In terms of their behavior, costs may be classified as fixed or variable. A fixed cost is cost that does not vary in total with the changes in output or volume. For example, if a car plant pays Rs 10 million per year toward the insurance of its â€˜xâ€™ model car plant, the total insurance cost remains at Rs 10 million, irrespective of the number of â€˜xâ€™ cars produced.
A variable cost, on the other hand, changes in total proportionately to changes in output or volume. For example, if the car plant buys a steering wheel for Rs 1,000 for its â€˜xâ€™ car, the total cost of steering wheels will be Rs 1,000 times the number of â€˜xâ€™ cars assembled.
Costs are regarded as fixed only in the short run or a brief period of time usually one to two years, during which the quantities of the available resources cannot be changed. In the long run, however, all costs are variable because equipment can be sold, plant can be shut down, employees can be laid off, and branches can be closed
Often the terms direct and variable are used interchangeably; so are the terms indirect and fixed. This is not correct because these classifications have different bases.
A direct cost may be fixed or variable; likewise an indirect cost may be fixed or variables.
The process of manufacture involves transforming material into finished goods by applying labor and capital employed in plant and equipment. Manufacturing costs comprise three elements, viz., direct material, direct labor, and manufacturing overhead. The sum of direct material cost and direct labor cost is referred to as prime cost whereas the sum of direct labor cost and manufacturing overhead is referred to as conversion cost.
Direct material cost includes the cost of all materials that become part of the finished product. Examples: iron ore to make steel, wood to make furniture, plastic to make toys, and microprocessors to make computers. The cost typically includes the purchase price of materials plus other costs such as freight, insurance, taxes, and duties.
Direct labor cost represents the cost of workers directly involved in producing the product. Examples: carpenters who make furniture, masons who build houses, and workers who assemble cars. Direct labor cost includes wages, fringe benefits, payroll taxes, bonus, and other types of compensation.
Manufacturing overhead comprises all other manufacturing costs besides direct material cost and direct labor cost. The important components of manufacturing overhead are:
* Indirect material glue, screws, and tape.
* Indirect labor like supervisory, maintenance, and support personnel.
* Depreciation of plant, equipment, and other assets.
* Utilities like electricity, gas, water, telephone and internet.
* Rent for factory and warehouse.
* Maintenance and repair costs for production facilities and warehouse.
* Allocated costs of service departments like purchasing material handling and quality control.
Non–manufacturing costs consist of selling and distribution cost, administration cost, financial cost, and research and development cost. Selling and distribution cost includes the salaries and commission of sales personnel, transportation cost, warehousing cost, sales promotion cost, advertising cost, and so on. Research and development cost represents the cost incurred for developing new products or processes, improving existing products or processes, and searching for new knowledge. Representing outlays on research and development efforts are costs not for production and marketing activities. These costs are assuming greater significance with rapid changes in technology. Financial cost includes interest on different kinds of borrowing, commitment fee, guarantee fee, and so on. Administration cost includes the cost of general administration and other costs which do not fit into any other category.