The level of costs incurred is affected by many components. For instance, costs will be increased over time due to inflation.
For many management tasks, such as areas of planning, decision-making, and controlling, this is essential to understand the behavior of cost pattern.
Without a basic knowledge of the way in which costs behave in relation to the level of activity, it would be impossible for managers to forecast and control costs.
An alternative word that can be used to refer to a fixed cost is also known as Period Cost.
This is a fixed cost incurred according to the time lapsed, rather than according to the level of activity.
Rent, Rates, Insurance, Executive Salaries, are examples of Fixed Cost.
However, this implies on a relevant range of activity. Within the relevant range, it is possible to increase activity without necessitating additional premises.
After expanded to the critical point, further premises will be needed to accommodate the increased level of activities.
Within the relevant range for each activity level, the cost is constant, but the total cost incurred increases to the next level when a critical level of activity is reached.
The likelihood of probabilities occurring in cost behavior patterns means that it is unreliable to forecast costs for activity levels which are outer the relevant range.
As the level of activity increased, the fixed cost per unit reduces. This is for the reason that the same amount of fixed cost is being extended over an aggregate number of units.
A cost which varies with a measure of activity is called variable cost.
Direct Material, Direct Labor and Variable Overheads are examples of Variable Cost.
On the graph, it is a straight line through the origin, which shows that the cost is NILL at ZERO activity level.
The Total Variable Cost increases in direct proportion when activity increases, as long as the activity level is still within the relevant range.
The Variable Cost per unit is constant, again, within a relevant range.
On the graph, it is a straight line parallel to the horizontal axis.
Curvilinear Variable Cost: A Variable Cost may be non-linear; the supposition that variable costs do fairly accurate to a linear function may not every time be realistic. It may have two scenarios:
In the first scenario, each successful unit of activity is adding more to the total variable cost than the previous unit. The graph of cost becomes steeper as the activity level increases.
In the second scenario, each successful unit of activity adds less to the total variable cost than the previous unit. The graph of cost becomes less steep as the activity level increases.
This cost is also referring to as mixed cost or semi-fixed cost. This cost is partially affected by a change in the level of activity due to containing both fixed and variable components.
Another scenario where the cost remains constant up to a certain level of activity and then increases as the variable cost element is incurred.
Analyzing Semi-Variable Cost
The utmost common cost behavior pattern in practice and in assessment situation is the Semi-Variable cost. One of the best examples is utility bills.
It is important for managers to know how much of it is fixed and how much is a variable cost.
The analysis is based on past costs record their connected activity levels.
The two most common methods are used to discrete the fixed and variable elements from Semi-Variable Cost. These are:
a. The High-Low Method
b. The Line of Best Fit Method
The High-Low Method
The Highest and Lowest activity levels are picked up from available data and investigate the change in cost which has occurred between them.
Let’s try to understand by an Example:
An XYZ Company has recorded the following data:
|Month||Activity Level||Cost Incurred|
The above data is a semi-variable cost. The highest activity level happened in May and the lowest in April. The cost resultant from the activity increase must be the variable cost as the amount of fixed cost incurred in each month is constant.
The Variable Cost is found for 700 units is $4,900. Now, calculate the Variable Cost per Unit:
Variable Cost per Unit = $4,900/700 = $7 per unit
Determine the Fixed Cost element by substituting back variable cost per unit in the data for May:
|Variable Cost (2,450 units X $7||17,150|
|Therefore, Fixed Cost per Month||24,000|
Since the elements of Fixed Cost and Variable Costs are identified, it is possible to estimate the total cost for any activity level within the range of 1750 to 2450.
The Line of Best Fit Method
This method is simple to use and also called The Scattergraph Method. However, it is very prone to inaccuracies that arise due to subjectivity and likelihood of human error as it takes accounts of all available historical data.