Cost Descriptors Paper

Cost Descriptors Paper

MEMO

TO: HR Manager

FROM: Shevonne Prescott-La Cour

DATE: February 7, 2010

RE: Cost Descriptor

It has come to my attention that since the last meeting, there has been some misunderstanding of the on-going budget discussion. There are several terms used to describe cost. Hopefully this memo will provide a better understanding of the terms used when discussing budget. The terms of importance, but not limit to include: fixed, variable, direct, indirect, sunk, marginal, and total cost.

Fixed Cost

Fixed cost is periodic cost that remains (more or less) unchanged irrespective of the output level or sales revenue of a firm, such as depreciation, insurance, interest, rent salaries, and wages. While, in practice, all costs vary over time and no cost is a purely fixed cost, the concept of fixed costs is necessary in short-term cost accounting. Firms with high fixed costs are significantly different from those with high variable costs. This difference affects the financial structure of the firm as well as its pricing and profits. The break even point in such firms (in comparison with high variable cost firms) is typically at a much higher level of output and their marginal profit (rate of contribution) is also much higher (www.businessdictionary.com). An example of fixed cost is lease payment. If our business is leasing this building at $2,500.00 per month, then we will pay that amount each month, no matter how well or how poorly our business is doing.

Variable Cost

Variable cost is the costs of production that vary directly in proportion to the number of units produced. Variable costs often include labor expenses and raw material costs, because labor and raw material usually must be increased to increase output. Firms for which variable costs represent a high proportion of total costs are usually less likely to experience large fluctuations in earnings, because changes in sales and revenues are accompanied by nearly equal changes in cost (www.yourdictionary.com). An example of variable cost is the fuel for an airline. This cost changes with the number of flights and how long the trips are.

Direct Cost

Direct cost can be traced directly to a cost object such as a product or a department. In other words, direct costs do not have to be allocated to a product, department, or other cost object (www.accountingcoach.com). An example of direct cost is, if a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are direct costs they are clearly traceable to the production department and to each item produced- no allocation was needed.