Cost behavior analysis is the study of how specific costs respond to changes in the level of business activity. The activity index identifies the activity that causes changes in the behavior of costs. With an appropriate activity index, companies can classify the behavior of costs in response to changes in activity levels into three categories: variable, fixed, or mixed. Relevant Range: Range of activity over which a company expects to operate during a year. Variable costs are costs that vary in total directly and proportionately with changes in the activity level. If the level increases 10%, total variable costs will increase 10%. If the level of activity decreases by 25%, variable costs will decrease 25%. Examples of variable costs include direct materials and direct labor for a manufacturer; cost of goods sold, sales commissions, and freight-out for a merchandiser; and gasoline in airline and trucking companies. A variable cost may also be defined as a cost that remains the same per unit at every level of activity . Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, supervisory salaries, and depreciation on buildings and equipment. Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, unit cost declines, and vice versa . Mixed costs are costs that contain both a variable element and a fixed element. Mixed costs, therefore, change in total but not proportionately with changes in the activity level. The high-low method uses the total costs incurred at the high and low levels of activity to classify mixed costs into fixed and variable components. The difference in costs between the high and low levels represents variable costs, since only the variable-cost element can change as activity levels change. 1. Determine variable cost per unit from the following formula. 2. Determine the fixed costs by subtracting the total variable costs at either the high or the low activity level from the total cost at that activity level.
Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on a company's profits. CVP analysis is important in profit planning. It also is a critical factor in such management decisions as setting selling prices, determining product mix, and maximizing use of production facilities. Because CVP is so important for decision-making, management often wants this information reported in a cost-volume-profit (CVP) income statement format for internal use. The CVP income statement classifies costs as variable or fixed and computes a contribution margin. Contribution margin (CM) is the amount of revenue remaining after deducting variable costs. It is often stated both as a total amount and on a per unit basis.