a) Explain what you understand by the term 'cost'

The term ‘cost’ can be defined as 'the resources consumed or used up to achieve a certain objective'. This objective may be the running of a business or a department within a business. Thus cost represents the expenditure occurred in running a business on a day to day basis.

b) Explain what you understand by the 'elements of costs'.

 The ‘elements of costs’ refer to a cost classification system. Cost analysis involves classifying costs according to their common characteristics. There are a number of different classification systems, each differing according to the purpose to which the cost data is to be used. Cost classification by element is a system that classifies costs according to what they are. It normally classifies cost into three categories namely, materials, labour and expenses that are incurred in making a product or offering a service. Thus in the case of a restaurant, materials represent food and beverages, subsequently labour (chefs and waiters) and production facilities (kitchen equipment) are used to convert the materials into a finished product to be sold. Expenses include the light and heat, insurance, advertising, depreciation, repairs, maintenance and rent used to ensure the product is sold. This classification system is generally used for profit and loss presentations in financial reporting.

c) Distinguish between the following, giving examples of each

• Direct and indirect costs.
• Fixed and variable costs.

CIMA Official Terminology describes direct cost as ‘expenditure that can be attributed to a specific cost unit’. A direct cost is a cost that can be traceable and thus attributable to a particular product or service. Direct costs can be further broken into direct materials, direct labour and direct expenses. An example of a direct cost is the ingredients in a meal. Indirect costs are costs that cannot be traced to an individual product or service. This would include all costs that are not direct costs. Indirect costs can be further broken down into indirect material, indirect labour and indirect expenses. The total of all indirect costs is known as overhead. CIMA Official Terminology describes overhead as ‘expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit’. Examples of overheads include costs such as supervision and management (unless only one product or service is involved), electricity, depreciation, insurance and advertising.

The classification of costs into fixed and variable categories relates to how costs behave in relation to changes in sales volume. This costs classification systems is important in terms of planning and decision-making. Fixed costs are costs that are a function of time rather than sales activity and thus are not sensitive to changes in sales volume. As sales volume increases, these costs would be expected to remain the same or maybe increase due to other reasons such as inflation. Examples of fixed costs would include rent, rates, insurance and management salaries. Any of these costs would not be expected to increase as sales volume increases. It does not matter if there are 100 people or one person in a restaurant, the same rent must still be paid. Variable costs are costs that increase as sales or production volume increases. For example if sales volume fluctuates by 10 per cent then variable costs will fluctuate also by 10 per cent or close to it. Thus a variable cost is a cost that is sensitive to changes in sales activity. Examples would include direct materials as identified above. The cost of food or beverages for a restaurant would be considered a variable cost. The cost of toys in a toyshop would be a variable cost.