South African Grade 11 and 12 Accounting: Manufacturing Accounts - Different types of costs

Different types of costs

When we look at the costs of a manufacturing business, we have a number of different ways of breaking them up. The first way breaks up all the expenses of the business, while the other two ways look at production costs in particular.

Production, Selling and Distribution, and Administration Costs

The first way that we will break up costs lets us break up all the expenses in the business into three different types of costs.

Production costs are any costs that have to do with production. They can be costs that are directly related to production, like the cost of raw materials, or they could be costs that are only indirectly related, like the rent for the factory where the goods are made. In tests and exams, these costs will often have "Factory" in the name, such as "Factory wages" or "Rent: Factory".

Selling and Distribution costs are any costs that have to do with either selling goods or with distributing the goods. This includes expenses such as advertising, wages of salesmen, or the rent of the shop. It also includes Bad Debts. In tests and exams, these costs will often have "Shop" in the name, such as "Insurance: Shop".

Administration costs are any costs to do with the administration of the business. For example, the salary of the business's accountant would be an administration cost. In tests and exams, administration costs will usually have "Office" in the name, such as "Salaries: Office Staff" or "Depreciation: Office Equipment".

In the manufacturing section, we are most interested in production costs, and for the remainder of this post we will ignore the others.

Direct and Indirect Costs

Note that these categories of costs only apply to Production Costs.

Direct Costs are costs that are directly applicable to the goods being produced. For example, the cost of the labourers who actually assemble each unit (Direct Labour Cost), or the cost of the materials used to make up each unit (Direct Materials Cost). We consider Direct Labour and Direct Materials Cost to be the only two direct costs. We call their sum "Prime Cost", i.e. Prime cost = direct labour cost + direct materials cost.

Indirect Costs, or Overheads, are all those costs that still form part of production costs, but are not directly applicable to the goods being produced. For example, the insurance of the factory or the wages of the cleaners in the factory.

Fixed, Variable, and Semi-variable Costs

Note that these categories of costs are only applied to Production Costs.

Fixed Costs are costs that are independent of the number of units produced. This means that fixed costs would be the same regardless of whether we produced zero, 100, or 1000 units. Note that this does not mean that fixed costs have to stay the same every month -- it just means that fixed costs have nothing to do with the number of units produced. For example, depreciation is a fixed cost -- it does not depend on the number of units produced, even though it may be different from one period to the next if we calculate it using the diminishing balance method.

Variable Costs are costs that vary according to the number of units produced. This means that variable costs will be zero if no goods are produced, and would be bigger if 100 units were produced, and even bigger if 1000 units were produced. If you do economics, you may be used to quite complicated look curves for variable costs, but in school accounting we assume that variable costs are linear -- in other words, they are directly proportional to the number of goods we produce. This means that if the variable cost to produce 1 unit of stock is R5, the total variable cost to produce 100 units is R500, and the total variable cost to produce 1000 units is R5000.

Semi-variable Costs are costs that have a fixed component and a variable component. For example, in many businesses, electricity would be a variable cost. If we produced no goods at all, the cost wouldn't be zero, because we'd still have to pay for lighting, electric fences, security cameras and so on. However, when we started producing, our machines would use more electricity and so we would have costs that rose as we produced more. In Grade 11 and 12, we usually assume that costs that might be semi-variable in the real world are actually fixed costs -- so electricity would be a fixed cost.

A post on this topic showing the fixed and variable costs on graphs will be put up as well, as well as a post on the maths behind them -- and how we derive the break-even point.