Cost terms , behaviour and classifications

Cost terms

Cost unit

Is a unit or a batch of product or service from which cost is ascertained or has costs attached

to it. The cost unit is usually the control point for costing purposes.

Examples: a unit of book, batch of 100 greeting cards, a/per patient per night.

Cost object

Any activity for which a measurement of costs is required by users

Examples: cost of an output , cost of air travel, operating costs of a department

Cost centre

A person or location or function or activity or item of equipment which are the collecting places

for costs before further analysis.

Behaviour of costs

It is important to know how cost reacts over time and also when there are shifts in volume.

Consider the cost structure of the business. This requires analysing the specific types of costs

that are to be incurred and trying to understand their attributes.

Variable costs: Variable costs will vary in direct proportion to changes in the level of an activity.

For example, direct material, direct labor, sales commissions, fuel cost for a trucking company,

and so on, may be expected to increase with each additional unit of output.

Assume that GoSound produces digital music players. Each unit produced requires a circuit

board (PCB) that costs $11. For example, $165,000 is spent when 15,000 units are produced

(15,000 X $11 = $165,000). The data are plotted on the graphs. The top graph reveals that

total variable cost increases in a linear fashion as total production rises. The slope of the line

is constant. Of course, when plotted on a "per unit" basis (the bottom graph), the variable cost

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is constant at $11 per unit. Increases in volume do not change the per unit cost. In summary,

every additional unit produced brings another incremental unit of variable cost.

The activity base is the item or event that causes the incurrence of a variable cost. It is easy

to think of the activity base in terms of units produced. Actually it can also be hours worked,

units sold, purchases made or others.

Fixed costs: The opposite of variable costs are fixed costs. Fixed costs do not fluctuate with

changes in the level of activity. Assume that GoSound leases the manufacturing facility where

the portable digital music players are assembled. Assume that rent is $200,000 no matter the

level of production. The rent is said to be a "fixed" cost, because total rent will not change as

output rises and falls. Please also note that fixed cost per unit declines as production

increases.

Many fixed costs are only fixed for a certain level of production. For example, a machine or

manufacturing plant can reach towards a certain level of capacity without the need to expand

or get further equipment. To increase production beyond a certain level, additional machinery

(or a new plant, additional supervisors, etc.) must be deployed. This will cause a major step

upward in the fixed cost. Fixed costs that behave in this fashion are also called step costs.

These costs are illustrated by the following diagram. It is important to remember that fixed

costs are only fixed over some particular range of activity.This range is normally called the

relevant range. By definition the relevant range refers to the level of activity you expect to

operate at, and moving outside that range can significantly alter the cost structure.

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Variable cost total Variable cost per unit

Fixed cost total

Fixed cost per unit

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Steps cost ( Fixed cost at different ranges) Mixed cost/Semi Variable/ fixed cost

Mixed costs: Many costs contain both variable and fixed components. These costs are called

mixed or semi-variable. With a mixed cost, there is some fixed amount plus a variable

component attached to an activity. Mixed costs (because of the variable cost compenent) also

change in response to changes in volume. But, the fixed cost remains unchange. This means

the overall change in cost is not directly proportional to the change in activity.

Separating variable and fixed costs: High low method

The high low method is a very simple method of segregating between fixed and variable costs.

It requires collecting cost data across a range of activity levels and uses the difference

between the highest and lowest level as a starting point to determine variable cost unit

Example:

The following summary data is provided for two periods:

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 Production costs Output

Period 1 £48,981 29,720 units

Period 2 £55,893 35,480 units

Using the high-low method, what are the estimated fixed costs per period?

Answer:

Step 1: determine variable costs per unit

Variable cost per unit = Highest cost-lowest cost

Difference in units highest-lowest

= 55893-48981

35,480-29720

= $1.20

Step 2: determine fixed costs total per period

Replace in one of the levels, TC @ 29,720 = 48981

29720 x1.2 + FC = 48981

35664 +FC = 48981

FC =13317

Other classification of costs

By Function

Cost classified by function refers to differentiating costs according which stage of the

operations the costs is incurred. This classification is very important in financial reporting and

the preparation of financial accounts. Costs are usually classified as follows:-

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 Production Direct materials- raw materials, labour-

production operator other direct labour,

production overhead like factory

maintenance, salary of production supervisor,

Administration Audit fees, salary of office employees,

stationery, other general office expenses

Marketing or selling and distribution Salesmen salary, advertising, promotion,

delivery, warehousing, carriage outwards

Research development Research, design, development cost, testing

costs

Traceability

Cost is classified as either being direct cost or indirect in terms of its traceability to the

products or service produced.

Direct costs Costs that can be traced in Direct materials,direct wages

full in an economic manner to Direct expenses

the end product or service Also known asa prime costs

Direct material – all those materials that Raw materials, component

become part of product or parts, packing materials,

used in significant amounts. work in progress transferred

from one process/department

in production

Wages- wages of labour working on Designer –clothes

product itself or others for Composer-music

Assembly worker-factory

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 testing or analysis specially

required for the production

Expenses Expenses incurred other than Royalty for production, hiring

materials and wages of special equipment

specifically for the product