Cost Classifications for Predicting Cost Behavior (Variable and Fixed Cost):
Learning objectives of this article:
- Define and explain variable cost and
fixed cost. Give examples of variable and fixed costs.
- What is the difference between
variable and fixed cost.
- 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
|
|
