4.2 Cost of An Enterprise

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4.

1 Costs of starting an enterprise


 Costs
 Costs are resources consumed or used to produce a unit
of product or service
 Every business generates costs, even if there is no
ongoing production, service or trading activities.
 To understand this, it is essential to know that there are
direct costs and indirect costs.

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Costs of starting an enterprise
 Direct and Indirect Costs
A. Direct costs:
 are those that only arise when an enterprise is
manufacturing goods or producing a service or
buying goods to resell. These costs depend directly
on the number of products, services or goods
produced.
 are composed of two cost sub-groups:

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Costs of starting an enterprise
 Direct and Indirect Costs
1. Direct material costs:
• Expenditures for all items that become part
of a product, or are used to produce a
service, or are bought for resale, enter into
the category of direct material costs.
• Costs linked to the acquisition of raw
materials, such as transport, are included in
the direct costs

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Costs of starting an enterprise
 Direct and Indirect Costs (Cont’d)
2. Direct labor costs:
• All wages for workers and helpers that are
directly involved in the production or the
delivery of services.
• This also includes costs for social security.
• Staff wages for the retailer and wholesaler
are not considered as direct costs because
one person generally sells many different
items.

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Costs of starting an enterprise
 Direct and Indirect Costs (Cont’d)

Direct Costs

Direct Material Costs Direct Labor Costs

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Costs of starting an enterprise
 Direct and Indirect Costs (Cont’d)
B. Indirect costs:
 are all other costs generated from business
activities that are not direct costs.
 are costs that cannot directly be attributed to a
specific product or service. for example rent for
the office premises, salary for the bookkeeper,
interest on the bank loan, telephone costs, fire and
car insurance, etc…
 are also called overhead costs.
 In wholesale or retail business, all staff costs are
indirect costs.
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Costs of starting an enterprise
 Classification of Costs by Categories
 Entrepreneurs also have to know the total amount of costs
their business generates during a month and during a
year.
 This information is of importance because it shows the
cost structure of the enterprise, and also gives an
indication of when particular costs are unnecessarily
high.
 With this information an entrepreneur can try to reduce
costs and become more competitive.
 A business starter has to forecast the total costs of his/her
business for at least one year in order to find out whether
the planned sales cover the costs or not.
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Costs of starting an enterprise
 Classification of Costs by Categories (Cont’d)
 All costs that the business’ activity creates for the
community are called externality costs.
 All costs that occur in a business can be put into
the following categories:
• Staff costs
• Material costs
• Other costs
• Capital costs

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Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
1. Staff Costs
 An entrepreneur who employs staff becomes an
employer and he/she will have legal and social
responsibility for his/her employees.
 This responsibility means that he/she has to fulfill a
number of requirements that are imposed by laws and
regulations, or by collective bargaining agreements
such as:
• Minimum wages
• Legal duration of working hours
• Overtime payment
• Annual leave
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Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
• Sick leave
• Social security
• Workplace accommodations for employees with
disabilities
 This enumeration shows that staff costs are not only
salaries or wages.
 The additional costs that come on top of the salaries
are often calculated as a percentage of the salary.

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Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
2. Material costs
 All materials that are used for the manufacturing of a
product, or to provide a service, fall under the
category “materials”.
 Materials that are not used for a product, but are
necessary for the functioning of the business, such as
office supplies or detergents for office cleaning, are
also counted as material costs.

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Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
 In production, a distinction is made among different
kinds of materials:
1. Raw materials, e.g. plywood, metal bars, metal
sheets, leather, wool, woven fabrics, plastics,
fluor, butter, etc.
2. Standard materials, e.g. nails, screws, bolts, nuts,
fittings, electrical appliances, spare parts, buttons,
zippers, etc.
3. Auxiliary materials, e.g. glue, paint, welding
electrodes, welding gas, saw blades, grinding
paper, yarn, threads, etc.
 In wholesale and retail business the costs for acquiring
finished goods for reselling are classed as material
costs. 12
Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
3. Other costs
 All expenditures for items and services that do
not fall under the above-mentioned categories
are put into the category “other costs”.
 These costs are mainly for electricity, water,
telephone, internet, insurance, rent, publicity,
administrative fees, etc.

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Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
4. Capital costs
 A businessperson, who contracts a loan, has to
pay interest for the duration of the loan.
 Interest is also due for an overdraft on the
entrepreneur’s current account.
 These payments are called capital costs.
 There is a very particular kind of capital cost
that is called depreciation.
 Depreciation is the loss of value of machines,
equipment or cars that are operating in an
enterprise. 14
Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
 This loss of value is a process that can last
several years.
 The duration of this process depends on the
type of machine.
 At the end of this process the machine, truck
or vehicle needs to be replaced.
 The annual loss is considered as capital cost
that allows the money that was paid for the
new machine to be recuperated in order to
replace it.

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Costs of starting an Enterprise
 Classification of Costs by Categories (Cont’d)
 How is depreciation calculated?
• Quite simply, the price of the newly bought
machine, car or whatever it may be is divided by
the expected lifespan of the machine.
• For example, a new delivery pick-up is purchased
for 12,000 Birr and its calculated lifespan is five
years.
• Its annual depreciation = 12,000 Birr / 5 = 2,400
Birr/year.

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