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Cost Behavior

 

When we talk about cost behavior, we aren't referring to "good" or "bad" behavior. Cost behavior is nothing more than the sensitivity of costs to changes in production or sales volume. The range of output or sales over which cost behavior patterns remain unchanged is called the relevant range.

Fixed costs: Fixed costs are constant in total over the relevant range. Fixed costs per unit often cause difficulties for students because of the inverse relationship between fixed costs and increases in production. As production increases, total fixed costs stay the same within the relevant range, but since we are dividing a constant numerator [total fixed costs] by a progressively larger denominator [total production or sales], the resulting costs per unit become smaller and smaller. Fixed costs include things like rent, insurance premiums, salaries, depreciation and property taxes. Click here for a graph of Charlie's fixed costs.

Variable costs: Variable costs vary in total with volume, but are constant per unit within the relevant range. Total variable costs for a given situation are equal to the number of units multiplied by the variable cost per unit. Variable costs include things like labor and materials. Some overhead [indirect costs] such as indirect labor, supplies and some utilities are also variable. Note that the graph of a variable cost is a straight line with positive slope, beginning at the origin. the slope of the variable cost line is the variable cost per unit.

Mixed costs: A mixed costs contains both fixed and variable elements. There are a variety of procedures that can be employed to separate the fixed and variable components. The easiest is to use two points on the total cost line to derive the slope and intercept. This is rough and ready and may yield inaccurate results. Regression analysis is a more accurate procedure which also has the benefit of providing measures of goodness of fit; these tell us how well the derived equation fits the observed data. The Y-intercept of a mixed cost line is the total fixed costs. The slope is the variable cost per unit, and any point on the line represents the total cost at the indicated volume. Click here for a graph.

Step costs: Yet another cost behavior pattern has a stair step pattern. Charlie doesn't happen to have any costs that behave this way, but if he did, they would look like this.

By now you have probably figured out that the relationship between revenues, costs, and production or sales volumes can be an important element in understanding the economics of a business. These relationships are typically referred to as cost volume profit [CVP] relationships. Analysis of these relationships is usually called CVP analysis. Before we can see how CVP analysis works, we need to define an important concept: contribution margin.

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Copyright 2004 Gerald M. Myers. All rights reserved. This site has been developed as aid to instructors and students in managerial accounting. The scenarios contained herein are not intended to reflect effective or ineffective handling of managerial situations. Any resemblance to existing organizations is purely coincidental.
Last modified: August 03, 2005