Cost Behavior

 

Cost Behavior

Cost behavior refers to how costs change in response to fluctuations in activity levels. It helps managers predict expenses and make informed decisions. Costs are classified into three main types:

1. Variable Costs – Change in direct proportion to activity levels (e.g., raw materials, sales commissions).
2. Fixed Costs – Remain constant regardless of activity levels (e.g., rent, salaries).
3. Mixed Costs – Contain both variable and fixed components (e.g., utility bills, maintenance costs).

The combination of these costs in a business is known as its cost structure, which influences financial planning and decision-making.

Variable Cost

A variable cost changes in total proportionally with activity levels. Common examples include cost of goods sold, direct materials, direct labor, and variable overhead costs (e.g., supplies and power).

Variable costs depend on an activity base or cost driver, which determines cost fluctuations. Common activity bases include:

• Units produced or sold
• Direct labor-hours
• Machine-hours
• Miles driven (e.g., salespersons)
• Beds occupied (e.g., hospitals)

In most cases, total output is the default activity base unless specified otherwise.

Fixed Costs

A fixed cost remains constant in total, regardless of changes in the activity level. Examples include rent, property taxes, insurance, depreciation, salaries, and advertising. Unlike variable costs, fixed costs do not fluctuate with production or sales volume. However, they may change due to external factors, such as an increase in rent.

For instance, if a company pays $500 per month for rent, this cost remains unchanged, whether the company serves 10 or 100 customers in a given month.

Committed and Discretionary Fixed Costs

Fixed costs can be categorized into committed and discretionary fixed costs:

1. Committed Fixed Costs

   • Long-term, difficult to reduce in the short term.
   • Includes investments in facilities, equipment, real estate taxes, insurance, and top management salaries.
   • Cutting these costs may lead to greater long-term expenses to restore operations.

2. Discretionary Fixed Costs

• Arise from annual managerial decisions.
• Examples: advertising, research, public relations, management training, and internships.
• Can be reduced temporarily without significant long-term impact on the organization’s goals.

Linearity Assumption and Relevant Range

• Linearity Assumption: Management accountants assume that cost behavior can be represented by a straight line within a certain range of activity.
• Curvilinear Costs: In reality, some costs follow a curved pattern, but they can be approximated as linear within a relevant range.
• Relevant Range: The activity level within which cost behavior assumptions remain valid.
  • Outside this range, fixed costs may increase (e.g., requiring additional equipment) or variable costs may not stay proportional to activity.
• Example:
• A diagnostic machine at a hospital costs $20,000 per month and has a capacity of 3,000 tests.
• If demand exceeds 3,000 tests, an additional machine is required, leading to a step-wise increase in costs.

The graph above illustrates the step-wise cost behavior within the relevant range. As the number of tests increases beyond a machine’s capacity (3,000 tests), an additional machine is required, causing a step increase in fixed costs (e.g., from $20,000 to $40,000 at 3,001 tests). This pattern continues as more capacity is needed.

Mixed Costs

A mixed cost includes both fixed and variable cost components. It is also referred to as a semivariable cost because it has characteristics of both. The fixed component remains constant regardless of activity level, while the variable component changes based on usage.

Example of Mixed Cost

A rafting company, Nooksack Expeditions, incurs a mixed cost for fees paid to the state. This includes:

• A fixed license fee of $25,000 per year
• A variable fee of $3 per rafting party

If the company conducts 1,000 rafting trips, the total cost will be:

• Fixed cost: $25,000
• Variable cost: 1,000 trips × $3 = $3,000
• Total mixed cost: $28,000

This means that even if the company does not run any trips, it still incurs the fixed cost of $25,000. However, as the number of rafting trips increases, the total cost increases in a linear fashion due to the variable component.

Test Your Knowledge

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1. Which of the following is an example of a variable cost?

a) Rent
b) Direct materials
c) Property taxes
d) Insurance
Answer: b) Direct materials

2. A cost that remains constant in total regardless of activity level is known as:

a) Variable cost
b) Fixed cost
c) Mixed cost
d) Step cost
Answer: b) Fixed cost

3. Which of the following is an example of a mixed cost?

a) Rent
b) Sales commission
c) Utility bill with a fixed charge and usage-based fee
d) Direct labor
Answer: c) Utility bill with a fixed charge and usage-based fee

4. The cost incurred to acquire or produce goods that will be sold later is called:

a) Period cost
b) Product cost
c) Sunk cost
d) Opportunity cost
Answer: b) Product cost

5. The cost of advertising is classified as a:

a) Variable cost
b) Committed fixed cost
c) Discretionary fixed cost
d) Mixed cost
Answer: c) Discretionary fixed cost

6. Property taxes and insurance expenses are considered:

a) Variable costs
b) Mixed costs
c) Committed fixed costs
d) Step costs
Answer: c) Committed fixed costs

7. Which of the following is a key characteristic of variable costs?

a) They remain constant per unit but vary in total
b) They remain constant in total but vary per unit
c) They remain unchanged regardless of the level of activity
d) They do not exist in a manufacturing environment
Answer: a) They remain constant per unit but vary in total

8. Which of the following is an example of a period cost?

a) Direct labor
b) Factory rent
c) Office supplies expense
d) Raw materials
Answer: c) Office supplies expense

9. If a company's activity level increases, its total fixed cost will:

a) Increase
b) Decrease
c) Stay the same
d) Become variable
Answer: c) Stay the same

10. A mixed cost is composed of:

a) Only fixed costs
b) Only variable costs
c) Both fixed and variable costs
d) Neither fixed nor variable costs
Answer: c) Both fixed and variable costs

11. The relevant range refers to:

a) The range of production where costs behave linearly
b) The difference between variable and fixed costs
c) The range where mixed costs turn into fixed costs
d) A period in which all costs remain unchanged
Answer: a) The range of production where costs behave linearly

12. If production volume decreases, the per-unit fixed cost will:

a) Increase
b) Decrease
c) Stay the same
d) Vary randomly
Answer: a) Increase

13. The fixed cost per unit of activity level will:

a) Remain unchanged
b) Increase as production increases
c) Decrease as production increases
d) Vary based on the type of product
Answer: c) Decrease as production increases

14. Salaries of top executives are typically classified as:

a) Variable costs
b) Mixed costs
c) Committed fixed costs
d) Step costs
Answer: c) Committed fixed costs

15. Which of the following would be classified as a step cost?

a) Raw materials cost
b) Supervisor salaries increasing after every 20 employees
c) Rent
d) Shipping expenses
Answer: b) Supervisor salaries increasing after every 20 employees

16. In cost behavior analysis, a cost driver is:

a) A fixed cost that does not change with activity level
b) An activity that causes a cost to increase or decrease
c) A period cost
d) An irrelevant factor in cost estimation
Answer: b) An activity that causes a cost to increase or decrease

17. Which of the following statements is true about discretionary fixed costs?

a) They cannot be changed without major long-term consequences
b) They include salaries of production workers
c) They can be adjusted in the short term without major impact
d) They always increase with production volume
Answer: c) They can be adjusted in the short term without major impact

18. The total cost of electricity, which includes a fixed charge and a charge per unit consumed, is an example of:

a) Fixed cost
b) Variable cost
c) Mixed cost
d) Period cost
Answer: c) Mixed cost

19. If a company pays for an annual insurance policy upfront, this cost is classified as a:

a) Period cost
b) Product cost
c) Sunk cost
d) Prepaid expense (asset) until used
Answer: d) Prepaid expense (asset) until used

20. When a company increases production, which of the following is most likely to decrease per unit?

a) Total variable cost
b) Total fixed cost
c) Fixed cost per unit
d) Variable cost per unit
Answer: c) Fixed cost per unit

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