Direct operating costs represent the capital expenditures a company makes in order to run its normal business operations. The two most common categories for these costs include fixed and variable. Fixed operating costs are those that do not change over time, such as rent, depreciation, certain employee salaries, and property taxes. Variable direct operating costs include direct materials, hourly worker wages, utilities, and maintenance fees. Both manufacturing and service-based companies can have these types of costs, although the latter businesses may be lower in some cases.
Fixed direct operating costs tend to cause more financial leverage in a business. In many cases, a company may need external funds in order to purchase operating facilities, equipment, and other machines necessary to produce goods or services. While these costs are easily mitigated when the company makes money, overleveraged companies in poor economies often face difficulties. The result is too much debt and associated payments that the company may not be able to make on time with low sales and profit. The usual way to lower fixed costs is to unload the equipment or pay cash for the items before setting them up.
Variable direct operating costs are not as problematic for a company. This is the result of variable costs not occurring if the company fails to produce products. For example, if a company shuts down a particular product line, then any direct materials for these products are not necessary. Therefore, the company will not have any variable materials costs for these products. This reduces overall costs for the business and potentially increases profits.
A company’s direct operating costs appear on both the income statement and balance sheet. When a company purchases buildings and equipment — both of which relate to fixed costs — the company will increase long-term assets and offset these assets with an increase to liabilities for debt or a reduction in cash. Variable costs work in a similar manner, though they have an extra step. Accountants increase inventory and reduce cash or increase short-term liabilities for these items. When a company sells the products, a portion of the variable and fixed costs go to the income statement as a reduction to overall sales.
Indirect operating costs are also present in a company’s business operations. These costs are necessary but do not have a direct impact on a company’s production process. Accountants typically place these costs into one account and allocate them to finished products when complete.