Accounting Cost Behavior

Cost drivers; variable, fixed, step variable and mixed costs; relevant range; methods to estimate total product costs: high-low method, scatter-graph, and least-squares regression.

1. Definition of cost driver

Let's start with an example. Suppose you and your friend established a company that produces valves for the automotive industry and named this company Friends Company. How much should you charge for one valve in order to stay in business? How many valves should be sold in a given month at a given price to cover your costs?

These questions can be answered with the aid of cost information. Cost information can support managers' decision-making. Let us define cost:

Cost is a payment of cash or its equivalent for the purpose of generating revenues.

In the case of the valve production business Friends Company has purchased material costs, labor costs, depreciation costs, rent costs, insurance costs, etc. All these costs are incurred for the purpose of generating profit from the product sales.

In financial accounting, costs and expenses are used interchangeably. In managerial accounting, costs differ from expenses. A cost is the amount of resources given up in order to receive some goods or services and represents future economic benefit to a company. An asset is a cost. As the future economic benefit of an asset decreases, the original cost of the asset expires and the cost becomes an expense. Expenses are matched with revenues on the income statement. A good example for understanding a cost and expense is a fixed asset. When a fixed asset is purchased, it is a cost to the company and is shown on the balance sheet. When the fixed asset is used, it is depreciated and a portion of the cost becomes a depreciation expense, which is included in the income statement and matched with the revenues.

Costs are determined by the manufacturing process and primarily depend on the volume of production. Some costs change in proportion to units produced, some only slightly react to changes in production, and others don't change at all. The factors impacting changes in costs are cost drivers, defined as follows:

Cost driver is any activity that causes a change in costs over a given period of time. These activities are also called activity bases or activity drivers.

In our example of valve production, we would like to know how much material to buy to ensure an uninterrupted production process. Common sense suggests that the amount of material we will need to purchase is driven by the number of valves we produce. Therefore, the production level is the cost driver for material costs. Other examples of costs and their cost drivers are maintenance expense and number of hours equipment is used, or hourly labor costs and how many hours employees work per day.

2. Cost behavior. Reaction of costs to changes in activity

In the previous section we discussed costs and cost drivers. We will continue by discussing how costs react to changes in activity.

For successful planning, managers must be able to predict how costs will behave under certain circumstances.

Cost behavior is the manner in which a cost changes in relation to changes in the related activity.

Understanding how costs behave in a particular situation is crucial for the decision-making process in an organization. Cost behavior information allows managers:

  • To prepare budgets
  • To predict cash flows
  • To plan dividend payments
  • To establish selling prices

From the cost behavior standpoint, there are four common cost types: variable, fixed, mixed, and step-variable.

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