Cost behavior analysis is the study of how specific costs respond to

changes in the level of business activity.

Example, for an airline company such as Southwest or United, the longer

the flight, the higher the fuel costs. On the other hand, Massachusetts
General Hospital’s costs to staff the emergency room on any given night
are relatively constant regardless of the number of patients treated.

- A knowledge of cost behavior helps management plan operations and

decide between alternative courses of action.

- Cost behavior analysis applies to all types of entities.

- The starting point in cost behavior analysis is measuring the key business
activities. Activity levels may be expressed in terms of sales dollars (in a
retail company), miles driven (in a trucking company), room occupancy (in a
hotel), or dance classes taught (by a dance studio). Many companies use
more than one measurement base. A manufacturer, for example, may use
direct labor hours or units of output for manufacturing costs, and sales
revenue or units sold for selling expenses. For an activity level to be useful
in cost behavior analysis, changes in the level or volume of activity should
be correlated with changes in costs.

The activity level selected is referred to as the activity (or volume) index. The
activity index identifies the activity that causes changes in the behavior of
costs. With an appropriate activity index, companies can classify the
behavior of costs in response to changes in activity levels into three
categories: *variable, *fixed, or *mixed.
  Variable Costs

Costs that vary in total directly and proportionately with changes in the
activity level. If the level increases 10%, total variable costs will increase
10%. If the level of activity decreases by 25%, variable costs will decrease
25%.

NOTE: Variable cost remains the same per unit at every level of activity.

Examples: direct materials and direct labor for a manufacturer; cost of goods
sold, sales commissions, and freight-out for a merchandiser; and gasoline in
airline and trucking companies.

Example: Assume that Damon Company manufactures tablet computers

that contain $10 cameras. The activity index is the number of tablet
computers produced.

- Companies that rely heavily on labor to manufacture a product, such as

Nike or Reebok, or to perform a service, such as Hilton or Marriott, are
likely to have many variable costs. Companies that use a high proportion of
machinery and equipment in producing revenue, such as AT&T or Duke
Energy Co., may have few variable costs.
Total cost of the cameras
will be $20,000 if Damon
produces 2,000 tablets,
and $100,000 when it
produces 10,000 tablets.

The unit cost of $10

for the cameras is
the same whether
Damon produces
2,000 or 10,000
 Fixed Costs tablets.

Costs that remain the same in total regardless of changes in the activity
level.
 NOTE: fixed costs per unit vary inversely with activity: As volume increases,
unit cost declines, and vice versa.

Examples: property taxes, insurance, rent, supervisory salaries, and

depreciation on buildings and equipment.

Example: Assume that Damon Company leases its productive facilities at a

cost of $10,000 per month.

Total fixed costs

of the facilities
will remain
constant at
every level of
activity

on a per unit basis, the cost of rent will decline as

activity increases.

At 2,000 units, the unit cost per tablet computer is $5

($10,000 / 2,000). When Damon produces 10,000 tablets,
the unit cost of the rent is only $1 per tablet ($10,000 /
10,000).

The trend for many manufacturers is to have more fixed costs and fewer
variable costs. This trend is the result of increased use of automation and
less use of employee labor. As a result, depreciation and lease charges
(fixed costs) increase, whereas direct labor costs (variable costs) decrease.
Relevant Range (also called normal or practical range)

In Illustration 5-1 part (a) (page 141), a straight line is drawn throughout the
entire range of the activity index for total variable costs. In essence, the
assumption is that the costs are linear. If a relationship is linear (that is,
straight-line), then changes in the activity index will result in a direct,
proportional change in the variable cost. For example, if the activity level
doubles, the cost doubles.
Is the straight-line relationship realistic? In most business situations, a
straight-line relationship does not exist for variable costs throughout the
entire range of possible activity. At abnormally low levels of activity, it may
be impossible to be cost-efficient. Small-scale operations may not allow the
company to obtain quantity discounts for raw materials or to use specialized
labor. In contrast, at abnormally high levels of activity, labor costs may
increase sharply because of overtime pay. Also, at high activity levels,
materials costs may jump significantly because of excess spoilage caused
by worker fatigue.
As a result, in the real world, the relationship between the behavior of a
variable cost and changes in the activity level is often curvilinear, as shown
in part (a) of Illustration 5-3. In the curved sections of the line, a change in
the activity index will not result in a direct, proportional change in the variable
cost. That is, a doubling of the activity index will not result in an exact
doubling of the variable cost. The variable cost may more than double, or it
may be less than double.
Total fixed costs also do not have a straight-line relationship over the entire
range of activity. Some fixed costs will not change. But it is possible for
management to change other fixed costs. For example, in some instances,
salaried employees (fixed) are replaced with freelance workers (variable).
Illustration 5-3, part (b), shows an example of the behavior of total fixed costs
through all potential levels of activity.
For most companies, operating at almost zero or at 100% capacity is the
exception rather than the rule. Instead, companies often operate over a
somewhat narrower range, such as 40–80% of capacity. The range over
which a company expects to operate during a year is called the relevant
range of the activity index.
  Although the linear (straight-line) relationship may not be completely
realistic, the linear assumption produces useful data for CVP
analysis as long as the level of activity remains within the relevant
range.

Mixed Costs

Mixed costs are costs that contain both a variable- and a fixed-cost element.
Mixed costs, therefore, change in total but not proportionately with
changes in the activity level.

Example: Assume that local rental terms for a 17-foot truck, including
insurance, are $50 per day plus 50 cents per mile. When determining the
cost of a one-day rental, the per day charge is a fixed cost (with respect to
miles driven), whereas the mileage charge is a variable cost. The graphic
presentation of the rental cost for a one-day rental is shown in Illustration 5-
5.
In this case, the fixed-cost element is the cost of having the service available.
The variable-cost element is the cost of actually using the service. Utility
costs such as for electricity are another example of a mixed cost. Each month
the electric bill includes a flat service fee plus a usage charge.