Cost Behavior

Now that we have identified the three key types of businesses, let’s identify cost behaviors and
apply them to the business environment. In managerial accounting, different companies use the
term cost in different ways depending on how they will use the cost information. Different
decisions require different costs classified in different ways. For instance, a manager may need
cost information to plan for the coming year or to make decisions about expanding or
discontinuing a product or service. In practice, the classification of costs changes as the use of
the cost data changes. In fact, a single cost, such as rent, may be classified by one company as a
fixed cost, by another company as a committed cost, and by even another company as a period
cost. Understanding different cost classifications and how certain costs can be used in different
ways is critical to managerial accounting.
Any discussion of costs begins with the understanding that most costs will be classified in one of
three ways: fixed costs, variable costs, or mixed costs. The costs that don’t fall into one of these
three categories are hybrid costs, which are examined only briefly because they are addressed in
more advanced accounting courses. Because fixed and variable costs are the foundation of all
other cost classifications, understanding whether a cost is a fixed cost or a variable cost is very
important.

Fixed versus Variable Costs

A fixed cost is an unavoidable operating expense that does not change in total over the short
term, even if a business experiences variation in its level of activity. Table 6.6 illustrates the types
of fixed costs for merchandising, service, and manufacturing organizations.

We have established that fixed costs do not change in total as the level of activity changes, but
what about fixed costs on a per-unit basis? Let’s examine Tony’s screen-printing company to
illustrate how costs can remain fixed in total but change on a per-unit basis.

Tony operates a screen-printing company, specializing in custom T-shirts. One of his fixed costs
is his monthly rent of $1,000. Regardless of whether he produces and sells any T-shirts, he is
obligated under his lease to pay $1,000 per month. However, he can consider this fixed cost on
a per-unit basis
.

Two specialized types of fixed costs are committed fixed costs and discretionary fixed costs.
These classifications are generally used for long-range planning purposes and are covered in
upper-level managerial accounting courses, so they are only briefly described here.

Committed fixed costs are fixed costs that typically cannot be eliminated if the company is going
to continue to function. An example would be the lease of factory equipment for a production
company.

Discretionary fixed costs generally are fixed costs that can be incurred during some periods and
postponed during other periods but which cannot normally be eliminated permanently.
Examples could include advertising campaigns and employee training. Both of these costs could
potentially be postponed temporarily, but the company would probably incur negative effects if
the costs were permanently eliminated. These classifications are generally used for long-range
planning purposes.

In addition to understanding fixed costs, it is critical to understand variable costs, the second
fundamental cost classification. A variable cost is one that varies in direct proportion to the level
of activity within the business. Typical costs that are classified as variable costs are the cost of
raw materials used to produce a product, labor applied directly to the production of the product,
and overhead expenses that change based upon activity. For each variable cost, there is some
activity that drives the variable cost up or down. A cost driver is defined as any activity that causes
the organization to incur a variable cost.

Unlike fixed costs that remain fixed in total but change on a per-unit basis, variable costs remain
the same per unit, but change in total relative to the level of activity in the business. Revisiting
Tony’s T-Shirts, Figure 6.26 shows how the variable cost of ink behaves as the level of activity
changes.

Distinguishing between fixed and variable costs is critical because the total cost is the sum of all
fixed costs (the total fixed costs) and all variable costs (the total variable costs). For every unit
produced, every customer served, or every hotel room rented, for example, managers can
determine their total costs both per unit of activity and in total by combining their fixed and
variable costs together. the variable cost per unit (per T-shirt) does not change as the number of
T-shirts produced increases or decreases. However, the variable costs change in total as the
number of units produced increases or decreases. In short, total variable costs rise and fall as the
level of activity (the cost driver) rises and falls.

Distinguishing between fixed and variable costs is critical because the total cost is the sum of all
fixed costs (the total fixed costs) and all variable costs (the total variable costs). For every unit
produced, every customer served, or every hotel room rented, for example, managers can
determine their total costs both per unit of activity and in total by combining their fixed and
variable costs together. The graphic in Figure 6.27 illustrates the concept of total costs.

Figure 6.27 Total Cost as the Sum of Total Fixed Costs and Total Variable Costs By: Rice University Source: Openstax CC BY-NC-SA 4.0

Remember that the reason that organizations take the time and effort to classify costs as either
fixed or variable is to be able to control costs. When they classify costs properly, managers can
use cost data to make decision plan for the future of the business.
Average Fixed Costs versus Average Variable Costs

Another way management may want to consider their costs is as average costs. Under this
approach, managers can calculate both average fixed and average variable costs. Average fixed
cost (AFC) is the total fixed costs divided by the total number of units produced, which results in
a per-unit cost. The formula is:

Figure 6.28 By: Rice University Source: Openstax CC BY-NC-SA 4.0

To show how a company would use AFC to make business decisions, consider Carolina Yachts, a
company that manufactures sportfishing boats that are sold to consumers through a network of
marinas and boat dealerships. Carolina Yachts produces 625 boats per year, and their total annual
fixed costs are $1,560,000. If they want to determine an average fixed cost per unit, they will find
it using the formula for AFC:
AFC=$1,560,000625=$2,496per boat AFC=$1,560,000625=$2,496per boat

When they produce 625 boats, Carolina Yachts has an AFC of $2,496 per boat. What happens to
the AFC if they increase or decrease the number of boats produced? Figure 6.29 shows the AFC
for different numbers of boats.

Figure 6.29 Average Fixed Costs for Carolina Yachts By: Rice University Source: Openstax CC BY-NC-SA 4.0

We see that total fixed costs remain unchanged, but the average fixed cost per unit goes up and
down with the number of boats produced. As more units are produced, the fixed costs are spread
out over more units, making the fixed cost per unit fall. Likewise, as fewer boats are
manufactured, the average fixed costs per unit rises. We can use a similar approach with variable
costs.

Average variable cost (AVC) is the total variable costs divided by the total number of units
produced, which results in a per-unit cost. Like ATC, we can use this formula:

Figure 6.30 By: Rice University Source: Openstax CC BY-NC-SA 4.0

To demonstrate AVC, let’s return to Carolina Yachts, which incurs total variable costs of
$6,875,000 when they produce 625 boats per year. They can express this as an average variable
cost per unit:
AVC=$6,875,000625=$11,000per boat AVC=$6,875,000625=$11,000per boat

Because average variable costs are the average of all costs that change with production levels on
a per-unit basis and include both direct materials and direct labor, managers often use AVC to
determine if production should continue or not in the short run. As long as the price Carolina
Yachts receives for their boats is greater than the per-unit AVC, they know that they are not only
covering the variable cost of production, but each boat is making a contribution toward covering
fixed costs. If, at any point, the average variable cost per boat rises to the point that the price no
longer covers the AVC, Carolina Yachts may consider halting production until the variable costs
fall again.

These changes in variable costs per unit could be caused by circumstances beyond their control,
such as a shortage of raw materials or an increase in shipping costs due to high gas prices. In any
case, average variable cost can be useful for managers to get a big picture look at their variable
costs per unit.

Mixed Costs and Stepped Costs

Not all costs can be classified as purely fixed or purely variable. Mixed costs are those that have
both a fixed and variable component. It is important, however, to be able to separate mixed costs
into their fixed and variable components because, typically, in the short run, we can only change
variable costs but not most fixed costs. To examine how these mixed costs actually work, consider
the Ocean Breeze hotel.

The Ocean Breeze is located in a resort area where the county assesses an occupancy tax that
has both a fixed and a variable component. Ocean Breeze pays $2,000 per month, regardless of
the number of rooms rented. Even if it does not rent a single room during the month, Ocean
Breeze still must remit this tax to the county. The hotel treats this $2,000 as a fixed cost. However,
for every night that a room is rented, Ocean Breeze must remit an additional tax amount of $5.00
per room per night. As a result, the occupancy tax is a mixed cost. Figure 6.31 further illustrates
how this mixed cost behaves.

Figure 6.31 Mixed Costs Example for Ocean Breeze By: Rice University Source: Openstax CC BY-NC-SA 4.0

Notice that Ocean Breeze cannot control the fixed portion of this cost and that it remains fixed
in total, regardless of the activity level. On the other hand, the variable component is fixed per
unit, but changes in total based upon the level of activity. The fixed portion of this cost plus the
variable portion of this cost combine to make the total cost. As a result, the formula for total cost
looks like this:

where Y is the total mixed cost, a is the fixed cost, b is the variable cost per unit, and x is the level
of activity.

Graphically, mixed costs can be explained as shown in Figure 6.33.

Figure 6.33 Ocean Breeze’s Mixed Cost Graph By: Rice University Source: Openstax CC BY-NC-SA 4.0 Long Description

The graph shows that mixed costs are typically both fixed and linear in nature. In other words,
they will often have an initial cost, in Ocean Breeze’s case, the $2,000 fixed component of the
occupancy tax, and a variable component, the $5 per night occupancy tax. Note that the Ocean
Breeze mixed cost graph starts at an initial $2,000 for the fixed component and then increases
by $5 for each night their rooms are occupied.

Some costs behave less linearly. A cost that changes with the level of activity but is not linear is
classified as a stepped cost. Step costs remain constant at a fixed amount over a range of activity.
The range over which these costs remain unchanged (fixed) is referred to as the relevant range,
which is defined as a specific activity level that is bounded by a minimum and maximum amount.
Within this relevant range, managers can predict revenue or cost levels. Then, at certain points,
the step costs increase to a higher amount. Both fixed and variable costs can take on this stair-
step behavior. For instance, wages often act as a stepped variable cost when employees are paid
a flat salary and a commission or when the company pays overtime. Further, when additional
machinery or equipment is placed into service, businesses will see their fixed costs stepped up.
The “trigger” for a cost to step up is the relevant range. Graphically, step costs appear like stair
steps (Figure 6.34).
Figure 6.34 Step Cost Graph By: Rice University Source: Openstax CC BY-NC-SA 4.0

If demand for these units increases and more than 80 inspections are needed per shift, the
relevant range has been exceeded and the business will have one of two choices:

(1) Pay the quality inspector overtime in order to have the additional units inspected. This
overtime will “step up” the variable cost per unit. The advantage to handling the increased cost
in this way is that when demand falls, the cost can quickly be “stepped down” again. Because
these types of step costs can be adjusted quickly and often, they are often still treated as variable
costs for planning purposes.

(2) “Step up” fixed costs. If the company hires a second quality inspector, they would be stepping
up their fixed costs. In effect, they will double the relevant range to allow for a maximum of 160
inspections per shift, assuming the second QA inspector can inspect an additional 80 units per
shift. The down side to this approach is that once the new QA inspector is hired, if demand falls
again, the company will be incurring fixed costs that are unnecessary. For this reason, adding
salaried personnel to address a short-term increase in demand is not a decision most businesses
make.

Step costs are best explained in the context of a business experiencing increases in activity
beyond the relevant range. As an example, let’s return to Tony’s T-Shirts.

Tony’s cost of operations and the associated relevant ranges are shown in Table 6.9.

Table 6.9 Tony’s T-Shirts Cost Options By: Rice University Openstax CC BY-NC-SA 4.0

Cost Type of Cost Relevant Range

Lease on Screen-Printing Machine $2,000 per month Fixed 0–2,000 T-shirts per month
 Table 6.9 Tony’s T-Shirts Cost Options By: Rice University Openstax CC BY-NC-SA 4.0

Cost Type of Cost Relevant Range

Employee $10 per hour Variable 20 shirts per hour

Tony’s Salary $2,500 per month Fixed N/A

Screen-Printing Ink $0.25 per shirt Variable N/A

Building Rent $1,500 per month Fixed 2 screen-printing machines and 2 employees

As you can see, Tony has both fixed and variable costs associated with his business. His one
screen-printing machine can only produce 2,000 T-shirts per month and his current employee
can produce 20 shirts per hour (160 per 8-hour work day). The space that Tony leases is large
enough that he could add an additional screen-printing machine and 1 additional employee. If he
expands beyond that, he will need to lease a larger space, and presumably his rent would increase
at that point. It is easy for Tony to predict his costs as long as he operates within the relevant
ranges by applying the total cost equation Y = a + bx. So, for Tony, as long as he produces 2,000
or fewer T-shirts, his total cost will be found by Y = $6,000 + $0.75x, where the variable cost of
$0.75 is the $0.25 cost of the ink per shirt and $0.50 per shirt for labor ($10 per hour wage/20
shirts per hour). As soon as his production passes the 2,000 T-shirts that his one employee and
one machine can handle, he will have to add a second employee and lease a second screen-
printing machine. In other words, his fixed costs will rise from $6,000 to $8,000, and his variable
cost per T-shirt will rise from $0.75 to $1.25 (ink plus 2 workers). Thus, his new cost equation
is Y = $8,000 + $1.25x until he “steps up” again and adds a third machine and moves to a new
location with a presumably higher rent. Let’s take a look at this in chart form to better illustrate
the “step” in cost Tony will experience as he steps past 2,000 T-shirts.

Tony’s cost information is shown in the chart for volume between 500 and 4,000 shirts.
Figure 6.35 By: Rice University Source: Openstax CC BY-NC-SA 4.0

It is important to remember that even though Tony’s costs stepped up when he exceeded his
original capacity (relevant range), the behavior of the costs did not change. His fixed costs still
remained fixed in total and his total variable cost rose as the number of T-shirts he produced
rose. Table 6.10 summarizes how costs behave within their relevant ranges.

Table 6.10 Summary of Fixed and Variable Cost Behaviors By: Rice University Openstax CC BY-NC-SA
4.0

Cost In Total Per Unit

Variable Changes in response to the level of Remains fixed per unit regardless of the level of
Cost activity activity

Does not change with the level of activity, Changes based upon activity within the relevant
Fixed
within the relevant range, but does range: increased activity decreases per-unit
Cost
change when the relevant range changes cost; decreased activity increases per-unit cost

Product versus Period Costs

Many businesses can make decisions by dividing their costs into fixed and variable costs, but
there are some business decisions that require grouping costs differently. Sometimes companies
need to consider how those costs are reported in the financial statements. At other times,
companies group costs based on functions within the business. For example, a business would
group administrative and selling expenses by the period (monthly or quarterly) so that they can
be reported on an Income Statement. However, a manufacturing firm may carry product costs
such as materials from one period to the other in order to have the costs “travel” with the units
being produced. It is possible that both the selling and administrative costs and materials costs
have both fixed and variable components. As a result, it may be necessary to analyze some fixed
costs together with some variable costs. Ultimately, businesses strategically group costs in order
to make them more useful for decision-making and planning. Two of the broadest and most
common grouping of costs are product costs and period costs.

Product costs are all those associated with the acquisition or production of goods and products.
When products are purchased for resale, the cost of goods is recorded as an asset on the
company’s balance sheet. It is not until the products are sold that they become an expense on
the income statement. By moving product costs to the expense account for the cost of goods
sold, they are easily matched to the sales revenue income account. For example, Bert’s Bikes is a
bicycle retailer who purchases bikes from several wholesale distributors and manufacturers.
When Bert purchases bicycles for resale, he places the cost of the bikes into his inventory
account, because that is what those bikes are—his inventory available for sale. It is not until
someone purchases a bike that it creates sales revenue, and in order to fulfill the requirements
of double-entry accounting, he must match that income with an expense: the cost of goods sold
(Figure 6.37).

Figure 6.37 Journal Entry for Cost of Goods Sold Product costs are collected in the finished goods inventory,
where they remain until the goods are sold By: Rice University Source: Openstax CC BY-NC-SA 4.0

Some product costs have both a fixed and variable component. For example, Bert purchases 10
bikes for $100 each. The distributor charges $10 per bike for shipping for 1 to 10 bikes but $8 per
bike for 11 to 20 bikes. This shipping cost is fixed per unit but varies in total. If Bert wants to save
money and control his cost of goods sold, he can order an 11th bike and drop his shipping cost
by $2 per bike. It is important for Bert to know what is fixed and what is variable so that he can
control his costs as much as possible.

What about the costs Bert incurs that are not product costs? Period costs are simply all of the
expenses that are not product costs, such as all selling and administrative expenses. It is
important to remember that period costs are treated as expenses in the period in which they
occur. In other words, they follow the rules of accrual accounting practice by recognizing the cost
(expense) in the period in which they occur regardless of when the cash changes hands. For
example, Bert pays his business insurance in January of each year. Bert’s annual insurance
premium is $10,800, which is $900 per month. Each month, Bert will recognize 1 ÷ 12 of this
insurance cost as an expense in the period in which it is incurred (Figure 6.38).

Figure 6.38 Journal Entry for Insurance Expense Bert applies 1 ÷ 12 of the prepaid insurance premium per month to the expense
account in order to match period costs with period revenues By: Rice University Source: Openstax CC BY-NC-SA 4.0

Why is it so important for Bert to know which costs are product costs and which are period costs?
Bert may have little control over his product costs, but he maintains a great deal of control over
many of his period costs. For this reason, it is important that Bert be able to identify his period
costs and then determine which of them are fixed and which are variable. Remember that fixed
costs are fixed over the relevant range, but variable costs change with the level of activity. If Bert
wants to control his costs to make his bike business more profitable, he must be able to
differentiate between the costs he can and cannot control.

Just like a merchandising business such as Bert’s Bikes, manufacturers also classify their costs as
either product costs or period costs. For a manufacturing business, product costs are the costs
associated with making the product, and period costs are all other costs. For the purposes of
external reporting, separating costs into period and product costs is not all that is necessary.
However, for management decision-making activities, refinement of the types of product costs
is helpful.

In a manufacturing firm, the need for management to be aware of the types of costs that make
up the cost of a product is of paramount importance. Let’s look at Carolina Yachts again and
examine how they can classify the product costs associated with building their sportfishing boats.
Just like automobiles, every year, Carolina Yachts makes changes to their boats, introducing new
models to their product line. When the engineers begin to redesign boats for the next year, they
must be careful not to make changes that would drive the selling price of their boats too high,
making them less attractive to the customer. The engineers need to know exactly what the
addition of another feature will do to the cost of production. It is not enough for them to get
total product cost data; instead, they need specific information about the three classes of product
costs: materials, labor, and overhead.

As you’ve learned, direct materials are the raw materials and component parts that are directly
economically traceable to a unit of production.

Table 6.11 provides some examples of direct materials.

 Table 6.11 Examples of Direct Materials By: Rice University Openstax CC BY-NC-SA 4.0

Manufacturing Business Product Direct Materials

Bakery Birthday cakes Flour, sugar, eggs, milk

Automobile manufacturer Cars Glass, steel, tires, carpet

Furniture manufacturer Recliners Wood, fabric, cotton batting

In each of the examples, managers are able to trace the cost of the materials directly to a specific
unit (cake, car, or chair) produced. Since the amount of direct materials required will change
based on the number of units produced, direct materials are almost always classified as a variable
cost. They remain fixed per unit of production but change in total based on the level of activity
within the business.

It takes more than materials for Carolina Yachts to build a boat. It requires the application of
labor to the raw materials and component parts. You’ve also learned that direct labor is the work
of the employees who are directly involved in the production of goods or services. In fact, for
many industries, the largest cost incurred in the production process is labor. For Carolina Yachts,
their direct labor would include the wages paid to the carpenters, painters, electricians, and
welders who build the boats. Like direct materials, direct labor is typically treated as a variable
cost because it varies with the level of activity. However, there are some companies that pay a
flat weekly or monthly salary for production workers, and for these employees, their
compensation could be classified as a fixed cost. For example, many auto mechanics are now
paid a flat weekly or monthly salary.

While in the example Carolina Yachts is dependent upon direct labor, the production process for
companies in many industries is moving from human labor to a more automated production
process. For these companies, direct labor in these industries is becoming less significant. For an
example, you can research the current production process for the automobile industry.

The third major classification of product costs for a manufacturing business is overhead.
Manufacturing overhead (sometimes referred to as factory overhead) includes all of the costs
that a manufacturing business incurs, other than the variable costs of direct materials and direct
labor required to build products. These overhead costs are not directly attributable to a specific
unit of production, but they are incurred to support the production of goods. Some of the items
included in manufacturing overhead include supervisor salaries, depreciation on the factory,
maintenance, insurance, and utilities. It is important to note that manufacturing overhead does
not include any of the selling or administrative functions of a business. For Carolina Yachts, costs
like the sales, marketing, CEO, and clerical staff salaries will not be included in the calculation of
manufacturing overhead costs but will instead be allocated to selling and administrative
expenses.

As you have learned, much of the power of managerial accounting is its ability to break costs
down into the smallest possible trackable unit. This also applies to manufacturing overhead. In
many cases, businesses have a need to further refine their overhead costs and will track indirect
labor and indirect materials.

When labor costs are incurred but are not directly involved in the active conversion of materials
into finished products, they are classified as indirect labor costs. For example, Carolina Yachts has
production supervisors who oversee the manufacturing process but do not actively participate in
the construction of the boats. Their wages generally support the production process but cannot
be traced back to a single unit. For this reason, the production supervisors’ salary would be
classified as indirect labor. Similar to direct labor, on a product or department basis, indirect
labor, such as the supervisor’s salary, is often treated as a fixed cost, assuming that it does not
vary with the level of activity or number of units produced. However, if you are considering the
supervisor’s salary cost on a per unit of production basis, then it could be considered a variable
cost.

Similarly, not all materials used in the production process can be traced back to a specific unit of
production. When this is the case, they are classified as indirect material costs. Although needed
to produce the product, these indirect material costs are not traceable to a specific unit of
production. For Carolina Yachts, their indirect materials include supplies like tools, glue, wax, and
cleaning supplies. These materials are required to build a boat, but management cannot easily
track how much of a bottle of glue they use or how often they use a particular drill to build a
specific boat. These indirect materials and their associated cost represent a small fraction of the
total materials needed to complete a unit of production. Like direct materials, indirect materials
are classified as a variable cost since they vary with the level of production. Table 6.12 provides
some examples of manufacturing costs and their classifications.

Prime Costs versus Conversion Costs

In certain production environments, once a business has separated the costs of the product into
direct materials, direct labor, and overhead, the costs can then be gathered into two broader
categories: prime costs and conversion costs. Prime costs are the direct material expenses and
direct labor costs, while conversion costs are direct labor and general factory overhead
combined. Please note that these two categories of costs are examples of cost categories where
a particular cost can be included in both. In this case, direct labor is included in both prime costs
and conversion costs.
These cost classifications are common in businesses that produce large quantities of an item that
is then packaged into smaller, sellable quantities such as soft drinks or cereal. In these types of
production environments, it easier to lump the costs of direct labor and overhead into one
category, since these costs are what are needed to convert raw materials into a finished product.

Although it seems as if there are many classifications or labels associated with costs, remember
that the purpose of cost classification is to assist managers in the decision-making process. Since
this type of data is not used for external reporting purposes, it is important to understand that
(1) a single cost can have many different labels; (2) the terms are used independently, not
simultaneously; and (3) each classification is important to understand in order to make business
decisions. Figure 6.39 uses some example costs to demonstrate these principles.

Figure 6.39 Classification Based on Cost Function Costs can fall into more than one category, sometimes making the
process of cost identification complex. DM, direct materials; DL, direct labor; OH, overhead. Classification Based on
Cost Function. By: Rice University Source: Openstax CC BY-NC-SA 4.0 Long Description

Effects of Changes in Activity Level on Unit Costs and Total Costs

We have spent considerable time identifying and describing the various ways that businesses
categorize costs. However, categorization itself is not enough. It is important not only to
understand the categorization of costs but to understand the relationships between changes in
activity levels and the changes in costs in total. It is worth repeating that when a cost is considered
to be fixed, that cost is only fixed for the relevant range. Once the boundary of the relevant range
has been reached or moved beyond, fixed costs will change and then remain fixed for the new
relevant range. Remember that, within a relevant range of activity, where the relevant range
refers to a specific activity level that is bounded by a minimum and maximum amount, total fixed
costs are constant, but costs change on a per-unit basis. Let’s examine an example that
demonstrates how changes in activity can affect costs.