Cost Behaviour is the change in the behavior of a cost (or costs) due to a change in business activity. The study of this change is the cost behavior analysis. For example, the electricity cost will move up if a business extends the working hours.
However, not all costs change with business activity. And, some costs may remain stagnant despite a change in business activity. For instance, a company needs to pay insurance whether or not it is operating. Some costs do not change in proportion to the change in business operations. A company usually uses mathematical cost functions to study the behavior of costs.
Before analyzing the behavior of costs, a manager needs to understand the crucial business activities that may impact the costs. Usually, a manager can define activity levels in terms of dollars, units; miles were driven, and more. Moreover, the manager should try to determine the correlation between activity levels and costs.
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Cost Behaviour – Importance
Following points highlight the importance of cost behavior:
- A manager needs to understand the behavior of the costs when creating an annual budget. Knowing this allows the manager to determine beforehand if any cost will decline or rise with the change in the business activity. For example, if a company is operating at the full production capacity, then to fulfill more demand, the company will have to invest more in the production line.
- Understanding cost behavior is essential for cost-volume-profit analysis as well. The cost-volume-profit (CVP) analysis studies the impact of change in costs and volume on the profit.
- It helps the management in planning and controlling costs.
Types of Cost by Behavior
Primarily, there are three types of cost by behavior:
Such costs vary directly (or in direct proportion) with the change in the business activity. In direct proportion means if the activity level changes by 10%, then the variable cost must also change by 10%. It holds good for both an increase and a decrease in the variable cost. For example, displays are a variable cost for a mobile manufacturer. The more the number of mobiles a manufacturer produces, the more will be the cost spent on displays.
An interesting observation is that the variable cost per unit remains constant despite a change in the level of business activity. For example, the total variable cost of Company ABC for three straight quarters is $5000, $20,000, and $15,000. Company ABC produces 5000, 20000, and 15000 units, respectively. The variable cost per unit in all three cases will be $1.
These costs do not change with any change in business activity. For example, a business will still need to pay rent even if it is generating zero sales. Depreciation is another example of a fixed cost.
A point to note is that a fixed cost per unit may increase or decrease with the change in the level of business activity. For example, suppose fixed cost for a business is $15,000, but the units produced for the three straight quarters were 3000, 5000 and 1000. The fixed cost per unit in the three cases is $5, $3, and $15, respectively.
Mixed or Semi-variable Costs
Such costs are a mixture of fixed and variable costs, and thus, contain the elements of both. For example, an internet bill includes a fixed monthly charge plus a variable fee based on usage. Generally, these costs are not very useful to the company in its original form. So, accountants usually split them based on their fixed and variable components. To do so, they use cost behavior analysis techniques, such as Scatter Diagram, Regression Analysis, High-Low Method, and more.
As said in the first paragraph, companies use mathematical cost functions to study the behavior of costs, usually the Mixed price. A cost function is often in the form of a mathematical equation, such as y = MX + b. One can also plot it on a graph. In the equation, b is the fixed cost, x is the number of units, and m is the variable cost or the slope.
To effectively or simplify the use a cost function, one needs to consider the following assumptions:
- Any change in the cost driver explains the difference in costs.
- One can summarize the cost behavior into a linear cost function having a relevant range. The range here means the field within which the relationship between the cost and the level of activity holds.
One can use quantitative techniques to define a cost function, and in turn, analyze the cost behavior. The simplest technique is the high-low method, which considers the highest and lowest values of the cost driver and the total costs to which that cost driver contributes.
For example, Company ABC incurs following overhead costs in the first five months – $10,000, $15,000, $8,000, $12,000 and $9,000. The labor hours during these months were 800, 1000, 600, 900, and 700, respectively.
The highest and lowest value for overhead costs of $15,000 and $8,000 while for labor hours 1000 and 600, respectively. Difference between the highest and lowest values is $7,000 ($15,000 Less $8,000) and 400 (1000 Less 600).
Calculating slope or variable cost = $7,000/400 = 17.5. It means that for additional labor hours, the overhead costs rise by $17.5.
Alternatively, we can use regression analysis (or the method of least squares) for the cost behavior analysis. Unlike the high-low method, the regression method uses all the values and not just the highest and lowest values. We can use the regression function in MS Excel for this.