Cost Behavior

Cost behavior is nothing more than the sensitivity of costs to changes in production or sales volume. The way a specific cost reacts to changes in activity levels is called cost behavior. Costs can be same or may change proportionately in response to the changes in activity. Having the knowledge of how cost reacts to a change in the level of activity makes it easier and helps us to create a budget, prepare a forecast, determine how much profit a new product will generate, and determine which of two alternatives should be selected.

Cost Behavior Analysis:

The process of dividing a mixed cost into its variable and fixed components . This process, involves: Determine which metric or activity drives costs. An example in manufacturing is machine hours. Using this technique, we could determine how much each machine hour affects our power bill. Making the scattered graph of data. When we plot our data, what were looking for is that a linear relationship exists between our cost driver and our costs. If a linear relationship doesnt exist, then it cant be a cost driver.

Types of cost:
1. Fixed cost 2. Variable cost 3. Mixed cost Fixed cost:
Fixed costs are those that stay the same in total regardless of the number of units produced or sold. Although total fixed costs are the same, fixed costs per unit changes as fewer or more units are produced. Example: Straight-line depreciation is an example of a fixed cost. It does not matter whether the machine is used to produce 1,000 units or 10,000,000 units in a month; the depreciation expense is the same

because it is based on the number of years the machine will be in service.

Types of fixed cost:

Fixed cost has two types;

This cost relates to the investment in facilities, equipment and the basic organizational structure of firm. For Examples it includes depreciation of buildings and equipments, taxes on real state, insurance and salaries of top management.The two key characteristics of committed fixed costs are: They are long term in nature They cant be significantly reduced even for shorter period of time

Committed fixed cost

Discretionary fixed cost

This cost usually arises from annual decisions by management to spend in certain fixed cost areas. For Examples advertising, research, public relations and internships for students. The two key characteristics of Discretionary fixed cost are : Short term in nature It can be reduced for short period of time

Variable cost:

These are the costs that change in total each time an additional unit is produced or sold. With a variable cost, the per unit cost stays the same, but the more units produced or sold, the higher the total cost. It includes things like labor and materials. Some overhead [indirect costs] such as indirect labor, supplies and some utilities are also variable. The graph of a variable cost is a straight line with positive slope, beginning at the origin. The slope of the variable cost line is the variable cost per unit.

Example: If it takes one yard of fabric at a cost of $5 per yard to make one chair, the total materials cost for one chair is $5. The total cost for 10 chairs is $50 (10 chairs $5 per chair) and the total cost for 100 chairs is $500 (100 chairs $5 per chair). Graphically, the total fixed cost looks like a straight horizontal line while the total variable cost line slopes upward.

The activity base: For a cost to be variable, it must varies with respect to something. That something is its activity base. An activity base is a measure of whatever causes the incurrence of variable cost. This can be sometimes referred to as a cost driver. Some of the most common activity bases are direct Labour-hours, machine-hours, units produced and units sold. True variable versus step-variable costs: True variable costs: A direct material is a true variable cost as the amount used during a period will vary in direct proportion to the level of production activity. Step-variable cost: A resource that is obtainable only in large chunks and whose costs increases or decreases only in response to fairly wide changes in activity is known as step-variable cost.

Mixed cost:
It contains both fixed and variable elements. It is also known as semi variable costs.

The Y-intercept is the total fixed costs. The slope is the variable cost per unit, and any point on the line represents the total cost at the indicated volume. As mixed cost is a straight line, the following equation is used to express relation between mixed cost and level of activity: Y=a+bX In this equation, Y=The total mixed cost a=The total fixed cost b=The variable cost per unit of activity X=The level of activity

Suppose total fixed cost is $25000 and variable cost per unit of activity is $3.00 and activity level is 800 rafting parties. Then total mixed cost will be; Y=25000+ (3.00 per rafting party) (800 rafting parties) = $27,400

Example: A company pays a fee of $1,000 for the first 800 local phone calls in a month and $0.10 per local call made above 800. During March, a company made 2,000 local calls. Its phone bill will be $1,120 ($1,000 +(1,200 $0.10)).