18 — Cost Behavior Patterns and Implications for Managing a Business

18 — Cost Behavior Patterns and Implications for Managing a Business

[MUSIC] I’m Larry Walther, this is
principlesofaccounting.com, Chapter 18. In this first module, we will look
at cost behavior patterns, and the implications for managing a business. Costs can be generally described as
variable in nature or fixed in nature. Variable costs are those that
vary in direct proportion to changes in the level of activity. Examples are direct material,
direct labor, sales force commissions, things of this nature. Each additional unit of
production produces another uniform increment in cost. Fixed costs are those that do not
fluctuate with changes in levels of activity. Examples include management
salaries that are fixed in nature. Rent for a facility, property tax amounts. No matter the level of volume for
the business, those costs are stable. Let’s look at a variable cost example. GoSound produces portable music players,
and each unit produced requires a digital
chip that costs GoSound $11. And so if we produce 100,000 units, we could expect to incur at $11 per unit,
a total cost of $1,100,000. And you can see as volume increases we also increase our variable costs
at the constant rate of $11 per unit. Graphically I plotted on
the left the total variable cost. The total variable cost is
rising as production increases. But if we look at on the right,
variable cost per unit, we can see it’s constant at $11 per unit. Variable cost needs to be
associated with the activity base. That is the activity base is the item or event that causes the incurrence
of a variable cost. The best example being units produced. Each unit produced requires
one more chip for example. Each variable cost needs to
be considered independently. In other words a business’s variable costs
will not all vary in the same fashion. Some may vary with production,
some may vary with sales. Some may vary on some other activity base. And so we have to associate each
variable cost with its activity base or the thing that causes it to vary. Let’s turn to fixed cost. GoSound also leases their
manufacturing facility for a total rent of $1,200,000,
no matter the level of production. So in this table on the left, I’ve kept
the same number of units, 100,000, 125,000, 150,000, and so forth. However, the factory rent,
the middle column is the same, no matter the level of production. Importantly, notice that
the rent per unit decreases. The more we produce the lower
is the fixed cost per unit. Graphically I plotted on
the left the total fixed cost. It’s the same no matter
the number of units produced. But I’ve plotted on the right
the fixed cost per unit. And you can see how it’s decreasing
with increases in production. Continuing on,
considering a business’s cost structure. That is, what proportion
of its costs are fixed, and what proportion of its costs are variable. Is very important in evaluating
the business and managing the business. And it varies a lot from
business to business. For example, airlines have a high fixed
cost in terms of their aircraft and the fuel they consume. But they fly whether the plane is full or
empty. But this causes them to struggle
during years when the economy is slow. And they cannot fill their airplanes. On the other hand during boom years,
they can be extremely profitable. Because many of their costs are fixed and
don’t vary. So additional passengers, the revenue
mostly goes to the bottom line. To control for fixed cost. Many businesses have attempted to
outsource much of their, for example, tech support. Paying on a per unit call basis. Rather than having a fixed staff that
charges the same no matter how many calls are received. It’s a way to avoid fixed cost so that a business’s profitability
can fluctuate with its volume. Moreso than being volatile as
it can be for the airlines. Consideration of the fixed
cost of the business also gives one to consider economies of scale. Certain efficiencies are achieved
as production levels rise. Because, as we’ve already seen, fixed costs can be spread over
a greater number of units. Also, one might consider that even
certain variable costs can fluctuate. You might get a quantity discount. For ordering larger volumes of
a particular raw material that’s need in production. All of these need to be considered
in managing a business. But what’s important for cost behavior analysis is to
consider the relevant range. The relevant range is the level
of activity for which cost and volume assumptions
are expected to hold true. Any pricing data outside of
the relevant range is irrelevant and need not be considered. Adopting a business strategy that
results in operating levels outside of the relevant range. Can upset business results via
significant deviations between actual and expected performance. Now, let’s consider how relevant range
matters in the context of ordering parts. A cost typically regarded as variable. Here I have a pricing table. And notice that I can either order in
quantities of 1, or 10, or 100, or 1000. And the price varies considerably
based on the quantity that I order. If I order 10 units the cost is
$0.30 per unit or $3 for 10. If I order instead 100 units the price
drops down to $0.13 per unit. And even a bigger drop if
it drops to 1000 units. If I need 250 units I
need to study that table. And very clearly determine what my
correct ordering strategy would be. Rather than ordering 10
units at a time 25 times. It would be much cheaper
to order in units of 100. In this case,
although I only need 250 units. I’m actually going to determine that
it’s much cheaper to order 300 units at $0.13 a unit, or $13 per hundred. Or in other words, a total of $39. That’s my cheapest option
to get access to 250 units. No other combination would give me a lower
total cost for the units that I need. So the variable cost per
unit over my relevant range. Would be regarded as $0.13 per
unit based on these calculations. Graphically one can consider
the relevant range in this fashion. Here I show the variable cost per unit and it declines as we increase
production significantly. There are some very low
price points out here but we’re not going to produce at that level. There’s a higher price point, but
we’re not gonna produce at that level. We have to think about our pricing
structure within our relevant range. So despite the decreasing
variable cost per unit, within the relevant stage
the cost is stable. A Step Cost is a type of fixed
cost that increases in increments. Fixed costs are only fixed
over a relevant range. At some point, capacity, fixed capacity,
would need to be increased. And so I’m showing units of production. And we have a fixed cost and then at a higher level of production
we incur another fixed cost. And yet another fixed cost. For example, if we’re manufacturing
something on an assembly line. The assembly line can only
produce say 1,000 units a day. If we need to increase
production to 2,000 units, we’ll need to add another assembly line. Add that additional fixed cost,
and so it would go for successively higher levels of production. So, once again in evaluating
fixed costs for a business, we have to think about the fixed
costs that are applicable. Or relevant over the range of activity
in which we expect to operate. When we consider the relevant range and
step cost. It makes sense that we would wanna
operate at the right-most edge of a step cost graphically speaking. Because that’s where we have
full capacity utilization. We’re fully utilizing a fixed cost. Without having to step
up another level and move to a higher step of fixed cost or
a higher grade. Of course in some cases full capacity
utilization is simply not possible. There may be some idle capacity for which we’re going to have to incur
the fixed cost for a period of time. And when we think further
about these concepts. We also need to think about fixed costs
as potentially committed in nature. They arise from an organization’s
commitment to engage in operations. Depreciation, rent,
insurance, property taxes. These costs we’re not going to avoid. They relate to our desired
long-run positioning for the firm, and they’re not easily adjusted. Other fixed costs however,
are discretionary in nature. So we talk about
discretionary fixed costs. As those that originate from top
management’s yearly spending plans. This could include an annual advertising
budget, an employee training program, and so forth. These fixed costs tend to have a short
term orientation or a short term focus. And they can be adjusted or
affected with proper planning. If the business cycle is turning down. We may eliminate certain
fixed cost in order to maintain some efficiency
in our business model. Certain variable costs are also
subject to adjustment. We saw an example of this with the part. Where we could order 10 units or
100 units or 1,000 units and get a different price per part. Basically, what we need to do is
optimize our purchasing and our order. There’s an economic order quantity formula
that we introduce later in the book. So, economic order quantities are used
to balance out the carrying and order cost for inventory. And perhaps achieve a lower
price point on the order. Also, direct labor can be adjusted for
overtime premiums. We think of labor as a variable cost. But if we cause our employees to work
overtime we may pay them a premium. Say one and
half times their normal hourly rate. And so proper planning can allow us to try
to avoid those overtime premiums by better balancing our workload. So, all of these thought
processes are necessary to effectively run a profitable business. [MUSIC]

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