Cost behaviour - an introduction

Introduction

Cost behavior is connected with learning how costs change due to change in a company's level of activity. The costs which tend to vary comparatively due to changes in the level of activity are called variable costs. On the other hand, costs which are not affected by changes in level of activity are called fixed costs. Cost behavior is not needed for external reporting under U.S GAAP. But in order to plan and control costs of a company, it is important for the management to understand cost behavior.

Fixed Costs

Costs which do not change as a result of increase or decrease in the quantity of goods and services produced are known as fixed costs. These are the costs which an organization has to pay, separate from any type of business activity. It, along with variable cost forms two vital components of total cost of a product or service. Fixed costs include rent, machinery etc. These costs are not permanently fixed, and change over a time period. But they are fixed to the amount of production over a particular time period.

Variable Costs

Variable costs tend to vary with production output. They are the costs are the sum of marginal costs over all units which have been produced. They tend to vary based on the production volume of an organization. Variable costs rise as a company's production increases and falls as production falls. They are different from fixed costs like rent and office supplies which usually remain the same despite changes in production output. Both of them comprise the total cost. Variable costs may include direct labor costs or direct material costs needed to finish a certain project.

Mixed Costs

Mixed costs include elements of both fixed costs and variable costs. For the management of a company, it is important to have a clear understanding of mixed costs, so that they can guess how costs will change with changes in different levels of business. A part of the mixed costs may be present in absence of all types of activity. Costs can also increase due to increase in the levels of activity.

Step Costs

Business costs which remain constant for a specific level of activity, but increase or decrease once that point has been costs. Step costs refer to those costs which change with increase or decrease in production levels of a business. When shown in a graph, step costs are shown in a stair step pattern, with no change over a particular volume range, then increase suddenly, then remain unchanged over the next volume range and then increase suddenly. The opposite happens when volume of activity declines.

Conclusion

From the management perspective, understanding cost behavior is important to understand how costs change due to changes in the level of activities of an organization. A clear understanding of cost behavior makes planning as well as control of costs easier for the management of an organization.