Imagine that a small engineering company makes fabricated steel frames used in the oil industry. A typical medium size frame costs £2,400 to manufacture.
How useful is this information?
From a pricing point of view, knowledge of total cost is vital, particularly if the company uses cost plus pricing (which is widely adopted).
However, from a cost control and management perspective, dividing this total up into its constituent parts may be far more useful.
The cost card for the product could look as follows:
- Direct Materials £600
- Direct Labour £800
- Direct Expenses £100
- Prime Cost £1,500
- Production Overhead £400
- Factory Cost £1,900
- Non-production overhead £500
- Total cost £2,400
The cost card above has categorised costs by type, i.e. direct and indirect costs.
Cost Behaviour and Type
Last year a company made and sold 12,000 units of its product at a total cost of £660,000.
It is expected that demand for the product will increase to 15,000 units next year. What costs should the company budget for next year given this level of activity?
The present unit cost for the company is £660,000 /12,000 = £55.
Is it therefore correct to predict a total cost of £825,000 for next year (15,000 x £55)?
Without more information it is very difficult to answer this question. Unless a management accountant has a solid understanding of how the costs for a business change with levels of activity, it becomes very difficult to make simple predictions of total cost for different levels of activity. Without this understanding, for instance, budgeting becomes impossible.
It is useful to look at the different ways that costs can be categorised and analysed.
An important part of the cost accounting function is matching and identifying costs with individual areas of the business and with individual units of output, whether a product or a service.
This cost exercise allows greater control over costs than if they were kept in total terms (i.e. for the business as a whole) and additionally provides valuable information for performance appraisal and decision-making.
Direct vs. Indirect
These are costs that can be economically traced, identified and matched to the product being produced or service provided,; Indirect costs (also called overheads) are those costs that cannot be are not identified to the product being produced or service provided, they effectively can be thought of as support and infrastructure costs.
For a manufacturing company direct costs would consist of raw materials (direct materials), wage and salary costs of those individuals making the product (direct labour) and (say) royalty and patent costs (direct expenses); for an airline company, direct materials would include the fuel used in the aircraft; direct labour would be the wage costs of the pilot and crew; for a restaurant, the direct materials would include the cost of the food and drink purchases, direct labour would include the wage costs of the chefs/cooks; for a theatre company, direct materials would include the costs of state set and scenery, direct labour would include the fees for the performers, direct expenses would include copyright and royalty fees.
Direct costs are normally divided into direct materials, direct labour and direct expenses. Whilst the first two are straightforward it is not always immediately clear what direct expenses are. The sum of the direct costs for a product or service is often referred to as prime cost.
These are also referred to as overheads; the term overhead itself has assumed a negative connotation in some circles. Indirect costs can be thought of those costs which are incurred to support to an organisations main activities For a manufacturing company indirect costs would consist of glues, screws, consumables, supervisory wages, depreciation and factory rent; for an airline company, indirect costs would include the wage costs of the ground crew, IT and HR costs; for a restaurant, indirect costs would include the costs of condiments, sauces, the wage costs of the waiting and front of house staff; for a theatre company, indirect costs wound include the depreciation of office computers, the wages of the admin staff and the rent payable on the building.
The production overhead cost of £400 represents a share of many different production overheads. Ways of determining how much production overhead should be added to the cost of a product are dealt with in the units on absorption costing and activity-based costing.
Non-production overheads are shared costs that do not directly relate to production of a product. These can include such items as administrative staff salaries, marketing costs and sales team salaries.
A distinction is often made between product costs and period costs. Product costs are those costs incurred as result of actually producing an item, and include both direct and indirect production costs. Period costs are all other costs not included in product costs.
The distinction is important due to the different accounting treatment of each group of costs.
Until an item of finished goods is sold, product costs appear as part of a company’s stock value i.e. they are a balance sheet item. In contrast, period costs are expensed in full to the profit and loss account in the period that they occur and never appear on the balance sheet.
By breaking down costs in this way, it becomes possible to identify the cause of costs within an organisation. From this it becomes possible to develop cost control and cost reduction strategies.
Planning and decision making are two key areas of management, an understanding of what our costs are and how they behave under certain conditions is of crucial importance to the decision making process.
Costs can be seen from the perspective of how they behave, react and fluctuate according to organisational activity; this is a very powerful management tool. In this context costs are either
- Fixed costs
- Stepped fixed costs
- Variable costs
- Semi-variable costs
Fixed costs are also called non-controllable costs and they remain the same whatever the level of activity that an organisation does over a period of time For example, the cost of our car road tax will be the same whether we drive it 200 miles a year or 15,000 miles. The same applies to insurance, purchase price, radios etc.
Other costs that will be largely fixed in nature, despite how much we sell (up to a point) include:
- Wages and salaries – fixed amounts
- Rent and rates
- Depreciation on assets
- Leasing charge
If our business expands or contracts to a certain point then we our fixed costs may alter.
Stepped Fixed Costs
These are fixed over a range of output and then suddenly increase in one big jump. Example: a staffing level of up to 20 people may only require one foreman but, if the staff level is more than 20, an extra foreman will be needed.
Variable costs are also called avoidable/controllable costs and fluctuate according to activity
If we refer to our car example above then a variable cost would be petrol, which will vary according to the amount of mileage that we do. Other examples of variable costs are:
- Wages and salaries – paid on the basis of piecework, hourly rate etc.
- Sales commissions
- Postage and stationery
- Semi-variable costs
We will have some costs, which will not fit the category of fixed or variable. Some of our costs have a fixed and variable element. For example, our telephone costs are made up of a rental element, which is fixed, and the costs of our actual calls, which are variable. Other examples of semi-variable costs are:
- Gas and electricity costs
- Photocopier rentals
The benefits of any decision-making will be improved if we can split our semi-variable costs into the fixed and variable elements – we need not concern ourselves with ‘insignificant’ amounts
High Low Method
One of the more common methods of splitting total costs into its fixed and variable elements is by the use of the High Low Method. The method only uses two data pairs and it is quick and easy to calculate. The method has limitations, for example assuming representative cost behaviour between the two data pairs.
The High Low method is so called because it involves using information on total cost for both the highest and lowest recorded activities, for example consider the two sets of cost data below regarding machine hire whereby costs will be analysed by behaviour and used to predict costs at a level of (say) 6,000 units.
Lowest Activity 3,000 units £18,000
Highest Activity 4,500 units £21,000
At this stage we do not know what the fixed cost part of the above totals is but we do know that it is constant at both levels of activity. From this we know that the difference in total cost between 3,000 and 4,500 units must be due to difference in total variable cost.
It is possible to write:
Unit variable cost = (Difference in cost)/(Difference in activity)
Using the figures above:
Unit Variable cost = (£21,000-£18,000)/(4,500 units – 3,000 units) = £2 per unit
Since we now have a unit variable cost, we can work out the fixed cost:
Total Cost = Fixed Cost + Total Variable Cost
TC = FC + TVC
For 3,000 units we can write:
£18,000 = FC + 3,000 x £2
£18,000 = FC + £6,000
FC = £12,000
We can now put together a simple expression for calculating total machine hire cost at any level of activity (Q):
TC = £12,000 + £2Q
Total cost for 6,000 units can then be calculated as:
TC = £12,000 + £2x 6,000
TC = £24,000