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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.
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