Cost Behavior Cost behavior is a term used to describe how costs change react to changes in the volume of activity Three Types of Costs in Cost Behavior Analysis 1 Variable Cost 2 Fixed Cost 3 Mixed Cost Variable Cost Variable costs in total change in direct proportion to changes in the volume of activity Variable cost per unit are constant meaning they do not change when the volume of activity changes Ex Direct raw materials and direct labor Unit Cost of Disk Device of Computers Produced 10 100 1 000 10 000 Fixed Cost 30 30 30 30 Total Cost 300 3 000 30 000 300 000 In total are constant meaning they do not change when volume of activity changes Fixed costs per unit change inversely with changes in the volume of activity as the volume of activity increases fixed cost per unit decreases Examples of costs that are typically fixed costs include depreciation rent and advertising of Computers Produced 1 10 100 1 000 Unit Cost of Disk Device 1 000 100 10 1 Total Cost 1 000 1 000 1 000 1 000 Mixed Costs Costs that contain both a variable and a fixed element Because mixed costs have both variable and fixed components neither the total cost neither the unit cost is constant Examples of costs that are typically mixed costs include utilities and overhead costs range Cost Behavior Assumptions 1 The cost behaviors we have just dicussed are assumed to exist over a relevant o Relevant Range made about cost behaviors by managers are valid the range of activity within which the assumptions 2 These cost behavior patterns are assumed to be linear within the relevant range the cost behavior pattern will plot as a straight line within the relevant range Very useful in management decision making o Cost behaviors analysis allows managers to develop expectations of costs at any level of activity In utilizing cost behavior analysis managers should use work with variable costs expressed on a per unit basis and fixed in total Both variable cost per unit and total fixed costs are considered constant at all activity levels o This assumption allows managers to make predictions about future costs What do we do with mixed costs We need to separate mixed cost into variable and fixed components High Low Methods 1 Choose 2 data points the high and low activity level not high and low cost 2 Calculate the variable cost per unit change in cost for 2 data points change in activity level for 2 data points 3 Calculate the total fixed cost Traditional Income Statement Look at example Sales Revenue COGS Gross Profit Expenses Net Income Sales Revenue Variable Costs Contribution Margin Fixed Costs Net Income The traditional income statement format is not used for internal decision making o Instead managers prefer to classify expenses by cost behavior as follows This is the contribution income statement format where the expenses are classified by cost behavior pattern Contributed margin o 1 Pay cover fixed costs o 2 Contribute toward profit represent the amount of revenue that is available to The key to this very important concept lies in understanding cost behavior patterns As revenues increase as a result of selling more products or providing more services variable costs will increase proportionally and so will contribution margin However fixed costs will not increase because they are not a function of the level of revenue generating activity These cost behaviors are used to create a budget a budget showing the different costs at a bunch of different Flexible budget activity levels Preparing a flexible budget Total variable costs change in direct proportion to changes in activity Total fixed costs remain unchanged within the relevant range
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