Understanding Cost Behavior (Predict Future Cost)

Managing ‘activities-and-their cost’ is a key to success in business. To be able to manage activities and costs, it is necessary to understand how costs respond to cost drivers—known as “cost behavior.”

Cost Behavior in a Nutshell

Cost behavior, in a nutshell, explains how the total amount—for various costs—responds to changes in activity volume of a business operation. Understanding cost behavior—which refers to the relationship between a given cost item and the quantity of its related cost driver—is essential, for management accountants, to predict future cost.

This post introduces and examines several typical cost behavior patterns and methods for developing cost equations that are useful for predicting future costs. But before that, let’s do a quick round on what an “activity” is and what a “cost driver” is.

What is Activity?

An activity is a unit of work. To serve a customer at a restaurant, for example, a waiter or waitress might perform the following units of work:

• Seat customer and offer menu
• Take customer order
• Send order to kitchen
• Bring food to customer
• Serve and replenish beverages
• Determine and bring bill to customer
• Collect money and give change
• Clear and reset table

Each of those above is an activity, and the performance of each activity consumes resources that cost money.
Cooper and Kaplan’s framework, for manufacturing situations, classifies activities into 4 categories:
1. A unit-level activity
2. A batch-level activity
3. A product-level activity
4. A facility-level activity

What is Cost Driver?

Cost driver is any activity that has a direct cause, effects relationship with the resources consumed.
“Customer demand” is known as the root of other cost drivers ever occurred, on a business operation; without the demand for products or services, a business can’t be exist.
To serve customers, managers and employees make decisions and take actions. These decisions and actions, which are undertaken to satisfy customer demand, drive costs.
There could be many ways of classifying cost drivers, in various activity levels, but I particularly love to break them down into 3 categories:
1. Structural Cost Driver – Choices about the size and scope of operations and structural technologies employed in delivering products or services to customers. For example: Google’s decision to enter the cable TV distribution business.
2. Organizational Cost Drivers – Choices concerning the organization of activities and the involvement of persons inside and outside the organization in decision making. Authorizing lower-level employees to make decisions to solve problems is an example of an organizational cost driver.
3. Activity Cost Drivers – Specific units of work (activities) performed to serve customer needs that consume costly resources. Assembling a product is an example of an activity cost driver.

I’ve discussed about cost driver and its hierarchies, in rather detail manner. Have a read the post.

4 Basic Cost Behavior Patterns

There could be unlimited number of ways that costs may respond to changes in cost drivers, but for a quick grasp, cost behavior can be classified into 4 categories:

• Variable Cost;
• Fixed Cost;
• Mixed Cost; and
• Step Cost

In a graphical presentation, “total cost” (the dependent variable) is measured on the vertical respond to axis, and “total activity” for the time period (the independent variable) is measured on the horizontal axis. And the four basic cost behavior patterns are shown below:

Let’s discuss a bit further, started with the first behavior pattern.

1. Variable Costs

Variable costs change in total in direct proportion to changes in activity. Their total amount increases as activity increases, equaling zero dollars when activity is zero and increasing at a constant amount per unit of activity. The higher the variable cost per unit of activity, the steeper the slope of the line representing total cost.
With the number of burgers served as the activity cost driver for a McDonald restaurant, the cost of beef meat is an example of a variable cost.
The relationship between total cost (Y axis) and total activity (X axis) for the variable cost behavior pattern is mathematically expressed as follows:
Y =bX
Where:
b=the variable cost per unit, sometimes referred to as “the slope of the cost function”

2. Fixed Costs

Fixed costs do not change in response to a change in activity volume. Hence, a line representing total fixed costs is flat with a slope (incline) of zero.
With the number of burgers sold as the cost driver (at a McDonald restaurant case), annual depreciation, property taxes, and property insurance are examples affixed costs.
While fixed costs may respond to structural and organizational cost drivers over time, they do not respond to short-run changes in activity cost drivers.
The relationship between total cost (Y axis) and total activity (X axis) for the fixed cost behavior pattern is mathematically expressed as follows:
Fixed cost: Y = a
Where:
a = total fixed costs. The slope of the fixed cost function is zero because fixed costs do not change with activity.

3. Mixed Costs

Mixed costs (sometimes called “semivariable costs”) contain a fixed and a variable cost element. Total mixed costs are positive (like fixed costs) when activity is zero, and they increase in a linear fashion (like total variable costs) as activity increases.
With the number of burgers sold as the cost driver, the cost of electric power is an example of a mixed cost. Some electricity is required to provide basic lighting, while an increasing amount of electricity is required to prepare food as the number of burgers served increases.
The relationship between total cost (Y axis) and total activity (X axis) for the mixed cost behavior pattern is mathematically expressed as follows:
Mixed cost: Y = a + bX
Where:
a = total fixed cost element b = variable cost element per unit of activity.

4. Step Costs

Step costs are constant within a narrow range of activity but shift to a higher level when activity exceeds the range. Total step costs increase in a steplike fashion as activity increases.
With the number of burgers served as the cost driver, employee wages is an example of a step cost. Up to a certain number of burgers, only a small staff needs to be on duty. Beyond that number, additional employees are needed for quality service and so forth.
The relationship between total cost (Y axis) and total activity (X axis) for the step cost behavior pattern is mathematically expressed as follows:
Step cost: Y = ai
Where:
ai = the step cost within a specific range of activity, identified by the subscript i.

The Shifting On Total Cost: Why Outsourcing Became Popular

The total cost function of most organizations has shifted in recent years toward more fixed costs and fewer variable costs, making it increasingly important for organizations to manage their fixed costs. Some organizations have done this by outsourcing activities rather than performing the activities internally. This avoids the many fixed costs of infrastructure in exchange for a variable cost per unit of activity.

Understanding Factors Affecting Cost Behavior Patterns

The four cost behavior patterns presented above are based on the fundamental assumption that: a unit of final output is the primary cost driver.
Another important assumption is that the time period is too short to incorporate changes in strategic cost drivers such as the scale of operations. This assumption is especially useful for short-range planning, not for the purpose of long-range plans. It is more appropriate to consider possible variations in one or more strategic cost drivers. When this is done, many costs otherwise classified as fixed are better classified as variable.

Even The Cost Of Depreciable Assets Can Be Viewed As Variable…

… if the time period is long enough. Assuming that the number of burgers served is the cost driver, for a single month the depreciation on all McDonald restaurants in the world is a fixed cost. Over several years, if sales are strong, a strategic decision will be made to open additional restaurants; if sales are weak, strategic decisions will likely be made to close some restaurants. Thus, over a multiple-year period, the number of restaurants varies with sales volume, making depreciation appear as a variable cost with sales revenue as the cost driver.

Total Cost Function for an Organization or Segment

To obtain a general understanding of an organization, to compare the cost structures of different organizations, or to perform preliminary planning activities, managers are often interested in how total costs respond to a single measure of overall activity such as units sold or sales revenue. This overview can be useful, but presenting all costs as a function of a single cost driver is seldom accurate enough to support decisions concerning products, services, or activities—doing so implies that all of an organization’s costs can be manipulated by changing a single cost driver—and this is seldom true.
In developing a total cost function, the independent variable usually represents some measure of the goods or services provided customers, such as total student credit hours in a university, total sales revenue in a store, total guest-days in a hotel, or total units manufactured in a factory. The resulting cost function is illustrated in the next graph:

The equation for total costs is:
Y = a + bX
Where:
Y= total costs
a = vertical axis intercept (an approximation of fixed costs)
b = slope (an approximation of variable costs per unit of X)
X = value of independent variable
In situations where the variable, fixed, and mixed costs, and the related cost functions, can be determined, a total cost equation can be useful in predicting future costs for various activity levels. However, generally, a total cost equation is useful for predicting costs in only a limited range of activity. The relevant range of a total cost equation is that portion of the range associated with the fixed cost of the current or expected capacity.

Case Example
Assume that a Wendy juice shop’s only fixed cost is the depreciation on its juicer machines, and that it is able to produce a maximum of 50 gallons of juice per day with a single juicer machine.
If it has four juicers in operation, and if it can readily adjust its fixed capacity cost by increasing or decreasing the number of juicer, the relevant range of activity for the Wendy’s current total cost equation is 151 to 200 gallons.
In the future, if Wendy expects to operate at more than 200 gallons per day, the current total cost equation would not predict total cost accurately, because fixed costs would have to be increased for additional machines. Conversely, if it expects to operate at 150 gallons or less, it may reduce the number of machines in the shop, thereby reducing total fixed costs.

Relevant Range

The use of straight lines in accounting models of cost behavior assumes a linear relationship between cost and activity with each additional unit of activity accompanied by a uniform increment in total cost. This uniform increment is known as the “variable cost of one unit”.
Economic models show a nonlinear relationship between cost and activity with each incremental unit of activity being accompanied by a varying increment in total cost. Economists identify the varying increment in total cost as the marginal cost of one unit.
It is useful to relate marginal costs to the following three levels of activity:

• Below the activity range for which the facility was designed, the existence of excess capacity results in relatively high marginal costs. Having extra time, employees complete assignments at a leisurely pace, increasing the time and the cost to produce each unit above what it would be if employees were more pressed to complete work. Frequent starting and stopping of equipment may also add to costs.
• Within the activity range for which the facility was designed, activities take place under optimal circumstances and marginal costs are relatively low.
• Above the activity range for which the facility was designed, the existence of capacity constraints again results in relatively high marginal costs. Near capacity, employees may be paid overtime wages, less-experienced employees may be used, regular equipment may operate less efficiently, and old equipment with high energy requirements may be placed in service.

A vertical axis intercept represents capacity costs. Corresponding to the high marginal costs at low levels of activity, the initial slope is quite steep. In the normal activity range, where marginal costs are relatively low, the slope becomes less steep. Then, corresponding to high marginal costs above the normal activity range, the slope of the economists’ total cost function increases again.

Understanding Committed and Discretionary Fixed Costs

Fixed costs are often classified as “committed” or “discretionary”, depending on their immediate impact on the organization if management attempts to change them.
1. Committed – Committed fixed costs, sometimes referred to as “capacity costs”, are the fixed costs required to maintain the current service or production capacity or to fill previous legal commitments. Examples of committed fixed costs include depreciation, property taxes, rent, and interest on bonds. Committed fixed costs are often the result of structural decisions about the size and nature of an organization.
2. Discretionary – Discretionary fixed costs, sometimes called “managed fixed costs”, are set at a fixed amount each period at the discretion of management. It is possible to reduce discretionary fixed costs without reducing production or service capacity in the short term. Typical discretionary fixed costs include advertising, maintenance, charitable contributions, employee training, and research and development.
Maintenance expenditures for discretionary fixed costs are frequently regarded as investments in the future. Research and development, for example, is undertaken to develop new or improved products that can be profitably produced and sold in future periods.
During periods of financial well-being, organizations may make large expenditures on discretionary cost items. Conversely, during periods of financial stress, organizations likely reduce discretionary expenditures before reducing capacity costs. Unfortunately, fluctuations in the funding of discretionary fixed costs may reduce the effectiveness of long-range programs.
A high-quality research staff may be difficult to reassemble if key personnel are laid off. Even the contemplation of layoffs may reduce the staff’s effectiveness. In all periods, discretionary costs are subject to debate and are likely to be changed in the budgeting process.

Additional Cost Behavior Patterns

Although we have considered the most frequently used cost behavior patterns, remember that there are numerous ways that costs can respond to changes in activity. Avoid the temptation to automatically assume that the cost in question conforms to one of the patterns discussed in this post; it is important to think through each situation and then select a behavior pattern that seems logical and fits the known facts.