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Cost Behavior, Analysis and Use

Variable cost, Fixed cost, and Mixed/Semi variable cost, types and behavior

Cost behavior refers to how cost will react or change as changes take place in the level of activity. An understanding of cost behavior is the key to many decisions in an organization. Managers who understand how costs behave are better able to predict what costs will be under various operating circumstances. Attempts at decision making without a thorough understanding of the costs involved-and how these costs will change with the activity level-can lead to disaster. For example, a decision to cut back production of a particular line might result in for less cost savings than managers had assumed if they confuse fixed costs with variable costs-leading to a decline in profits. To avoid such problems, a manger must be able to accurately predict what costs will be at various activity level.

In this chapter we will discuss variable, fixed and a third behavior pattern know as mixed or semi variable cost.

All three cost behaviors patterns-variable, fixed, and mixed- are found in most organizations. The relative proportion of each type of cost in an organization is known as its cost structure. For example, an organization might have many fixed costs but few variable or mixed costs. Alternatively, it might have many variable costs but few fixed or mixed costs. An organization's cost structure can have significant impact on decision making.

Variable Cost:

Variable cost is cost whose total dollar amount varies in direct proportion to changes in the activity level. If the activity level doubles, the total dollar amount of the variable cost also doubles. If the activity level increases by only 10%, then the total dollar amount of the variable cost increases by 10% as well. The idea that the variable cost is constant per unit but varies in total with the activity level is crucial to an understanding of cost behavior patterns.

The Activity Base:

For a cost to be variable, it must be variable with respect to something. That some thing is its activity base. An activity base is a measure of whatever causes the incurrence of variable cost. An activity base is sometimes referred to as cost driver. Some of the most common activity bases are direct labor hours, machine hours, units produced, and units sold. Other activity bases (cost drivers) might include the number of miles driven by sales persons, the number of pounds of laundry cleaned by a hotel, the number of calls handed by technical support staff at a soft ware company, and the number of beds occupied in a hospital.

T plan and control variable costs, a manger must be well acquainted with the various activity bases within the firm. People some times get the notion that if a cost doesn't vary with production or with sales, then it is not really a variable cost. This is not correct. As suggested by the range of bases listed above, costs are caused by many different activities within an organization. whether a cost is considered to be variable depends on whether is is caused by the activity under consideration. For example, if a manager is analyzing the cost of service calls under a product warranty, the relevant activity measure will be the number of service calls made. Those costs that vary in total with the number of service calls made are the variable cost of making service calls.  Nevertheless, unless stated otherwise, you can assume that the activity base under consideration is the total volume of goods and services provided by the organization.

Some of the most frequently encountered variable costs are listed below. This is not a complete list of all costs that can be considered variable. More some costs listed here may behave more like fixed than variable cost s in some organizations.

True Variable Versus Step Variable Costs:

Not all variable costs have exactly the same pattern. Some variable costs behave in a true variable or proportionately variable pattern. Other variable costs behave in a step-variable pattern.

True Variable Costs:
Direct material is a true variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts purchased but not used can be stored and carried forward to the next period as inventory.

Step-Variable Costs:
The wages of maintenance workers are often considered to be a variable cost, but this variable cost does not behave in quite the same way as the cost of direct materials. unlike direct materials, the time of maintenance workers is obtainable only in large chunks. More any maintenance time not utilized cannot be stored as inventory and carried forward to the next period. If the time is not used effectively it is gone forever. Furthermore, a maintenance crew can work at a fairly leisurely pace if pressures are light but intensify its efforts if pressures build up. For this reason small changes in the level of production may have no effect on the number of maintenance people employed by the company.

A resource that is obtained only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost.

Fixed Costs:

Fixed costs remain constant in total dollar amount within the relevant range of activity. The amount of fixed cost computed on per unit basis becomes progressively smaller as the level of activity increases.

Types of Fixed Costs

Fixed costs are some time referred to as capacity costs since they result from out lays made for building, equipment, skilled professional employees, and other items indeed to provide the basic capacity for sustained operations. For planning purposes, fixed costs can be viewed as being either committed or discretionary.

Committed Fixed Costs:
Committed fixed costs relate to the investment in facilities, equipment, and the basic organizational structure of a firm. Examples of such costs include depreciation of buildings and equipment, taxes on real estate, insurance and salaries of top management and operating personnel.

The two key characteristics of committed fixed cost are 1. They are long term in nature 2. they cannot be significantly reduced even for short period of time without seriously impairing the profitability or long run goals of the organization. Even if operations are interrupted or cut back, the committed fixed costs will still continue largely unchanged. During a recession, for example, a firm shall not usually discharge key executives or sell of key facilities.

Since it is difficult to change a committed fixed cost once the commitment has been made, management should approach these decisions with particular care. Decisions to acquire major equipment or to take on other committed fixed costs involve a long planning horizon. Management should make such commitments only after careful analysis of the available  alternatives. Once a decision is made to build a certain size facility, a firm becomes locked into that decision for many years to come.

While not much can be done about committed fixed costs in the short run, management is concerned about how these resources are utilized. The strategy of management must be to utilize the capacity of the organization as effectively as possible.

Discretionary Fixed Costs:
Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students.

Basically two key differences exist between committed fixed cost and discretionary fixed cost. First, the planning horizon of a discretionary fixed cost is fairly short term usually single year. By contrast committed fixed cost has a planning horizon that encompasses many years. Second, the discretionary fixed costs can be cut for short period of time with minimal damage to the long run goals of the organization. For example spending of management development programs can be reduced because of poor economic conditions. Although some unfavorable consequences may result from the cutback, it is doubtful that these consequences would be as great as those would result if the company decided to economize during the year by laying off key personnel.

Weather a fixed cost is regarded as committed or discretionary may depend on management's strategy. For example during recessions when the level home building is down, many construction companies may lay off most of their workers and virtually disband operations. Other construction companies retain large number of employees on the pay roll, even though the workers have little or no work to do. While these latter companies may face short term cash flow problems, it will be easier for them to respond quickly when economic conditions improve. And the higher moral and loyalty of their employees may give these companies significant competitive advantage.

The most important characteristics of discretionary cost is that management is not locked into a decision regarding such costs. They can be adjusted from year to year or even perhaps during the course of a year if circumstances may demand such a modification.   

Mixed Cost:

A mixed cost is one that contains most variable and fixed cost elements. Mixed costs are also known as semi variable costs.