Cost behavior analysis refers to management’s attempt to understand how operating costs change in relation to a change in an organization’s level of activity. These costs may include direct materials, direct labour, and overhead costs that are incurred from developing a product. Management typically performs cost behavior analysis through mathematical cost functions.
Cost functions are descriptions of how a cost (e.g., material, labour, or overhead) changes with changes in the level of activity relating to that cost. For example, total variable costs will change in relation to increased activity, while fixed costs will remain the same. Cost functions may come in various forms.
Cost Behaviour is the change in the behavior of a cost (or costs) due to a change in business activity. The study of this change is the cost behavior analysis. For example, the electricity cost will move up if a business extends the working hours.
- A manager needs to understand the behavior of the costs when creating an annual budget. Knowing this allows the manager to determine beforehand if any cost will decline or rise with the change in the business activity. For example, if a company is operating at the full production capacity, then to fulfill more demand, the company will have to invest more in the production line.
- It helps the management in planning and controlling costs.
- Understanding cost behavior is essential for cost-volume-profit analysis as well. The cost-volume-profit (CVP) analysis studies the impact of change in costs and volume on the profit.
Types of Cost by Behavior
Such costs vary directly (or in direct proportion) with the change in the business activity. In direct proportion means, if the activity level changes by 10%, then the variable cost must also change by 10%. It holds good for both an increase and a decrease in the variable cost. For example, displays are a variable cost for a mobile manufacturer. The more the number of mobiles a manufacturer produces, the more will be the cost spent on displays.
An interesting observation is that the variable cost per unit remains constant despite a change in the level of business activity. For example, the total variable cost of Company ABC for three straight quarters is $5000, $20,000, and $15,000. Company ABC produces 5000, 20000, and 15000 units, respectively. The variable cost per unit in all three cases will be $1.
These costs do not change with any change in business activity. For example, a business will still need to pay rent even if it generates zero sales. Depreciation is another example of a fixed cost.
A point to note is that a fixed cost per unit may increase or decrease with the change in the level of business activity. For example, suppose the fixed cost for a business is $15,000, but the units produced for the three straight quarters were 3000, 5000, and 1000. The fixed cost per unit in the three cases is $5, $3, and $15, respectively.
Mixed or Semi-variable Costs
Such costs are a mixture of fixed and variable costs and thus, contain the elements of both. For example, an internet bill includes a fixed monthly charge plus a variable fee based on usage. Generally, these costs are not very useful to the company in their original form. So, accountants usually split them based on their fixed and variable components. To do so, they use cost behavior analysis techniques, such as Scatter diagrams, Regression Analysis, High-Low Method, and more.
Tips for managing cost behavior
There are numerous factors to be mindful of when managing cost behavior for your organization. Here are tips for success in controlling cost behavior:
- Understand the steps of workflow processes
Cost behavior requires you to have a comprehensive understanding of a department’s workflow. This way, you’ll know to make budgetary decisions and provide insight as to where company resources need to be allocated.
- Know the type of cost behavior you’re working with
Once you know the different steps of a department’s workflow, you can identify which costs can be associated with it. Working with the manufacturing department means that production is a part of variable cost. If your organization magnifies the department’s budget to include fixed costs like rent of the facility, then you’ll also need to calculate mixed costs. It might be beneficial to separate rent to help compartmentalized budgetary requirements if it’s in management’s best interest.
- Calculate the total costs of behaviors to determine if it’s within budget
Calculate the cost for each behavior to see if the process conducted by a department meets budgetary goals. Management may want to take extra time to create a new budget that’s adjusted based on the workflow processes you communicated to them.