3.) Cost Behaviour

Question 1

What is Cost Behaviour?

Answer 1

• Refers to how costs change in relation to volume (no. of units) or activity (varies w/services etc.)
• Some costs vary with volume or operating activity, whilst others remain fixed as volume changes
• Fixed vs. variable vs. mixed
• Some costs exhibit characteristics between these two extremes (mixed costs)

Question 2

What cost classifications are there for predicting Cost Behaviour?

Answer 2

• Total variable costs change when activity changes

- Total fixed costs remain unchanged when activity changes

Question 3

What is The Management Cycle?

Answer 3

• Managers use their knowledge of cost behaviour to estimate future costs and the impact of operational changes on future profitability
• Managers use assumptions about cost behaviour in almost every decision they make
• Managers must understand cost behaviour patterns to anticipate cost ramifications of alternatives in order to decide correctly

Question 4

What are Variable Costs?

Answer 4

• Total costs that change in direct proportion to changes in productive output (within the relevant range)
• On a per unit basis, however variable costs remain constant as volume changes (within wide range of activity)
  E.g. direct materials, each car radio costs a certain amount

Question 5

Give an example of Total Variable Cost.

Answer 5

E.g. total petrol bill:

• Based on how many miles you drive
• A cost that varies with activity
• Straight diagonal line of y = mx; directly proportional

Question 6

Give an example of Variable Cost per Unit

Answer 6

E.g. cost per mile driven is approximately constant:

• E.g. 10p per mile
• Assumption that it is constant; straight line going flat across of y = constant

Question 7

What are some examples of Variable Cost?

Answer 7

• Direct materials
• Direct and indirect labour (hourly ONLY; no. of hours an employee works dictates how much they’re paid, in turn related to volume/activity, N/A w/annual salaries though)
• Operating supplies (helping an organisation to run)
• Sales commissions (level of sales dictates cost of commission)

Question 8

What Variable Costs do Retailers incur?

Answer 8

• Cost of Goods Sold

Question 9

What Variable Costs do Service Organisations incur?

Answer 9

• Supplies and travel e.g. delivery organisation, cost of medicines in a hospital

Question 10

What Variable Costs do Manufacturers incur?

Answer 10

• Direct Materials
• Direct Labour
• Variable Manufacturing Overhead

Question 11

What Variable Costs do both Retailers and Manufacturers incur?

Answer 11

• Sales commissions and shipping costs

Question 12

What are Fixed Costs?

Answer 12

• Total costs that remain constant within a relevant range of volume/activity
• On a per unit basis, fixed costs vary inversely with changes in volume (per unit cost decreases w/greater activity)
  E.g. Cost per mile road tax decreases with more miles driven, but total cost stays the same.
  »> BUT, fixed costs are not normally unitised, particularly when not changing w/volume or activity.

Question 13

Give an example of a Total Fixed Cost and its corresponding Per Unit Cost.

Answer 13

Total Fixed Cost:

• Road tax is fixed and does not change if you drive more miles
• Graph of y = 3 (a straight line across, not necessarily 3)

Per Unit (fixed) cost:

• But, the fixed cost per mile (unit) decreases as more miles are driven
• Road tax is effectively cheaper on a per mile basis if more miles are driven; but in reality, fixed costs are not paid this way.

Question 14

What are some examples of Fixed Costs?

Answer 14

• Depreciation (assets depreciate in value over time)
• Rent
• Supervisory salaries
• Auditors’ fees (mandatory)

Question 15

What is an Activity Base? Give examples.

Answer 15

• The thing that the variable cost varies with; a cost can be potentially variable WRT to one activity base, and fixed WRT to another
• It is the cost driver; measure of the event causing the incurrence of a variable cost

E.g.:
> Petrol cost varies with miles driven, but is fixed WRT how many people are in the car
> Road tax varies with the size (emissions) of the vehicle, but remains fixed WRT miles driven

Question 16

What do the following activity bases (cost drivers), drive?

• Units produced
• Miles driven
• Machine hours
• Labour hours

Answer 16

Units produced:
- Drives direct materials cost (variable costs)

Miles driven:
- Driver for petrol cost

Machine hours:
- Drives cost of power (electricity) for machines)

Labour hours:
- Driver for direct labour costs

Question 17

What is meant by the Relevant Range?

Answer 17

• The volume range within which actual operations are likely to occur
  »> A fixed cost is not fixed over ALL levels of activity

Question 18

Describe the Linearity Assumption and Relevant Range.

Answer 18

• Many costs are curvilinear; where a straight line closely approximates a curvilinear variable cost line within the relevant range
• In this relevant range, variable cost is in direct proportion to activity/volume
• The relevant range is where assumption of direct relationship holds true; in linearity assumption and the relevant range graph (where lines overlap in straight line bit – the range of activity)
  • Thus within the range of activity, it can be a unit constant e.g. 10p per mile petrol
  • E.g. volume discounts; outside range of relevant activity, cost of procurement may decrease with bulk purchase, but cost remains constant within initial relevant range
  • Caveat: cost is directly proportional within relevant range of activity, but is curvilinear otherwise.

Question 19

What does the Common Fixed-Cost Behaviour Pattern entail?

Answer 19

• Where there is an original relevant range (for a set range of Units of Output e.g. 0 - 600,000) pertaining to an initial Fixed overhead cost (fixed cost pattern)
• Then exhibits step pattern to a new Fixed overhead cost
• New Fixed overhead cost sustains higher range of Units of output
• New Fixed overhead cost as a result of the organisation’s expenditure of new labour/machines; organisation pays fixed cost all at once hence the step pattern
  »> This is known as Capacity Cost

Question 20

What are Mixed Costs?

Answer 20

• Has both variable and fixed components
• Part of the cost changes with volume/usage, part of the cost is fixed over time.

E.g:
> Utilities (electricity, gas, water etc. – fixed connection to utility, variable cost w/use),
> Manufacturing overhead (FC = supervisory salaries, VC = per hour wage)

Question 21

How can Mixed Costs be expressed graphically? What do the functions represent?

Answer 21

y = bx + a 
(y = mx + c)

> a = total fixed cost (y intercept)
b = variable cost per unit of activity (slope of the line/the gradient; m)
x = level of activity (e.g. Kilowatt Hours)
y = total mixed cost (e.g. Total Utility Cost)

Question 22

What are the two different types of Fixed Costs?

Answer 22

Committed:
- Long-term, cannot be reduced in the short term
- Committed fixed costs cannot be reduced as easily without a bad impact on profit
E.g. depreciation on building, equipment, cars, long-term leases

Discretionary:

• May be altered in the short-term by current managerial decisions
• Can be altered annually as part of budgeting process; altered in-line to achieve objectives
• Discretionary fixed costs can be reduced with less impact on profit e.g. w/reduced demand

Question 23

What does is meant by the Trend towards Fixed Costs?

Answer 23

Due to:

• Increased automation (FCs of machinery)
• Increase in salaried, knowledge workers who are difficult to train and replace (e.g. with decreased demand, it is not feasible to get rid of these employees)

Question 24

What are the implications as a result of the Trend towards Fixed Costs?

Answer 24

• Managers are more ‘locked-in’ with fewer decision alternatives
• Planning becomes imperative as FCs are difficult to change w/current operating decisions (particularly committed FCs, though they can be changed if required)

Question 25

What does a Contribution Format statement tell us?

Answer 25

• The contribution margin format emphasis cost behaviour; contribution margins covers fixed costs and provides for profit
• Isolates variable cost and fixed cost
• For internal use by managers; fixed costs not added to cost of products as they don’t change w/volume or activity
• Effective for assessing profitability of a product

Question 26

What is the layout of a Contribution Format statement?

Answer 26

- Sales revenue
> Minus variable costs
- Contribution
> Minus fixed costs
= Net profit

Question 27

How does the Contribution (Format) Profit Statement compare to the Traditional Profit Statement?

Answer 27

Traditional:

• Used primarily for external reporting
• Costs organised by function
• Costs of goods sold is subtracted instead of variable costs; would include Fixed Costs in it - does not give a good indication of product profitability

Contribution:

• Used primarily by management (internally, for decision-making, not part of external statement)
• Gives a contribution margin intermediate figure instead of gross margin; of which fixed costs are subtracted (as they have to be paid) to give profit.