cost behaviors

cost behavior

term used to describe how cost changes (react) to changes in the volume activity (very useful in management decision-making)

3 classifications of costs in cost behavior analysis

1. variable costs

2. fixed costs

3. mixed costs

variable costs

• in total change in direct proportion to changes in the volume of activity

• per unit are constant meaning they do not change when the volume of activity changes

• examples include direct materials and direct labor

fixed costs

• in total are constant meaning they do not change when the volume of activity changes

• per unit change inversely with changes in volume of activity (as volume of activity increases, fixed cost per unit decrease)

• examples typically include depreciation, rent, and advertising

mixed costs

• costs that contain both a variable and a fixed element

• because it has both variable and fixed components neither the total cost nor the unit cost is constant

• examples include utilities and overhead

cost behavior assumptions

1. the cost behaviors discussed are assumed to exist over a relevant range

2. assumed to be linear within the relevant range (will plot as a straight line)

relevant range

the range of activity within which the assumptions made about cost behaviors by managers are valid

high-low method

used to separate a mixed cost into its fixed and variable components

1. from a set of data, choose 2 data points - the high and low activity level (not cost)

2. calculate the variable cost per unit = change in cost for 2 data points / change in activity level for 2 data points

3. calculate the total fixed cost

contribution income statement

sales revenue - variable costs = contribution margin - fixed costs = net income

contribution margin

represents the amount of revenue that is available to :

1. pay (cover) fixed costs

2. contribute towards a profit

key concepts

• as revenues increase as a result of selling more products or providing more services, variable costs will increase proportionally and so will contribution margin

• fixed costs will not increase because they are not a function of the level of revenue-generating activity