Costs and cost behaviour

Accounting AS · Cost and management accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Costs are classified in two ways. By behaviour: how does the total change when output changes? By traceability: can the cost be linked to one unit of product? A direct cost can be traced to a unit, such as the wood in a table. An indirect cost (overhead) cannot, such as factory rent.

Materials bought at different prices must be given a value when they are issued and when they remain in inventory. FIFO assumes the oldest units are issued first. AVCO uses a weighted average cost.

Under just in time (JIT), materials arrive only when needed. Storage and insurance costs fall, but production may stop if a supplier delivers late.

Rules to remember

Fixed cost: total stays the same within the relevant range, so the cost per unit falls as output rises. Variable cost: total rises in proportion to output; cost per unit stays the same.
Semi-variable cost = fixed part + variable part. Stepped cost: fixed over a range of output, then jumps to a higher level.
High-low method: variable cost per unit = difference in total cost ÷ difference in units; fixed cost = total cost − (units × variable cost per unit).
Prime cost = direct materials + direct labour + direct expenses.
FIFO: issues are priced at the oldest costs, so closing inventory is valued at the most recent costs.
AVCO: average cost = total cost of units held ÷ number of units held. Perpetual: recalculated after every receipt. Periodic: one average for the whole period.
When prices are rising, FIFO gives a higher closing inventory and a higher profit than AVCO.

Common mistake

Valuing FIFO closing inventory at the oldest prices. Under FIFO the oldest units have gone out, so what remains is valued at the latest purchase prices.

Worked example

A business uses perpetual AVCO. On 1 May it holds 200 units at $6.00 each. On 8 May it receives 300 units at $7.00. On 15 May it issues 400 units. On 22 May it receives 100 units at $7.40. What is the value of closing inventory?

After 8 May: 500 units costing $1,200 + $2,100 = $3,300, so average = $3,300 ÷ 500 = $6.60.
After the issue on 15 May: 100 units left at $6.60 = $660.
After 22 May: 200 units costing $660 + $740 = $1,400, so average = $1,400 ÷ 200 = $7.00.

Answer: Closing inventory is 200 units valued at $1,400.

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