[MUSIC] Costs should be well known from the financial accounting material that we've looked at, things like purchases and wages. However, for a management accounting, we need a more detailed analysis. That's often what's required. For example, our purchases, we normally call those materials. These are often analyzed into various different categories, wood, timber, components, paint, etc. Wages, we call labor. And these can be analyzed into different departments or functions. Assembly labor, paint shop labor, supervision cost, etc. For this purpose, it's ideal to actually classify our costs. And two of the most commonly used classifications are whether costs can be identified with a particular cost unit or cost object? In other words, whether they're direct, willingly related with that or indirectly related? Or whether these costs change with the level of activity or work done? In other words, do they vary or are they fixed within a relevant range? Let's have a look at direct costs and indirect costs. Direct costs can be identified with a particular cost unit or cost object. For example, the amount of wire that's in a box of paper clips. These direct costs normally comprise of direct materials, direct labor and direct expenses. Those cost which cannot be identified with a particular cost unit or object are known as indirect costs. Another term for indirect costs are overhead, so you may come across that term. If we look at the variable and fixed costs. The key concept to understand is that of the level of activity which relates to the amount of work done in an enterprise on a particular job event. If we look at manufacturing, for example. This will be the volume of production, the amount of units that are actually produced. In a service industry, the measure might be a little bit more difficult. In hospitals, for example, the level of activity is often measured in patient days. Fixed costs tend to be unaffected by any changes in the level of activity. For example, the managing director's salary, normally constant, this is regardless of the amount that is actually produced. Fixed cost can be thought of as time cost because they're dependent upon a particular time period rather than a level of activity. Factory rent will be x amount of pounds per annum whether anything is produced or not, as an example. Most so-called fixed costs are in fact, what we call step fixed costs. That's is costs which are fixed, but only within a specific level of activity or within a relevant range. An example would be the factory rent which is fixed of course, but only up to the maximum output of that particular factory. If you wanted to expand and add capacity, then you'd need to have additional factory space that would cause the rental cost to increase or take a step up. Variable costs change directly with the level of activity. You think of that maybe as the number of units. As activity increases, so do the variable costs in the same proportion. Materials are the other type or variable costs. Material making one thing may cost you 50 pence to make an item, and to make two it's a pound. To make three it's 1 pound 50, etc. There are some costs, however, that include both a fixed and variable element. And these costs are known as semi-variable, semi-fixed costs. A good example for this would be your home telephone bill. That normally has two elements. There's a fixed charge, the landline if you wish, plus there's a variable part that changes dependent on the number of calls that you make. This analysis of costs into their fixed and variable elements is a difficult and often subjective exercise, and labor's a great example of that. Do we treat labor as being fixed or variable? It depends. [MUSIC]
