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Unformatted text preview: the business. This requires drilling
down into the specific types of costs that are to be incurred and trying to understand their unique
attributes. 1.2 Variable Costs
Variable costs will vary in direct proportion to changes in the level of an activity. For example,
direct material, direct labor, sales commissions, fuel cost for a trucking company, and so on, may be
expected to increase with each additional unit of output.
Assume that GoSound produces portable digital music players. Each unit produced requires a
printed circuit board (PCB) that costs $11. Below is a spreadsheet that reveals rising PCB costs with
increases in unit production. For example, $1,650,000 is spent when 150,000 units are produced
(150,000 X $11 = $1,650,000). The data are plotted on the graphs. The top graph reveals that total
variable cost increases in a linear fashion as total production rises. The slope of the line is constant.
Of course, when plotted on a “per unit” basis (the bottom graph), the variable cost is constant at $11
per unit. Increases in volume do not change the per unit cost. In summary, every additional unit
produced brings another incremental unit of variable cost. Download free ebooks at bookboon.com
7 Cost Behavior Cost Analysis The activity base is the item or event that causes the incurrence of a variable cost. It is easy to think
of the activity base in terms of units produced, but it can be more than that. Activity can relate to
labor hours worked, units sold, customers processed, or other such “cost drivers.” For instance, a
dentist uses a new pair of disposable gloves for each patient seen, no matter how many teeth are
being filled. Therefore, disposable gloves are variable and key on patient count. But, the material
used for fillings is a variable that is tied to the number of decayed teeth that are repaired. Some
patients have none, some have one, and others have many. So, each variable cost must be
considered independently and with careful attention to what activity drives the cost. 1.3 Fixed Costs
The opposite of variable costs are fixed costs. Fixed costs do not fluctuate with changes in the level
of activity. Assume that GoSound leases the manufacturing facility where the portable digital music
players are assembled. Assume that rent is $1,200,000 no matter the level of production. The rent is
said to be a “fixed” cost, because total rent will not change as output rises and falls. The following
spreadsheet reveals the factory rent incurred at different levels of production and the resulting “per
unit” rent amount. Observe that the fixed cost per unit will decline with increases in production.
This attribute of fixed costs is important to consider in assessing the scalability of a business
proposition. There are numerous types of fixed costs. Examples include administrative salaries,
rents, property taxes, security, networking infrastructure support, and so forth. Download free ebooks at bookboon.com
8 Cost Behavior Cost Analysis 1.4 Business Implications of the Fixed Cost Structure
The nature of a specific business will have a lot to do with defining its inherent fixed cost structure.
Airlines have historically been burdened with high fixed costs related to gates, maintenance,
contractual labor agreements, computer reservation systems, aircraft, and the like. As you are aware,
airlines have struggled during lean years because they are unable to cover fixed costs. During boom
years, these same companies have been extremely profitable, because costs do not rise (much) with
increases in volume. Basically, there is not much cost difference in flying a plane empty or full!
Software companies have a big investment in product development, but very little cost in
reproducing multiple electronic copies of the finished product. Their variable costs are low.
Other businesses have attempted to avoid fixed costs so that they can maintain a more stable stream
of income relative to sales. For example, a computer company might outsource its tech support.
Rather than having a fixed staff that is either idle or overloaded at any point in time, they pay an
independent support company a per-call fee. The effect is to transform the organization’s fixed costs
to variable, and better insulate the bottom line from fluctuations brought about by the related ability
to cover or not cover the fixed costs of operations. Download free ebooks at bookboon.com
9 Cost Behavior Cost Analysis Every business is unique, and a savvy business person will be careful to understand their cost
structure. For a long time, the trend for many businesses was toward increased fixed costs. Some of
this was the result of increased investment in robotics and technology. However, those components
have become more affordable. And, we are now seeing more outsourcing, elimination of health
insurance, conversion of pension plans, and so forth. These activities suggest attempts to structure
businesses with a definitive margin (revenues minus variable costs) that scales up and down with
changes in the...
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