9 Identify and Apply Basic Cost Behavior Patterns

Now that we have established the three vital types of businesses, let’s determine price behaviors and also use them to the service atmosphere. In managerial audit, different suppliers use the term cost in various methods relying on just how they will use the cost indevelopment. Different decisions call for various costs classified in various means. For instance, a manager may need price information to arrangement for the coming year or to make decisions around broadening or discontinuing a product or business. In practice, the classification of prices transforms as the usage of the cost data transforms. In truth, a solitary price, such as rent, may be classified by one agency as a solved price, by one more company as a committed expense, and also by even another agency as a period expense. Understanding different price classifications and how certain costs deserve to be used in various ways is critical to managerial accountancy.

You are watching: Which of the graphs in figure 21-1 illustrates the behavior of a total fixed cost?


Institute of Management Accountants and also Certified Management Accountant Certification

Managerial accountants administer businesses with clear and also direct insight into the financial impacts of any type of certain operational action under consideration. They are intended to report financial information in a transparent and ethical fashion. The Institute of Management Accountants (IMA) provides the Certified Management Accountant (CMA) certification. IMA members and CMAs agree to uphold a set of moral ethics that has honesty, fairness, objectivity, and also duty. Any managerial accountant, even if not an IMA member or certified CMA, must act in accordance with these principles and also encourage coemployees to follow honest values for reporting financial outcomes and monetary results of financial decisions pertained to their organization. The IMA Committee on Ethics encourages organizations and also individuals to take on, promote, and also execute service practices continuous via high ethical criteria.1


Major Cost Behavior Patterns

Any discussion of prices begins with the understanding that a lot of costs will certainly be classified in one of three ways: resolved costs, variable costs, or mixed prices. The prices that don’t autumn into one of these 3 categories are hybrid prices, which are examined just briefly because they are addressed in even more progressed accountancy courses. Since addressed and variable expenses are the foundation of all other expense classifications, understanding whether a price is a resolved expense or a variable expense is extremely crucial.


Fixed versus Variable Costs

A addressed cost is an unpreventable operating expense that does not change in full over the brief term, even if a company experiences variation in its level of activity. (Figure) illustprices the kinds of solved expenses for merchandising, company, and also manufacturing institutions.

Examples of Fixed CostsType of BusinessFixed Cost
MerchandisingRent, insurance, managers’ salaries
ManufacturingProperty taxes, insurance, tools leases
ServiceRent, straight-line depreciation, administrative salaries, and also insurance

We have actually established that resolved prices carry out not readjust in complete as the level of activity changes, however what around resolved prices on a per-unit basis? Let’s research Tony’s screen-printing company to illustrate exactly how costs deserve to remajor fixed in complete however change on a per-unit basis.

Tony operates a screen-printing firm, specializing in practice T-shirts. One of his resolved prices is his monthly rent of ?1,000. Regardmuch less of whether he produces and sells any T-shirts, he is obligated under his lease to pay ?1,000 per month. However, he have the right to think about this resolved cost on a per-unit basis, as presented in (Figure).


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As (Figure) mirrors, the variable cost per unit (per T-shirt) does not change as the variety of T-shirts produced rises or decreases. However before, the variable prices adjust in full as the number of units developed increases or decreases. In short, total variable costs rise and also autumn as the level of task (the expense driver) rises and falls.

Distinguishing between resolved and also variable prices is crucial bereason the complete expense is the amount of all addressed prices (the complete addressed costs) and all variable costs (the full variable costs). For eexceptionally unit created, eextremely customer offered, or eextremely hotel room rented, for instance, supervisors have the right to determine their full costs both per unit of task and also in total by combining their addressed and variable prices together. The graphic in (Figure) illustprices the concept of complete prices.


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To show just how a company would certainly usage AFC to make company decisions, think about Carolina Yachts, a agency that manufactures sportfishing watercrafts that are sold to consumers through a netoccupational of marinas and watercraft dealerships. Carolina Yachts produces 625 watercrafts per year, and their total yearly solved prices are ?1,560,000. If they desire to identify an average addressed price per unit, they will certainly discover it making use of the formula for AFC:


When they produce 625 watercrafts, Carolina Yachts has actually an AFC of ?2,496 per boat. What happens to the AFC if they increase or decrease the number of boats produced? (Figure) shows the AFC for different numbers of watercrafts.


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To show AVC, let’s return to Carolina Yachts, which incurs full variable prices of ?6,875,000 when they produce 625 watercrafts per year. They deserve to expush this as an average variable cost per unit:


Due to the fact that average variable costs are the average of all expenses that change with manufacturing levels on a per-unit basis and encompass both straight materials and direct labor, supervisors frequently use AVC to determine if manufacturing should continue or not in the short run. As long as the price Carolina Yachts receives for their boats is better than the per-unit AVC, they understand that they are not only covering the variable cost of manufacturing, however each boat is making a contribution towards covering addressed prices. If, at any type of allude, the average variable price per boat rises to the point that the price no much longer covers the AVC, Carolina Yachts might consider halting manufacturing till the variable prices loss aget.

These alters in variable expenses per unit might be brought about by scenarios past their manage, such as a shortage of raw products or a rise in shipping costs because of high gas prices. In any situation, average variable expense can be helpful for supervisors to acquire a huge image look at their variable expenses per unit.


Watch the video from Khan Academy that provides the scenario of computer system programming to teach resolved, variable, and marginal cost to learn more.


Mixed Costs and also Stepped Costs

Not all prices have the right to be classified as pucount fixed or pudepend variable. Mixed prices are those that have actually both a solved and variable component. It is necessary, yet, to be able to sepaprice blended prices right into their addressed and variable components because, typically, in the short run, we can only readjust variable prices yet not the majority of resolved costs. To examine how these combined expenses actually job-related, think about the Ocean Breeze hotel.

The Ocean Breeze is located in a rekind area wbelow the county assesses an occupancy tax that has both a resolved and a variable component. Ocean Breeze pays ?2,000 per month, regardless of the number of rooms rented. Even if it does not rent a solitary room throughout the month, Ocean Breeze still need to remit this tax to the county. The hotel treats this ?2,000 as a solved expense. However before, for eexceptionally night that a room is rented, Ocean Breeze have to remit an additional taxation amount of ?5.00 per room per night. As a result, the occupancy taxation is a combined cost. (Figure) even more illustrates just how this combined price behaves.


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where Y is the total mixed price, a is the resolved price, b is the variable expense per unit, and also x is the level of task.

Graphically, blended prices deserve to be explained as presented in (Figure).


The graph shows that mixed prices are typically both fixed and straight in nature. In other words, they will often have actually an initial expense, in Ocean Breeze’s case, the ?2,000 resolved component of the occupancy tax, and also a variable component, the ?5 per night occupancy taxes. Keep in mind that the Ocean Breeze blended expense graph starts at an initial ?2,000 for the fixed component and then rises by ?5 for each night their rooms are occupied.

Some prices behave actually less linearly. A cost that alters through the level of task but is not straight is classified as a stepped cost. Step costs remain constant at a solved amount over a variety of activity. The selection over which these expenses remajor unreadjusted (fixed) is described as the appropriate array, which is identified as a particular task level that is bounded by a minimum and maximum amount. Within this appropriate range, supervisors have the right to predict revenue or expense levels. Then, at particular points, the step prices rise to a greater amount. Both fixed and also variable prices deserve to take on this stair-action actions. For circumstances, weras regularly act as a stepped variable price as soon as employees are paid a flat salary and also a commission or once the firm pays overtime. Additional, as soon as extra machinery or tools is put right into organization, businesses will watch their solved prices stepped up. The “trigger” for a price to action up is the appropriate array. Graphically, step prices show up choose stair steps ((Figure)).


For example, intend a top quality inspector deserve to inspect a maximum of 80 units in a continuous 8-hour change and also his salary is a addressed cost. Then the relevant selection for QA inspection is from 0–80 systems per change. If demand also for these systems increases and also even more than 80 inspections are needed per shift, the relevant variety has actually been surpassed and the company will have actually among 2 choices:

(1) Pay the high quality inspector overtime in order to have the added devices inspected. This overtime will certainly “action up” the variable price per unit. The benefit to handling the enhanced cost in this method is that as soon as demand drops, the cost deserve to conveniently be “stepped down” aobtain. Since these forms of step costs have the right to be readjusted easily and often, they are regularly still treated as variable prices for planning purposes.

(2) “Step up” addressed costs. If the agency hires a 2nd high quality inspector, they would certainly be stepping up their solved prices. In impact, they will certainly double the pertinent array to allow for a maximum of 160 inspections per transition, assuming the second QA inspector have the right to check a second 80 devices per transition. The down side to this approach is that as soon as the brand-new QA inspector is hired, if demand drops aobtain, the firm will certainly be incurring fixed expenses that are uncrucial. For this reason, adding salaried personnel to address a short-lived rise in demand also is not a decision many businesses make.

Step costs are ideal explained in the conmessage of a organization experiencing increases in activity beyond the relevant variety. As an example, let’s return to Tony’s T-Shirts.

Tony’s cost of operations and also the associated pertinent varieties are presented in (Figure).

Tony’s T-Shirts Cost Options CostType of CostRelevant Range
Lease on Screen-Printing Machine?2,000 per monthFixed0–2,000 T-shirts per month
Employee?10 per hourVariable20 shirts per hour
Tony’s Salary?2,500 per monthFixedN/A
Screen-Printing Ink?0.25 per shirtVariableN/A
Building Rent?1,500 per monthFixed2 screen-printing devices and also 2 employees

As you have the right to see, Tony has both fixed and variable costs associated via his service. His one screen-printing machine have the right to just develop 2,000 T-shirts per month and also his existing employee can create 20 shirts per hour (160 per 8-hour work day). The space that Tony leases is large sufficient that he could include an additional screen-printing machine and 1 added employee. If he increases past that, he will certainly need to lease a larger room, and also presumably his rent would certainly increase at that point. It is simple for Tony to predict his prices as long as he operates within the appropriate varieties by applying the total cost equation Y = a + bx. So, for Tony, as long as he produces 2,000 or fewer T-shirts, his full expense will certainly be uncovered by Y = ?6,000 + ?0.75x, where the variable price of ?0.75 is the ?0.25 cost of the ink per shirt and also ?0.50 per shirt for labor (?10 per hour wage/20 shirts per hour). As shortly as his production passes the 2,000 T-shirts that his one employee and one machine can manage, he will certainly need to include a second employee and also lease a 2nd screen-printing machine. In various other words, his solved costs will certainly increase from ?6,000 to ?8,000, and also his variable cost per T-shirt will certainly rise from ?0.75 to ?1.25 (ink plus 2 workers). Therefore, his brand-new cost equation is Y = ?8,000 + ?1.25x until he “measures up” aacquire and also adds a 3rd machine and moves to a brand-new place through a presumably greater rent. Let’s take a look at this in chart form to better highlight the “step” in cost Tony will certainly experience as he procedures previous 2,000 T-shirts.

Tony’s expense indevelopment is shown in the chart for volume between 500 and 4,000 shirts.

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When presented graphically, alert what happens as soon as Tony procedures external of his original pertinent array and has to add a second employee and a second screen-printing machine:


It is important to remember that even though Tony’s expenses stepped up when he exceeded his original capacity (pertinent range), the behavior of the costs did not adjust. His resolved costs still continued to be addressed in total and also his full variable expense climbed as the variety of T-shirts he created increased. (Figure) summarizes just how costs behave within their appropriate arrays.

Overview of Fixed and also Variable Cost BehaviorsCostIn TotalPer Unit
Variable CostChanges in response to the level of activityRemains solved per unit regardless of the level of activity
Fixed CostDoes not adjust via the level of task, within the relevant variety, but does adjust when the appropriate array changesChanges based upon task within the pertinent range: increased task decreases per-unit cost; reduced task rises per-unit cost

Product versus Period Costs

Many businesses have the right to make decisions by dividing their expenses into addressed and also variable prices, however tright here are some organization decisions that require grouping prices differently. Sometimes companies need to think about exactly how those expenses are reported in the financial statements. At other times, service providers team costs based on features within the service. For instance, a service would certainly team administrative and also marketing expenses by the period (monthly or quarterly) so that they deserve to be reported on an Income Statement. However before, a production firm may carry product expenses such as materials from one duration to the other in order to have the expenses “travel” with the units being produced. It is possible that both the offering and governmental costs and also products costs have both addressed and also variable components. As a result, it might be crucial to analyze some resolved costs in addition to some variable costs. At some point, businesses strategically group expenses in order to make them even more valuable for decision-making and also planning. Two of the broadest and also many prevalent grouping of costs are product prices and also period expenses.

Product expenses are all those associated via the acquisition or manufacturing of goods and products. When products are purchased for resale, the cost of items is tape-recorded as an ascollection on the company’s balance sheet. It is not until the commodities are sold that they end up being an cost on the earnings statement. By relocating product expenses to the cost account for the price of items offered, they are easily matched to the sales revenue income account. For instance, Bert’s Bikes is a bicycle retailer that purchases bikes from a number of wholesale distributors and manufacturers. When Bert purchases bicycles for resale, he locations the price of the bikes right into his inventory account, because that is what those bikes are—his inventory obtainable for sale. It is not till someone purchases a bike that it creates sales revenue, and also in order to meet the demands of double-entry accounting, he must match that revenue through an expense: the cost of goods sold ((Figure)).


Some product costs have actually both a addressed and variable component. For instance, Bert purchases 10 bikes for ?100 each. The distributor charges ?10 per bike for shipping for 1 to 10 bikes however ?8 per bike for 11 to 20 bikes. This shipping price is solved per unit however varies in complete. If Bert desires to conserve money and also regulate his price of goods sold, he can order an 11th bike and also drop his shipping expense by ?2 per bike. It is necessary for Bert to know what is resolved and what is variable so that he have the right to control his prices as much as possible.

What about the costs Bert incurs that are not product costs? Period expenses are ssuggest every one of the expenses that are not product costs, such as all selling and governmental expenses. It is important to remember that duration prices are treated as expenses in the period in which they take place. In various other words, they follow the rules of accrual accounting practice by recognizing the cost (expense) in the period in which they take place regardmuch less of when the cash alters hands. For instance, Bert pays his service insurance in January of every year. Bert’s yearly insurance premium is ?10,800, which is ?900 per month. Each month, Bert will certainly recognize 1/12 of this insurance cost as an price in the duration in which it is incurred ((Figure)).


Why is it so necessary for Bert to recognize which prices are product expenses and also which are period costs? Bert might have actually little manage over his product expenses, but he maintains an excellent deal of control over many of his period costs. For this reason, it is crucial that Bert have the ability to recognize his period costs and also then determine which of them are resolved and which are variable. Remember that addressed costs are solved over the appropriate range, yet variable expenses adjust through the level of task. If Bert desires to control his expenses to make his bike organization more profitable, he need to have the ability to distinguish in between the prices he deserve to and also cannot regulate.

As with a merchandising business such as Bert’s Bikes, manufacturers also classify their expenses as either product prices or duration prices. For a production service, product expenses are the prices linked with making the product, and duration costs are all various other costs. For the objectives of external reporting, separating costs into duration and product prices is not all that is important. However before, for monitoring decision-making tasks, refinement of the types of product prices is useful.

In a manufacturing firm, the require for monitoring to be aware of the types of expenses that comprise the expense of a product is of paramount prestige. Let’s look at Carolina Yachts aobtain and also research how they have the right to classify the product costs linked through building their sportfishing watercrafts. As with automobiles, each year, Carolina Yachts renders changes to their boats, introducing brand-new models to their product line. When the designers start to restyle boats for the following year, they should be cautious not to make changes that would drive the offering price of their watercrafts also high, making them less attractive to the customer. The designers have to understand specifically what the enhancement of another function will carry out to the price of manufacturing. It is not sufficient for them to obtain complete product price data; rather, they require particular indevelopment about the 3 classes of product costs: materials, labor, and also overhead.

As you’ve learned, straight products are the raw materials and component components that are directly financially traceable to a unit of production.

(Figure) offers some examples of direct products.

Examples of Direct MaterialsManufacturing BusinessProductDirect Materials
BakeryBirthday cakesFlour, sugar, eggs, milk
Automobile manufacturerCarsGlass, steel, tires, carpet
Furniture manufacturerReclinersWood, towel, cotton batting

In each of the examples, managers are able to map the cost of the materials directly to a specific unit (cake, car, or chair) produced. Due to the fact that the amount of direct materials compelled will certainly adjust based upon the number of systems developed, direct products are virtually always classified as a variable expense. They remain addressed per unit of manufacturing yet readjust in full based upon the level of task within the service.

It takes more than materials for Carolina Yachts to build a watercraft. It calls for the application of labor to the raw materials and component parts. You’ve also learned that straight labor is the job-related of the employees that are directly involved in the manufacturing of products or services. In truth, for many type of sectors, the biggest cost incurred in the manufacturing procedure is labor. For Carolina Yachts, their direct labor would certainly incorporate the wperiods passist to the carpenters, painters, electricians, and welders who build the watercrafts. Like direct products, direct labor is typically treated as a variable expense bereason it varies with the level of task. However, there are some carriers that pay a level weekly or monthly salary for production workers, and for these employees, their compensation might be classified as a addressed cost. For example, many type of auto mechanics are currently phelp a level weekly or monthly salary.

While in the example Carolina Yachts is dependent upon direct labor, the manufacturing process for suppliers in many kind of industries is moving from humale labor to an extra automated production process. For these suppliers, direct labor in these industries is ending up being much less substantial. For an example, you can research study the current manufacturing process for the car industry.

The third significant classification of product prices for a production service is overhead. Manufacturing overhead (occasionally described as manufacturing facility overhead) has every one of the costs that a manufacturing service incurs, various other than the variable expenses of straight products and straight labor compelled to build products. These overhead costs are not straight attributable to a certain unit of manufacturing, yet they are incurred to support the production of items. Some of the items contained in manufacturing overhead incorporate supervisor salaries, depreciation on the factory, maintenance, insurance, and utilities. It is vital to note that manufacturing overhead does not include any type of of the selling or administrative features of a organization. For Carolina Yachts, prices favor the sales, marketing, CEO, and clerical staff salaries will not be had in the calculation of production overhead costs but will certainly instead be alsituated to offering and governmental expenses.

As you have actually learned, much of the power of managerial audit is its capacity to break expenses down into the smallest possible trackable unit. This likewise uses to production overhead. In many type of situations, businesses have actually a must additionally refine their overhead expenses and also will track indirect labor and instraight materials.

When labor expenses are incurred however are not straight connected in the active conversion of materials into finiburned products, they are classified as indirect labor prices. For instance, Carolina Yachts has actually production supervisors who overcheck out the production process but carry out not proactively participate in the construction of the watercrafts. Their wages mostly assistance the manufacturing process yet cannot be traced ago to a single unit. For this factor, the production supervisors’ salary would be classified as instraight labor. Similar to straight labor, on a product or department basis, instraight labor, such as the supervisor’s salary, is regularly treated as a fixed cost, assuming that it does not vary via the level of task or number of units developed. However before, if you are considering the supervisor’s salary cost on a per unit of production basis, then it might be taken into consideration a variable expense.

See more: 1-Chloro-1-Phenylethane Melting Point, Material Safety Data Sheet 1

Similarly, not all products provided in the manufacturing process can be traced ago to a certain unit of production. When this is the instance, they are classified as instraight material expenses. Although needed to develop the product, these indirect material costs are not traceable to a specific unit of manufacturing. For Carolina Yachts, their instraight materials encompass supplies like devices, glue, wax, and also cleaning supplies. These products are required to develop a watercraft, but management cannot easily track just how a lot of a bottle of glue they use or just how often they usage a specific drill to construct a specific boat. These instraight products and also their associated cost recurrent a tiny fractivity of the complete products needed to finish a unit of production. Like straight materials, indirect products are classified as a variable cost since they vary through the level of manufacturing. (Figure) provides some examples of production costs and also their classifications.

Instances of Classifications of Manufacturing CostsCostClassificationFixed or Variable
Production supervisor salaryInstraight laborFixed
Raw products supplied in productionDirect materialsVariable
Wperiods of production employeesDirect laborVariable
Straight-line depreciation on factory equipmentGeneral production overheadFixed
Glue and adhesivesIndirect materialsVariable