Cost behavior analysis is the study of how certain costs behave in a business. Understanding cost behavior is crucial for managers so they can control costs effectively. In this post, we will give a brief overview of cost behavior and the different types of costs a manager can analyze. More information can be found on this topic in our Accounting Tutorial.
The first step in analyzing costs is understanding and measuring key business activities. Activity levels are expressed in financial terms and can be in sales dollars, miles driven, classes taught, etc. The activity level should be correlated with changes in costs. The activity index identifies the activity that causes changes in the behavior of costs. This allows managers to make decisions to further control costs. There are three types of costs: variable, fixed, and mixed.
Variable costs are costs in a business that vary in total directly and proportionately with the changes in an activity level. For example, if an activity level increases 20%, total variable costs will increase 20%. The proportion is the same if the activity level decreases. Examples of variable costs include direct materials and direct labor. For example, the more a company drives, the more gasoline expenses they will have. So if the activity level “driving” goes up 25%, the costs for gasoline and other driving expenses will go up 25%.
Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, salaries, etc. Because fixed costs do not change with activity level, as volume increases, unit cost declines and vice versa. For example, let’s say a company’s rent was $10,000 a month. While the rent expense is constant no matter how much the company produces, the unit cost of each part produced will go down in cost as volume goes up. If the company produces 10% more parts in a month, the total cost per part produced will go down 10%.
Mixed costs are costs that contain both a variable element and a fixed element. A truck rental is a good example of a mixed cost. For example, renting a truck has a fixed cost of $100, but also variable costs of $0.50 a mile.
In order to classify and analyze mixed costs, managers use the high-low method. The high-low method uses the total costs incurred at the high and low levels of activity to classify mixed costs into their two components: fixed and variable. The difference in costs between the high and low levels represents variable costs, since only the variable cost can change as activity levels change.
Steps in computing fixed and variable costs using High-low method:
- Determine Variable cost per unit
- Determine the fixed cost by subtracting the total variable cost at either the high or low activity level from the total cost at that activity level
Besides cost behavior in general, managers should be aware of the effect of costs on profits. Cost-volume-profit analysis is the study of the effects of changes in costs and volume on a company’s profits. CVP analysis is important for cost controlling and also for profit planning and budgeting. It can also be used when making decisions with selling prices, determining product mix, and maximizing use of production facilities.