cost behavior and analysis

• Cost Behavior


  How a cost will react or change as the level of business activity changes
• Types of cost


  • Variable
  • Fixed
  • Mixed
• Understanding cost behavior


  • Allows managers to predict what costs will be at various business activity levels
  • This information is essential for managing your business efficiently
• Variable cost


  • Total variable cost is proportional to the activity level within the relevant range
  • Variable cost per unit remains the same over wide ranges of activity
• Fixed cost


  • Total fixed cost remains the same even when the activity level changes within the relevant range
  • Fixed cost per unit goes down as activity level goes up
• Activity base


  A measure of the event that causes the incurrence of a variable cost - a cost driver
• True variable cost


  Total cost is based on how many units of the activity base are consumed
• True variable cost example


  • Total long distance telephone bill based on minutes talked
• Step-variable cost


  Total cost remains constant within a narrow range of activity, then increases to a new higher cost for the next higher range of activity
• Relevant range


  • A range of business activity within which the assumptions made about cost behavior are valid
  • Variable costs on a per unit basis remain the same
  • Fixed costs in total remain fixed
• Fixed cost example


  • Monthly basic telephone bill does not change when making more local calls
• Fixed cost per unit

  Decreases as more units of the activity base are consumed
• Examples of normally variable costs

  • Cost of goods sold, direct material, direct labor, variable manufacturing overhead, sales commissions, shipping costs, supplies, travel
• Examples of normally fixed costs

  • Real estate taxes, insurance, sales salaries, depreciation, advertising
• Discretionary fixed costs


  May be altered in the short-term by current managerial decisions
• Committed fixed costs


  Long-term, cannot be reduced in the short term
• Example of committed fixed cost


  • Office space rental increasing as business grows
• Fixed costs and relevant range
• How fixed costs differ from step-variable costs

  Fixed costs have a wider activity range before increasing, and are less quickly adjustable
• Mixed cost


  Has both fixed and variable components
• Total mixed cost can be expressed as an equation: Y = a + bX
• Contribution margin


  • What is left after subtracting variable costs from sales
  • Covers fixed costs and provides for income
• Contribution format income statement

  1. Segregate variable and fixed costs

  2. Sales revenue - Variable costs = Contribution margin

  3. Contribution margin - Fixed costs = Net operating income