Cost Analysis

Categories of Cost

To appreciate the impact of ‘hidden’ costs on the total cost of ownership, it is essential to understand the different types or categories of cost. These may be broadly segregated into two groups:

• direct costs, and
• indirect costs.

Porter’s Value Chain may help you to understand how all of your organisation’s activities are connected and have an impact on costs. The way in which value chain activities are performed determines costs and affects profits. This tool identifies the sources of value for your organisation.

Costs can be separated into two categories:

• Direct costs: Costs that are directly associated with the production of goods or services. These costs are represented as red in the diagram below.
• Indirect costs: General running costs of the organisation, also known as overheads. These are represented as green in the diagram below.

The balance of direct and indirect costs directly affects your profitability. However in the public sector direct materials and services are the ones that have a direct impact on patients e.g. medicines and consumables.

It is worth noting that capital expenditure is also a key feature in health sector procurement as this covers items such as X-ray machines and body scanners. These are also part of your infrastructure in the diagram below.

Another way to classify costs is to consider whether they are fixed costs or variable costs.

• Fixed costs do not change according to the level of output of your organisation: they stay the same whether you produce more or produce less. For example, monthly lease payments on your vehicle will not change if you make more or fewer deliveries to the clinic.
• Variable costs do vary according to the number of products made. The more you make, the higher the cost. If you make fewer products, the cost falls. For example, if you sell more syringes, your packaging costs will rise.

Another way to classify costs is to consider whether they are fixed costs or variable costs.

• Fixed costs do not change according to the level of output of your organisation: they stay the same whether you produce more or produce less. For example, monthly lease payments on your vehicle will not change if you make more or fewer deliveries to the clinic.
• Variable costs do vary according to the number of products made. The more you make, the higher the cost. If you make fewer products, the cost falls. For example, if you sell more syringes, your packaging costs will rise.

Not all costs fall neatly into either of these categories. Some costs can be both and are sometimes referred to as semi-variable costs. For example, producing at a certain level of capacity is seen as a fixed cost but as soon as workers start doing overtime this is the variable cost element.

Cost analysis can take up management time and incur expense. But in the long run it will improve the quality of the information you can use to make decisions about the products and services you buy from suppliers. This will help you to achieve better value for money for your organisation.