Solutions to Review Questions

Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition

Chapter 8

8.1In process costing, the total production costs for a period are divided by the number of completed units of output for the period to deduce the full cost. Where there is work in progress at the beginning and/or the end of the period complications arise.

The problem is that some of the completed output incurred costs in the preceding period. Similarly some of the costs incurred in the current period lead to completed production in the subsequent period. Account needs to be taken of these facts, if reliable full cost information is to be obtained.

8.2The only reason for distinguishing between direct and indirect costs is to help to deduce the full cost of a unit of output in a job-costing environment. In an environment where all units of output are identical, or can reasonably be regarded as being so, a process costing approach will be taken, obviating the need for identifying direct and indirect costs separately.

Direct costs form that part of the total costs of pursuing some activity that can, unequivocally, be associated with that particular activity. Examples of direct costs in the typical job-costing environment include direct labour and direct materials.

Indirect costs are the remainder of the costs of pursuing some activity. Identifying direct costs reduces the extent to which costs must be related to individual jobs on a, more or less, arbitrary basis. In practice, knowledge of the direct costs tends to provide the basis used to charge overheads to jobs.

The distinction between direct and indirect costs is not really important for any other reason.

Directness and indirectness is dictated by the nature of that which is being costed, as much as the nature of the cost.

8.3The notion of direct and indirect costs is concerned only with the extent to which particular costs can unequivocally be related to and measured in respect of a particular cost unit, usually a product or service. The distinction between direct and indirect costs is made exclusively for the purpose of deducing the full cost of some cost unit, in an environment where each cost unit is not identical, or close enough to being identical for it to be treated as such. Thus it is typically in the context of job costing, or some variant of it, that the distinction between direct and indirect costs is usefully made.

The notion of variable and fixed costs is concerned entirely with how costs behave in the face of changes in the volume of output. The value of being able to distinguish between fixed and variable costs is that predictions can be made of what total costs will be at particular levels of volume and/or what reduction or addition to costs will occur if the volume of output is reduced or increased.

Thus the notion of direct and indirect costs, on the one hand, and that of variable and fixed costs, on the other, are not connected with one another. Though it so happens that, in most contexts, some direct costs are variable, some direct costs are fixed. Similarly indirect costs might be fixed or variable.

8.4The full cost includes all of the costs of pursuing the cost objective, including a ‘fair’ share of the overheads. Generally the full cost represents an average cost of the various elements, rather than a cost that arises because the business finds itself in a particular situation.

The fact that the full cost reflects all aspects of cost should mean that, were the business to sell its output at a price exactly equal to the full cost, the sales revenues for the period would exactly cover all of the costs and the business would break even, that is make neither profit nor loss.