways to ALLOCATE INDIRECT COSTS to the product or service delivered. This is as much more of an ART than a SCIENCE.

For instance, you could allocate Rent based on meals served or on a percentage of revenue. Part of the formula for understanding cost will be understanding UTILIZATION (more on this in a another post). Improved UTILIZATION can lower the INDIRECT costs because you are dividing costs, like rent, over more meals or revenue.

There will be many more blog posts on COSTS. Understanding COSTS is critical to understanding how to effectively allocate resources. If you don't know your costs then how can you understand what you are allocating?

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