💰 Costs and Cost Behaviour: Understanding the Engine of the Business (AS Level 9706)

Welcome to the essential world of Cost and Management Accounting! This chapter, 2.1 Costs and cost behaviour, is crucial because it teaches you how to look inside a business and understand where every penny is being spent. Why is this important? Because knowing your costs is the key to setting profitable prices, managing resources, and making smart decisions (like whether to expand or cut back).

Don't worry if this seems tricky at first. We will break down costs using simple classifications based on two main ideas: traceability (can we link the cost directly to the product?) and behaviour (how does the cost change when we make more or fewer products?).

1. Classification of Costs by Traceability: Direct vs. Indirect

When you classify costs by traceability, you are asking: Can this cost be directly and easily measured against a specific product or service?

a) Direct Costs (Prime Cost)

Direct costs are expenses that can be directly identified and attributed to the specific output (product or service). If you stop making the product, these costs immediately disappear.

  • Direct Material: Raw materials that form a physical part of the finished product.
    Example: The flour and sugar in a loaf of bread; the steel frame in a bicycle.
  • Direct Labour: Wages paid to employees who are physically involved in converting the raw material into the finished product.
    Example: The salary of the assembly line worker; the baker’s wages.
  • Direct Expenses: Expenses (other than material or labour) incurred specifically for a product or service. These are rare but important.
    Example: Hiring specialized machinery just for one specific job; royalties paid per unit produced.

The sum of all direct costs is known as the Prime Cost.

\( \text{Prime Cost} = \text{Direct Material} + \text{Direct Labour} + \text{Direct Expenses} \)

b) Indirect Costs (Overheads)

Indirect costs, also called overheads, are incurred for the general operation of the business and cannot be traced easily to a specific product unit.

Analogy: Think of a pizza restaurant. The dough, tomato sauce, and chef’s wages are Direct Costs. The rent for the building, the manager’s salary, and the electricity for the lights are Overheads. They are necessary, but they support *all* the pizzas, not just one.

  • Indirect Material: Materials used that are either too small to track (e.g., glue, oil for machinery) or support the whole factory (e.g., cleaning supplies).
  • Indirect Labour: Wages paid to employees who do not directly make the product but support the production process.
    Example: Supervisors, security guards, maintenance staff.
  • Indirect Expenses: General running costs.
    Example: Factory rent, insurance, depreciation of machinery, electricity (factory power).

Total Cost of Production is calculated as:

\( \text{Total Cost} = \text{Prime Cost} + \text{Overheads} \)

Quick Review: Traceability

The goal of classifying costs this way is to calculate the cost unit (the cost of making one item).

Key Takeaway: Direct costs are product-specific. Indirect costs are factory/business-specific.

2. Classification of Costs by Behaviour

When you classify costs by behaviour, you are asking: How does the total amount of this cost react to changes in the level of production or activity?

Understanding cost behaviour is crucial for management decision-making, particularly in budgeting and break-even analysis.

a) Fixed Costs (FC)

Fixed costs remain constant in total regardless of the volume of production, within a relevant range of activity.

  • Key Feature: Total FC stays the same (e.g., $10,000 per month).
  • Per Unit Feature: FC per unit decreases as production increases. (If rent is $1,000, and you make 100 units, cost per unit is $10. If you make 1,000 units, cost per unit is $1.)
  • Example: Rent, insurance premiums, executive salaries, depreciation (straight-line method).
b) Variable Costs (VC)

Variable costs change in total in direct proportion to the volume of activity or output.

  • Key Feature: Total VC changes proportionally with output.
  • Per Unit Feature: VC per unit remains constant. (If material costs $5 per unit, it always costs $5 per unit, regardless of how many units you make.)
  • Example: Direct materials, direct labour, sales commissions, packaging costs.

Remember the trick! Focus on the definition of the cost in total first, then consider the cost per unit.

Memory Aid: Variable costs Vary (in total). Fixed costs are Firm (in total).

c) Semi-Variable Costs (Mixed Costs)

These costs have both a fixed component and a variable component.

  • Example: Electricity or utility bills. You pay a fixed connection fee (standing charge) every month, plus a variable amount based on how much you consume (usage).
d) Stepped Costs (Step-Fixed Costs)

These costs remain fixed for a given level of activity but jump to a new fixed level once that activity level is exceeded.

  • Example: A factory needs one supervisor for every 10 workers. If activity is 1–10 workers, one supervisor salary (fixed) is paid. If activity is 11–20 workers, a second supervisor is hired, and the cost jumps to a higher fixed amount.
Did You Know? The Relevant Range

Fixed costs are only 'fixed' within the relevant range. This is the normal operating capacity of the business. If production exceeds maximum capacity, the business might need to buy new machinery or rent a new building, causing fixed costs to jump dramatically (acting like a stepped cost).

3. Accounting for Materials (Inventory Valuation)

Materials (inventory) are a significant cost. When identical inventory items are purchased at different prices over time, management needs a method to decide which price to assign to the items sold (Cost of Sales) and which price to assign to the remaining items (Closing Inventory).

The syllabus requires you to understand First In, First Out (FIFO) and Weighted Average Cost (AVCO) using both perpetual and periodic inventory systems.

a) First In, First Out (FIFO)

This method assumes that the oldest inventory purchased is the first inventory sold.

  • In practice: This usually matches the physical flow of goods (especially perishable goods like food).
  • Effect on Accounts: In a period of rising prices (inflation):
    • Cost of Sales is lower (using older, cheaper costs).
    • Closing Inventory value is higher (using newer, more expensive costs).
    • Result: Higher reported profit.
b) Weighted Average Cost (AVCO)

This method calculates a new average cost every time a new purchase is made (Perpetual AVCO) or calculates one average cost for the entire period (Periodic AVCO).

The main principle is to smooth out price fluctuations.

i) Periodic AVCO

An average cost is calculated only at the end of the accounting period based on total materials available.

$$ \text{Average Cost per Unit} = \frac{\text{Total Cost of Opening Inventory} + \text{Total Cost of Purchases}}{\text{Total Units in Opening Inventory} + \text{Total Units Purchased}} $$

This single cost is then applied to all units sold and all units remaining in closing inventory.

ii) Perpetual AVCO

A new weighted average cost is calculated immediately after every purchase. This cost is then used for the next issue (sale or use in production).

$$ \text{New Average Cost per Unit} = \frac{\text{Total Cost of Remaining Stock} + \text{Total Cost of New Purchase}}{\text{Total Units Remaining} + \text{Total Units Purchased}} $$

c) Just-In-Time (JIT) Management of Inventory

JIT is a philosophy focused on eliminating waste by ensuring materials are only received exactly when they are needed in the production process.

  • Principle 1: Zero Inventory: The ideal is to hold no inventory, thus reducing storage costs, obsolescence risk, and capital tied up in stock.
  • Principle 2: Efficiency: JIT demands highly efficient production and strong relationships with reliable suppliers, as there is no buffer stock to cover delays.
  • Implication for Costing: While JIT is an operational strategy, it dramatically reduces indirect costs related to storage (e.g., warehouse rent, insurance) and can highlight inefficiencies in production flow.
Common Mistake Alert!

When calculating AVCO or FIFO, ensure you correctly distinguish between total cost and unit cost. If a question asks for the value of closing inventory, you must multiply the number of units by the relevant cost per unit.

4. Accounting for Labour Costs

Labour costs are recorded based on the wages paid to workers. As covered in Section 1, the crucial step is classifying this expenditure correctly:

a) Direct Labour

Wages paid to workers whose time can be traced directly to the product.

Example: Production line staff paid based on hours worked on a specific batch.

b) Indirect Labour

Wages paid to support staff (cleaners, supervisors, security). These are treated as overheads.

The total labour cost calculation must account for various components like basic wages, overtime, bonuses, and mandatory deductions (which are often ignored in basic AS level costing calculations unless specified).

Final Summary and Application

By classifying costs by both traceability (Direct/Indirect) and behaviour (Fixed/Variable), management obtains the critical data needed for:

  1. Product Costing: Calculating the total manufacturing cost of one unit.
  2. Pricing: Setting a selling price that covers all costs and achieves a target profit.
  3. Decision Making: Determining the impact of volume changes on profit (used in Marginal Costing and Break-Even Analysis in Chapter 2.2).