classification of costs
Profit = income - costs
Profit is a prime objective of most firms. Thus costs are a major factor in determining the overall success of a firm, as measured by its profit. Organisations need to understand their costs if they wish to improve their profit.
Reasons for classifying costs:
1. Output
Classifying costs allows a company to calculate the financial repercussions of changing its level of output. In reality it is impossible to predict the exact change in each and every cost, so general classifications of costs are used to estimate the likely effect of output changes on individual costs.
Fixed costs - costs that do not vary directly with output
Variable costs - costs that vary with the level of output
Total costs - calculated by adding fixed costs and variable costs
2. Product
Classifying costs enables a firm to allocate costs to individual products and so calculate the standard cost of making a given product. This allows the firm to control its efficiency by comparing the costs of production of different products.
Direct costs are those costs that can be related directly to a product or service (e.g. raw materials).
Indirect costs are those costs that cannot be related directly to a product or service (e.g. the managing director's salary).
Opportunity cost
Opp. cost is the next best alternative foregone. Opp. cost can apply to decisions relating to finance, resources and the use of time. Where financial costs are involved, decisions should be taken only if the alternatives are known, since a profitable decision may prevent a more profitable alternative.
Profit is a prime objective of most firms. Thus costs are a major factor in determining the overall success of a firm, as measured by its profit. Organisations need to understand their costs if they wish to improve their profit.
Reasons for classifying costs:
- to assess the impact of changes in output on the costs of production
- to calculate the costs of making a particular product in a multi-product company
1. Output
Classifying costs allows a company to calculate the financial repercussions of changing its level of output. In reality it is impossible to predict the exact change in each and every cost, so general classifications of costs are used to estimate the likely effect of output changes on individual costs.
Fixed costs - costs that do not vary directly with output
Variable costs - costs that vary with the level of output
Total costs - calculated by adding fixed costs and variable costs
2. Product
Classifying costs enables a firm to allocate costs to individual products and so calculate the standard cost of making a given product. This allows the firm to control its efficiency by comparing the costs of production of different products.
Direct costs are those costs that can be related directly to a product or service (e.g. raw materials).
Indirect costs are those costs that cannot be related directly to a product or service (e.g. the managing director's salary).
Opportunity cost
Opp. cost is the next best alternative foregone. Opp. cost can apply to decisions relating to finance, resources and the use of time. Where financial costs are involved, decisions should be taken only if the alternatives are known, since a profitable decision may prevent a more profitable alternative.