BASIC MANAGEMENT ACCOUNTING TECHNIQUES
1 Cost behaviour patterns and levels of activity
Introduction
Cost behaviour describes how costs vary depending on the level of activity undertaken.
1.1 Levels of activity
The level of activity refers to the amount of work done, or the number of events that have occurred.
Measures of the level of activity include:
• The volume of production in a period • The number of invoices issued
• The number of items sold • The number of units of electricity consumed
• The value of items sold • The number of purchase orders placed
1.2 Basic principles of cost behaviour and cost behaviour patterns
The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. The question is to determine, for each item of cost, the relationship between costs and the level of activity.
The level of activity will generally be taken to be the volume of production/output.
1.3 Fixed costs
A fixed cost tends to be unaffected by changes in the volume of output. Fixed costs are a period charge, relating to a time period; as the period increases, so too will the fixed costs. Examples of fixed costs include the salary of the managing director and factory rent.
1.4 Stepped fixed cost
Consider the depreciation of a machine which may be fixed if production remains below 1,000 units per month. If production exceeds 1,000 units, a second machine may be required, and the cost of
depreciation (on two machines) would go up a step. This type of cost is a step cost or a stepped fixed cost.
Examples of step costs may include rent, as accommodation requirements increase with higher output levels, or pay of employees as higher output may require, more employees.
1.5 Variable costs
A variable cost is a cost which tends to vary directly with the volume of output. The variable cost per unit is the same amount for each unit produced whereas total variable cost increases as volume of output increases.
Examples of variable costs may be the cost of raw materials (where there is no discount for bulk purchasing since bulk purchase discounts reduce the unit cost of purchases), sales commission or direct labour costs. The latter are usually classed as a variable cost even though basic wages are often fixed.
1.6 Non-linear variable costs
Although variable costs are usually assumed to be linear, there are situations where these are curvilinear.
Graph (a) Graph (b)
Graph (a) becomes steeper as levels of activity increase. Each additional unit of activity is adding more to total variable cost than the previous unit. Graph (b) becomes less steep as levels of activity increase. Each additional unit is adding less to total variable cost than the previous unit.
1.7 Semi-variable costs (or semi-fixed costs or mixed or hybrid costs)
Semi-variable/semi-fixed/hybrid or mixed costs are costs which are part-fixed and part-variable and which are thus partly affected by a change in the level of activity.
Examples of semi-variable costs may be electricity and gas bills, where there is a basic charge plus a charge per unit of consumption. A sales representative's salary is another example where a basic monthly amount is supplemented by commission on the value of sales made.
The behaviour of a semi-variable cost can be presented graphically as follows.
Cost£
Volume of output Variable part
Fixed part
Graph of semi-variable cost
or
Graph of semi-variable cost
Cost£
Volume of output Fixed part Variable part
1.8 Cost behaviour and total and unit costs
If the variable cost of producing a unit is £5 per unit then it will remain at that cost per unit no matter how many units are produced. However, if the business's fixed costs are £5,000 then the fixed cost per unit will decrease the more units are produced. One unit will have fixed costs of £5,000 per unit, but if 2,500 are produced the fixed cost per unit will be £2. If 5,000 are produced the fixed cost per unit will be only £1. Thus as the level of activity increases the total costs per unit (fixed cost plus variable cost) will decrease.
In sketch graph form this may be illustrated as follows.
Variable cost Fixed cost Total cost
1.9 Assumptions about cost behaviour
It is often possible to assume that, within the normal or relevant range of output, costs are either fixed, variable or semi-variable. Predictions of costs for activity levels which are outside the relevant range are unreliable. The other problem is that we usually use data which relates to the past. This may not be representative of what will happen in the future. Managers need to bear this in mind when making decisions.
Select the correct words in the following sentence.
The basic principle of cost behaviour is that as the level of activity rises, costs will usually (a) rise/fall/stay the same. In general, as activity levels rise, the variable cost per unit will (b) rise/fall/stay the same, the fixed cost per unit will (c) rise/fall/stay the same and the total cost per unit will (d) rise/fall/stay the same.
Show, by means of a sketch, a separate graph of cost behaviour patterns for each of the listed items of expense. In each case the vertical axis should relate to total cost. Label each horizontal axis clearly.
(a) Electricity bill: a standing charge for each period plus a charge for each unit of electricity consumed.
(b) Supervisory labour.
(c) Production bonus, which is payable when output in a period exceeds 10,000 units. The bonus amounts in total to £20,000 plus £50 per unit for additional output above 10,000 units.
(d) Sales commission, which amounts to 2% of sales turnover.
(e) Machine rental costs of a single item of equipment. The rental agreement is that £10 should be paid for every machine hour worked each month, subject to a maximum monthly charge of £480.
Section summary
Costs which are not affected by the level of activity are fixed costs or period costs.
A step cost is a cost which is fixed in nature but only within certain levels of activity.
Variable costs increase or decrease with the level of activity.
Semi-variable/semi-fixed or mixed costs are costs which are part-fixed and part-variable and which are thus partly affected by a change in the level of activity.
Question 6a.2 Cost behaviour graphs
Question 6a.1 Activity levels