Costs | ICSE Class 10 Commercial Studies Notes

This note covers the fundamental concept of cost in business: what cost means, why costs are classified, the classification of costs by behaviour into fixed, variable and semi-variable costs, the classification of costs by nature into direct and indirect costs, how a semi-variable cost is split into its fixed and variable parts, and the advantages and limits of classifying costs. A short extension at the end shows how the classification is used in a cost sheet and in simple decisions.

What is cost and why does a business classify costs?

Cost is the amount of money a business spends, or commits to spend, in order to produce goods or to provide services.

It includes the price paid for materials, the wages paid to workers, the rent of premises, the electricity bill and many other payments.

Cost is different from expense and from price: cost is what the business gives up, price is what it charges the customer, and profit is what remains when cost is deducted from the revenue earned.

Why a business needs to know its costs

Every business needs to know its costs for three reasons. First, to fix a selling price that covers costs and leaves a profit.

Second, to control spending, because a business that does not measure its costs cannot tell where money is being wasted.

Third, to take decisions such as whether to accept a special order, whether to make a part or buy it, and how many units must be sold before the business stops making a loss.

Why a single total is not enough

Because costs behave in different ways and arise at different stages, a single total figure is not enough.

A manager needs to know which costs will rise when output rises, which will stay the same, and which can be traced to a particular product.

This is why costs are classified, that is, grouped into categories that share a common feature. The two classifications studied here are:

• Classification by behaviour: how a cost changes when the level of activity changes. This gives fixed, variable and semi-variable costs.
• Classification by nature: whether a cost can be traced directly to a product or not. This gives direct and indirect costs.

Definition: cost. The money value of the resources used, or to be used, in producing goods or providing services, including materials, labour and other expenses.

Definition: cost classification. The grouping of costs into categories that share a common feature, such as how they behave when output changes or whether they can be traced to a product.

The level of activity is usually measured by output (units produced), sales (rupees of revenue) or hours worked. In the explanations below, output is used as the measure of activity unless stated otherwise.

How are costs classified on the basis of behaviour?

Classification by behaviour asks one question: if the business produces one more unit, or ten fewer units, what happens to this cost? The answer divides costs into three groups.

Fixed costs

Fixed costs stay the same in total over a range of output and over a period of time. They are also called period costs or capacity costs, because they are incurred to keep the business ready to operate.

Rent of a factory, insurance of the building, salaries of permanent managers and depreciation of machinery on the straight-line method are typical fixed costs.

If a factory makes 1,000 units or 5,000 units in a month, the rent payable is the same.

Variable costs

Variable costs change in total in direct proportion to the level of output. If output doubles, the total variable cost doubles; if output falls by half, the total variable cost falls by half.

Raw materials, direct wages paid per piece, power consumed by machines and packing materials are variable costs.

A shirt factory that uses 2 metres of cloth per shirt will use 2,000 metres for 1,000 shirts and 4,000 metres for 2,000 shirts.

Semi-variable costs

Semi-variable costs, also called mixed costs, have both a fixed part and a variable part. A telephone bill has a fixed monthly rental plus charges for calls made.

An electricity bill for a factory may have a fixed demand charge plus a charge per unit consumed. A salesperson may receive a fixed salary plus a commission on sales.

The fixed part has to be paid even when there is no activity at all; the variable part rises with activity. So the total rises as activity rises, but not in direct proportion.

Definition: fixed cost. A cost that remains constant in total over a range of output and over a period of time, and therefore falls per unit as output rises.

Definition: variable cost. A cost that changes in total in direct proportion to changes in the level of output, and therefore remains constant per unit.

Definition: semi-variable cost. A cost that contains both a fixed element, incurred whatever the level of activity, and a variable element that rises with activity.

How do fixed and variable costs behave per unit?

The most important idea in this topic is that the behaviour of a cost per unit is the opposite of its behaviour in total.

A fixed cost is constant in total but falls per unit as output rises, because the same amount is spread over more units.

A variable cost rises in total but stays the same per unit, because each unit uses the same quantity of the resource.

The bakery illustration

Suppose a small bakery pays rent of ₹20,000 a month, which is a fixed cost, and spends ₹10 on flour, sugar and other materials for each cake, which is a variable cost.

At 1,000 cakes the fixed cost per cake is ₹20 and the variable cost per cake is ₹10, so the total cost per cake is ₹30.

At 2,000 cakes the fixed cost per cake falls to ₹10 while the variable cost per cake stays at ₹10, so the total cost per cake falls to ₹20.

This is why larger output usually brings a lower cost per unit, an effect known as economies of scale arising from the spreading of fixed costs.

Worked example 1. A bakery has fixed costs of ₹20,000 a month and a variable cost of ₹10 per cake. Find the total cost and the cost per cake at 1,000 cakes and at 2,000 cakes.

Answer: At 1,000 cakes, fixed cost = ₹20,000, variable cost = 1,000 × ₹10 = ₹10,000, total cost = ₹30,000, cost per cake = ₹30,000 ÷ 1,000 = ₹30.

At 2,000 cakes, fixed cost = ₹20,000, variable cost = 2,000 × ₹10 = ₹20,000, total cost = ₹40,000, cost per cake = ₹40,000 ÷ 2,000 = ₹20.

The fixed cost per unit fell from ₹20 to ₹10 while the variable cost per unit stayed at ₹10.

The horizontal axis shows output in units and the vertical axis shows cost in rupees. The fixed cost line is horizontal, showing the same total at every output.

The variable cost line starts at the origin and slopes upward in a straight line, showing a constant rise with output.

The total cost line is parallel to the variable cost line but starts above the origin by the amount of the fixed cost. (to draw)

The per-unit view

A second graph is useful for the per-unit view. On it the fixed cost per unit is a downward-sloping curve that never touches the horizontal axis, the variable cost per unit is a horizontal line, and the total cost per unit is a curve that falls and then flattens towards the variable cost per unit. (to draw)

How are costs classified on the basis of nature?

Classification by nature asks a different question: can this cost be traced, easily and accurately, to a particular product, job or department? If yes, it is a direct cost; if no, it is an indirect cost. This classification is also described as the division into direct costs and overheads.

Direct costs

Direct costs are incurred for and can be identified with a specific unit of output.

They usually include direct materials (the wood in a table), direct labour (the wages of the carpenter who makes the table) and direct expenses (the hire of a special machine for a particular job). Together these are called prime cost.

Indirect costs

Indirect costs, also called overheads, are incurred for the business as a whole and cannot be traced to one unit of output.

Factory rent, the supervisor's salary, insurance, lighting of the factory, depreciation of general machinery and the manager's office expenses are indirect costs.

They must be apportioned to products on some reasonable basis, such as floor area for rent or machine hours for power.

Definition: direct cost. A cost that can be identified with, and traced directly to, a particular product, job or department, such as direct materials and direct labour.

Definition: indirect cost. A cost that is incurred for the business as a whole and cannot be traced to a particular product, so it is apportioned as an overhead.

Note: the two classifications are independent. A cost can be direct and variable (cloth in a shirt), direct and fixed (the salary of a supervisor appointed only for one contract), indirect and variable (power for the whole factory) or indirect and fixed (rent of the office).

Do not assume that direct means variable or that indirect means fixed.

What are the advantages and limitations of classifying costs?

Classifying costs is not an end in itself. It is a tool that helps a manager to price, to control and to decide. Like every tool it has strengths and weaknesses, and a good answer states both.

Advantages of cost classification

• It helps in fixing selling prices, because the business knows its total cost per unit at a given output and can add the profit it wants.
• It helps in controlling costs, since each category can be watched and compared with a budget, and a rise in one category can be traced to its cause.
• It separates the effect of output changes from the effect of price changes, making forecasts of cost more reliable.
• It supports decisions such as break-even analysis, make-or-buy and the acceptance of a special order at a lower price.
• It helps in identifying waste, because an unexpected rise in a variable cost per unit points to inefficiency in materials or labour.
• It shows which costs are committed for the long term and which can be reduced quickly when demand falls.

Limitations of cost classification

• The fixed and variable split is not always clear; many costs are semi-variable and must be estimated, so the split is only as good as the estimate.
• Fixed costs are fixed only within a relevant range; a large rise in output may need a new factory and a jump in rent.
• Classification by nature depends on judgement, because a cost that is direct for one product may be indirect for another.
• Apportioning overheads requires a chosen basis, and a different basis gives a different cost per unit for the same product.
• Classification is a tool for understanding, not a substitute for judgement about the market, the customer and the competitor.
• It describes cost behaviour in the past; a sudden change in prices or technology can make the classification out of date.

Note: use the classification, do not worship it. A manager should treat the fixed and variable labels as useful guides within the relevant range, and should re-examine them whenever output, prices or technology change substantially.

What a good answer should contain

When a question asks for the advantages or limitations of classifying costs, each point should name the benefit or drawback and then say what it means in practice. A point such as "helps in control" is weak on its own; "helps in control because each category can be compared with a budget" is complete.

A balanced answer gives the advantages first, then the limitations, and ends with a short judgement on when the classification is most useful.

1. State the benefit or drawback in one clear sentence.
2. Explain how it works in practice, with an example where possible.
3. Give the opposite side, so the answer is balanced.
4. End with a short judgement on the usefulness of the classification.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it. They show how the classification of costs is used in a cost sheet and in simple decisions.

How is a simple cost statement prepared?

A cost statement, also called a cost sheet, arranges costs in a logical order so that the total cost and the profit can be seen.

The usual order begins with direct materials, adds direct labour and direct expenses to reach prime cost, adds factory overheads to reach factory or works cost, adds office and selling overheads to reach total cost, and finally adds profit to reach the selling price.

Order of a cost statement

1. Enter direct materials consumed, adjusting opening and closing stock of materials.
2. Add direct labour, that is, wages paid to workers engaged on the product.
3. Add direct expenses, such as hire of special equipment, to obtain prime cost.
4. Add factory overheads, such as factory rent and power, to obtain works cost.
5. Add office and administration overheads and selling and distribution overheads to obtain total cost.
6. Add the desired profit to obtain the selling price.

Worked example 3. A furniture maker produces 100 chairs in a month. Direct materials cost ₹40,000, direct labour ₹25,000, direct expenses ₹5,000, factory overheads ₹20,000 and office and selling overheads ₹10,000.

Prepare the cost per chair and fix a selling price that gives a profit of 20 per cent on total cost.

Answer: Prime cost = ₹40,000 + ₹25,000 + ₹5,000 = ₹70,000. Works cost = ₹70,000 + ₹20,000 = ₹90,000. Total cost = ₹90,000 + ₹10,000 = ₹1,00,000. Cost per chair = ₹1,00,000 ÷ 100 = ₹1,000.

Profit at 20 per cent = ₹20,000, so total selling price = ₹1,20,000 and selling price per chair = ₹1,200.

What the statement shows

The same statement shows which costs are direct and which are indirect. Materials, labour and direct expenses are direct; factory, office and selling overheads are indirect. It also shows which costs are likely to be fixed and which variable, which helps in forecasting.

How is cost behaviour used to find the break-even point?

The break-even point is the level of sales at which total revenue equals total cost, so the business makes neither profit nor loss. It uses the idea of contribution, which is sales revenue minus variable cost.

Each unit sold contributes its share towards covering the fixed costs; once fixed costs are covered, every further unit adds to profit.

The two standard relationships

The two standard relationships are:

Contribution = Sales − Variable cost

Break-even units = Fixed cost ÷ Contribution per unit

Worked example 4. A trader sells a product at ₹50 per unit. The variable cost is ₹30 per unit and fixed costs are ₹40,000. Find the contribution per unit, the break-even quantity and the profit if 3,000 units are sold.

Answer: Contribution per unit = ₹50 − ₹30 = ₹20. Break-even quantity = ₹40,000 ÷ ₹20 = 2,000 units. At 3,000 units, total contribution = 3,000 × ₹20 = ₹60,000, so profit = ₹60,000 − ₹40,000 = ₹20,000.

The business must sell 2,000 units to cover its fixed costs and makes a profit of ₹20,000 at 3,000 units.

The horizontal axis shows units sold and the vertical axis shows rupees. The fixed cost line is horizontal at ₹40,000. The total cost line starts at ₹40,000 and rises with a slope of ₹30 per unit.

The sales line starts at the origin and rises with a slope of ₹50 per unit.

The two lines cross at 2,000 units and ₹1,00,000, which is the break-even point; the area between them to the right of that point is profit. (to draw)

Why break-even matters

Break-even thinking shows why a business with high fixed costs is riskier: it must sell more units before it earns any profit. It also shows why a low contribution per unit forces a high volume of sales.

Choosing between two courses of action

Suppose a trader can either make a part in its own workshop or buy it from an outside supplier. The classification helps the decision: the direct materials and direct labour of making the part are avoidable if it is bought, while the factory rent is not avoidable in the short run.

The manager should compare the avoidable cost of making with the purchase price, and recommend buying only if the purchase price is lower than the avoidable cost of making.

Worked example 5. A firm makes 1,000 units of a part. Direct materials cost ₹40 per unit, direct labour ₹25 per unit and variable overheads ₹15 per unit. The factory rent of ₹30,000 a month is a fixed cost that will continue whether the part is made or bought. An outside supplier offers the part at ₹90 per unit.

Answer: Avoidable variable cost of making = ₹40 + ₹25 + ₹15 = ₹80 per unit. Total avoidable cost = 1,000 × ₹80 = ₹80,000. Purchase price = 1,000 × ₹90 = ₹90,000.

The fixed rent of ₹30,000 is not avoidable, so it does not change the comparison. Making saves ₹90,000 − ₹80,000 = ₹10,000, so the firm should choose to make the part.

Worked example 6. A firm has fixed costs of ₹50,000, a selling price of ₹40 per unit and a variable cost of ₹25 per unit. A customer offers to buy 2,000 extra units at ₹32 per unit, and the firm has spare capacity so no extra fixed cost is needed. Advise the firm.

Answer: Contribution per unit on the special order = ₹32 − ₹25 = ₹7. Total contribution from the order = 2,000 × ₹7 = ₹14,000.

Because the fixed costs are already covered by normal sales and no extra fixed cost arises, the whole ₹14,000 adds to profit. The firm should accept the order, since the offer price of ₹32 is above the variable cost of ₹25.

What is a semi-variable cost and how is it split?

A semi-variable cost is not a rare exception; many real bills are of this kind.

The fixed part is the charge for being connected or for keeping capacity ready, and the variable part is the charge for actually using the service. To plan and control such a cost, managers separate it into its two parts.

The standard school method is the high-low method, which uses the total cost at the highest and lowest levels of activity.

Steps in the high-low method

1. Identify the highest and the lowest levels of activity and the total semi-variable cost at each level.
2. Subtract the lower total cost from the higher total cost to get the change in cost.
3. Subtract the lower activity from the higher activity to get the change in activity.
4. Divide the change in cost by the change in activity to get the variable cost per unit.
5. Multiply the variable cost per unit by the activity at either level and subtract the result from the total cost at that level to get the fixed part.

Worked example 2. A factory's electricity bill is ₹18,000 in a month when 4,000 units are produced and ₹26,000 in a month when 8,000 units are produced. Split the bill into its fixed and variable parts.

Answer: Change in cost = ₹26,000 − ₹18,000 = ₹8,000. Change in output = 8,000 − 4,000 = 4,000 units. Variable cost per unit = ₹8,000 ÷ 4,000 = ₹2.

At 4,000 units the variable part is 4,000 × ₹2 = ₹8,000, so the fixed part = ₹18,000 − ₹8,000 = ₹10,000.

Check at 8,000 units: 8,000 × ₹2 = ₹16,000, and ₹16,000 + ₹10,000 = ₹26,000, which matches the bill.

Using the split to forecast

Once the split is known, the manager can forecast the bill at any output. At 6,000 units the expected bill is ₹10,000 + (6,000 × ₹2) = ₹22,000. This kind of forecast is the practical reason for studying cost behaviour.

Glossary

• Cost: the money value of the resources used in producing goods or providing services.
• Cost classification: the grouping of costs by a shared feature such as behaviour or nature.
• Fixed cost: a cost that stays constant in total over a range of output.
• Variable cost: a cost that changes in total in direct proportion to output.
• Semi-variable cost: a cost with both a fixed part and a variable part.
• Direct cost: a cost that can be traced to a particular product or job.
• Indirect cost: a cost that cannot be traced to a product and is treated as an overhead.
• Overhead: another name for an indirect cost, apportioned to products on a suitable basis.
• Prime cost: direct materials plus direct labour plus direct expenses.
• Contribution: sales revenue minus variable cost, the amount available to cover fixed costs.
• Break-even point: the level of sales at which total revenue equals total cost.
• High-low method: a method of splitting a semi-variable cost using the highest and lowest activity levels.
• Relevant range: the band of output within which a cost behaves as fixed or variable.

Common errors and misconceptions

• Misconception: A fixed cost is fixed per unit. Correct: A fixed cost is fixed in total; per unit it falls as output rises.
• Misconception: A variable cost rises per unit as output rises. Correct: A variable cost stays constant per unit and rises only in total.
• Misconception: Direct costs are always variable. Correct: A direct cost can be fixed, for example a supervisor hired only for one contract.
• Misconception: Indirect costs are always fixed. Correct: Power for the whole factory is an indirect cost that varies with output.
• Misconception: Every cost is either fixed or variable. Correct: Semi-variable costs, such as a telephone bill with a fixed rental and a charge per call, have both a fixed part and a variable part.
• Misconception: Fixed costs never change. Correct: They stay fixed only within the relevant range; a big rise in output may raise them.

Exam-style questions with model answers

Q1. Define fixed cost and give one example. [2 marks]

1. A fixed cost is a cost that remains constant in total over a range of output and over a period of time, whatever the level of activity.
2. Example: the rent of a factory, which is the same whether 1,000 units or 5,000 units are produced.

Q2. Distinguish between direct cost and indirect cost with one example of each. [3 marks]

1. A direct cost can be traced easily and accurately to a particular product, job or department, for example the cloth used in making a shirt.
2. An indirect cost is incurred for the business as a whole and cannot be traced to one product, for example the rent of the factory building.
3. Direct costs are added directly to the cost of the product, while indirect costs are apportioned to products on a suitable basis such as floor area.

Q3. A firm has fixed costs of ₹30,000 and a variable cost of ₹15 per unit. It produces 2,000 units. Calculate the total cost and the cost per unit, and state what happens to the fixed cost per unit if output rises to 3,000 units. [4 marks]

1. Variable cost at 2,000 units = 2,000 × ₹15 = ₹30,000.
2. Total cost = ₹30,000 + ₹30,000 = ₹60,000, so cost per unit = ₹60,000 ÷ 2,000 = ₹30.
3. At 3,000 units the fixed cost per unit = ₹30,000 ÷ 3,000 = ₹10, down from ₹15 at 2,000 units.
4. The variable cost per unit stays at ₹15, so the total cost per unit falls to ₹25; the fall is due to the spreading of fixed costs over more units.

Q4. Explain the classification of costs on the basis of behaviour. [5 marks]

1. Classification by behaviour groups costs according to how they change when the level of activity changes.
2. Fixed costs remain constant in total over a range of output, such as factory rent, and fall per unit as output rises.
3. Variable costs change in total in direct proportion to output, such as raw materials, and stay constant per unit.
4. Semi-variable costs have both a fixed part and a variable part, such as a telephone bill with a rental plus call charges.
5. This classification helps a business to forecast costs, fix prices and find its break-even point.

Q5. Explain semi-variable costs and give three examples. [4 marks]

1. Semi-variable costs, also called mixed costs, have both a fixed part and a variable part.
2. The fixed part must be paid even when there is no activity, while the variable part rises with activity, so the total rises with activity but not in direct proportion.
3. A telephone bill has a fixed monthly rental plus charges for the calls made, and an electricity bill for a factory may have a fixed demand charge plus a charge per unit consumed.
4. A salesperson may receive a fixed salary plus a commission on sales, which is also a semi-variable cost to the firm.

Q6. State any four advantages of classifying costs. [4 marks]

1. It helps in fixing selling prices, because the total cost per unit at a given output is known.
2. It helps in controlling costs, since each category can be compared with a budget.
3. It makes forecasting more reliable by separating the effect of output changes from price changes.
4. It supports decisions such as break-even analysis, make-or-buy and acceptance of special orders.

Key takeaways

• Cost is the money value of resources used in production; classifying costs helps in pricing, control and decisions.
• Fixed costs are constant in total but fall per unit as output rises, for example factory rent.
• Variable costs change in direct proportion to output but stay constant per unit, for example raw materials.
• Semi-variable costs have a fixed part and a variable part, such as a telephone bill or salary plus commission.
• Semi-variable costs have a fixed part and a variable part, so their total rises with activity but not in direct proportion.
• Direct costs can be traced to a product; indirect costs are overheads apportioned on a suitable basis.
• Direct and variable are not the same, and indirect and fixed are not the same; the two classifications are independent.
• Fixed costs are fixed only within the relevant range; a large rise in output may raise them.

Test yourself

What is meant by cost classification?

Cost classification is the grouping of costs into categories that share a common feature, such as how they behave when output changes or whether they can be traced to a product.

Give two examples of fixed costs.

Factory rent and the salary of a permanent manager. Both remain the same in total whatever the level of output within the relevant range.

Why does fixed cost per unit fall as output rises?

The same total fixed cost is spread over more units, so each unit carries a smaller share of it. The total itself does not change.

What is prime cost?

Prime cost is the sum of direct materials, direct labour and direct expenses. It is the first total shown in a cost statement.

Give two examples of a semi-variable cost.

A telephone bill with a fixed monthly rental plus charges for calls, and a salesperson's pay made up of a fixed salary plus a commission on sales.

Is a supervisor's salary always an indirect cost?

No. It is indirect when the supervisor serves the whole factory, but it is a direct cost if the supervisor is appointed only for one particular contract.