Question

Identify basic cost behavior patterns and explain how changes in activity level affect total cost and unit cost?

Answer 1

Answer:

The two basic cost behavior patterns are:

1. Variable cost and

2. Fixed Cost

Variable costs are costs that change as the activity level changes. If the activity level is zero, variable costs are zero and as activity level increases, variable costs also increase at the same proportion.

Direct material, direct labor, variable overheads (like fuel, power etc) are example of variable costs.

For example, let us assume a manufacturing set us is working at 50% capacity level at which its production is, say 4,000 units of say, Product A.

Let us assume:

Direct material required per unit of output = 2 units and cost per unit is $5 and Direct labor per unit of output required is 3 hours and rate per hour $10.

Hence,

Direct material cost per unit = $5*2 =$10

Direct labor cost per unit = $10 *3=$30

Total variable cost per unit = $10 + $30 = $40

Total variable cost for 4,000 units (50% capacity) = 4000 * $40 = $160,000

If activity level (capacity) increases by say 20% from 50% (4000 units) to 60% (4.800 units):

Total Variable costs at 60% capacity level will be = 4800 * $40 = $192,000  

As such variable also changes by [($192,000 - $160,000) / $160,000=] 20%

Fixed Costs are costs that do not change with activity level. Fixed costs remain same irrespective of changes in activity level.

Examples of fixed costs are Depreciation, Amortization, Rent, Property Tax, Property Insurance premium, Salary of Manager/Supervisors etc. Fixed cost does not have bearing on activity level and are period costs. They are incurred and committed costs.

In above example, if rental costs of manufacturing facility is say, $30,000 per year. This cost will remain same even if activity level changes from 50% capacity to 60% capacity.

As the fixed cost in total remains same, per unit fixed cost will decrease as activity level increases and increase as activity level decreases. In the example total rent expense will remain same at $30,000 when activity level changes from 50% capacity (4,000 units) to 60% capacity (4,800 units). But per unit rent cost decreases from ($30,000 / 4,000=) $7.50 to ($30,000/4,800 =) $6.25 when capacity increases from 50% level to 60% level.

On the contrary, total variable costs will change in proportion to changes in activity level but per unit variable costs remain same irrespective of changes in activity level. As explained example above, total variable costs increase by 20% when activity level increases by 20%. However per unit variable cost remain same at $40 when activity level increases by 20%.

Determination of costs into variable costs and fixed costs based on behavior is critical in planning, decision making and controlling.