Types of Costs (Cambridge (CIE) A Level Accounting): Revision Note

Direct & indirect costs

How are material and labour costs accounted for?

• Material and labour costs are accounted so they can be included in the cost of production

• Accounting for material costs involves:

  • Recording purchases and usage of inventory

  • Allocating direct material costs to production costs

  • Allocating indirect material costs to overheads

• Accounting for labour costs involves: 

  • Recording wages 

  • Allocating direct labour costs to production 

  • Allocating indirect labour costs to overheads

What is a direct cost?

• Direct costs are those that can be specifically associated with the manufacture of one unit of production

• Examples include:

  • Direct materials 

  • Direct labour 

  • Other direct costs

    • E.g. royalties

How are direct costs calculated?

• Direct material and labour costs are calculated by multiplying the rate per unit by the quantity used 

  • $\mathrm{Direct}\mathrm{materials}\mathrm{cost}=\mathrm{Cost}\mathrm{per}\mathrm{unit}\times \mathrm{Units}\mathrm{used}$

    • Unit could be kg, litres, metres etc.

  • $\mathrm{Direct}\mathrm{labour}\mathrm{cost}=\mathrm{Cost}\mathrm{per}\mathrm{hour}\times \mathrm{Hours}\mathrm{used}$

• Other direct costs are also included in direct costs 

  • E.g. royalties costed $200, so include $200 in direct costs 

What are indirect costs?

• Indirect costs are those that cannot economically be specifically associated with the manufacture of one unit of production

• Indirect costs are also known as overheads and can be classified as

  • production overheads

    • Production overheads are included in production costs 

  • administrative overheads

  • or sales and distribution overheads 

    • Administrative overheads and sales and distribution overheads are included in total costs but not production costs 

• Examples include:

  • Depreciation of machinery 

  • Electricity 

  • Rent of factory 

  • Maintenance costs

How are indirect costs calculated?

• Indirect costs are often divided into a factory portion and an administrative portion using specified allocation percentages

  • The factory portion is included in production cost

  • While the administrative portion is not included in production cost

• Indirect cost included in production cost = Indirect cost × Allocation percentage

Fixed, variable, semi-variable & stepped costs

What are fixed costs?

• Fixed costs are costs that remain unchanged within a certain level of activity/output

  • E.g. depreciation of machinery  

What are variable costs?

• Variable costs are costs that are constant per unit

• Total variable cost increases as output increases

  • E.g. direct material costs

How can fixed costs and variable costs be calculated? 

• Use the high-low method: 

• STEP 1

  Identify periods with higher and lower activity level 

• STEP 2

  Calculate the variable cost per unit

  $\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}=\frac{\left(\mathrm{Higher}\mathrm{activity}\mathrm{total}\mathrm{cost}-\mathrm{Lower}\mathrm{activity}\mathrm{total}\mathrm{cost}\right)}{\left(\mathrm{Higher}\mathrm{output}\mathrm{units}-\mathrm{Lower}\mathrm{output}\mathrm{units}\right)}$

• STEP 3

  Calculate the fixed cost

  $\mathrm{Fixed}\mathrm{cost}=\mathrm{Higher}\mathrm{activity}\mathrm{total}\mathrm{cost}-\left(\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}\mathrm{x}\mathrm{Higher}\mathrm{output}\mathrm{units}\right)$

  OR

  $\mathrm{Fixed}\mathrm{cost}=\mathrm{Lower}\mathrm{activity}\mathrm{total}\mathrm{cost}-\left(\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}\mathrm{x}\mathrm{Lower}\mathrm{output}\mathrm{units}\right)$

What are semi-variable costs?

• Semi-variable costs are costs that are partly fixed and partly affected by production level

• For example, electricity is a semi-variable cost

  • Fixed: Standing charge 

  • Variable: Cost per unit of electricity used 

How can semi-variable costs be calculated? 

• Use the high-low method: 

• STEP 1
  Identify periods with higher and lower activity level

• STEP 2
  Find the variable cost per unit

  • $\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}=\frac{\left(\mathrm{Higher}\mathrm{activity}\mathrm{total}\mathrm{cost}-\mathrm{Lower}\mathrm{activity}\mathrm{total}\mathrm{cost}\right)}{\left(\mathrm{Higher}\mathrm{output}\mathrm{units}-\mathrm{Lower}\mathrm{output}\mathrm{units}\right)}$

• STEP 3
  Find the fixed costs

  • $\mathrm{Fixed}\mathrm{cost}=\mathrm{Higher}\mathrm{activity}\mathrm{total}\mathrm{cost}-\left(\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}\times \mathrm{Higher}\mathrm{output}\mathrm{units}\right)$

  • Or $\mathrm{Fixed}\mathrm{cost}=\mathrm{Lower}\mathrm{activity}\mathrm{total}\mathrm{cost}-\left(\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}\times \mathrm{Lower}\mathrm{output}\mathrm{units}\right)$

• STEP 4
  Write it as a formula

  • $\mathrm{Semi}-\mathrm{variable}\mathrm{cost}=\mathrm{Fixed}\mathrm{costs}+\left(\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}\times \mathrm{Number}\mathrm{of}\mathrm{units}\right)$

What are stepped costs?

• Stepped costs are fixed for a given level of activity and increases when that level is exceeded

• For example, factory rent is a stepped cost 

  • Rent is fixed for one space but increases when an additional space is rented 

How can stepped costs be calculated?

• From identifying ranges: 

• STEP 1

  Identify the ranges and the relevant costs for these ranges

• STEP 2

  Add the relevant costs together