Cost Classifications for Predicting Cost Behavior

Cost Classifications for Predicting Cost Behavior
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LEARNING OBJECTIVE 5

Define and give examples of variable costs and fixed costs.

Quite frequently, it is necessary to predict how a certain cost will behave in response to a change in activity. For example, a manager at Qwest may want to estimate the impact a 5% increase in long-distance calls would have on the company’s total electric bill. Cost behaviorThe way in which a cost reacts to changes in the level of activity. refers to how a cost reacts to changes in the level of activity. As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must be able to estimate how much it will change. To help make such distinctions, costs are often categorized as variable or fixed.

Variable Cost

A variable costA cost that varies, in total, in direct proportion to changes in the level of activity. is a cost that varies, in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, such as units produced, units sold, miles driven, beds occupied, lines of print, hours worked, and so forth. Direct materials is a good example of a variable cost. The cost of direct materials used during a period will vary, in total, in direct proportion to the number of units that are produced. As an example, consider the Saturn Division of General Motors. Each auto requires one battery. As the output of autos increases and decreases, the number of batteries used will increase and decrease proportionately. If auto production goes up 10%, then the number of batteries used will also go up 10%. The concept of a variable cost is shown graphically in Exhibit 1-10.

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Video 1-1

EXHIBIT 1-10	Variable and Fixed Cost Behavior

The graph on the left-hand side of Exhibit 1-10 illustrates that the total variable cost rises and falls as the activity level rises and falls. This idea is presented below, assuming that a Saturn’s battery costs $24:

While total variable costs change as the activity level changes, it is important to note that a variable cost is constant if expressed on a per unit basis. For example, the per unit cost of batteries remains constant at $24 even though the total cost of the batteries increases and decreases with activity.

There are many examples of costs that are variable with respect to the products and services provided by a company. In a manufacturing company, variable costs include items such as direct materials, shipping costs, sales commissions, and some elements of manufacturing overhead such as lubricants. We will also usually assume that direct labor is a variable cost, although direct labor may act more like a fixed cost in some situations as we shall see in a later chapter. In a merchandising company, the variable costs of carrying and selling products include items such as cost of goods sold, sales commissions, and billing costs. In a hospital, the variable costs of providing health care services to patients would include the costs of supplies, drugs, meals, and perhaps nursing services.

When we say that a cost is variable, we ordinarily mean that it is variable with respect to the amount of goods or services the organization produces. However, costs can be variable with respect to other things. For example, the wages paid to employees at a Blockbuster Video outlet will depend on the number of hours the store is open and not strictly on the number of videos rented. In this case, we would say that wage costs are variable with respect to the hours of operation. Nevertheless, when we say that a cost is variable, we ordinarily mean it is variable with respect to the amount of goods and services produced. This could be how many Jeep Cherokees are produced, how many videos are rented, how many patients are treated, and so on.

IN BUSINESS

Brown is Thinking Green

United Parcel Service (UPS) truck drivers travel more than 1.3 billion miles annually to deliver more than 4.5 billion packages. Therefore, it should come as no surprise that fuel is a huge variable cost for the company. Even if UPS can shave just a penny of cost from each mile driven, the savings can be enormous. This explains why UPS is so excited about swapping its old diesel powered trucks for diesel-electric hybrid vehicles, which have the potential to cut fuel costs by 50%. Beyond the savings for UPS, the environment would also benefit from the switch since hybrid vehicles cut emissions by 90%. As UPS television commercials ask, “What can Brown do for you?” Thanks to diesel-electric technology, the answer is that Brown can help make the air you breathe a little bit cleaner.

Source: Charles Haddad and Christine Tierney, “FedEx and Brown Are Going Green,” BusinessWeek, August 4, 2003, pp. 60–62.

Fixed Cost

A fixed costA cost that remains constant, in total, regardless of changes in the level of activity within the relevant range. If a fixed cost is expressed on a per unit basis, it varies inversely with the level of activity. is a cost that remains constant, in total, regardless of changes in the level of activity. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total fixed costs remain constant unless influenced by some outside force, such as a price change. Rent is a good example of a fixed cost. Suppose the Mayo Clinic rents a machine for $8,000 per month that tests blood samples for the presence of leukemia cells. The $8,000 monthly rental cost will be incurred regardless of the number of tests that may be performed during the month. The concept of a fixed cost is shown graphically on the right-hand side of Exhibit 1-10

IN BUSINESS

Food Costs at a Luxury Hotel

The Sporthotel Theresa (http://www.theresa.at/), owned and operated by the Egger family, is a four star hotel located in Zell im Zillertal, Austria. The hotel features access to hiking, skiing, biking, and other activities in the Ziller Alps as well as its own fitness facility and spa.

Three full meals a day are included in the hotel room charge. Breakfast and lunch are served buffet-style while dinner is a more formal affair with as many as six courses. A sample dinner menu appears below:

The chef, Stefan Egger, believes that food costs are roughly proportional to the number of guests staying at the hotel; that is, they are a variable cost. He must order food two or three days in advance from suppliers, but he adjusts his purchases to the number of guests who are currently staying at the hotel and their consumption patterns. In addition, guests make their selections from the dinner menu early in the day, which helps Stefan plan which foodstuffs will be required for dinner. Consequently, he is able to prepare just enough food so that all guests are satisfied and yet waste is held to a minimum.

Source: Conversation with Stefan Egger, chef at the Sporthotel Theresa.

Very few costs are completely fixed. Most will change if activity changes enough. For example, suppose that the capacity of the leukemia diagnostic machine at the Mayo Clinic is 2,000 tests per month. If the clinic wishes to perform more than 2,000 tests in a month, it would be necessary to rent an additional machine, which would cause a jump in the fixed costs. When we say a cost is fixed, we mean it is fixed within some relevant range. The relevant rangeThe range of activity within which assumptions about variable and fixed cost behavior are valid. is the range of activity within which the assumptions about variable and fixed costs are valid. For example, the assumption that the rent for diagnostic machines is $8,000 per month is valid within the relevant range of 0 to 2,000 tests per month.

Fixed costs can create confusion if they are expressed on a per unit basis. This is because the average fixed cost per unit increases and decreases inversely with changes in activity. In the Mayo Clinic, for example, the average cost per test will fall as the number of tests performed increases because the $8,000 rental cost will be spread over more tests. Conversely, as the number of tests performed in the clinic declines, the average cost per test will rise as the $8,000 rental cost is spread over fewer tests. This concept is illustrated in the table below:

Note that if the Mayo Clinic performs only 10 tests each month, the rental cost of the equipment will average $800 per test. But if 2,000 tests are performed each month, the average cost will drop to only $4 per test. More will be said later about the misunderstandings created by this variation in average unit costs.

Examples of fixed costs include straight-line depreciation, insurance, property taxes, rent, supervisory salaries, administrative salaries, and advertising.

A summary of both variable and fixed cost behavior is presented in Exhibit 1-11.

EXHIBIT 1-11	Summary of Variable and Fixed Cost Behavior

IN BUSINESS

The Power of Shrinking Average Fixed Cost Per Unit

Intel has recently built five new computer chip manufacturing facilities that have put its competitors on the defensive. Each plant can produce chips using a 12-inch wafer that is imprinted with 90-nanometer circuit lines that are 0.1% of the width of a human hair. These plants can produce 1.25 million chips a day or about 375 million chips a year. Better yet, these new plants slash Intel’s production costs in half since each plant’s volume of output is 2.5 times greater than any of Intel’s seven older plants. Building a computer chip manufacturing facility is a very expensive undertaking due to the required investment in fixed equipment costs. So why are Intel’s competitors on the defensive? Because they are struggling to match Intel’s exceptionally low average fixed cost per unit of output. Or, in an economist’s terms they are struggling to match Intel’s economies of scale.

Source: Cliff Edwards, Intel, BusinessWeek, March 8, 2004, pp. 56–64.

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Home > Chapter 1 > Cost Classifications for Predicting Cost Behavior

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		Ch. 4 FIFO Supplement Video Library Bonus Variable Costing...

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	Quizzes
		Practice Quiz
	More Resources
		PowerPoint Presentations Alternate Problems Excel Templates
	eBook
		Chapter Opener ftnote Comparison of Financia... The Work of Management... Cost Classification... Cost Classifications O... Cost Classifications f... Cost Classifications f... General Cost Classific... Product Costs Versus P... Product Cost Flows Summary Guidance Answer to You... Guidance Answers to Co... Review Problem 1: Cost... Review Problem 2: Sche... Glossary Questions Brief Exercises Exercises Problems Building Your Skills