Cost Behavior (Lecture 9)
In this free online accounting lesson we define cost drivers and classify costs by their behavior as variable, fixed, step variable and mixed costs. After that we discuss differences between all these costs and summarize the cost behavior concepts. Also we define the relevant range and give examples. Finally, we provide information about several methods used to estimate total product costs: the high-low method, a scatter-graph, and least-squares regression. Accounting examples are provided for most learning objectives.
9.1 Cost driver
Let’s start with an example. Suppose you and your friend established a company that produces DVDs and named this company Friends Corporation. How much should you charge for one DVD in order to stay in business? How many DVDs should be sold in a given month at a given price to cover costs?
All these questions can be answered with the aid of cost information. So cost information can support managers in decision-making. Let us define a cost.
Cost is a payment of cash or its equivalent for the purpose of generating revenues.
For example, in case of the DVD production business we have purchased materials cost, labor costs, depreciation costs, rent costs, insurance costs, etc. All these costs are incurred for the purpose of generating profit from the sales of the ready product.
Costs are not constant, they can change. Costs can increase, fall or stay unchanged.
So why do the costs change? There are some activities, called cost drivers that cause change of costs.
Cost driver is any activity that causes change of costs over a given period of time. These activities are also called activity bases or activity drivers.
For example, hospital administration must plan and control food costs. In order to understand these cost changes, the hospital needs to identify and analyze the activity that causes the food costs to be incurred. In our case, it is the number of patients that stay in the hospital. Other examples of costs and their drivers are as follows: maintenance costs of the car and number of machine hours; or translation costs and volume of text to be translated.
9.2 Cost behavior. Reaction of costs to changes in activity
In the previous section we discussed costs and cost drivers. Now let us discuss how costs react to changes in activity.
When a cost driver changes, the cost may change or stay the same. For successful planning, managers must be able to predict how cost is to behave under certain circumstances.
Cost behavior is the manner in which a cost changes in relation to changes in the related activity.
Understanding of how costs behave in a particular situation is crucial for decision-making process in an organization. Cost behavior information allows managers:
- To estimate costs
- To predict profits as sales and production volumes change
- To forecast expenses
- To set price
So, studying the cost behavior is very important for proper planning and decision-making.
Depending on the cost behaviors, there are four common cost types, which are variable, fixed, mixed, and step-variable costs.
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