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What are the three ways to classify costs?
- By Nature - Materials, Labour, Overheads
- By Function - Production costs vs Non-production costs
- By Behaviour - Fixed, Variable, Semi-variable, Stepped-fixed
What are Materials costs?
Costs related to raw materials and components used in production. These are tangible inputs that become part of the finished product (e.g., wood for furniture, flour for bakery, steel for manufacturing).
What are Labour costs?
Costs related to wages and salaries of employees, including: direct labour (production workers), indirect labour (supervisors, maintenance staff), and related employment costs (national insurance, pension contributions).
What are Overhead costs?
All other indirect costs that cannot be directly traced to a specific product or service. Examples include: rent, utilities, insurance, depreciation, and administrative expenses.
What are Production Costs?
Costs directly related to manufacturing goods, including: Direct Materials, Direct Labour, and Production Overheads (factory rent, machine depreciation, factory utilities).
What are Non-Production Costs?
Costs not directly related to manufacturing, including: Administration costs (office salaries, legal fees), Marketing costs (advertising, sales commissions), Distribution costs (delivery, warehousing).
What are Fixed Costs?
Costs that remain constant in total regardless of the level of activity within the relevant range. Examples: rent, salaries, insurance, depreciation (straight-line). These are TIME-RELATED costs.
What are Variable Costs?
Costs that change in direct proportion to the level of activity. If activity doubles, variable costs double. Examples: raw materials, piece-rate wages, packaging. Cost per unit remains constant.
What are Semi-Variable Costs (Mixed Costs)?
Costs with both a fixed and a variable component. They contain a base fixed charge plus a variable element that changes with activity. Examples: telephone bill (fixed line rental + variable call charges), electricity (standing charge + usage charge).
What are Stepped-Fixed Costs?
Costs that are fixed within a certain range of activity but increase in discrete steps once that range is exceeded. Example: warehouse rent (fixed for 0-5000 units, then increases to accommodate 5001-10000 units), supervisory salaries.
What is the High-Low Method?
A technique used to separate the fixed and variable components of a semi-variable cost. It uses the highest and lowest activity levels to calculate the variable cost per unit and then derives the fixed cost.
High-Low Method - Step 1
Identify the highest and lowest activity levels (not costs!) and their associated total costs.
Example: High: 1,000 units at £7,000; Low: 400 units at £4,000
High-Low Method - Step 2 Formula
Calculate Variable Cost per Unit:
Variable Cost per Unit = (Cost at Highest Activity - Cost at Lowest Activity) / (Highest Activity - Lowest Activity)
Example: (£7,000 - £4,000) / (1,000 - 400) = £3,000 / 600 = £5 per unit
High-Low Method - Step 3 Formula
Calculate Total Fixed Cost:
Fixed Cost = Total Cost at Highest Activity - (Variable Cost per Unit × Highest Activity)
OR
Fixed Cost = Total Cost at Lowest Activity - (Variable Cost per Unit × Lowest Activity)
Example: £7,000 - (£5 × 1,000) = £2,000
High-Low Method - Step 4
Formulate the Cost Equation:
Total Cost = Total Fixed Cost + (Variable Cost per Unit × Activity Level)
Example: Total Cost = £2,000 + (£5 × Activity Level)
What are Direct Costs?
Costs that can be directly and economically traced to a specific cost object (product, service, department). Examples: direct materials (wood for a specific table), direct labour (wages of workers making that table).
What are Indirect Costs?
Costs that cannot be directly traced to a specific cost object, either because it’s not economically feasible or not physically possible. These are also called overheads. Examples: factory rent, supervisor salaries, machine depreciation shared across multiple products.
Why is understanding cost behaviour important?
- Budgeting - Predicting costs at different activity levels
- Decision-making - Understanding how decisions affect costs
- Pricing - Setting prices that cover costs and provide profit
- Breakeven analysis - Determining profitability at various volumes
- Performance evaluation - Distinguishing controllable from uncontrollable costs
What is the relevant range in cost behaviour?
The relevant range is the range of activity within which assumptions about cost behaviour are valid. Outside this range, fixed costs may change (e.g., need to rent additional space) or the variable cost per unit may change (e.g., bulk discounts).
Give an example calculation using the High-Low Method
Given: High activity = 800 units, cost = £6,400; Low activity = 200 units, cost = £2,800
Step 1: Variable cost per unit = (£6,400 - £2,800) / (800 - 200) = £3,600 / 600 = £6 per unit
Step 2: Fixed cost = £6,400 - (£6 × 800) = £6,400 - £4,800 = £1,600
Step 3: Cost equation = £1,600 + (£6 × Activity)
To predict cost at 500 units: £1,600 + (£6 × 500) = £4,600
