Mark fielding-Pritchard Cost Behavior Mark fielding-Pritchard mefielding.com

A measure of what causes the incurrence of a variable cost The Activity Base Units produced Miles driven Labor hours Machine hours A measure of what causes the incurrence of a variable cost An activity base (also called a cost driver) is a measure of what causes the incurrence of variable costs. As the level of the activity base increases, the variable cost increases proportionally. Variable costs may be caused by a variety of different activity bases. Gasoline consumption in your car is largely determined by the number of miles driven and the speed at which you travel. mefielding.com

True Variable Cost Example A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. Your total long distance telephone bill is based on how many minutes you talk. Total Long Distance Telephone Bill A true variable cost is one whose total dollar amount varies in direct proportion to changes in the level of activity. On your land-line, your total long distance telephone bill is determined by the number of minutes you talk. An activity base, or cost driver, is a measure of what causes the incurrence of variable costs. As the level of activity base increases, the variable cost increases proportionally. mefielding.com Minutes Talked

Variable Cost Per Unit Example A variable cost remains constant if expressed on a per unit basis. The cost per minute talked is constant. For example, 10¢ per minute. Per Minute Telephone Charge A variable cost remains constant if expressed on a per unit basis. For your land-line, the cost per long-distance minute talked may remain the same at 10¢ per minute. Minutes Talked mefielding.com

Extent of Variable Costs The proportion of variable costs differs across organizations. For example . . . A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. A public utility like Florida Power and Light, with large investments in equipment, will tend to have fewer variable costs. A manufacturing company like Black and Decker will often have many variable costs associated with the manufacture and distribution of its products to customers. A merchandising company like Wal-Mart will usually have a high proportion of variable costs such as the cost of merchandise purchased for resale. Some service companies, such as restaurants, have a high proportion of variable costs due to their raw material costs. Other service companies, such as an architectural firm, have a high proportion of fixed costs in the form of highly trained salaried employees. A merchandising company usually will have a high proportion of variable costs like cost of sales. A service company will normally have a high proportion of variable costs. mefielding.com

Examples of Variable Costs Merchandising companies – cost of goods sold. Manufacturing companies – direct materials, direct labor, and variable overhead. Merchandising and manufacturing companies – commissions, shipping costs, and clerical costs such as invoicing. Service companies – supplies, travel, and clerical. Here are some examples of variable costs we are likely to find in different types of businesses: 1.    Merchandising companies  cost of goods sold. 2.    Manufacturing companies  direct materials, direct labor, and variable overhead. 3.    Merchandising and manufacturing companies  commissions, shipping costs, and clerical costs such as invoicing. 4. Service companies  supplies, travel, and clerical. mefielding.com

True Variable Cost Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Cost Recall that we talked earlier about how true variable costs vary directly and proportionately with changes in activity. Direct material is an example of a cost that behaves in a true variable pattern. Now let’s look at what are known as step-variable costs. mefielding.com Volume

Step-Variable Costs A resource that is obtainable 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. Volume Cost A step variable cost remains constant within a narrow range of activity, so it tends to look like a fixed cost. Maintenance workers are often considered to be a variable cost, but this labor cost does not behave as a true variable cost. Fairly wide changes in the level of production will cause a change in the number of maintenance workers employed and the total maintenance cost. mefielding.com

Step-Variable Costs Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed. Volume Cost For a step-variable cost, total cost increases to a new higher level when we reach the next higher range of activity. For example, a maintenance worker is obtainable only as a whole person who is capable of working approximately 2,000 hours per year. mefielding.com

Step-Variable Costs Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed Volume Cost Only fairly wide changes in the level of activity will cause a change in a step-variable cost. Maintenance workers are obtainable only in large chunks of a whole person who is capable of working approximately 2,000 hours a year. mefielding.com

The Linearity Assumption and the Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Economist’s Curvilinear Cost Function Total Cost Accountant’s Straight-Line Approximation (constant unit variable cost) Part I Economists correctly point out that many costs that accountants classify as variable costs actually behave in a curvilinear fashion. Part II In many important decisions, accountants tend to treat costs as linear in nature. Part III As long as the company is operating within the relevant range of activity, the accountant’s approximation of the economist’s curvilinear cost function seems to work quite well. The relevant range is the range of activity within which the assumptions made about cost behavior are valid. mefielding.com Activity

Total Fixed Cost Example A fixed cost is a cost whose total dollar amount remains constant as the activity level changes. Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. Monthly Basic Telephone Bill If you have a land-line in your home, you pay a flat connection fee that is the same every month. This fee is fixed because it does not change in total, regardless of the number of calls made. mefielding.com Number of Local Calls

Fixed Cost Per Unit Example Average fixed costs per unit decrease as the activity level increases. The fixed cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call As you make more and more local calls, the connection fee cost per call decreases. If your connection fee is $15 and you make one local call per month, the average connection fee is $15 per call. However, if you make 100 calls per month, the average connection fee drops to 15¢ per call. mefielding.com Number of Local Calls

Types of Fixed Costs Committed Discretionary Examples Examples Long-term, cannot be significantly reduced in the short-term. Discretionary May be altered in the short-term by current managerial decisions Part I One type of fixed cost is known as committed fixed costs. These are long-term fixed costs that cannot be significantly reduced in the short-term. Some examples include depreciation on equipment and buildings and real estate taxes. Part II Another type of fixed cost is known as discretionary fixed costs. These types of fixed costs may be altered in the short-term by current management decisions. Some examples of discretionary fixed costs include advertising and research and development costs. For example, some construction companies may lay off workers during months with minimal customer demand. However, other construction companies may opt to retain their workers all year. A cost may be discretionary or committed depending on management’s strategy. Examples Depreciation on Buildings and Equipment and Real Estate Taxes Examples Advertising and Research and Development mefielding.com

The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles. Knowledge workers tend to be salaried, highly-trained and difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable. Part I In many industries, we see a trend toward greater fixed costs relative to variable costs. In the past fifteen years, we have seen computers and robotics take over many mundane tasks previously performed by humans. For example, H&R Block employees used to fill out tax returns for customers by hand. Now, computer software is used to complete tax returns. Safeway and Kroger employees used to key-in prices by hand on cash registers. Now, barcode readers enter price and other product information automatically. Part II In today’s world economy, knowledge workers are in demand for their experience and knowledge, rather than for their muscle. Most knowledge workers tend to be salaried, highly trained, and very difficult to replace. The cost of these valued employees tends to be fixed rather than variable. mefielding.com

Is Labour a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In France, Germany, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. In much of Europe, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs tend to be viewed as more fixed than variable. In recent years, we have seen some changes in management’s flexibility. In the U.S. and United Kingdom, management has much greater latitude to adjust the size of the labor force. Labor costs in some industries are still viewed as more variable than fixed. In the United States and the United Kingdom, management has greater latitude. Labor costs are more variable in nature. mefielding.com

Fixed Costs and Relevant Range 90 Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Relevant Range 60 Rent Cost in Thousands of Dollars 30 Fixed costs only stay constant in total within the relevant range of activity. As we adjust the relevant range of activity upward or downward, we see changes in total fixed costs. These upward or downward adjustments are generally very wide. 0 1,000 2,000 3,000 Rented Area (Square Feet) mefielding.com

Fixed Costs and Relevant Range The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows, more space is rented, increasing the total cost. An example of changes in total fixed costs might be rent for office space. A company can rent 1,000 square feet of office space for $30,000 per year. If the company fills its current space and needs additional office space, the next 1,000 square feet will cost an additional $30,000 per year. So when a company needs 1,000 square feet of office space, the fixed office rent is $30,000. If another 1,000 square feet are needed, the fixed office rent will be $60,000. mefielding.com

Fixed Costs and Relevant Range Step-variable costs can be adjusted more quickly and . . . The width of the activity steps is much wider for the fixed cost. How does this type of fixed cost differ from a step-variable cost? The question becomes, how do changes in fixed costs outside the relevant range differ from step-variable costs? Step-variable costs can be adjusted more quickly and the width of the change in activity is much wider for changes in fixed costs. For example, a step-variable cost such as maintenance workers may have steps with a width of 40 hours a week. However, fixed costs may have steps that have a width of thousands or tens-of-thousands of hours of activity. mefielding.com

Fixed Monthly Utility Charge Mixed Costs A mixed cost has both fixed and variable components. Consider your utility costs. X Y Total mixed cost Total Utility Cost A mixed cost has both a fixed and variable element. When you pay your utility bill, you know that a portion of your total bill is fixed. This is the standard monthly utility charge. The variable portion of your utility costs depends upon the number of kilowatt hours you consume. Your total utility bill has both a fixed and variable element. The graph demonstrates the nature of a normal utility bill. Variable Cost per KW Fixed Monthly Utility Charge Activity (Kilowatt Hours) mefielding.com

Analysis of Mixed Costs Account Analysis and the Engineering Approach Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. In account analysis, we can analyze mixed costs by looking at each account and classifying the cost as variable, fixed or mixed based on the cost behavior over time. A more sophisticated way to analyze the nature of costs is to ask our engineers to evaluate each cost in terms of production methods, material requirements, labor usage and overhead. Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. mefielding.com