3.2. Costs and Revenues

The graph shows that the cost is constant for all levels of activity. However, it is important to note that this is only true for the relevant range of activity. Consider the behaviour of the rent cost. Within the relevant range it is possible to expand activity without needing extra premises and therefore the rent cost remains constant.

Variable Cost

A variable cost is a cost that varies with a measure of activity. Examples of variable cost are direct material, direct labour and variable overheads.

A linear variable cost is illustrated by a straight line through the origin, which means that the cost is nil at zero activity level. When activity increases, the total variable cost increases in direct proportion. For example, if activity goes up by 10% then the total variable cost also increases by 10% as long as the activity level is still within the relevant range.

The gradient of the line will depend on the amount of variable cost per unit. A higher variable cost per unit will result in a steeper line.

Semi-variable cost

A semi-variable cost is also referred to as a semi-fixed or mixed cost. It is a ‘cost containing both fixed and variable components and thus partly affected by a change in the level of activity’.

Examples of semi-variable costs are gas and electricity. Both of these expenditures consist of a fixed amount payable for the period regardless of the level of use, with a further variable amount which is related to the consumption of gas or electricity.

Alternatively, a semi-variable cost behaviour pattern might look like this:

Calculate the variable cost per unit and total fixed cost

Task 2: The following data relate to the overhead costs of a commercial laundry for the latest two periods

A formula that could be used to estimate the overhead costs for a forthcoming period is: Overhead cost = $a + ($b x number of items laundered)

Determine the value of a and b

Task 3: P Ltd is preparing the production budget for the next period. Based on previous experience, it has found that there is a linear relationship between production volume and production costs. The following cost information has been collected in connection with production:

What would be the production cost for a production volume of 2700 units?

Task 4: The following data have been collected for four types of cost types, W, X, Y and Z at two activity levels:

Explanations

• Direct Materials: this is the material that actually becomes part of the finished product.
• Direct labour: this is the labour cost incurred directly as a result of making one unit of the product.
• Direct expenses: these are expenses caused directly as a result of making one more batch of the product. For example, the company might be required to pay the designer of the product a royalty of $2 for each product produced.
• The three direct costs are summed to derive the prime cost of $22.
• Production overheads are basically the same three costs as for direct cost, but they are identified as indirect costs because they cannot be specifically identified with any particular unit of the product or batch of the product. Indirect costs must be shared out over all the cost objects using a fair and equitable basis.
• Indirect materials: these are those production materials that do not actually become part of the product. This might include the cleaning materials and lubricating oils for the machinery. The machines must be clean and lubricated in order to carry out production, but will probably not be necessary to spend more on these materials in order to manufacture a further batch. This cost is therefore only indirectly related to the production of this batch.
• Indirect Labour: this is the production labour cost which cannot be directly associated with the production of any particular batch. It would include the salaries of supervisors who are overseeing the production of the product as well as all the other products manufactured in the factory.
• Indirect expenses: these are all the other production overheads associated with running the factory, including factory rent and rates, heating and lighting. These indirect costs must be shared out over all of the batches produced in a period.
• Selling and distribution overheads: these include the sales force salaries and commission, the cost of operating delivery vehicles and renting a storage warehouse. These are indirect costs which are not specifically attributable to a particular cost unit.
• Administration overhead: these include the rent on the administrative office building, the depreciation of office equipment, postage and stationery costs. These are also indirect costs which are not specifically attributable to a particular cost unit.

Task 5: Consider whether the following statements are true or false

a) Production labour is a direct cost because it can be directly linked to the units produced

b) A supervisor’s salary is a direct cost if he/she monitors work over a number of different product lines

c) The research and development costs of a specific product are an indirect cost

d) The human resource management department costs are a direct cost

e) Power is an indirect cost in a plant producing a number of different products

Task 6: Calculate the fixed, variable and total costs for trading at Sycks Buckets

Task 7: Assuming all the costs listed below fall into the category of being either fixed or variable and either indirect or direct, indicate which two categories each belongs to.