Cost Classifications for Predicting Cost Behavior (Variable and Fixed Cost)


Cost Classifications for Predicting Cost Behavior (Variable and Fixed Cost):

Learning objectives of this article:

  1. Define and explain variable cost and fixed cost. Give examples of variable and fixed costs.
  2. What is the difference between variable and fixed cost.
  3. What are the types of variable and fixed costs.

Definition of Cost Behavior:

Cost behavior refers to how a cost will react or respond to changes in the level of business activity. As the level of activity rises and falls, a particular cost may rise and fall as well–or it may remain constant. Quite frequently, it is necessary to predict how a certain cost will behave in response to a change in activity. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must know by how much it will change. To help make such distinctions, costs are often characterized as variable or fixed.

Variable Cost:

Definition and Explanation:

A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, Such as units produced, units sold, miles driven, beds occupied, hours worked and so forth. Direct material is a good example of variable cost.

The cost of direct materials will vary in direct proportions to the number of units produced. When we speak the term variable cost we mean that the total cost rises and falls as the activity rises and falls. One interesting aspect of variable cost is that a variable cost is constant if expressed on a per unit basis. For a cost to be variable, it must be variable with respect to something. That some thing is its activity base. An activity base is a measure of whatever causes the incurrence of variable cost. An activity base is sometimes referred to as cost driver. Some of the most common activity bases are direct labor hours, machine hours, units produced, and units sold. Other activity bases (cost drivers) might include the number of miles driven by sales persons, the number of pounds of laundry cleaned by a hotel, the number of calls handed by technical support staff at a software company, and the number of beds occupied in a hospital. To plan and control variable costs, a manger must be well acquainted with the various activity bases within the firm. .

People some times get the notion that if a cost doesn’t vary with production or with sales, then it is not really a variable cost. This is not correct. As suggested by the range of bases listed below, costs are caused by many different activities within an organization. whether a cost is considered to be variable depends on whether it is caused by the activity under consideration. For example, if a manager is analyzing the cost of service calls under a product warranty, the relevant activity measure will be the number of service calls made. Those costs that vary in total with the number of service calls made are the variable cost of making service calls.¬† Nevertheless, unless stated otherwise, you can assume that the activity base under consideration is the total volume of goods and services provided by the organization.

Some of the most frequently encountered variable costs are listed below. This is not a complete list of all costs that can be considered variable. More, some costs listed here may behave more like fixed than variable costs in some organizations.

Most Frequently Encountered Variable Costs

Type of organization Costs that are normally variable with respect to volume of output
Merchandising company Cost of goods (merchandise) sold
Manufacturing company Manufacturing costs:
Direct materials
Direct labor
Variable portion of manufacturing overhead:
Indirect materials
Lubricants
Supplies
Power
Both merchandising and manufacturing companies Selling, general and administrative costs:
Commissions
clerical costs, such as invoicing
Shipping costs
Service organizations Supplies, travel, clerical

True Variable Versus Step Variable Costs:

Not all variable costs have exactly the same behavior pattern. Some variable costs behave in a true variable or proportionately variable pattern. Other variable costs behave in a step-variable pattern.

True Variable Cost:
A cost that varies in direct proportion to the level of activity is called true variable cost. Direct material is an example of true variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts of direct materials purchased but not used can be stored and carried forward to the next period as inventory.

Step-Variable Cost:
The wages of maintenance workers are often considered to be a variable cost, but this variable cost does not behave in quite the same way as the cost of direct materials. unlike direct materials, the time of maintenance workers is obtainable only in large chunks. More any maintenance time not utilized cannot be stored as inventory and carried forward to the next period. If the time is not used effectively it is gone forever. Furthermore, a maintenance crew can work at a fairly leisurely pace if pressures are light but intensify its efforts if pressures build up. For this reason small changes in the level of production may have no effect on the number of maintenance people employed by the company. A resource that is obtained only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost.

Fixed Cost:

Definition and Explanation:

A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, the fixed costs remain constant in total amount unless influenced by some outside forces, such as price changes. Rent is a good example of fixed cost. Fixed cost can create confusion if they are expressed on per unit basis. This is because average fixed cost per unit increases and decreases inversely with changes in activity. Examples of fixed cost include straight line depreciation, insurance property taxes, rent, supervisory salary etc.

Committed Fixed Vs Discretionary Fixed Costs:

Fixed costs are some time referred to as capacity costs since they result from out lays made for building, equipment, skilled professional employees, and other items indeed to provide the basic capacity for sustained operations. For planning purposes, fixed costs can be viewed as being either committed or discretionary.

Committed Fixed Cost:
Committed fixed costs relate to the investment in facilities, equipment, and the basic organizational structure of a firm. Examples of such costs include depreciation of buildings and equipment, taxes on real estate, insurance and salaries of top management and operating personnel.

The two key characteristics of committed fixed cost are 1. They are long term in nature. 2. They cannot be significantly reduced even for short period of time without seriously impairing the profitability or long run goals of the organization. Even if operations are interrupted or cut back, the committed fixed costs will still continue largely unchanged. During a recession, for example, a firm shall not usually discharge key executives or sell of key facilities.

Since it is difficult to change a committed fixed cost once the commitment has been made, management should approach these decisions with particular care. Decisions to acquire major equipment or to take on other committed fixed costs involve a long planning horizon. Management should make such commitments only after careful analysis of the available  alternatives. Once a decision is made to build a certain size facility, a firm becomes locked into that decision for many years to come.

While not much can be done about committed fixed costs in the short run, management is concerned about how these resources are utilized. The strategy of management must be to utilize the capacity of the organization as effectively as possible.

Discretionary Fixed Cost:
Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed costs include advertising, research, public relations, management development programs, and internships for students.

Basically two key differences exist between committed fixed cost and discretionary fixed cost. First, the planning horizon of a discretionary fixed cost is fairly short term usually single year. By contrast committed fixed cost has a planning horizon that encompasses many years. Second, the discretionary fixed costs can be cut for short period of time with minimal damage to the long run goals of the organization. For example spending of management development programs can be reduced because of poor economic conditions. Although some unfavorable consequences may result from the cutback, it is doubtful that these consequences would be as great as those would result if the company decided to economize during the year by laying off key personnel.

Weather a fixed cost is regarded as committed or discretionary may depend on management’s strategy. For example during recessions when the level of home building is down, many construction companies may lay off most of their workers and virtually disband operations. Other construction companies retain large number of employees on the pay roll, even though the workers have little or no work to do. While these latter companies may face short term cash flow problems, it will be easier for them to respond quickly when economic conditions improve. And the higher moral and loyalty of their employees may give these companies significant competitive advantage.

The most important characteristics of discretionary cost is that management is not locked into a decision regarding such costs. They can be adjusted from year to year or even perhaps during the course of a year if circumstances may demand such a modification.

Summary of Variable and Fixed Cost Behavior

Cost

Behavior of the cost (within the relevant range)

In Total

Per Unit

Variable Cost
Fixed cost

Total variable cost increases and decreases in proportion to changes in the activity level.

Total fixed cost is not affected by changes in the activity level within the relevant range.

Variable cost remains constant per unit

Fixed cost per unit decreases as the activity level rises and increases as the activity level falls

You may also be interested in other useful articles from “cost terms, concepts and classifications” chapter:

  1. Manufacturing and Non-manufacturing Costs
  2. Product Costs Versus Period Costs
  3. Cost Classifications on Financial Statement
  4. Cost Classifications for Predicting Cost Behavior (Variable and Fixed cost)
  5. Mixed or Semi variable Cost
  6. Cost classification for Assigning Costs to Cost Objects (Direct and Indirect Cost)
  7. Decision making costs – cost classification for decision making
  8. Quality Costs
  9. Further Classification of Labor Costs

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