ZIMSEC O Level Business Studies Notes: Business Finance and Accounting: 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. 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

Classification by type

  • 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 by behavior

  • 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

Cost per unit

  • In costing it is important to determine the cost per unit
  • This is the fixed or variable cost per each unit
  • While total variable costs per unit varies the variable cost per unit is fixed

To access more topics go to the O Level Business Notes

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