In this chapter we shall examine cost behaviour i.e. the way costs behave at different levels of activity and how the analysis of costs in this manner can help management to make the best choice from a number of alternatives. In addition, we shall be covering the techniques to enable the break-even point to be established and how these calculations
can assist in the decision making process.
Cost behaviour means the way that a cost changes as the volume of activity or output changes. For example, if a company manufactures shirts, we would expect the total cost of making and selling 10,000 shirts to be more than the total cost of making and selling 5,000 shirts. In other words, total costs should rise as the volume of output and sales rises. However, not all individual items of expense will incur higher costs as the output level rises.
Cost behaviour analysis is concerned with how costs change with the 'level of activity' and by how much. Individual items of cost can be classified according to their cost behaviour. There are many different cost behaviour 'patterns', but many costs can be classified according to behaviour as:
1. Fixed costs
2. Variable costs
3. Semi-variable (and semi-fixed) costs
4. Step costs.
Fixed costs are costs that are not affected in total by the level of activity, but remain the same amount regardless of how much or how little work is done in a period. Fixed cost is also called time cost and period cost. An example is the rent of a factory, which is a constant amount each period regardless of how much or how little is manufactured inside it. The rent paid on a factory may be Rs. 50,000 per month whether 2 shirts or 200 shirts or 2,000 shirts are made, as in the diagram below:
Note that a fixed cost is not a cost that necessarily stays the same over a period of time. The key is that it doesn't vary with activity. So, for example, heating costs are generally considered to be fixed as they must be paid regardless of the level of production. These costs will be higher in winter than in summer. If an item of cost is fixed in total, then the cost per unit must fall as the activity level increases, as in the diagram that follows:
If 2 shirts are made the fixed cost per unit is Rs.5,000. i.e. Rs.2,500 per bat.
If 200 shirts are made the fixed cost per unit is Rs.5,000, i.e. Rs.25 per bat.
As the activity level increases, fixed costs remain the same in total, but the cost per unit of activity falls. For cost accounting purposes, fixed costs stay at the same level irrespective of the level of output.
Variable costs are costs that change in direct proportion to the level of activity. It may be defined as the amount at any given volume of output by which aggregate costs are charged if the volume of output is increased or decreased by one unit. Marginal cost is the variable cost comprising prime cost and variable overheads. The variable costs will usually comprise raw materials and direct labour - the prime costs of the product. Each additional unit produced of a product needs the same quantity of materials, which costs the same. Similarly, direct labour is treated as a variable cost, because each extra unit produced needs the same time as the previous units. Also, any direct expenses or variable overheads (an example would be royalties payable on the basis of number of units produced.) Increase in output will lead to increase in total variable cost and decrease in output will lead to reduction in total variable cost. For example, if the cost of direct materials is two metres at Rs.20 per kg for each shirt, this amounts to Rs.40 per shirt. So, the total materials cost is Rs.40 if one unit is made, Rs.80 if 2 units are made and Rs.8,000 if 200 units are made, as in the diagram below:
MARGINAL COST = VARIABLE COST = DIRECT LABOUR + DIRECT MATERIAL + DIRECT EXPENSE + VARIABLE OVERHEADS
However, variable cost per unit of production remains the same irrespective of increase or decrease in volume of production. This is illustrated in the diagram below:
As the level of activity increases, total variable costs increase in direct proportion to the increase in activity, but the variable cost per unit of activity remains the same. For cost accounting purposes, variable costs move directly in line with output.
Semi-variable costs are those which have both fixed and variable elements. An example is telephone costs, which consist of a fixed period rental and charges for calls made. Since call charges tend to vary with the volume of activity, telephone charges are roughly semi-variable in relation to the volume of production and sales. Semi-variable costs are usually divided into their fixed and variable components. The fixed portion is included in fixed costs for the period and the variable portion included within total variable costs.
In cost accounting, it is usual to analyse semi-variable costs by separating them into their fixed and variable elements. An important technique for doing this is the high-low method, which is described later.
Step costs are costs that are constant for a range of activity levels, and then change, and are constant again for another range. An example is the cost of invigilators salaries. For example, for invigilation of upto 50 students, it might be sufficient to have just one invigilator, whereas if 50 to 100 are supervised two invigilators would be necessary and so on. The key feature of step costs is that they are fixed within a limited range of activity, but then go up a step as the activity level rises beyond a certain level.
Knowing about step costs can be important for decision-makers, who need to know whether as of any decision they take some costs might rise or fall a step. In practice, however, it is often to treat step costs as either fixed costs for the period (on the assumption that activity will within a range that keeps the cost on the same level) or variable costs, where there are number of small steps as activity increases. When there are a large number of small steps as levels rise, it becomes reasonably accurate to treat the cost as a variable cost item, sacrificing much accuracy.
This knowledge about the changes in behaviour of costs can yield wonderful results for any business in decision-making. Based on these changes in behaviour of costs, a very effective cost accounting technique emerges. It is known as marginal costing. Marginal Costing is a management technique of dealing with cost data. It is based primarily on the behavioural study of cost.