Fixed costs, variable costs, direct costs and indirect cost

Cost accounting is the accounting function concerned with calculating costs
Cost is an amount that has to be paid or given up in order to get something
In business costs are expressed in monetary terms
In this discussion costs include:
1. 1. Labour costs
  2. Raw material costs
  3. Overhead costs among other things
In order to make various decisions for example setting the price of products or budgeting
It is important to know and understand the nature of costs involved
This involves classifying costs
There are two basic methods of classifying costs:
Grouping costs by type i.e Direct and Indirect costs
Grouping costs by their behavior i.e. Fixed and Variable costs
While there are other more sophisticated ways of classifying costs the Ordinary Level student should only concern themselves about these

Here a cost is examined with consideration as to whether or not they are associated with the actual production of the product or not
Direct Costs- are expenses that can be traced directly to (or identified with) a specific cost center or cost object such as a department, process, or product
Examples include the cost of raw materials used in production for example sugar and flour to a baker you can touch and taste both in the final product
Indirect costs-refers to those production costs that cannot be attributed or identified to a specific cost center or cost object such as a department, process, or product
These are also known as production overheads
Examples include: factory lighting expenses, lubrication etc you cannot see these for example in a loaf of bread
Indirect costs are jointly shared while direct costs can be traced and are caused by specific product

Classification of costs by behavior examines the impact of changes in output/level of production on a given cost
Accordingly there are:
1. Fixed costs and
2. Indirect costs

Fixed Cost Curve

Fixed costs- these are costs that remain unchanged when the level of production changes at least in the short run
These costs remain constant irrespective of the level of production
Examples include rent, interest payments, depreciation, insurance, salaries of supervisors
If a baker pays rent for example it is unlikely to change due to the number of loaves of bread he makes

Variable costs curve

Variable costs- these are costs change in response to changes in the level of production/output
Usually they vary directly with output/level of activity
If more units are produced the costs increase
Examples of such costs include:
cost of raw materials, royalties and patents etc
It is important to note that fixed costs are fixed in the short run
Short run – a indeterminate period of time that is only long enough to allow some factors to be changed but not others e.g. a month, year etc
For example if the baker’s level of production exceeds a certain level he might need to rent additional space in order to house new equipment etc
This would mean rent which is normally fixed would increase (change)
But it would normally take the baker at least a month to acquire the additional space
Hence the short run period in this example would be one month

To access more topics go to the O Level Business Notes

Fixed costs, variable costs, direct costs and indirect cost- Updated 2024