- Define and show examples of Variable Costs - Define and show examples of Fixed Costs - Define and show examples of Mixed Costs - Explain the concept of Linearity Assumption and the Relevant Range [SLIDE 1] Costs do not always remain constant. Managers have to understand how costs are affected if a change occurs. Managers quite frequently find it necessary to determine how a certain cost will behave when there is a change in activity. Cost behavior is how a cost will react to a change in the level of activity within a relevant range. There are three basic types of cost behavior patterns. These cost behavior patterns are:
  1. Variable Cost
  2. Fixed Cost
  3. Mixed Cost
We will discuss each one of these categories in more detail. We will also discuss the concept of the linearity assumption and relevant range of cost behavior. [SLIDE 2] Variable cost is a cost that varies, in total, in direct proportion with changes in the volume of activity. The activity can take many different forms depending on the organization. In order for a cost to be variable, it must be variable with respect to its activity base. An activity base is a measure of whatever causes an occurrence of a variable cost. An activity base is also referred to as a cost driver. Examples of cost drivers/activity bases in a manufacturing company include direct labor hours, machine hours, units produced and units sold. Other examples in a nonmanufacturing company might include number of beds in a hospital, number of calls handled by technical support staff or call center, or number of pounds of laundry cleaned by a hotel. As you can see, there are several different types of cost drivers that management can use to determine changes in cost for a company. Variable cost only affects the total cost and does NOT have any bearing on the per-unit cost of the product being produced or service being offered. Variable costs are affected by different activities depending on the organization. The goal of management is to find the activity that causes the variable cost so that accurate cost estimates can be made. [SLIDE 3] Fixed costs are costs that remain the same in total with changes in volume activity. A fixed cost is constant within a defined relevant range set by the company. While a fixed cost is constant in total amount, on a per-unit basis, it varies inversely with changes in the level of activity. When we look at building rent, the amount remains the same each month. If the company increases production, the rent does not increase with this increase in production but stays the same. Another example would be a plant manager's salary. The manager gets paid the same amount each month and just because the company increases production, the manager's salary does not change. There are two types of Fixed Cost:
  1. Committed
  2. Discretionary
Committed fixed cost refers to long-term fixed costs that cannot significantly be reduced in the short term without having significant impact on the organization. Examples include depreciation on equipment and buildings, property taxes, executive salaries, and insurance. Committed fixed costs remain unchanged in the short-term if operations are interrupted or cut back because the cost of restoring these costs later can be far greater than any savings that might be realized in the short run. Discretionary fixed costs are short-term fixed costs that can be changed in the short run without having a significant impact on the organization. Examples include advertising, research and development, and donations. Discretionary fixed costs are also termed as "managed fixed costs" and can change annually based on decisions by management and create minimal impact on the long-run goals of an organization. [SLIDE 4] Mixed cost is a cost that has both fixed and variable cost elements. Mixed costs are also known as semi-variable cost. This cost behavior causes both total cost and per-unit costs to change with change in activity. An example of this is electricity, where there is a basic monthly service charge and then a per kilowatt hour change for electricity used over the base amount that is included in the monthly service charge. When managers are performing cost planning and control, mixed costs must be separated into their variable and fixed components in order to properly perform analysis and planning for the company. We will further discuss mixed cost analysis in a future lesson. [SLIDE 5] Linearity assumption is when someone assumes that costs are strictly linear, meaning the relation between cost and activity can be represented by a straight line. While this is true, some costs are actually curvilinear, meaning the relation between cost and activity is a curve and not strictly linear. Although cost is not strictly linear, managers can approximate a straight line within a narrow band of activity known as the relevant range. Relevant range is the span of activity in which a company expects to operate. Within this range, it is assumed that both total fixed cost and per unit variable costs are constant. For example, a fixed cost is fixed only in relation to a given wide range of total activity or volume (at which the company is expected to operate) and only for a given time span, usually a particular budget period. If you are looking at variable cost, then the variable costs may not change proportionately with changes in production volume outside of the relevant range at with the company expects to operate. One note to remember is that assumptions made about cost behavior may not be valid if activity falls outside of the determined relevant range. [SLIDE 6] To make good decisions, managers must know how costs are structured (fixed, variable, or mixed). Costs react differently depending on production levels and activity. Accurately predicting what costs will be in the future can help managers answer several important questions like the examples below: The only way to accurately predict costs is to understand how costs behave given changes in activity. The ability to predict how costs behave helps managers in planning, controlling and making decisions for a company.