What’s it all about?
The basic terminology and concepts that you will need to know to be able to do any Management Accounting. Most of them also crop up in Financial Accounting and in general discussion of business. You’ll need to know this stuff even if you never do any accounting yourself but employ others to do it for you.
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The importance of understanding accounting terminology.
What you should be able to do.
Explain the differences between direct and indirect costs.
Explain the differences between variable costs, fixed costs and stepped fixed costs.
Separate the fixed and variable costs from a semi–variable cost.
Write a standard cost schedule.
We are all probably familiar with assembly instructions – a good way for us to think about Direct and Indirect costs.
Anything that is needed to physically make the table is a Direct Cost. So basically, if you can kick it, it is Direct.
Direct Materials – that’s the top and the legs. You might also say the screws, but see Direct Expenses in a moment.
Direct Labour – yes you can kick the time taken to put it together. If it hadn’t been put together, it wouldn’t be a table, just a pile of bits on the floor.
Direct Expenses – not one you will see in every question, they tend to be the things in the product that are too awkward to measure separately or not valuable enough to spend the time on counting every time. Typical examples would be the screws and varnish on the table top. You are never going to use more than one top or four legs, but you might use a different number of screws or a slightly different amount of varnish.
These three together make our total Variable cost of a table.
- Direct Materials (DM)
- Direct Labour (DL)
- Direct Expenses(DE)
Indirect Costs – anything that isn’t physically required to make the table. These are all the costs you incur to be able to make the table – e.g. your tools, the room where you do it, the supervisor, the lighting. You need them, will spend money on them, but they are not ‘in’ the table.
So we have seen that the three categories of Direct Cost make up our total Variable Cost – so each is in itself a Variable Cost. But what do we mean by Variable Cost?
There are loads of different definitions, but I think mine is the best.
“A cost which in total varies with the level of output, within a range.”
The key points:
‘in total’, ‘varies with output’ ‘within a range’.
- A table top is going to be the same price individually every time – it is not the price of the table top that varies but the total amount we pay for table tops.
- The more we buy, the more we spend (buy fewer and the total cost goes down) and this change is by the amount a table top costs.
- If we buy loads and loads we are going to expect a discount – that’s the ‘within a range’ bit. the cost isn’t going to change within the range of units up until the point where we are going to get a discount.
- Note the emphasis on ‘total’. There are things that vary in price regularly. We are all familiar with petrol prices at the pump changing every few days. This is not ‘variable’ as we mean it in Management Accounting terms.
So what about the Indirect Costs?
Well some might vary – e.g. the electricity used in making the tables as the more tables we make the more electricity we use (we will come back to this issue later), but the majority don’t change (sort of).
These are usually called Fixed Costs or Overheads and pretty much interchangeably.
“A cost which DOESN’T in total vary with the level of output, within a range.”
If you make tables in a room you are renting, you have a rent cost every day. Make 1 table the rent is the same as if you make 10 tables on a day or no tables at all. It is not changing with the ‘level of output’.
It doesn’t mean that it will never change. Your rent might go up for example. But it is not changing with the number of tables. But now we need to consider the ‘within a range’ bit.
There will come a point when you want to make more tables than the space in your room allows. To make more you are going to have to get another room – a bigger one or a second one – now your total rent will go up.
Let’s look at how total costs are affected by production then.
Here’s the costs of making one unit of our product.
|Direct Material per unit||£ 10.00|
|Direct Labour per unit||£ 8.00|
|Direct Expenses per unit||£ 2.00|
|Total Direct cost per unit||£ 20.00|
And let’s say it costs £500 per week to rent our room where we make the product.
We can see then that making one unit in a week will have a variable cost of £20 AND we will have to pay £500 for the room for the week.
Breaking it down, the variable costs for different levels of output will be as in the table below. Note how the total varies with output, the cost of each table stays the same.
(Sorry about using pdfs posted into the blog, but Excel is a nightmare to use in WordPress)
So, that’s the basics, the most important concepts. All covered again, in different voices, in the videos below. If you want to play with the Excel spreadsheet that was used in the example above, you can access it here: Excel spreadsheet for variable and fixed cost graphs
Using the information to calculate costs.
We use a standard layout for the calculations (it’s not that you have to, it’s just easier to understand if we tend to do the same thing).
When doing questions you will probably not refer to the prime cost as the prime cost, I’ve only clarified it here in case you come across the term somewhere else.
Don’t worry about the Overheads, we will cover them shortly. Just for now remember that the fixed costs we have been talking about so far are the Factory overheads.
We will probably do calculations using the above format where we also have sales figures. In that case, Sales -Prime Cost = Gross Profit. And, Gross Profit – the three overheads = Net Profit.
What else do we need to know?
Stepped Fixed Cost.
Thinking back to our previous example, we said we could make units in a room costing us £500 to rent. there will be a limit to how many we can do in that room in a week (that’s the ‘within a range’ bit of our definition).
Say we can do 100 in a week in that room. If we want to make 101 in a week, we are going to need a bigger room or another room. Our fixed cost will then go up. It will go up again in the future when we reach the capacity of that extra space and have to get and even bigger room (or a third room).
This will give us a Fixed Costs Graph with a series of horizontal lines at different levels of production. the graph looks like as series of steps.
I’ve assumed here that we can make up to 30 units with a fixed cost of £500 and that every increase of up to 30 costs and extra £500 fixed costs.
This four-minute video will explain it for you too. This chap (American) calls them Stepped Variable instead of Stepped Fixed (he is American), but the explanation is good.
This is the term for a situation where the total cost changes with output, but we don’t know how much of the total cost is caused by the variable cost element and how much is caused by the fixed cost element.
It’s as if we only have the upper total cost line as in the graph above.
There is a technique for working out how much is variable and how much is fixed . It’s called ‘separating a semi-variable cost’ and we will see how to do this simple technique now.
(There is another method – the High Low Method – which we will look at elsewhere on this site. By the way, I don’t like it).
Let’s use the information we used in the graphs above and pretend we don’t know what the variable cost per unit is nor do we know what the fixed costs are.
We would look for two sets of costs, ideally close together in time. Let’s pretend that the two of the total costs given are actually for two months.
January 60 tables with total cost of £1,700
February 70 tables with total cost of £1,900
Because fixed costs don’t change, any change in the total has to be caused by the increase in units made. So the increase in total cost of £200 is caused by an increase in units made of 10.
It’s nice and easy to see that £200/10 = a variable cost of £20 per table.
Now we need to work out the fixed costs. Remembering that
total cost = total variable costs + fixed costs
we can see that the total cost of £1,700 for January’s 60 tables is made up of 60 tables @ £20 each + the fixed costs. So, £1,700 = £1,200 + fixed costs. Obvious what it is here, but the method to calculate is £1,700 – £1,200 = £500. That’s total cost – total variable = fixed.
We were expecting £500 as we already knew what the numbers were, but, to prove you know what you are doing, work out the fixed costs from the February costs and units, you know that the variable cost is £20 per unit.
In a test you should calculate the fixed costs from both sets of data to make sure you get the same answer. If you just do one, you might make a mistake and you wouldn’t know.
The videos below will have other examples.
Where would we use this technique? When we have bills which include a fixed cost element, but we don’t know what it is and we want to make a prediction of costs in the future at different levels of production.
Photocopying bills are a common example. A company may pay a lease to have the copier (the fixed cost element) and a charge per page printed (the variable cost element).
How do we know it is a semi-variable cost in the first place and not just a variable cost?
If it were just a fixed cost, it would be unlikely to change for a small increase in units. It’s possible that we were at the edge of a step change, but unlikely. If it were just a variable cost, then dividing the total cost by the number of units would give you the same cost per unit. try it with the numbers we used above. You’ll see they are not the same, therefore there has to be some fixed cost in there somewhere.
You may come across these, they are used elsewhere in specific situations, this is just to make you aware of them.
Period Cost/Product Cost.
Usually considered at the same time.
Product costs are those included in the product themselves (like the direct materials, labour, expenses we’ve talked about and the factory overhead sometimes) – they are in the value of the stock. This is discussed on another page.
Period costs are costs incurred (we’ve spent money on) but are not in the product value. so they are usually costs associated with selling the product or administration of the business. This is dealt with on the Overheads page.
Expired Cost/Unexpired Cost.
I haven’t come across this much, but just in case…
If you spend money say on a raw material and haven’t used it all… the stuff used is the expired cost, the stuff you haven’t used is the unexpired cost.
Check your understanding of the topic with this quick multiple choice quiz.
(Remember, videos like these that are produced to cover whole topics may include material that isn’t relevant to your own exam at your institution. don’t get hung up on it)
Somebody else who uses tables as their example. A review of variable and fixed costs including relevant range.
More on Variable and Fixed costs including an explanation of Stepped Fixed Costs plus comments on the Relevant Range.
Another video explaining the difference between Fixed and Variable costs.
I’ll post stuff here if I find anything important, otherwise keep an eye on the Facebook page for posts relevant to this topic. It tends not to be a subject itself because it is the building blocks, but it is involved in most issues in some way.
How Factory overheads (a form of Fixed Cost) can increase over time as you switch from people to equipment.
Costs shift from Direct Labour to Factory Overhead as you buy equipment rather than employ staff. A possible consequence though is redundancy of equipment. Usually people can be retrained as your requirements change. Equipment cannot always be repurposed. Think of the expensive electronics you have lying around the house that you don’t use.
Might happen to me too
An example of a semi-variable cost – water bills.
An example from Canada applied to water supply. Note how the fixed costs are loaded on to those most likely to use the most water (a good idea) rather than being equal for all customers.
Your water bill is going to have a fixed cost associated with the size of your supply and a variable cost charged at the amount you use. No discounts for big users which strikes me as a good idea if you are trying to save water.
Costs per mile.
Each company/industry will have specific ways of monitoring costs depending upon the anture of their business. If you are in road haulage it will be costs per mile. the marginal cost is the variable cost of driving per mile and note how this is made up of principally divers’ wages and fuel.
“ATRI’s report, An Analysis of the Operational Costs of Trucking, found that the average marginal cost per mile in 2014 was $1.70 compared with $1.68 in 2013. This comes despite decreasing fuel costs in the same period of time.”
How costs are becoming less variable and more fixed.
Over time there has been a transition from Variable Costs (Labour here) to Fixed Costs (allocated per machine hour). The trend continues. This reduces Variable Costs as a percentage of total costs, but to a certain extent makes companies less adaptable if they tie up vast sums in capital equipment.
Possible Written Questions.
(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.
You are unlikely to get a significant written question on these topics as they are the basic building blocks of the rest of your studies of management accounting.
You might be asked to “distinguish between” different types of cost or to give brief definitions, but expect more to have multiple choice type questions (see the Quiz above) or short questions. I think it unlikely that you would have a long written question as this is all so basic.