COST BEHAVIOR: INTRODUCTION TO FIXED AND VARIABLE COSTS

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The idea of cost behavior is one of the most important concepts in managerial accounting.
Determining how a cost will behave is critical to planning, decision making and controlling. Two
types of costs are discussed in this post: variable costs and fixed costs. These types of costs get
their names because of how they behave when we look at the costs in total.

Variable Costs

Variable costs are costs that increase incrementally as a driver increases. A driver is an activity
or event that causes a cost to increase. All variable costs must have a driver. Two of the most
common drivers used in managerial accounting are units and hours, but there are lots of
different drivers that could be used like customers or miles. If you can determine that a cost is
driven by a particular activity, you can use that driver to calculate a variable cost.

A variable cost must have a rate. The rate is expressed as a cost per unit of the driver. For
example, direct labor costs are expressed as dollars per direct labor hour. To calculate the total
variable cost, multiply the rate by the units of activity.

Total Variable Cost = Rate x Activity

In our planning and decision making calculations, we assume that the variable rate stays the
same. Only the driver increases or decreases. Because the rate stays the same, the cost will
increase by the amount of the rate for each additional unit of activity. All variable costs will be
zero if there is no activity.

 Cost Behavior – Meaning, Importance, Types

Cost Behavior is the change in the behavior of a cost (or costs) due to a change in business
activity. The study of this change is the cost behavior analysis. For example, the electricity cost
will move up if a business extends the working hours.

However, not all costs change with business activity. And, some costs may remain stagnant
despite a change in business activity. For instance, a company needs to pay insurance whether
or not it is operating. Some costs do not change in proportion to the change in business
operations. A company usually uses mathematical cost functions to study the behavior of costs.
Table of Contents
Before analyzing the behavior of costs, a manager needs to understand the crucial business
activities that may impact the costs. Usually, a manager can define activity levels in terms of
dollars, units; miles were driven, and more. Moreover, the manager should try to determine the
correlation between activity levels and costs.

Cost Behavior – Importance

Following points highlight the importance of cost behavior:

o A manager needs to understand the behavior of the costs when creating an annual
budget. Knowing this allows the manager to determine beforehand if any cost will
decline or rise with the change in the business activity. For example, if a company is
operating at the full production capacity, then to fulfill more demand, the company will
have to invest more in the production line.

o Understanding cost behavior is essential for cost-volume-profit analysis as well. The

cost-volume-profit (CVP) analysis studies the impact of change in costs and volume on
the profit.

o It helps the management in planning and controlling costs.

Types of Cost by Behavior

Primarily, there are three types of cost by behavior:

Variable Costs

Such costs vary directly (or in direct proportion) with the change in the business activity. In
direct proportion means if the activity level changes by 10%, then the variable cost must also
change by 10%. It holds good for both an increase and a decrease in the variable cost. For
example, displays are a variable cost for a mobile manufacturer. The more the number of
mobiles a manufacturer produces, the more will be the cost spent on displays.

An interesting observation is that the variable cost per unit remains constant despite a change
in the level of business activity. For example, the total variable cost of Company ABC for three
straight quarters is 5000, 20,000, and 15,000. Company ABC produces 5000, 20000, and 15000
units, respectively. The variable cost per unit in all three cases will be 1.
Fixed Costs
These costs do not change with any change in business activity. For example, a business will still
need to pay rent even if it is generating zero sales. Depreciation is another example of a fixed
cost.

A point to note is that a fixed cost per unit may increase or decrease with the change in the
level of business activity. For example, suppose fixed cost for a business is 15,000, but the units
produced for the three straight quarters were 3000, 5000 and 1000. The fixed cost per unit in
the three cases is 5, 3, and 15, respectively.
Mixed or Semi-variable Costs

Such costs are a mixture of fixed and variable costs, and thus, contain the elements of both. For
example, an internet bill includes a fixed monthly charge plus a variable fee based on usage.
Generally, these costs are not very useful to the company in its original form. So, accountants
usually split them based on their fixed and variable components. To do so, they use cost
behavior analysis techniques, such as Scatter Diagram, Regression Analysis, High-Low Method,
and more.

Cost Functions
As said in the first paragraph, companies use mathematical cost functions to study the behavior
of costs, usually the Mixed price. A cost function is often in the form of a mathematical
equation, such as y = MX + b. One can also plot it on a graph. In the equation, b is the fixed cost,
x is the number of units, and m is the variable cost or the slope.

To effectively or simplify the use a cost function, one needs to consider the following
assumptions:

o Any change in the cost driver explains the difference in costs.

o One can summarize the cost behavior into a linear cost function having a relevant range.
The range here means the field within which the relationship between the cost and the
level of activity holds.

One can use quantitative techniques to define a cost function, and in turn, analyze the cost
behavior. The simplest technique is the high-low method, which considers the highest and
lowest values of the cost driver and the total costs to which that cost driver contributes.

For example, Company ABC incurs following overhead costs in the first five months – 10,000,
15,000, 8,000, 12,000 and 9,000. The labor hours during these months were 800, 1000, 600,
900, and 700, respectively.
The highest and lowest value for overhead costs of 15,000 and 8,000 while for labor hours 1000
and 600, respectively. Difference between the highest and lowest values is 7,000 (15,000 Less
8,000) and 400 (1000 Less 600).
Calculating slope or variable cost = 7,000/400 = 17.5. It means that for additional labor hours,
the overhead costs rise by 17.5.

Alternatively, we can use regression analysis (or the method of least squares) for the cost
behavior analysis. Unlike the high-low method, the regression method uses all the values and
not just the highest and lowest values. We can use the regression function in MS Excel for this.

Cost behavior is an important concept in accounting. The efficient use of the concept would
assist the management in exercising and managing control costs, and in turn, boost the profit
margin

Example #1

Direct materials cost per unit of a product is 4 per unit. What is the total cost of direct
materials if 1,000 units are produced? What if 2,500 units are produced?

Direct materials are a variable cost. We have a rate and a driver. The driver in this case is units.
For each unit that is produced, the total cost of direct materials increases by 4.

To calculate the total cost of materials, take the rate and multiply by the activity.

4 per unit X 1,000 units = 4,000

4 per unit X 2,500 units = 10,000

Yes, it is really that easy.

Some other variable costs include direct labor, variable manufacturing overhead, and variable
selling costs.

Fixed Costs

Fixed costs are costs that do not change as activity levels increase. Fixed costs do not have a
driver. Most fixed costs are expressed in terms of time, like per month or per year. No matter
what happens during that time, the cost stays the same. If the company pays 12,000 per month
for rent, it does not matter if the company produces no units or is at maximum capacity. The
rent is the same.

Sometimes, fixed costs are expressed as a per unit cost or a per hour cost for a certain level of
activity. These leads people to believe that these are actually variable costs. It is possible to
express a fixed cost on a per unit basis but remember that the total cost is not driven by that
activity. The total cost is still the same no matter how many units of activity occur.

Example #2
Fixed manufacturing overhead costs are estimated to be 5 per unit for 10,000 units. What is
the total manufacturing overhead cost for 12,000 units assuming that the companies
manufacturing capacity is 15,000 units?

When quickly looking at the example, it would appear that the manufacturing costs are variable
because they are expressed as a per unit rate. However, this rate is only valid when 10,000
units are produced because we are told that the cost is fixed.

o calculate the total fixed overhead, multiply the rate by the number of units for which that
rate applies.

5 per unit X 10,000 units = 50,000

Because this cost is fixed, the total cost will be the same for 12,000 units as it is for 10,000
units. Remember, fixed costs are fixed in total!

What happens to the rate as we produce more units? Let’s take a look.

Example #3

Using the solution from Example #2, calculate the fixed cost per unit for 12,000 units.

Will the per unit rate for fixed manufacturing overhead be the same if we produce 12,000 units
instead of 10,000 units? No, it won’t. That’s because we are taking the same total cost and
allocating it over more units. Therefore, the per unit cost will fall.

To calculate the per unit cost, take the total cost and divide it by the number of units.

50,000 / 12,000 units = 4.17 (rounded)

The cost per unit is lower for 12,000 units than for 10,000 units because the total costs stay the
same.

Relevant Range

When we make these assumptions about cost, we have to consider the relevant
range. Relevant range is the range of activity in which the assumptions are true. If the activity is
outside the relevant range, then cost assumptions about variable rate and fixed cost will
change.

For example, if the company pays 12,000 per month for rent and the maximum production
capacity because of space limitations is 15,000 units, what happens when the company wants
to make 16,000 units? Well, the company can’t make 16,000 units in its current space. If it
wanted to make an additional 1,000 units, the company would need to rent additional space or
move to a new space. Producing 16,000 units is outside the relevant range and therefore
12,000 per month for rent would no longer be valid at that production level. The relevant range
for the rent is zero units produced to 15,000 units produced.

Final thoughts

When considering how a cost behaves, look at how the cost behaves in total. Variable costs
vary in total based on the level of activity. If there is no activity the total cost is zero. Fixed costs
do not change based on activity. The cost will stay the same in total as long as activity is within
the relevant range. Because fixed costs are fixed in total, the per unit rate will change as
production changes. The higher the level of production, the lower the per unit rate will be
because a fixed amount of money is being spread out among more units.

COST BEHAVIOR: INTRODUCTION TO FIXED AND VARIABLE COSTS

The idea of cost behavior is one of the most important concepts in managerial accounting.
Determining how a cost will behave is critical to planning, decision making and controlling. Two
types of costs are discussed in this post: variable costs and fixed costs. These types of costs get
their names because of how they behave when we look at the costs in total.

Variable Costs

Variable costs are costs that increase incrementally as a driver increases. A driver is an activity
or event that causes a cost to increase. All variable costs must have a driver. Two of the most
common drivers used in managerial accounting are units and hours, but there are lots of
different drivers that could be used like customers or miles. If you can determine that a cost is
driven by a particular activity, you can use that driver to calculate a variable cost.

A variable cost must have a rate. The rate is expressed as a cost per unit of the driver. For
example, direct labor costs are expressed as dollars per direct labor hour. To calculate the total
variable cost, multiply the rate by the units of activity.

Total Variable Cost = Rate x Activity

In our planning and decision making calculations, we assume that the variable rate stays the
same. Only the driver increases or decreases. Because the rate stays the same, the cost will
increase by the amount of the rate for each additional unit of activity. All variable costs will be
zero if there is no activity.

Example #1

Direct materials cost per unit of a product is 4 per unit. What is the total cost of direct
materials if 1,000 units are produced? What if 2,500 units are produced?
Direct materials are a variable cost. We have a rate and a driver. The driver in this case is units.
For each unit that is produced, the total cost of direct materials increases by 4.

To calculate the total cost of materials, take the rate and multiply by the activity.

4 per unit X 1,000 units = 4,000

4 per unit X 2,500 units = 10,000

Yes, it is really that easy.

Some other variable costs include direct labor, variable manufacturing overhead, and variable
selling costs.

Fixed Costs

Fixed costs are costs that do not change as activity levels increase. Fixed costs do not have a
driver. Most fixed costs are expressed in terms of time, like per month or per year. No matter
what happens during that time, the cost stays the same. If the company pays 12,000 per month
for rent, it does not matter if the company produces no units or is at maximum capacity. The
rent is the same.

Sometimes, fixed costs are expressed as a per unit cost or a per hour cost for a certain level of
activity. These leads people to believe that these are actually variable costs. It is possible to
express a fixed cost on a per unit basis but remember that the total cost is not driven by that
activity. The total cost is still the same no matter how many units of activity occur.

Example #2

Fixed manufacturing overhead costs are estimated to be 5 per unit for 10,000 units. What is
the total manufacturing overhead cost for 12,000 units assuming that the companies
manufacturing capacity is 15,000 units?

When quickly looking at the example, it would appear that the manufacturing costs are variable
because they are expressed as a per unit rate. However, this rate is only valid when 10,000
units are produced because we are told that the cost is fixed.

To calculate the total fixed overhead, multiply the rate by the number of units for which that
rate applies.

5 per unit X 10,000 units = 50,000

Because this cost is fixed, the total cost will be the same for 12,000 units as it is for 10,000
units. Remember, fixed costs are fixed in total!
What happens to the rate as we produce more units? Let’s take a look.

Example #3

Using the solution from Example #2, calculate the fixed cost per unit for 12,000 units.

Will the per unit rate for fixed manufacturing overhead be the same if we produce 12,000 units
instead of 10,000 units? No, it won’t. That’s because we are taking the same total cost and
allocating it over more units. Therefore, the per unit cost will fall.

To calculate the per unit cost, take the total cost and divide it by the number of units.

50,000 / 12,000 units = 4.17 (rounded)

The cost per unit is lower for 12,000 units than for 10,000 units because the total costs stay the
same.

Relevant Range

When we make these assumptions about cost, we have to consider the relevant
range. Relevant range is the range of activity in which the assumptions are true. If the activity is
outside the relevant range, then cost assumptions about variable rate and fixed cost will
change.

For example, if the company pays 12,000 per month for rent and the maximum production
capacity because of space limitations is 15,000 units, what happens when the company wants
to make 16,000 units? Well, the company can’t make 16,000 units in its current space. If it
wanted to make an additional 1,000 units, the company would need to rent additional space or
move to a new space. Producing 16,000 units is outside the relevant range and therefore
12,000 per month for rent would no longer be valid at that production level. The relevant range
for the rent is zero units produced to 15,000 units produced.

Final thoughts

When considering how a cost behaves, look at how the cost behaves in total. Variable costs
vary in total based on the level of activity. If there is no activity the total cost is zero. Fixed costs
do not change based on activity. The cost will stay the same in total as long as activity is within
the relevant range. Because fixed costs are fixed in total, the per unit rate will change as
production changes. The higher the level of production, the lower the per unit rate will be
because a fixed amount of money is being spread out among more units.

Another way to look at it is:

Variable rate does not change, but total variable cost does change as activity changes.

Total fixed costs do not change, but fixed rate does change as activity changes.

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