Cost Behavior

Cost Behavior

The level of costs incurred is affected by many components is called Cost Behavior. 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 patterns.

Without a basic knowledge of how costs behave about the level of activity, it would be impossible for managers to forecast and control costs.

Fixed Cost

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, and Executive Salaries, are examples of Fixed Costs.

However, this implies a relevant range of activity. Within the relevant range, it is possible to increase activity without necessitating additional premises.

After expanding 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 that are outer the relevant range.

As the level of activity increases, 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.

Variable Cost

A cost that varies with a measure of activity is called variable cost.

Direct Material, Direct Labor, and Variable Overheads are examples of Variable Costs.

On the graph, there 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 accurately to a linear function may not every time be realistic. It may have two scenarios:

In the first scenario, each successful unit of activity adds 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.

Semi-Variable Cost

This cost is also referred 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 is 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 assessment situations is the Semi-Variable cost. One of the best examples is utility bills.

Managers need 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 (Cost Behavior)

The Highest and Lowest activity levels are picked up from available data and investigate the change in cost that 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
  (units) $
January 1950 37,650
February 1800 36,600
March 2000 38,000
April 1750 36,250
May 2450 41,150
June 2100 38,700

The above data is a semi-variable cost. The highest activity level happened in May and the lowest was 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.

Month Activity Level  
May 2450 41,150
April 1750 36,250
Increase 700 4,900

The Variable Cost 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:

May $
Total Cost 41,150
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 is also called The Scattergraph Method. However, it is very prone to inaccuracies that arise due to subjectivity and the likelihood of human error as it takes account of all available historical data.


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