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Cost Behavior Assumptions

The analysis of cost behavior is important for decision-making. For instance, if a manufacturing facility manager determines that the quality costs makes up 25% of its revenues, by understanding the relationship between fixed costs, variable costs, and mixed cost with the output, this manager can take positive steps to reduce rework by reducing the number of defective units. Reducing the cost of rework activity increases the plant efficiency.

Cost behavior is the response of costs to changes in production or sales volume. Others define it as the changes in costs as changes in output occur. Costs react to output in many different ways: Fixed costs, variable costs, and mixed costs. The range of output or sales over which cost behavior patterns remain unchanged is called the relevant range.

Fixed costs: Fixed costs are constant in total over the relevant range. Fixed costs per unit portray the inverse relationship between fixed costs and increases in production. As production increases, total fixed costs stay the same within the relevant range, but since we are dividing a constant numerator [total fixed costs] by a progressively larger denominator [total production or sales], the resulting costs per unit become smaller and smaller. Fixed costs include things like rent, insurance premiums, salaries, depreciation and property taxes. Although numerous activities are performed within a manufacturing facility we want to analyze a single product. Notice that total fixed cost does not depend on the output measure. It is the same no matter what the output is. For example, a lease of a machine in Santre Corp. is \$65,000 if it produces zero units of a given product or if it produces 250,000 units. However the impact as cost behavior is that the unit cost decreases as the number of units increases. For example:

Lease of Machines (a) Number of Units Produced (b)
Unit Cost (c)
\$60,000 0 N/A
60,000 60,000 1,00
60,000 120,000 0.50
60,000 180,000 0.33
60,000 240,000 0.25

Variable costs: Variable costs vary in total with volume, but are constant per unit within the relevant range. Total variable costs for a given situation are equal to the number of units multiplied by the variable cost per unit. Variable costs include things like labor and materials. Some overhead [indirect costs] such as indirect labor, supplies and some utilities are also variable. Variable costs do change as output changes. A variable cost is a cost that, in total, varies in direct proportion to changes in output. It means that a variable cost goes up as output goes up and it goes down as output goes down.

For example, if a manufacturing facility, electricity is consumed only if output is produced, and as more output is produced, more power is used. The total variable cost is determined by multiplying the variable cost per unit by the number of units. If zero units are produced, variable costs are zero too. As the number of units produced increases, the total cost variable increases.

Mixed costs: A mixed costs contains both fixed and variable components. A typical example of mixed costs is the compensation of sales representatives. They are often paid a salary plus a commission on sales.

Managerial accounting helps organization achieve efficiency by streamlining processes and planning output that optimizes cost behavior on behalf of the organization.