Cost Behavior 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.
The way a specific cost reacts to changes in activity levels is called cost behavior. Costs may stay the same or may change proportionately in response to changes in inactivity. Knowing how a cost reacts to a change in the level of activity makes it easier to create a budget, prepare a forecast, determine how much profit a new product will generate, and determine which of two alternatives should be selected.
Cost Behaviour – Importance
The 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
Fixed costs are those that stay the same in total regardless of the number of units produced or sold. Although total fixed costs are the same, fixed costs per unit change as fewer or more units are produced. Straight‐line depreciation is an example of a fixed cost.
It does not matter whether the machine is used to produce 1,000 units or 10,000,000 units in a month, the depreciation expense is the same because it is based on the number of years the machine will be in service.
Variable costs are the costs that change in total each time an additional unit is produced or sold. With a variable cost, the per-unit cost stays the same, but the more units produced or sold, the higher the total cost. Direct material is a variable cost.
If it takes one yard of fabric at a cost of $5 per yard to make one chair, the total materials cost for one chair is $5. The total cost for 10 chairs is $50 (10 chairs × $5 per chair) and the total cost for 100 chairs is $500 (100 chairs × $5 per chair).
Mixed costs or semi-variable costs have properties of both fixed and variable costs due to the presence of both variable and fixed components in them. An example of mixed cost is telephone expense because it usually consists of a fixed component such as line rent and fixed subscription charges as well as variable cost charged per minute cost. Another mixed cost example is a delivery cost which has a fixed component of depreciation cost of trucks and a variable component of fuel expense.
Since mixed cost figures are not useful in their raw form, therefore they are split into their fixed and variable components by using cost behavior analysis techniques such as the High-Low Method, Scatter Graph Method, and Regression Analysis.
Cost Behaviour Analysis
Quantitative Cost Analysis
It is common for management to use quantitative analysis methods to illustrate cost functions. The simplest approach is the high-low method. This method uses only the highest and lowest values of the cost driver and its respective costs to determine the cost function.
Although there are many limitations to this approach, it is a simple first attempt at examining the relationship between the cost driver and the overall costs.
Regression analysis is another method that uses statistical methods to measure the average amount of change in the dependent variable associated with changes in the independent variable. The regression approach is a much better indication of the relationship between the variables. Software such as Microsoft Excel is a useful tool for performing regression analysis.
What if one did not know the “formula” by which the water bill was calculated? Instead, the only information is a few past bills. Could one estimate how much the bill should be for a particular level of usage? This type of problem is frequently encountered, as many expenses contain both fixed and variable components.
One approach to sorting out mixed costs is the high-low method. It is perhaps the simplest technique for separating a mixed cost into fixed and variable portions. However, beware that it can return an imprecise answer if the data set under analysis has a rogue data point.
Method Of Least Squares
As cautioned, the high-low method can be quite misleading. The reason is that cost data are rarely as linear as presented in the preceding illustration, and inferences are based on only two observations (either of which could be a statistical anomaly or “outlier”). For most cases, a more precise analysis tool should be used.
Regression analysis or the method of least squares is ideally suited to cost behavior analysis. This method appears to be imposingly complex, but it is not nearly so complex as it seems. Start by considering the objective of this calculation.
The goal of least squares is to define a line so that it fits through a set of points on a graph, where the cumulative sum of the squared distances between the points and the line is minimized (hence, the name “least squares”).
Simply, if a railroad company was laying out a straight train track to serve a lot of cities, least squares would define a straight-line route amongst all of the cities, so that the cumulative distances (squared) from each city to the track is minimized.
Examples of Cost Behavior
An example of a variable cost is the cost of flour for a bakery that produces artisan bread. The greater the number of loaves produced, the greater the total cost of the flour used by the bakery.
An example of a fixed cost is the depreciation and insurance on the bakery facility and equipment. Regardless of the quantity of artisan bread produced in a month, the total amount of depreciation and insurance cost for the month will remain the same.
An example of a mixed cost or semi-variable cost is the bakery’s cost of natural gas. Some of the monthly gas bills are a flat fee charged by the utility and some of the gas bills are the cost of heating the building. These two components of the gas bill are fixed since they will not change when the bakery produces more or fewer loaves of its bread.
However, a third component of the gas bill is the cost of operating the ovens. This component is a variable cost since it will increase when the ovens must operate for a longer time in order to produce additional loaves of bread.
Tips for managing cost behavior
There are numerous factors to be mindful of when managing cost behavior for your organization. Here are tips for success in controlling cost behavior:
Understand the steps of workflow processes
Cost behavior requires you to have a comprehensive understanding of a department’s workflow. This way, you’ll know to make budgetary decisions and provide insight as to where company resources need to be allocated.
Know the type of cost behavior you’re working with
Once you know the different steps of a department’s workflow, you can identify which costs can be associated with it. Working with the manufacturing department means that production is a part of variable cost.
If your organization magnifies the department’s budget to include fixed costs like the rent of the facility, then you’ll also need to calculate mixed costs. It might be beneficial to separate rent to help compartmentalize budgetary requirements if it’s in management’s best interest.
Calculate the total costs of behaviors to determine if it’s within budget
Calculate the cost for each behavior to see if the process conducted by a department meets budgetary goals. Management may want to take extra time to create a new budget that’s adjusted based on the workflow processes you communicated to them.