Some costs, are changed in terms of production and some costs are fixed up to a specific level of production, then changed in terms of production. Again, some costs are not changed at all. Characteristics of the costs are called cost behavior.
On the other hand, cost behavior refers to the way different types of production costs change when there is a change in the level of production.
Elements of Cost Behavior
There are 3 main types of costs or elements of cost behavior are;
- Fixed Costs.
- Variable Costs.
- Mixed Costs.
Fixed costs are those which do not change .with the level of activity within the relevant range. These costs will incur even if no units are produced.
For example rent expense, straight-line depreciation expense, etc.
The main features of the fixed cost are:
Fixed cost is a cost that does not vary in the short term
A fixed cost is a cost that does not vary in the short term, irrespective of changes in production or sales levels, or other measures of activity.
For example, the rent on a building will not change until the lease runs out or is re-negotiated, irrespective of the level of business activity within that building. Examples of other fixed costs are insurance, depreciation, and property taxes.
Sufficient margin to offset the fixed cost
When a company has a large fixed cost component, it must generate a significant amount of sales volume to have a sufficient contribution margin to offset the fixed cost.
Once that sales level has been reached, however, this type of business generally has a relatively low variable cost per unit, and so can generate outsized profits above the breakeven level.
Fixed costs are allocated under the absorption basis of cost accounting
Fixed costs are allocated under the absorption basis of cost accounting. Under this arrangement, fixed manufacturing overhead costs are proportionally assigned to the units produced in a reporting period, and so are recorded as assets.
Once the units are sold, the costs are charged to the cost of goods sold. Thus, there can be a delay in the recognition of those fixed costs that are allocated to inventory.
Classification of Fixed Cost According to its Behavior
Fixed cost is the cost that accrues about the passage of time and which, within certain limits, tends to be unaffected by fluctuations in the level of activity.
A going business should have physical facilities and an organization for use.
These things provide the capacity to manufacture and sell. The continuing costs of having capacity incurred in anticipation of future activity are termed as “capacity costs”. In case capacity is utilized, additional costs are incurred.
Such additional costs of manufacturing and selling are controllable with current activity, while capacity costs tend to continue regardless of the current rate of activity as long as the same capacity is maintained.
Fixed costs are those which are not expected to change in total within the current budget year, irrespective of variations in the volume of activity.
Such costs are fixed for a given period over a relevant range of output, on the assumption that technology and methods of’ manufacturing remain unchanged. For cost analysis, fixed costs may be classified as follows:
These costs cannot be eliminated instantly. These costs are incurred to maintain basic facilities. Example: Rent, rates, taxes, insurance.
Policy and Managed Costs
Policy costs are incurred in enforcing management policies. Example: Housing scheme for employees. Managed costs are incurred to ensure the operating existence of the company. Example: Staff services.
These are not related to operations. These can be controlled by the management. These occur at the discretion of the management.
Variable costs change in direct proportion to the level of production. This means that the total variable cost increase when more units are produced and decreases when fewer units are produced.
Although variable in total, these costs are constant per unit. The main features of variable costing are:-
- All the costs like production, administration, selling and distribution costs are classified into a fixed and variable cost.
- Variable costs are charged to production costs. Fixed costs are not charged to production costs. Rather, it is charged to the contribution margin.
- All the fixed costs are taken as periodical cost and it is charged to the profit and loss account of that year when it occurred.
- Finished goods and work in progress are valued by taking variable manufacturing costs only.
- It has its method of calculation of profit. The profit is determined by deducting the total fixed cost from the contribution margin. The contribution margin is ascertained by deducting the total variable cost from sales.
Mixed costs or semi-variable costs have properties of both fixed and variable costs due to the presence of both variable and fixed components in them.
An example of mixed cost is telephone expense because it usually consists of a fixed component such as line rent and fixed subscription charges as well as variable cost charged per minute cost.
Another example of mixed cost is a delivery cost which has a fixed component of depreciation cost of trucks and a variable component of fuel expense.
Methods of Segregating Mixed Cost
To segregate semi-variable cost into fixed cost and variable cost is necessary because, with this, we can add a fixed cost proportion in total fixed cost and variable cost proportion in total variable cost.
So, with the following method, we can carry out this.
With the graphical method, we draw the graphic line of semi-variable cost by taking output on the x-axis and total semi-variable cost at the y-axis.
After this, we do judgment and select a point where will be our fixed cost in semi-variable cost. After this, we draw the line of best fit. This line shows the fixed cost which will not be changed after changing output.
High Points and Low Points Method
Under this method, we calculate total sales and total costs at the highest level of production. Then we calculate total sale and total cost at the lowest level of production.
Because semi-variable cost has both variable and fixed costs.
We first calculate the variable rate with the following formula:
Variable Cost (b) = (Highest value-Lowest value) / (Highest activity – Lowest activity)
Estimate the fixed Cost Level:
Fixed Cost (a) = Total Cost – Variable Cost.
Under this method, the cost accountant does some analysis for dividing semi-variable cost into fixed cost and variable cost. After this, he calculates fixed cost on that rate which analyzed.
Suppose, a cost accountant says that in the total semi-variable cost, there may be a 30% fixed cost and 70 % variable cost. Now the total semi-variable cost will be divided on this basis.
If the production level will increase, the variable cost’s proportion will increase at the same rate. But the fixed cost will not change.
Level of Activity Method
In this method, we compare two-level of production with the number of expenses in these levels. Variable cost will be calculated with the following method.
Level of Activity = Change in semi-variable cost / Change in production volume
Least Square Method
This is a statistical method in which we use this method for calculating a line of best fit. This method is based on the linear equation y = mx+c, y is the total cost, x is the volume of output and c is a total fixed cost.
By solving this equation mathematically, we can calculate the variable cost(M) at different levels of production.