Recap: Cost classification

Every cost of a business that makes things is one of three kinds. They are called the elements of cost.

Materials

the things that are bought and used, such as wood, screws and glue

Labour

the pay of the people who work for the business

Overheads

every other running cost, such as rent, electricity and insurance. Also called expenses

Fernhill Furniture makes oak dining tables in a rented workshop.

A profit centre has income as well as costs. Its manager is judged on the profit it makes.

Fernhill Furniture's showroom sells tables to the public. In July its sales were £38,000 and its costs were £29,500.

Costs can also be sorted by how they behave when the business makes more or fewer units.

Variable cost

rises and falls in step with output. Twice the tables, twice the cost

Fixed cost

stays the same in total when output changes, such as rent

Each table uses £430 of oak. The rent of the workshop is £4,000 a month.

The direct costs are variable: £640 for every table. Treat the indirect costs as fixed at £11,000 a month.

In July Fernhill Furniture makes 125 tables.

The variable cost of each table does not change. The fixed costs are spread over more tables.

A direct cost can be traced to one unit of the product. For Fernhill Furniture, one unit is one table.

An indirect cost cannot be traced to one table. It is shared by everything the workshop makes. Indirect costs are also called overheads.

Direct materials

materials that end up in the product, such as the oak in a table

Direct labour

pay for the time spent making the product, such as the wages of the workers who cut and assemble it

Direct expenses

any other cost of one job alone, such as hiring a machine for one customer's order

Indirect costs

everything else: the supervisors, rent, electricity, insurance

Glue and sandpaper are materials, but the amount used on one table is too small to measure. They are treated as indirect.

A profit centre has income as well as costs. Its manager is judged on the profit it makes.

Fernhill Furniture's showroom sells tables to the public. In July its sales were £38,000 and its costs were £29,500.