How are costs classified?

(Finance, Accounting, Taxes & creative knowledge)

costs are classified

Cost of production:

Although efficient, large –scale production can create economies of scale which help to reduce costs; a business still has to meet the various costs of production. Businesses group these costs under different headings to help analyse and control them. Figure illustrates the typical costs to business.

Typical costs of production these are shared between the different product lines and do not relate to one particular product line. 

*The difference between ….

- Fixed, variable and semi-variable costs.

- Direct and indirect costs

- Average and marginal costs

*Fixed and variable costs:

We can separate the different costs of a business into those that are fixed and those that are variable.

*Fixed costs do not change as output changes:

 Examples include factory and office rent, office salaries (these do not depend on the number of items produced) and insurance premiums, e.g. for business vehicles. These costs will not change whether the factory is working at 100% capacity or whether it is closed.

*variable costs change as output changes:

These costs arise from a business’s production activities, and therefore change as the output level changes.

Example includes the costs of raw materials used to make the products, and piece- work’ wages where employees are paid by the number of number of items they make.

In reality, the distinction between fixed and variable is not always easy to make many costs are semi-variable, containing elements that are fixed and variable. For example, a factory’s power costs may carry a fixed ‘standing charge’ element that must be paid whether or not any power is used, and a (variable) charge per unit of power used.

Key words:

Fixed costs will change over time – insurance premiums go up, staff salaries rise, factory rent increases – but they do not change in the short –term as output changes.

*Direct and indirect costs:

A business’s direct costs are those that can be directly linked to particular product lines. Examples include the costs of running the machinery used to manufacture individual products, And the cost of raw materials used in the product.

Indirect costs are known as overheads. These are shared between the different product lines and do not relate to one particular product line. Examples include the cost of stationery used for all the company’s product and services salaries of office staff who are involved with all the products and the office and factory rent. Managers want to know the cost of making individual products to calculate their profitability so decisions can be made (e.g. about prices). An accountant will therefore apportion (share out) the indirect costs to the different product lines. E.g. sharing factory rent on the amount of floor space used by each product line.

Key Words:

The total costs for a business consist of fixed plus variable costs; they also consist of direct plus indirect costs.

*Average and marginal costs:

Economies of sales create lower unit costs (cost per item made). This average cost of production is found by dividing total output by total cost. The marginal cost of a production is the cost of making that individual product. The marginal cost will not normally be the same as the product’s average cost because of the way fixed costs are distributed.

For Example, if total fixed costs are Rs 3000 and variable costs are Rs 100 per item made:

*Average cost of making one item = 3100/1 = Rs. 3100.

*Average cost of making two item=3200/2 =Rs. 1600.

*Average cost to make three items =3300/3 =Rs.1100.

The marginal cost of the second and third items is, however, only Rs. 100.

Key words:

Managers find this information helpful, e.g. when deciding whether to take on a new order and what price to change for it.