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Costs of Business

Understanding How the Costs of Business Relate to Lean

Reducing the costs of doing business is one of the main goals of Lean. But, as I worked on the term ‘costs’ for The Continuous Improvement Companion, it struck me that there are a significant number of ways to look at costs.

I’ve compiled many of the different ways I’ve heard the term ‘cost’ used in projects over the years.

  • Fixed Costs & Variable Costs: Fixed costs are the expenses that are the same no matter how much you are producing. (Rent, business licenses, etc.) Variable costs change as production levels change. (Materials, labor, shipping, etc.)
  • Marginal Costs (or incremental costs): This is the cost of building one additional unit at a given level of production. At some point, though, there will be a step up when a new facility is needed, or another person needs to be hired, so the marginal cost cannot be projected out very far.
  • Direct Costs & Indirect Costs: Direct costs can be traced to a specific product, such as materials or labor from that production team. Indirect costs are the overhead of doing business-marketing, accounting, etc-that don’t flow down to a single product.
  • Cost of Goods Sold (COGS): This is the cost related to making a product. It generally includes labor, materials, and factory overhead. This is an accounting term, and finds its way into income statements. It is a summary of the direct expenses associated with making a product.
  • Standard Cost: Standard Costs are the set costs for a product, used for accounting purposes to determine the COGS. They are generally calculated annually, and account for the current estimate as to how much a product costs. The difference between the standard cost and the actual cost is called variance.
  • Cost Center: Cost centers are organizations that have control over their costs, but do not have overall control over profitability. A manufacturing group might be a cost center, because they do not control sales. A customer service (repair) organization might be a profit center, since they control the costs as well as the revenue they generate.
  • Opportunity Costs: This is the cost related to the value you are giving up by using your resources for one option over another option.
  • Sunk Costs: These are the costs that you have already paid and are perhaps the most misunderstood of all costs. The money you have already spent is irrelevant in determining the value of continuing a project. They are gone no matter what. What matters is the amount it will still cost to finish a project.
  • Tangible Costs & Intangible Costs: Tangible costs are the ones that you can measure-time, money, kilowatts, etc. Intangible costs are the ones that can’t be easily measured-trust, job satisfaction, morale, etc.
  • Projected Savings & Actual Savings: Most projects, at the moment of completion, can only project savings. You look forward and estimate what will be saved over time. If you lower the cost of producing the WidgetMax 3000, the cost will show in all future earnings-but only a small sliver of the total gain can be felt on the day the improvement was implemented. Later, though, you can look back and point to actual savings-the ones that really materialized. Why does this matter to continuous improvement? Kaizen teams tend to overstate their projections when talking about the success of their events.
  • Cost Avoidance & Cost Reduction: Continuous improvement works to lower costs in two ways. First, it actually reduces costs on an existing expense-it lowers the price of inventory, cuts floorspace, or frees up employees. (Continuous improvement efforts should never result in a job loss, or employee commitment to it will evaporate in an instant.) Cost avoidance is when a projected cost is no longer needed. For example, an open position is closed, or a new factory is put on hold.

If you come up with any other ideas, I’d love to hear about them in the comments section.


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