COSTS

1. Introduction
2. Lets talk about costs
3. Costs classification
4. Importance of the time period chosen
5. Lets summarize some basic concepts
6. References

Introduction

Greetings, dear apprentices!

Welcome to this reading activity about costs.

Throughout this document you will learn how to:

Communicate in easy and routine tasks that

require a simple and direct exchange of daily and
technical information in English language.

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 1. Lets talk about costs

How do we define the cost of an input or output product?

1. Through a physical quantity measurement?

2. Through a price measurement?

If you answered both, you are right. For example, if a

production process uses 100 kg of material with a price
of 5 per kg, the material cost is 500. Additionally, if a
production process uses 200 hours of labor time at a rate
of 4 per hour, the labor cost is 800. The analysis of the
separate elements of quantity and price shows the whole
process cost is 1300. In costs, it is necessary to separate
the quantity items and price items to know the physical
flow of inputs and outputs. Sometimes, it is also necessary
to separate quantity and price from the unit price.

Activities as costs
An activity is described as any physical operation that takes place in a company. In a manufacturing
business that provides floor cleaning machines, for example, the activities will include ordering
and assembling parts, delivering the finished products to shops for sale, devolutions for repairing
under warranty, paying employees and checking on the quality of the goods produced. These are all
activities and they represent costs.

Each activity represents an item within the classification of costs

How are activities measured?

Activities are measured to value them or recognize their costs. In a retail store, the number of items
of clothing sold, or the value of clothing sold can determine the high costs of the items or the number
of items to be produced. As a result, an activity can be measured by cost classification or by cost
behavior.

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Whats an output product or service?
An output product or service is that provided by the enterprise or by one of its internal sections. In
the example, the output of a service engineer can be the repair of washing machines.

3. Costs classification

In business, cost classification systems vary according to the sector in which they are used or
implemented. These are the most traditional types of cost classification:

Direct and
indirect
costs
Product
costs and
periodic
costs

Cost
types

Variable and fixed costs

Costs behave in different ways as the level of activity changes. Some costs increase in direct
proportion to the increased level of activity. These are called variable costs. Examples of variable
costs are:

Materials used to manufacture an output unit or to provide a service

Labor costs related to the manufacturing of an output unit or to the production of a service
Commissions paid to a salesperson
Fuel used by a haulage company

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Example of costs of clay related to activity levels:

Example of costs of clay related to activity levels:

Output (number of vases) 100 200 300

Total cost (s) 1,000 2,000 3,000

The total cost increases by 10 for every vase produced, so it is described as variable. While the unit
cost of 10 per vase is constant. The example is now represented in the form of a graph. It shows
the activity level (number of vases produced) on the horizontal axis and total cost on the vertical axis.
The graph reinforces the idea that the total cost is a variable cost. It shows the straight line moving
upwards to the right. The fact that the line is straight, rather than curved, means that the total cost
increases in direct proportion to the increase in activity, that is, total cost increases by 10 for every
unit or output.

Variable cost measured as activity increases

y = 5,6452x 1016,1
Total costs in s

R = 0,40323
2

Activity in units

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Fixed costs
A fixed cost is one which is not affected by changes in the level of activity over a defined period of
time, although it may vary in the longer term. Examples of fixed cost are:

Rent of buildings
Salary paid to supervisors
Advertising in trade journals
Business rates paid to local authorities
Depreciation of machinery

In the example, the pottery company sets out the cost of renting a building to place its kiln (an oven
to ceramic) and other production facilities. The total cost remains fixed at 3,000 irrespective of how
many vases are produced. The unit cost decreases as output increases, because the fixed cost is
extended over more vases.

Example of costs of clay related to activity levels:

Example of costs of clay related to activity levels:

Output (number of vases) 100 200 300

Total cost (s) 1,000 2,000 3,000

Example of unit cost related to pottery rental:

Example of unit cost related to pottery rental:

Output (number of vases) Total cost ()

100 30

200 15

300 10

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 y = 3000
R2 = #N/A
Total costs in s

Activity in units

Step costs
A fixed cost that increases in steps is called a step cost. The cost is fixed over a specific level of
activity but then increases as a further amount of fixed costs is incurred. An example is the cost of
renting storage space, because the rent is unchanged while the output is adjusted into one store, but
as soon as a second store has to be rented the total rental cost increases. In the following graph, the
horizontal axis measures time rather than activity. However, it is also possible to estimate the activity
levels expected over the five-year period.

Step costs for a five year period, with annual increase

Rent

Year

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Semi-variable costs
A semi-variable cost is one which is partly fixed and partly variable with changes in the level of
activity, over a defined period of time. Examples of semi-variable costs are:

Office salaries where there is a core long-term secretarial staff plus employment of temporary
staff when activity levels rise.
Maintenance charges where there is a fixed basic charge per year, plus a variable element
depending on the number of call-outs per year.

In the following example, a telephone sales company sets out the costs incurred in the enterprise.
The company pays a fixed rental of 2,000 per month and a call charge of 1 per telephone sale
call. This total cost has a mixed behavior, which may be described as semi-variable. It has a fixed
component of 2,000 and a variable component of 1 per telephone sale.

Example of telephone rental costs:

Example of costs of clay related to activity levels:

Activity (number of calls) 100 200 300

Cost (s) 2,000 2,200 2,300

In the graph, the fixed cost is shown by the point where the line of the graph meets the vertical axis.
The variable component is shown by the inclination of the graph. The inclination of the graph shows
the total cost increasing by 1 for every extra unit activity. The fixed component of 2,000 is shown
as the point where the line of the graph meets the vertical axis.

Illustration of semi-variable cost

y = 1,375x 1912,5
Total costs in s

R = 0,86429
2

Activity in units

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Direct costs and indirect costs

The costs of a business activity can also be classified as direct or

indirect costs. The definition of direct and indirect costs depends
on the purpose for which the cost will be used. Direct costs are
those which are directly related to a particular object (such as a
product which has been manufactured) or a particular service
(such as a repair job completed) or a particular location (such as
a department within the organization).

Indirect costs are spread over a number of identifiable units of

the business, such as products or services or departments, for
which costs are to be determined. Indirect costs are also called
overhead costs; these are costs which cannot be identified
directly with products or services.

Product costs and period costs

Another way of looking at the cost of an output unit is to distinguish

product costs from period costs. Product costs are those
which are identified with goods or services intended for sale to
customers. These costs belong to the products and stay with
them until they are sold. If goods remain unsold or uncompleted,
then the product costs stay with the unsold or uncompleted goods
in the inventory (stock).

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Product costs include direct and indirect costs of production. In the example, the statement of product
cost includes direct and indirect costs:

Statement of product cost

Direct materials xxx
Direct labour xxx
Other direct costs xxx
Prime cost xxx
Indirect materials xxx
Indirect labour xxx
Other direct costs xxx
Production overhead cost xxx
Total product cost xxx

Take into account that

Period costs are those costs which are treated as expenses of the period and are not
registered as part of the inventory (stock) value.
Prime Cost is the total of direct materials, direct labor and other direct costs.
Production overhead cost comprises indirect materials, indirect labor, and other indirect
costs of production.

Example of product and period costs in a

manufacturing business
In a manufacturing organization, all manufacturing costs are regarded as product costs. These
include the direct and indirect costs of manufacturing, and costs incurred beyond the completion of
manufacture (period costs), such as the costs of administration and selling. The valuation of unsold
inventory (stock) is based on product cost.

Here an example is shown:

A toy manufacturer produces hand-crafted rocking horses. During one week, six rocking horses are
completed. These are the costs:

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 The direct materials cost of wood and leather materials
amount to 180 per horse.

The indirect materials cost of glue and paint amount to
20 per horse.

The direct labor cost for craft working is 150 per horse.

The indirect labor cost of handling within the production
department is 50 per horse.

Advertising amount to 1,200 per week.

Statement of costs Units Cost per uni tTotal

Direct materials: wood & leather 6 180 1080

Product Indirect materials: glue & paint 6 20 120

cost
Direct labour: craft work 6 150 900

Indirect labour: handling 6 50 300

Period cost Advertising 1200

Five completed rocking horses were sold for 1,000 each. At the beginning of the week, there were
none in inventory. Let us take a look at the following chart:

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The calculation of profit would be:

Sales: 5 completed rocking horses 5000
Direct materials 1080

Indirect materials 120

Direct labour 900

Product
cost Indirect labour 300
2400
Less unsold inventory (stock), (400)
1 x (180 + 20 + 150 + 50)

Product cost of 5 horses sold (2000)

Period cost Advertising (1200)

1800

4. Importance of the time period chosen

Costs are related to the time of period selected. In manufacturing picnic tables, the cost of the plastic
frame and the table top are variable costs, as is the labor cost of assembly. The annual rent of the
warehouse where the tables are assembled is a fixed cost for the year, but will increase in steps (a
step cost) over a period of several years if there is a rent review each year.

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5. Lets summarize some basic concepts

Lets summarize some basic concepts

Fixed costs do not vary whatever the level of activity is.

Fixed costs that increase in steps are called step costs.

Direct costs are those which are directly related to a
particular object or service.
Indirect costs are those which are not directly related to
a particular object, service or department of a business.

Product costs are associated with goods or services

purchased or produced for sale to customers.
Period costs are those which are treated as expenses in the
period in which they are incurred.
Prime cost is the total of direct materials, direct labor and
other direct costs.
Production overhead costs comprise indirect material,
indirect labor and other indirect costs of production.

Now, let us do the activities in the document called Self-assessment

activities on cost and inventory cost

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6. References

Weetman, P. (2006). Classification of costs. In Financial and Management Accounting (pp.

448-458). Pearson Education Limited, London: Prentice Hall.

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