Cost Concepts and Behaviour
Begin with the cost object
A cost can be direct to one object and indirect to another.
| Cost | Product model | Factory | Customer order |
|---|---|---|---|
| Battery used in a Cargo bike | Direct | Direct | Direct if traced |
| Factory supervisor salary | Indirect | Direct | Indirect |
| Special delivery requested by one customer | Depends on tracing to model | Outside factory production cost | Direct |
“Direct” means economically traceable to the chosen object, not physically touchable.
Four useful classification lenses
| Lens | Categories | Decision use |
|---|---|---|
| Traceability | Direct / indirect | Cost assignment |
| Behaviour | Variable / fixed / mixed / step | Forecast and CVP |
| Function | Production / selling / administration | Reporting and responsibility |
| Relevance | Incremental / avoidable / opportunity / sunk | Alternatives |
These classifications answer different questions. A fixed cost can also be direct, while a variable cost may be irrelevant to a decision if both alternatives incur it.
Classify one cost more than once
Suppose a supervisor works only on the Cargo model and receives a fixed monthly salary. That salary is direct to the Cargo product line, fixed within the agreed staffing range, and a production cost. Whether it is relevant to discontinuing Cargo is a separate question: will the salary actually cease, or will the supervisor move elsewhere at unchanged pay?
To classify a cost, specify the cost object, activity driver and time horizon. Rent may be fixed this month but change when the lease comes up for renewal or can be terminated. “Fixed” describes how the cost behaves within a particular range and period, not whether it can ever be avoided.
Northstar monthly cost map
| Item | Behaviour within 1,000–3,000 bikes | Traceability to model | Short explanation |
|---|---|---|---|
| Battery packs | Variable | Direct | One pack per bike |
| Assembly wages paid per unit | Variable | Direct | Change with output under the stated contract |
| Factory rent | Fixed | Indirect | Same total within current capacity |
| Electricity | Mixed | Mostly indirect | Base load plus machine use |
| Second quality supervisor after 2,500 units | Step-fixed | Indirect | Capacity changes at a threshold |
| Last year’s design study | Sunk | Depends on object | Cannot be changed by today’s choice |
Mixed-cost estimate
Maintenance cost was £18,000 at 1,000 machine hours and £24,000 at 1,600 hours.
High-low estimate:
Estimated cost equation:
At 1,300 hours, predicted maintenance is £21,000.
Choose the highest and lowest activity observations, not simply the largest and smallest bills. The £10 slope means an extra machine hour adds an estimated £10 within the observed range. The £8,000 intercept is the model's fixed component, not proof that an idle factory would incur exactly that cost outside the range. Substitute both observed activity levels back into the equation before forecasting.
High-low uses only two observations. Plot the data, inspect outliers and use regression or engineering analysis when the decision warrants it.
The fixed-cost-per-unit trap
Factory rent is £120,000:
| Output | Total fixed rent | Rent per unit |
|---|---|---|
| 1,000 | £120,000 | £120 |
| 2,000 | £120,000 | £60 |
| 3,000 | £120,000 | £40 |
Northstar's rent per unit falls because the same total is spread across more units; the business has not saved any rent. Producing unwanted inventory merely to lower unit cost can waste cash and expose the business to write-downs.
Relevant cost test
A number is relevant to a choice only if it is:
- future; and
- different between alternatives.
An opportunity cost is the benefit forgone by choosing one alternative, and it may not appear in the ledger. A sunk cost is recorded but cannot be changed by the decision. Relevance depends on the alternatives, not on whether a cost is visible in the accounts or has been allocated to them.
Quick check
Northstar owns an idle machine with a £50,000 carrying amount. It can use the machine for an order or rent it out for £8,000. Which amount is relevant?