Topic 2: Behavior of cost

Variable Cost
A variable cost 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, kilometres driven,
beds occupied, or hours worked.
A good example of a variable cost is direct materials. The cost of direct materials used during a
period will vary, in total, in direct proportion to the number of units that are produced. To explain
this idea, consider a company manufacturing cars. Each car requires one battery. As the output of
cars increases and decreases, the number of batteries used will increase and decrease
proportionately. If cars production goes up 10%, then the number of batteries used will also go up
10%.
Although total variable costs change as the activity level changes, it is important to note that
variable cost per unit is constant (within relevant range). So the per unit cost of batteries remains
constant even though the total cost of the batteries increases and decreases with activity levels.

Graphical presentation
Consider a small company that provides tours. After every tour, which lasts about two hours, the company
gives each customer a drink (coffee, tea, or hot chocolate) and a light snack. The drinks and snacks
(“refreshments”) cost of company is $10 per person. If we look at the cost of the refreshments on a per
person basis, the cost is constant at $10. This $10 cost per person will not change, regardless of how many
customers are served by company. However with increase in number of customer, total refreshment cost
will increase.
The behavior of this variable cost, on both per unit and total basis, is tabulated as follows:

Number of Refreshment cost per Total cost of refreshment

customers customer
100 $10 $1,000
200 $10 $2,000
400 $10 $4,000
800 $10 $8,000

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There are many examples of costs that are variable with respect to the production and services
provided by a company. In a manufacturing company variable costs include items such as direct
materials, direct labour, lubricating oil, sales commissions etc.
When we say that a cost is variable, we usually mean that it is variable with respect to the
products and services the organization produces or provides. However, costs can be variable
with respect to other activities as well.

Step variable cost

The assumption of variable cost being constant per unit is only valid till a relevant range (discussed later)
and can change beyond that.

Graphical presentation
Suppose that fabric (material) cost is $4 per meter but this cost may change if company buy bulk material
from supplier (say more than 2,500 meter) and get a discount of $1 per meter resulting in net cost equals to
$3 per meter as shown below.

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(Note: MA1 students may ignore step variable cost in total graph)

Fixed cost
A fixed cost is a cost that remains constant, in total regardless of changes in the level of activity.
Fixed costs are not affected by changes in activity. Consequently, as the activity level rises and
falls, the total fixed costs remain constant.
Rent is a good example of fixed cost. Suppose a 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 is
incurred regardless of the number of tests performed during the month. However increase in
number of tests will decrease rent cost per test.

Monthly rental cost Number of tests performed Average cost per test
$8,000 10 $800
$8,000 500 $16
$8,000 2,000 $4

Graphical presentation
Assume a tourist company decides to hire a van for rent (lease) of $400 per month to pick up
customers at their hotel and return them there after the tour. The total amount of the rent (lease)
payments is the same regardless of the number of customers the company takes on its tours
during any given month. This cost behavior pattern is shown graphically below.
Since fixed costs remain constant in total, the average fixed cost per unit becomes progressively
smaller as the level of activity increases. If company has only 100 customers in a month, the $400
fixed rental cost amounts to an average of $4 per customer. If there are 800 customers, the fixed
rental cost averages only $0.50 per customer.
Note that as the number of customers increases, the average unit cost drops, but it drops at a
decreasing rate. The first customers have the greatest impact on the average fixed costs per unit.

Number of Total rent Rent cost per

customers (lease) customer
200 $400 $2
400 $400 $1
600 $400 $0.67
800 $400 $0.5

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Step fixed cost
Very few costs are completely fixed. Most will change if there is a large enough change in activity.
For example, suppose that the capacity of the leukemia diagnostic machine at a clinic is 2,000
tests per month. If the clinic needs to perform more than 2,000 tests in a month, it will be
necessary to rent an additional machine which will cause an increase in the fixed costs. When we
say a cost is fixed, we mean it is fixed within some relevant range (discussed later).

Graphical presentation
Rent of a machinery is $15,000 and it has a capacity of 2,500 units (meaning company can
manufacture maximum 2,500 units by using that machinery in a given period). In case company
needs to produce more output, it has to hire one more machinery at a rental cost of $15,000.
Following is a table which can illustrate this situation

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As we can see that from production of 1 to 2,500 units, only one machinery was required so
increase in number of units produced, decreased rent cost per unit of the product.
For output more than 2500 units, company hired another machinery which increased total fixed
cost (from $15,000 to $30,000) and fixed cost per unit (from $6 per unit to $12 per unit)

The relevant range is the range of activity within which the assumptions about variable and fixed
costs are valid.

Semi variable cost (Mixed cost)

Some costs contain variable and fixed cost elements: these are called mixed costs. An example is
the total wages paid to sales staff. A portion of these wages is usually a fixed salary and does not
vary with the level of selling activity. However, quite often a portion (sales commissions) of the
total wages varies directly with the amount of sales generated by the salesperson.

Graphical presentation
A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semi-
variable costs.
For example, a company pays $3,000 per month in van rental (lease) payments plus $4 per
kilometre to operate the van. If the company drives 1,000 kilometres in a month, the total vehicle
costs will be $7,000, made up of $3,000 in fixed cost plus $4,000 in variable cost.
Even if it doesn’t operate vehicle for a complete month, the company still have to pay the $3,000
fixed lease cost for the van.
Consider the table and graph in the next page for the explanation

Note: (in above graph, fixed cost is $3,000 and variable cost is $4 per unit)

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MCQs
Q1. Following are some details given about some expenses of company
Expense at Expense at Expense at Expense at
500 units 1000 units 2000 units 2,500 units
£ £ £
Expense A 2,000 2,000 2,000 2,000
Expense B 625 1,250 2,500 3,125
Expense C 400 800 1,600 2,000
Expense D 11,500 16,500 26,500 31,500
Required: -
Classify above costs according to their behaviors that either they are fixed, variable or semi variable.
A __________________.
B __________________.
C __________________.
D __________________.

2. Which of the following would be classified as a Variable Cost in the operation of a motor vehicle?
A Oil change every 10,000 kilometres B Petrol
C Insurance D Tyre replacement

3. The total cost of making product X is shown on the graph.

What is the variable cost per unit?

A $0.50 B $0.83 C $1.00 D $1.50

4. The graph shows the way in which a cost increases according to the level of activity of the business.

Which cost follows this pattern?

A administrative salaries B commission on sales
C Insurance of factory D office rent

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5. If production level increases then which of the following statements are consistent with it?
i. total fixed cost will remain same [true / false]
ii. fixed cost per unit increases [true / false]
iii. total variable cost will also increase [true / false]
iv. variable cost per unit will remain same [true / false]

6. The chart below shows the behaviour of a total cost as the volume of output changes:

What sort of cost is being illustrated?

A Fixed cost B Semi-variable cost
C Stepped-fixed cost D Variable cost

7. A production worker gets payment of £500 per month plus £4 per unit manufactured by him. His
payment will be classified as
A. fixed cost B. variable cost
C. semi variable cost D. step cost

8. Variable costs are deemed to:

A. be constant per unit of output within relevant range.
B. vary per unit of output as production volumes changes
C. be constant in total when production volumes changes
D. Vary, in total, from period to period when production is constant.

9. Fixed cost per unit increases when

A. Production volume decreases C. Production volume increases
B. Variable cost per unit decreases D. Variable cost per unit increases

10. A manufacturing company has four types of cost (identified as T1, T2 , T3 and T4).
The total cost for each type at two different production levels is:
Total cost for Total cost for
Cost type 125 units 180 units
£ £
T1 1,000 1,260
T2 1,750 2,520
T3 2,475 2,826
T4 3,225 4,644
Which two cost types would be classified as being variable cost?
A T1 and T3 B T1 and T4 C T2 and T3 D T2 and T4

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11. The following charts demonstrate various costs in relation to activity:

Which of the above charts represents unit fixed cost?

A Chart 1 B Chart 2 C Chart 3 D Chart 4

12. What is meant by classification of costs by behavior?

A. classification of costs as materials, labour or expenses
B. classification of costs according to how they change according to activity levels
C. classification of costs as direct or indirect
D. classification of costs according to their function within the business

13. Following is a graph

What is fixed cost in above graph?

A. $5,000 C. $2,000
B. $3,000 D. $7,000

14. Which ONE of the following costs would be included in prime cost in a food processing company?
A The cost of renting the factory building.
B The salary of the factory manager.
C The maintenance cost of equipment located in the materials store.
D The cost of ingredients.

15. A firm has to pay £0.20 per unit royalty to the inventor of a device which it manufactures and sells.
How would the royalty charge be classified in the firm’s accounts?
A. Direct expense
B. Production overheads
C. Administration overheads
D. Selling Expense

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16. A hospital’s records show that the cost of carrying out health checks in the last four accounting
periods have been as follows:
Period Number of patients seen Total cost
$
1 650 17,125
2 940 17,800
3 1,260 18,650
4 1,150 18,360
Using the high-low method and ignoring inflation, the estimated cost of carrying out health checks on
850 patients in period 6 is
______________.

17. Following are expected costs of a company:

Output in units 120 000 80 000
Total fixed and variable costs $660 000 $500 000
What are the variable costs per unit?
____________

18. The following shows the cost per unit of an item of expense at different levels of activity:
Activity (units) Cost per unit (£)
1 10,000
50 200
100 120
150 80
What is the correct behavioural classification for the expense item?
A Fixed cost B Semi-variable cost
C Stepped-fixed cost D Variable cost

19 & 20. Bowen plc provides a call centre service to a number of utility and financial services
customers. It has four separate call centre buildings plus a head office. Many of the telephone staff are
students and casual employees who are paid weekly, on an hourly basis. Their contracts state that
Bowen plc has no duty to provide them with work. The telephone staff are managed by permanent
supervisors and managers. Although there are no direct material costs as such, the company incurs
telephone charges which are directly related to the number of calls it handles. There is a central
computerised exchange which routes the calls received.

19. Which of the following costs would you classify as fixed costs?
(1) Lease charges for the buildings
(2) Telephone staff costs
(3) Supervisor and management costs
(4) Telephone charges
(5) Computer exchange lease costs
A (1), (3) and (4) B (2) and (4)
C (1), (3) and (5) D All of them

20. Which of the costs would you classify as variable costs?

A (1), (3) and (4)
B (2) and (4)
C All of them