Determining How Costs Behave - Research Paper Example

Behavior of Cost Affiliated Behavior of Cost General understanding of cost implies an amount of money required to pay for a purchase. In manufacturing or service industry cost indicates amount of resources spent to produce or acquire something. The said concept also implies that the cost is composed of different parameters. This understanding allows us to accept cost as a depended variable and influencing on cost parameters as independent variables. Mathematically this concept can be represented by the equation Y = a + b*X.

In this equation, Y is the predicted cost, “a” is a fixed cost, “b” variable cost per unit, and X is the cost driver. The purpose of this assignment is to study the behavior of fixed, variable and total cost at different level of business activities. The behavior of cost is related to the level of business activity (“Identifying Cost Behavior”, n.d.). It implies that a change in business activity exerts influence on the parameters of the above equation. This reaction of it is called cost behavior.

Some costs may stay same, and others may change proportionally in response to a change in business activity. That is why; for managers of a company, it is necessary to understand how a cost reacts to a change in the business activity. This knowledge helps managers to determine future profit from a new product, prepare a forecast and create a budget (Horngren, Sunden, Schatzberg, & Burgstahler, 2012). From the perspective of cost behavior, there are three type of costs: fixed, variable, and mixed.

Fixed are those costs that do not change due to the change of level of activity. However, fixed cost, if expressed per unit basis, varies inversely due to the change of level of activity (Caplan). Some of the examples of fixed costs are salaries, rent, and property taxes. Variable are those costs that change due to the change of level of activity. It is constant per unit. In linear equation, variable costs vary linearly with the change of level of activity. Variable costs, by definition, are considered as cost drivers (Horngren, Sunden, Schatzberg, & Burgstahler, 2012).

Cost drivers also demonstrate cause and effect relationship between the level of an activity and costs related to that activity (“Types of Cost Behavior”, n.d.). Some of the examples of variable costs are direct material, direct labor, and sales commission. Mixed are those costs that have both fixed and variable components. The discussion above can be expressed as Total cost = Total fixed cost + Total variable cost. From this equation, we can achieve Total cost per unit = Total fixed cost per unit + Total Variable cost per unit.

Using these expressions as benchmarks, we can study fixed and variable costs from different perspectives. From manufacturing business standpoint, fixed costs are for examples rent, salary and insurance costs. These costs remain unchanged whether there is a production or not. For example, the company XYZ manufactures valves; pays $50,000 property insurance per month as total fixed costs. In this example, insurance is total fixed cost, paid monthly and irrelevant to the number of valves produced in a month.

However, total fixed cost can be interpreted using per unit production. Figure 1 and Figure 2 shows the behavior of fixed cost based on two approaches (“Accounting Cost Behavior”, n.d.). . Figure 2. Fixed cost per unit The above two graphs illustrate that fixed cost $50,000 with respect to monthly payment is constant, while with respect to per unit is not constant. Total Variable cost changes with the level of production. It decreases when fewer valves are produced and increases when more valves are manufactured.

However, per unit variable costs remain fixed irrespective of number of valves produced in a month (“Variable Cost”, n.d.). Figure 4. Variable cost per unit Figure 3 and Figure 4 show behavior of variable costs from two viewpoints. Total variable costs increase linearly with the production of valves; however, it stays constant with respect to per unit cost. The above discussion presented behavior of two costs that constitute the total cost. Total cost, at the same time, is an example of a mixed cost; a portion of it represents fixed cost, and another part represents a variable cost.

It can be expressed using a linear equation Y = a + b*X; where Y is total cost of the product, and “X” is the product (Horngren, Sunden, Schatzberg, & Burgstahler, 2012). The level of activity exerts influences on the total cost. That is why; the same formula is also known as cost equation. It is used to forecast total cost of a business based on previous observations. The parameters “a” and “b” are derived using data from earlier observations. Once parameters “a” and “b” are known, total cost can be calculated at any activity level.

Two popular methods are used to evaluate the parameters “a” and “b”. They are high and low method and regression analysis. Based on previous observation of a business one can collect data for “Y” and “X”. Using a technique of high and low method one can find the equation; Y = Fixed costs + (Variable cost per unit of activity) * Activity. Say, the equation Y = $500 + $20 * X; where “X” is gallon of water used and “Y” is total cost; furthermore $500 fixed cost and $20 cost per gallon.

The equation becomes a mixed cost type equation, which allows finding the total cost for any quantity of gallons of water. The discussion above reviewed how fixed and variable costs behave at different levels of activity. In the above example, when we considered the business level activity as monthly payment then fixed cost is constant whereas the same value demonstrated non-linear behavior when considered per unit. Similarly, the variable cost behavior showed a linear relationship with respect to per month production whereas constant with respect to per unit production.

The cost equation evaluates the total cost based on the value of cost driver. This assignment only studied the linear form between these variables. However, behavior between total and cost driver as well as presented through nonlinear relations. ReferencesAccounting Cost Behavior. (n.d.). Retrieved from http://simplestudies.com/accounting-cost-behavior.html/page/3Caplan, D. (n.d). Management accounting: Concepts and techniques. Retrieved from http://classes.bus.oregonstate.edu/fall-06/ba422/Management%20Accounting%20Chapter%204.

htmHorngren, T. C., Sunden, L.G., Schatzberg, O.J., & Burgstahler. (2012). Introduction to management account. New Jersey: Prentice Hall Identifying Cost Behavior. (n.d.). Retrieved from http://www.unf.edu/~dtanner/dtch/dt_ch4.htmTypes of Cost Behavior. (n.d.). Retrieved from http://accountingexplained.com/managerial/cost-behavior/Variable Cost. (n.d.). Retrieved from http://www.investopedia.com/terms/v/variablecost.asp