In any business operation, cost is an integral aspect that affects the way activities are carried out. Costs in business are classified in to various categories depending on the cost center where they are incurred in the business and their behavior as various activities change. The behavior of costs in the business greatly determines how decisions will be carried out in the business and what cost drive to be undertaken. Cost behavior is the responsiveness of costs to the increase or decrease in the level of cost drives.
It shows how various aspects of costs respond to changes in production level.
Effects Cost Behavior Selection of Cost Drivers and Management Decisions
Observing the sensitivity of costs to changes in the production level are very important in every firm because it plays a big role in the selection of the activities to be carried out and also the management decisions.
Any activity in a firm that causes changes in the costs incurred in the firm is called a cost drive and is studied over a given period of time. The firm will select the cost drives that are less cost sensitive to minimize the costs (Saunders, 2010, 26). Since cost behavior defines the effect of cost drives to the cost of the organization, the firm tends to undertake the activities that are cost effective but still meet the production target of the firm.
The decisions of management regarding the production are highly affected by the cost behavior. For instance, the decision regarding the process to be used in processing a certain product might be redesigned to get the easiest and cheapest way to produce (Langfield-Smith, & Thorne, 2006, 62). Some product feature also may be eliminated to reduce the cost drivers. Designing the product feature could be an expensive cost driver and their elimination would save the company a lot of costs.
During the period of low performance, the products may not be able to cover their variable and the fixed costs. Most of the activities are therefore cost sensitive. The management might therefore reduce some activities that are meant to add product value since the product will not pay the cost.
The capacity decision of the management is also sensitive to cost behavior and the management might be forced to change it in periods of high sensitive cost behaviors. The management will seek to reduce the capacity costs and still meet capacity decision. During good economic conditions, the firm can operate at full capacity and meet the fixed costs. The management can also afford to allow workers work overtime for a payor even outsource production. When the economic conditions are adverse, the cost behavior is very sensitive to change in production level. A slight increase in the production level may incur the firm a proportionally high cost. The management will therefore choose to stop outsourcing production and also eliminate overtime instead of laying off employees. The employees will be needed during the favorable economic times.
The management costs regarding committed fixed costs are also affected by the cost behavior. These are costs that the firm incurs in the acquisition of facilities and equipments, and they will increase as more of such equipments are acquired (Saunders, 2010, 24). During low economic periods, the firm may not be able cover these costs and therefore the management will opt to reduce these costs by reducing the number of equipment bought at a given time. Reducing these costs will reduce the firms break even point.
Differences between Fixed Costs and Variable Costs
Costs could be categorized into fixed and variable costs depending on their behavior as the level of production or activities changes in business operations.
Variable costs remain unchanged irrespective of the changes in the cost drives or the production levels.
These costs vary at different levels of production. At low activity level, less of variable costs are incurred while at high activity level, more are incurred. For instance the cost of purchasing raw materials for a manufacturing firm is variable. If the cost of a unit of the material is $10, ten units of the material will cost $100. As the level of production increases, the number of materials needed also increases and hence the cost. The per-unit variable cost remains constant irrespective of the changes in the cost drivers (Langfield-Smith, & Thorne, 2006, 59).
Fixed costs on the other hand are costs that remain constant at various levels of production but only within the relevant range. The fixed cost per unit goes down as the level of production of that unit (s) increases. This is because the same fixed costs are spread over more units as production increases. For instance, the cost of purchasing a machine for producing a certain product is constant. The cost remains the same whether the production level increases or decreases. The per-unit cost, however, will decrease as more units are produced.
Cost behavior is an important factor in decision making in any organization. The sensitivity of costs to the production level may determine the activities to carry out in the organization. Both the behavior of fixed and variable cost play a big role in decision making in the organization. The decision of the cost driver to be carried out or be eliminated depends on the cost behavior.
Langfield-Smith, K. & Thorne, H., (2006). Management accounting: information for managing and creating value. Australia: McGraw-Hill Australia.
Saunders, D. A., (2010). Cost behavior. Canada: Society of Management Accountants of Canada.