University:
Boston University
Course:
QST FE 200 | Principles of Finance
Academic year:

2021
Views:

133

Pages:

2
Author:

Accinkiquicpqw

Cost Behaviors ● ● ● ● ● Cost Behavior is a term used to describe how costs change to changes in the volume of activity. Three classifications of costs ○ Variable Cost ■ Variable costs IN TOTAL change in direct proportion to changes in the volume of activity. ■ Variable costs PER UNIT are constant meaning they do NOT change when the volume of activity changes. ■ Examples of variable costs include direct materials and direct labor. ○ Fixed Cost ■ Fixed costs IN TOTAL are constant meaning they do NOT change when the volume of activity changes. ■ Fixed costs PER UNIT change inversely with changes in the volume of activity (as the volume of activity increases, fixed costs per unit decrease). ■ Examples of costs that are typically fixed costs include depreciation, rent, and advertising. ○ Mixed Costs ■ Mixed costs are costs that contain both a variable and a fixed element. ■ Because mixed costs have both variable and fixed components neither the total cost nor the unit cost is constant. ■ Example of costs that are typically mixed costs includes utilities and overhead. Cost Behavior Assumption ○ The cost behaviors we have just discussed are assumed to exist over a relevant range. ○ The cost behavior patterns we have discussed are assumed to be linear within the relevant range. ○ Reminder: A mixed cost does not have a constant component. Why the ideas behind cost behavior analysis are very useful in management decision-making? ○ Cost behavior analysis allows managers to develop expectations of costs at any level of activity. The reason in utilizing cost behavior analysis, managers should use variable costs expressed on a per unit basis and fixed costs in total: ○ ● ● ● ● Both variable costs per unit and total fixed costs are considered ‘constant’ at all activity levels. This assumption of being ‘constant’ allows managers to make predictions about future costs. Problem: What do we do with mixed costs as they do NOT have a constant component. ○ Solution: We need a means of separating the mixed cost into its fixed and variable components so that we can isolate these ‘constant components’. Methods used to separate a mixed cost into its fixed and variable components: ○ High-low method 1. From a set of data, choose 2 data points - the high and the low ACTIVITY LEVEL. 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 Format ○ Sales Revenue - COGS = GP | GP - other Expenses = Net Income Contribution Income Statement ○ The traditional income statement format is not used for internal decision-making. Instead, managers prefer to classify expenses by cost behavior as follows: ○ Sales Revenue - VC = Contribution Margin | CM - Fixed Cost = Net Income ○ Contribution margin - represents the amount of revenue that is available to: 1. Pay (cover) fixed costs. 2. Contribute toward a profit ○ As revenue increases 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.