Cost Behavior

What is Cost Behavior?

Cost behavior refers to the way costs change in response to variations in activity levels within a business. That activity may be producing more units, or it may be using more employees on a project. Companies need to know how costs behave as activity changes. It is generally expected that costs will increase as output increases, but some costs behave differently. The four key types of cost behavior are fixed costs, step fixed costs, variable costs, and mixed costs.

Importance of Cost Behavior

Understanding cost behaviours and how costs change with output helps companies to budget accurately. Budgeting helps with two core objectives, planning and control. It is a financial or quantitative plan of operations for the forthcoming period, i.e., how much does the company think it’s going to spend next year.

Firstly, planning – this relates to how much is going to be spent and how much finance is needed to support all of the spending. This will involve working out elements such as how many units need to be produced, how many units of material need to be purchased and how much resource need to be set aside. A key component of this is typically labor hours and the number of employees required. All of this budgeting helps companies plan for future growth.

Secondly, control is an important aspect of budgeting. A target or plan helps to determine what a reasonable cost will be. This can involve in-depth analysis such as calculating how much someone should be paid for an hour of work. Controllers will also need to understand how long it should take to produce one unit of output and the maximum that can be produced at key times.

Types of Cost Behavior

Different costs behave differently as output rises:

1)     Fixed Costs

A fixed cost does not increase as output goes up, so as a company produces more units or operates for longer time periods, the cost will stay fixed. This may be something such as the annual rent on a facility or site. Once rented it will not fluctuate in price depending on how much is produced on site. The fixed cost formula is shown below:

Fixed Cost Formula

The graph below shows fixed costs, the X horizontal axis shows Output, and the vertical Y axis shows Costs. As you can see an increase in output does not lead to an increase in costs.

Step Fixed Costs

A step fixed costs means cost is fixed for a certain amount of production, but it increases in incremental rises. We might see an incremental rise in factory costs when a second factory is opened or additional production facilities. This is represented on a graph as a stepped line.

Variable Costs

Variable costs fluctuate in direct proportion to changes in activity levels. For instance, as production increases, expenses like raw materials and hourly wages for workers also increase. This is represented by a diagonal line on the graph, as output increases cost directly increases. The variable cost formula is shown below:

Variable Costs Formula

Mixed Costs

Mixed costs have both a fixed and a variable element. An example of this is employees paid an annual salary (the starting fixed cost) but may also be paid a bonus linked to their production output level. As their output increases, they are gradually paid more, so that gives us a variable cost on top of the fixed cost. The mixed cost formula is shown below:

Mixed Cost Formula

 

Examples of Cost Behaviors

While a fixed cost isn’t going to go up as units increase, step fixed costs, variable cost and mixed costs are going to see increases in our budgets as activity increases.

Some examples of these cost behaviors include:

Fixed Costs

Insurance premiums are an example of fixed costs; the premium remains constant regardless of the number of units produced. The annual insurance premium of $11,500 would be unaffected by any variance in units produced.

Step Fixed Costs

Setting up a second or third factory, or introducing a second production shift, increases labor costs are examples of step fixed costs. Factory labor costs could be $650,000 per annum for the main factory. Setting up a second factory could add a further $350,000 p.a. to the overall labor costs from the date the factory is commissioned.

Variable Costs

Staff who are paid by the hour working more hours increases the cost of labor. As production increases, these viable costs will typically rise.

Mixed Costs

This may be any kind of service where a company pays for a base amount (such as labor or a fixed amount for utilities). If it exceeds the agreed amount in the contract, it will face additional costs. Utility bills typically have a base cost, along with additional usage costs. Employees may have a basic salary of $50,000 p.a. but the opportunity to earn an additional 10% or $5,000 if production targets are met.

High-Low Cost Behavior

High-Low Cost Behavior is a method used to estimate the fixed and variable components of a company’s costs. It considers two factors: analyzing total dollars of the mixed costs at the highest volume of activity, and the total dollars of the mixed costs at the lowest volume of activity.

In our example, we can look at a manufacturer of footballs where production varies each month. Analysts will want to know the variable cost component of production and the fixed cost component. This will help determine optimal production for management.

Download the free excel template on Cost Behavior to access the data and solution for this example of High Low cost calculations.

If we look at the monthly production and cost data for a football manufacturer, we can analyze the cost structure by looking at the highest and the lowest production month – August and December. These are the steps to follow:

1. Calculate the variable cost per unit using the high and low periods

This is done using the following formula:

In our Example this is:

Variable Cost per unit = ($303,000-$190,000) / (140,000-72,000)

Variable Cost per unit = $1.662

2. The next step is to calculate the fixed cost for the period by using the following formula:

Using the information, we can extrapolate the fixed cost of production

$303,000 = ($1.662 x 140,000) + Total Fixed cost

Total Fixed cost = $303,000 – $232,647.1

Total Fixed cost = $70,352.9

3. Finally, we can collate all the cost data and display it as:

This is a simple method to analyze the cost structure using the peak and trough production times, although it does not consider all factors. In our example, it does not account for the fewer working days during December due to the Holiday season. Using regular monthly data would allow for more sensitive analysis.

Conclusion

Cost behavior analysis is vital for businesses to understand how costs change with activity levels. It helps with accurate budgeting for planning and control purposes. Being able to weigh up the variable versus fixed cost elements of a business can provide valuable insights into optimal production levels. Business analysts will carefully monitor any changes in costs and assess the potential impact on company profitability.

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