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Financial elements of cost
There are several elements that make up the cost of anything. It is convenient to use the following categories to analyze the financial dimension of costs:
- 1. People cost
- 2. Material cost
- 3. Facilities and equipment cost
- 4. Operating expenses
- 5. Admin and general overhead cost
- 6. Financial costs
Beyond financial elements of cost
In the TVM logical framework there are also these elements of cost
- 7. Profit as a cost
- 8. Consumption of social value
- 9. Cost of external constraints
Drill down to elements of cost is important because the elements of cost all change in different ways ... have different behaviors ... and different impact on the community.
The purpose of data in the TVM environment is to have data to understand ... and to use this understanding to improve decision making and the quality of life!
People cost (1)
People cost depends on (1) how many people and what skills and job types; (2) the wage rates for each group; (3) the benefit costs associated with each group. The costing is complicated by matters such as training and the use of consultants and service contractors instead of direct paid staff.
People costs vary enormously depending on the mix of local and international staff. Local staff are usually paid much less than international staff. There might be a cost offset to the extent that international staff can do some work more efficiently than local staff due to their knowledge, training and experience.
Material cost (2)
Material costs are a function of a bill of material and the purchase price of the materials. A scrap factor should be included. Most production processes require more raw material inputs than there is output because of process losses (in machining, in casting, etc.).
Facilities and equipment cost (3)
Equipment costs do not behave in a simple way, and care must be taken in costing equipment use appropriately. Some of the characteristics that must be taken into consideration include (1) the life of the equipment in elapsed time; (2) the life of the equipment based on usage; (3) the utilization of the equipment in any given period; (4) the costs associated with running the equipment such as fuel and maintenance; (5) the cost of periodic major maintenance, etc.
In some cases, as for example, in using an aircraft for vector control, there are people and material costs that have variability depending on equipment utilization. All fixed assets have use costs that should be brought into account for costing.
Depreciation
Depreciation is a part of the cost framework. It is a concept that is derived from the economic life of an asset ... and in this context, nothing to do with tax law and allowable write-offs. The aim of depreciation is simply to relate the cost of using an asset to the activities the asset is used for. If an asset has a three year life, and is used most of the time, each of the year periods should be charged one third of the capital cost. This would give a reasonable result. On the other had an piece of equipment may have a life that depends on how much it is used (for example, an aircraft) ... say it will be useful for 50,000 hours of use. In this case the hourly cost can be computed and the asset charged to the activity for each hour it is used, and offset against the depreciation provision for the asset.
Operating overhead cost (4)
Operating overhead costs are costs associated with the supervision and management of operations. They are made up of elements of cost (1), (2) and (3) above, and allocated to specific units of activity.
Cost of capital employed (5)
Cost of capital employed is the cost of using fixed and working capital. It is calculated by reference to the investment made in equipment, buildings vehicles, etc (fixed assets) and the investment needed for material inventory, work in progress and finished goods, receivables and cash (working capital) that are used for specific activities.
The calculation uses a cost of capital rate that varies depending on the ownership structure of the operation and the goals of this ownership. The cost to “rent” capital may vary from 2% to in excess of 200% per annum. This has become one of the most expensive aspects of modern capital market capitalism.
General overhead cost (6)
The general overhead cost is similar to operating overhead. It is made up of the same elements and allocated to operating activities o a basis that reasonably reflects the structure of the organizations and activities.
Cost is a key metric ... while it is usually the subject of intense analysis within an organization, it is difficult for the public to get access to cost information. In the corporate for profit business, reducing cost is a way to increase profit ...other things remaining the same. Little is put into the public domain about costs ... but cost is a critical part of performance metrics both for determining money profit and also socio-economic performance.
Cost of profit (7)
One of the biggest elements of cost in modern business is the cost of capital ... which is essentially the idea that profit becomes an essential part of the cost of product or service. In a system where the computation of (corporate) value is a function of the level of profit and the growth of profit ... then the profit behaves more like a cost than merely being the derivative of corporate performance.
Element of Cost – 3
Facilities and Equipment Costs
Cost to purchase
The initial cost to purchase is usually a substantial outlay, but because the life of the equipment is long ... several years ... the period cost is relatively low. The cash cost is high and immediate ... the operating cost may, however, be quite low.
Depreciation
Depreciation is the way accountants allocate cost to the current period from equipment that has a long life. If the equipment will last five years, the annual depreciation is the total cost divided by five. This is referred to as straight line depreciation because the annual charge is the same over the five years of the equipment's life.
Provision for depreciation
The annual or periodic depreciation charge is credited to an account usually called a provision for depreciation ... and specifically associated with the equipment item. As the equipment gets older the provision for depreciation becomes larger. When the equipment reaches the end of its life ... that is accounting life ... the cost to purchase and the accumulated provision for depreciation are the same.
Net book value
The net book value is the cost of purchase less the provision for depreciation. At the end of the accounting life the net book value of an equipment item is zero. Usually this is adjusted to be $1 so that there continues to be a flag in the accounts about this equipment.
Fully depreciated equipment
Fully depreciated equipment does not require ongoing depreciation charges, and is to this extent lower cost than newer equipment not yet depreciation. On the other hand technical considerations may mean that maintenance is higher cost and there may also be operating qualities issues to be taken into account.
Operating costs
Most equipment has considerable operating costs ... operator costs (labor) ... fuel and lubricants ... maintenance ... operating supplies ... etc.
Machine hour costing
Sometimes it is convenient to calculate a machine hour rate for costing. This might be calculated incorporating all the operating costs, or may be simply the cost of the equipment depreciation for the period divided by the anticipated hours of use anticipated for the period.
Variability of cost
Because each cost has a different behavior, it is usually preferable to limit the costs that are aggregated for calculation. There is a trade-off between precision and convenience.
Element of Cost – 4
General Operating Expenses
General expenses
Everything that is not already included in people costs, equipment and material costs should flow through general expenses. There are many things that must be included.
Rent
Element of Cost – 5
Admin and General Overhead
Operating overhead
In most organizations there are multiple levels in the organization. An operating overhead are the expenses that are incurred in running a unit that is not directly involved with the operations.
These units may be responsible for several operating units. Thee expenses have to be “allocated” between the various units to get the true total cost of the operating unit.
Element of Cost – 6
Financial Costs
Financial costs
Money has a cost ... though there are cases where money comes at no cost as, for example, as a gift or grant ... but usually free money comes with some strings or constraints.
If money is borrowed, and there are fees and interest to be paid, this is a cost that must be taken into consideration
When money must be paid back ... this is not a cost, but it is a very important drain on the cash of the organization, and there must be planning for repayment.
A good way of costing the use of money is to compute how much of the organization's assets are deployed to do the work. Assume a cost of capital ... of say 12% per annum ... and think of this is as the cost of capital. It is a useful discipline. The best operations are those that do valuable work with the least possible use of resources.
Element of Cost – 7
Profit as a Cost
Element of Cost – 8
Consumption of Social Value
Element of Cost – 9
External Constraints and Inefficiency
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