Accounting: The Language of Business - Vol. 1 (Part 120)

"The wildlife of today is not ours to do with as we please. The original stock was given to us in trust for the benefit both of the present and the future. We must render an accounting of this trust to those who come after us." - Theodore Roosevelt  

 Cost Behavior and Cost-Volume-Profit Analysis (Part B) 

by

Charles Lamson

Fixed Costs

Fixed costs are costs that remain the same in total dollar amount as the level of activity changes. To illustrate, assume that Minton Inc. manufactures, bottles, and distributes Le Fleur Perfume at its Los Angeles plant. The production supervisor at the Los Angeles plant is Jane Sovissi, who is paid a salary of $75,000 per year. The relevant range of activity for a year is 50,000 to 300,000 bottles of perfume. Sovissi's salary is a fixed cost that does not vary with the number of units produced. Regardless of the number of bottles produced within the range of 50,000 to 300,000 bottles, Sovissi receives a salary of $75,000.

Although the total fixed cost remains the same as the number of bottles produced changes, the fixed cost per bottle changes. As more bottles are produced, the total fixed costs are spread over a larger number of bottles, and thus the fixed cost per bottle decreases. This relationship is shown below for Jane Sovissi's $75,000 salary.

Exhibit 2 illustrates how the fixed cost of Jane Sovissi's salary behaves in total and on a per-unit basis as production changes. When units produced is the measure of activity, examples of fixed costs include straight-line depreciation of factory equipment, insurance on factory plant and equipment, and salaries of factory supervisors. Other examples of fixed costs and their activity bases for a variety of businesses are as follows:

Mixed Costs

A mixed cost has characteristics of both a variable and a fixed cost. For example, over one range of activity, the total mixed cost may remain the same. It thus behaves as a fixed cost. Over another range of activity, the mixed cost may change in proportion to changes in the level of activity. It thus behaves as a variable cost. Mixed costs are sometimes called semivariable or semifixed costs.

To illustrate, assume that Simpson Inc. manufactures sails, using rented machinery. The rental charges are $15,000 per year, plus $1 for each machine hour used over 10,000 hours. If the machinery is used 8,000 hours, the total rental charge is $15,000. If the machinery is used 20,000 hours, the total rental charge is $25,000 [$15,000 + (10,000 hours X $1)], and so on. Thus, if the level of activity is measured in machine hours and the relevant range is 0 to 40,000 hours, the rental charges are a fixed cost up to $10,000 and a variable cost thereafter. This mixed behavior is shown graphically in Exhibit 3.

In analyses, mixed costs are usually separated into their fixed and variable components. The high-low method is a cost estimation technique that may be used for this purpose. The high-low method uses the highest and lowest activity levels and their related costs to estimate the variable cost per unit and the fixed cost component of mixed costs.

To illustrate, assume that the Equipment Maintenance Department of Kason Inc. incurred the following costs during the past five months:

The number of units produced is the measure of activity, and the number of units produced between June and October is the relevant range of production. For Kason Inc., the difference between the number of units produced and the difference between the total cost at the highest and lowest levels of production are as follows:

Since the total fixed cost does not change with changes in volume of production, the $20,250 difference in the total cost is the change in total variable cost. Hence, dividing the difference in the total cost by the difference in production provides an estimate of the variable cost per unit. For Kason Inc., this estimate is $15, as shown below:

Variable cost per unit = Difference in total cost / Difference in production

Variable cost per unit = $20,250 / 1,350 units = $15

The fixed cost will be the same at both the highest and lowest levels of production. Thus, the fixed cost can be estimated at either of these levels. This is done by subtracting the estimated total variable cost from the total cost, using the following total cost equation: 

Total cost = (Variable cost per unit X Units of production) + fixed cost

The total equipment maintenance cost for Kason Inc. can thus be analyzed as a $30,000 fixed cost and a $15 per unit variable cost. Using these amounts in the total cost equation, the total equipment maintenance cost at other levels of production can be estimated.

Summary of Cost Behavior Concepts

The following table summarizes the cost behavior attributes of variable costs and fixed costs: 

Examples of common variable, fixed, and mixed costs when the number of units produced is the activity base are:

Mixed costs contain a fixed cost component that is incurred even if nothing is produced. For analyses, the fixed and variable cost components of mixed costs should be separated. Separating costs into their variable and fixed components for reporting purposes can be useful for decision making. One method of reporting variable and fixed costs is called variable costing or direct costing. Under variable costing only the variable manufacturing costs (direct materials, direct labor, and variable factory overhead) are included in the production cost. The fixed factory overhead is an expense of the period in which it is incurred. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 828-831*

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