A basic rule in this area: no classification is always right — only a classification that suits a particular purpose. A supervisor’s salary is direct to their department and indirect to any one product.
1 Direct and indirect
- A direct cost: can be traced to the cost unit easily and economically — the materials that go into the product and the wage of the worker who makes it.
- An indirect cost: serves more than one unit and cannot be traced directly — factory rent and electricity, or the production manager’s salary.
2 Fixed, variable and semi-variable
| Type | Behaviour as activity changes | Example |
|---|---|---|
| Variable | The total changes in proportion to volume · the per-unit amount is constant | Raw materials · sales commission · packaging |
| Fixed | The total is constant within the relevant range · the per-unit share falls as output rises | Rent · depreciation · administrative salaries |
| Semi-variable | Part fixed and part variable | An electricity bill with a standing charge and consumption |
| Step fixed | Constant, then jumps once a certain capacity is passed | An extra supervisor for every 20 workers |
The relevant range
“Fixed costs are fixed” holds only inside a relevant range of activity. Double the output and you will need another warehouse and another rent — at which point the fixed cost jumps.
Factory rent is SAR 60,000 a month, and materials cost SAR 25 per unit.
| Output (units) | Total rent | Rent per unit | Materials per unit | Total materials |
|---|---|---|---|---|
| 2,000 | 60,000 | 30 | 25 | 50,000 |
| 4,000 | 60,000 | 15 | 25 | 100,000 |
| 6,000 | 60,000 | 10 | 25 | 150,000 |
The takeaway: a fixed cost is fixed in total and variable per unit, and a variable cost is exactly the opposite. This is where economies of scale come from: the more you produce, the smaller each unit’s share of fixed costs.
3 Product costs and period costs
- A product cost: is charged to inventory and stays in the statement of financial position until the product is sold, at which point it becomes “cost of sales”.
- A period cost: goes to the income statement in the period it is incurred — selling and administrative expenses, for example.
The consequence of this distinction is large: wrongly classifying a cost as a product cost defers its appearance in the income statement and shows a higher profit than was actually earned.
4 Costs for decisions
Differential
The difference between two alternatives — the relevant one
Sunk
Already spent and unrecoverable — ignore it entirely
Opportunity
The return given up by choosing one option over another
Avoidable
Disappears if the activity is stopped
The costs relevant to a decision are only those that change because of it
The sunk cost fallacy
“We have spent 300,000 on this project, so we cannot stop now.” That amount is sunk and will not come back whether you continue or stop. The right question is: does what will be spent from now on justify the return expected from now on?
Lesson summary
- Classification follows purpose; the same cost is classified in different ways.
- Direct costs are traced to the unit; indirect costs are allocated.
- A fixed cost is fixed in total within the relevant range and variable per unit.
- Product costs pass through inventory; period costs go straight to the income statement.
- Decisions rest on differential costs, and sunk costs are ignored.
5 Test yourself
Three quick questions
Choose the answer you think is correct — the result appears immediately.
1. Output rose from 2,000 to 4,000 units. What happens to each unit’s share of the rent?
The total is unchanged while the units doubled, so the share per unit falls — the essence of economies of scale.
2. A feasibility study costing SAR 80,000 was paid for last year. In evaluating the project today it is:
The amount has been spent and will not change with any decision now, so it stays out of the comparison.
3. A sales representative’s commission is 3% of the sale value. What type of cost is it?
Its total rises and falls with sales while the rate per unit is constant — that is variable cost behaviour.