Understanding Cost Behavior and Classification

Cost behavior refers to a cost's reactions to activity levels. A cost may rise, fall, or remain constant as activity levels fluctuate. Dependent upon this behavior, the many costs incurred by the organization can be classified as variable, fixed, or mixed costs. Understanding and appropriate classification of this cost behavior serves management through providing specific process and product information that is necessary for successful manufacturing operations. These cost classifications apply within a relevant activity range. The relevant range represents a measure of activity or volume in which the costs are applicable. For instance, some fixed expenses will change over time as prices increase, but will still be considered fixed costs but only relevant during the time in which they are unchanged (Horngren, Datar, & Foster, 2006). Employing the data produced through classifying costs incurred by the organization by their behavior facilitates better informed decisions in areas such as choices in product line, pricing strategies, creating realistic budgets and creation or adjustment of operational strategy (Horngren, et al.).

As activity increases or decreases, total variable costs will proportionately increase and decrease respectively (CTU Online, 2008). Variable costs also apply at a per unit basis, only the behavior of the variable per unit cost is different. As activity increases and decreases, variable cost per unit remains constant. This is because variable costs are classified as variable due to their respective relationship with a particular activity base or cost driver (Garrison, Noreen, & Brewer, 2008). Although the cost of a particular item remains the same, the total costs associated with that one item will increase or decrease in relation with a specific activity, such as sales volume. Therefore, it is important, when classifying cost behaviors, that we understand how volume increases and decreases will be affected on a per unit basis. For example, it costs $30 to produce gadget A. That price is fixed on a per unit basis, but as sales increase and decrease, the total cost of production, made up of the per unit costs, increases and decreases in proportion with the sales volume. Although the cost per unit stays the same, the total costs associated with producing Gadget A is classified as a variable cost in relation to fluctuation in production activities.

Evident variable costs related to production or sales volume could include selling expenses, raw materials purchases, direct labor, bad debt expense, accounts payable and income tax. Assuming that expenses associated with selling are based upon performance or volumes of sales, the total expenses relating to sales would increase or decrease respectively. Purchases of raw materials will increase or decrease with production volumes and sales volumes, as would the direct labor expenses as more labor is required to produce more product. With the increase in sales and credit accounts, the percentage of accounts classified as bad debt should fluctuate with the increase or decrease in credit account activity. Income tax will be payable based on a specific percentage of the profit dollar amount. As production and sales will determine profits, income taxes due will increase and decrease relative to these activities.

Fixed costs are total costs that remain unchanged at any level of activity. However, fixed per unit costs are contradictory as those costs will increase and decrease as a result of sales or production activity (Edmonds, Edmonds, Tsay, & Olds, 2006). This relationship is essential in proper behavioral classification of costs. Realization that although costs will vary on a per unit basis, the total costs associated with those individual units relative to a specific activity base or cost driver will not vary, making the total cost a fixed cost. For example, if it costs $1500 to operate a specific machine over a 12 hour period, the cost per unit associated with those daily activities is dependent upon the number of items produced within that period. The per unit costs associated with production vary with production levels, but regardless of the production level achieved for that 12 hour operating period, it will result in a fixed cost of $1500.00.

Identifiable fixed costs that may be found in the journal activities of the manufacturing organization might include administrative expenses, factory insurance expenses, factory salaries, property taxes, depreciation, prepaid expenses, land, interest, notes payable, and bonds payable. Administrative expenses and other salaries generally remain constant at any production level as some functions must continue at a specific pace regardless of how well sales and production are performing. Likewise, insurances and property taxes will remain constant based on an overall umbrella figure of protection and the value of properties unaffected by volume. The depreciation method is determined during the first year of depreciation for depreciable assets, and remains unchanged from that point forward. There is a depreciation method that calculates depreciation in terms of usage, such as hourly or by the mile, known as the units-of-production method. In such a case, depreciation would directly reflect changes in production or usage and therefore be classified as a variable cost (Horngren, Harrison, & Bamber, 2005). Notes payable and bonds payable will represent obligations due at a predetermined time, and a predetermined rate of pay or interest and should remain unchanged relative to production and sales levels. Although plant and equipment values are subject to change on occasion with need for additional space or equipment to meet increased production demands that result from increases in sales, these expenses remain fixed as they pertain to their relevant range. These expenses will not and should not change often as reflected in periodic performance reports, but will show occasional change that reflects their influence as fixed costs within the range of associated additional expense.

Studying these two examples, it is evident that cost behaviors will inherently impact profitability. Respective to fixed costs, we understand that the more we can produce at a fixed value, the less each individual unit costs and the greater the potential sales volume. Total fixed and per unit cost behaviors provides the user with information relative to pricing and understanding income demands as they relate to covering the costs incurred with operations. Sales volume directly influences net income, to what degree is determined by what portion of those sales are allocated to fixed costs, mixed costs, or variable costs. Income statements that present costs according to their behavior are called contribution margin income statements, representing the income available to cover fixed expenses once all variable expenses are accounted for (Edmonds, et al.).

Containing both fixed and variable cost components, mixed costs require accurate segregation of the fixed and variable components for appropriate application into managerial accounting practices. The fixed component is the minimum cost associated with having a specific service or product ready for consumption, or the minimum cost associated with a specific operation or process. The variable component represents costs that incur as a result of actual consumption of the service, product, or usage of the operation or process (Garrison, et al.).

There are several ways or methods to delineate between the fixed and variable elements of mixed costs for accurate cost classification. The high-low method, the least squares regression analysis, and multiple regression all assist management into segregating these mixed costs and providing more specific financial cost data for implementation into their many planning and controlling activities (CTU Online, 2008). The high-low method approach to segregating the costs in mixed cost figures identifies the highest and lowest costs along with their respective activity levels. The differences between the costs and the activity levels is then calculated, and divided by the difference in activity levels to produce an estimated variable per unit cost. Applying the variable data to the total cost produces the fixed cost portion of the mixed cost figure (Heitger & Crumbley, January 2005). Least squares regression analysis and multiple regression can provide costing information data, but require considerably more complicated application of data analysis, and ample historic performance data to provide an accurate figure for the fixed and variable costs associated with particular products or activities (Zeltkevic, 1998). The direct linear relationship as presented in regression analysis also provides managers with a forecasting tool that allows accurate segregation of fixed and variable components as they pertain to different activity levels within relevant range (Garrison, et al.).

Many expense items of the manufacturing organization will qualify as mixed costs and require segregation of fixed and variable costs for appropriate future planning and operational analysis. Factory supplies consists of a fixed element in which it is understood that a specific amount of supplies will be necessary for general operations, however as a result of increased operations, supplies expenses will increase as more supplies are consumed. The same holds true for factory maintenance expenses and utilities. A base amount is expected to be incurred to keep the factory ready and available for production at any level, however the expense above that level will be directly related to production volume.

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