Accounting: The Language of Business - Vol. 1 (Part 119)

“Never take your eyes off the cash flow because it’s the lifeblood of business.”

—Sir. Richard Branson

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

by

Charles Lamson

What are the costs of operating your car? You will normally pay a license plate (tag) fee once a year. This cost does not change, regardless of the number of miles you drive. On the other hand, the total amount you spend on gasoline during the year changes on a day-to-day basis as you drive. The more you drive, the more you spend on gasoline.

How does such operating cost information affect you? Information on how your car's operating costs behave could be relevant in planning a summer vacation. For example, you might be trying to decide between taking an airline flight or driving your car to your vacation destination. In this case, your license plate fee and annual car insurance costs will not change, regardless of whether you drive your car or fly.  Thus, these costs would not affect your decision. However, the estimated cost of gasoline and routine maintenance would affect your decision.

As in operating your car, all of the costs of operating a business do not behave in the same way. In the next several posts, we discuss commonly used methods for classifying costs according to how they change. We will also discuss how management uses cost-volume-profit analysis as a tool in making decisions.

Cost Behavior

Knowing how costs behave is useful to management for a variety of purposes. For example, knowing how costs behave allows managers to predict profits as sales and production volumes change. Knowing how costs behave is also useful for estimating costs. Estimated costs, in turn affect a variety of management decisions, such as whether to use excess machine capacity to produce and sell a product at a reduced price.

Cost Behavior refers to the manner in which a cost changes as a related activity changes. To understand cost behavior, two factors must be considered. First, we must identify the activities that are thought to relate to the cost incurred. Such activities are called activity bases (or activity drivers). Second, we must specify the range of activity over which the changes in the cost are of interest. This range of activity is called the relevant range.

To illustrate, hospital administrators must plan and control hospital food costs. To fully understand why food costs change, the activity that causes costs to be incurred must be identified. In the case of food costs, the feeding of patients is a major cause of these costs. The number of patients treated by the hospital would not be a good activity base, since some patients are outpatients who do not stay in the hospital. The number of patients who stay in the hospital, however, is a good activity base for studying food costs. Once the proper activity base is identified, food costs can then be analyzed over the range of the number of patients who normally stay in the hospital (the relevant range).

Three of the most common classifications of cost behavior are variable costs, fixed costs, and mixed costs. In this post, we will discuss variable costs. In part 120, we will discuss fixed costs and mixed costs.

Variable Costs

When the level of activity is measured in units produced, direct materials and direct labor costs are generally classified as variable costs. Variable costs are costs that vary in proportion to changes in the level of activity. For example, assume that Jason Inc. produces stereo sound systems under the brand name of J-Sound. The parts for the stereo systems are purchased from outside suppliers for $10 per unit and are assembled in Jason Inc.'s Waterloo Plant. The direct materials costs for model JS-12 for the relevant range of 5,000 to 30,000 units of production are shown below.

Variable costs are the same per unit, while the total variable cost changes in proportion to changes in the activity base. For model JS-12, for example, the direct materials cost for 10,000 units ($100,000) is twice the direct materials cost for 5,000 units ($50,000). The total direct materials cost varies in proportion to the number of units produced because the direct materials cost per unit ($10) is the same for all levels of production. Thus, producing 20,000 additional units of JS-12 will increase the direct materials cost by $200,000 (20,000 * $10), producing 25,000 additional units will increase the materials cost by $250,000, and so on.

Exhibit 1 illustrates how the variable costs for direct materials for model JS-12 behave in total and on a per-unit basis as production changes.

There are a variety of activity bases used by managers for evaluating cost behavior. The following list provides some examples of variable costs, along with their related activity basis for various types of businesses. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 826-827*

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