Types of cost behavior patterns exercises 5 1 5 6 5 7

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Types of Cost Behavior Patterns. (Exercises 5-1, 5-6, 5-7, 5-8, 5-11, and 5-12.) At least three cost behavior patterns—variable, fixed, and mixed—are found in most organizations. Of course, many other types of cost behavior patterns exist, but these three patterns are fairly common and the mixed cost model can be used to provide approximations to more complex cost behavior patterns within a relevant range. It is important for managers to understand the behavior of each type of cost. 1. Variable Costs. The total amount of a variable cost varies in direct proportion to changes in the activity level. When expressed on a per unit basis, variable costs are constant. Examples of costs that are normally variable with respect to output volume are listed in Exhibit 5-2. Be careful to point out to students that some of these costs may be fixed in some organizations. This is particularly true of direct labor and other employee wages and salaries that may be effectively fixed due to labor laws in a country, custom, labor contracts, or the organization’s personnel policies. Exhibit 5-8 in the text points out that in practice there is a wide variation in how some of these costs are classified by individual companies. a. Activity base (cost driver). For a cost to be variable, it must be variable with respect to some activity base. An activity base is a measure of whatever causes the incurrence of a variable cost. Some of the most common activity bases are machine-hours, units produced, and units sold. A measure of activity should be used to allocate a cost for decision-making purposes only if it actually causes the cost. b. True variable and step-variable costs. Some variable costs, such as direct materials, vary in direct proportion to the level of activity. These costs are called true variable costs. A cost that is obtainable only in large chunks and that increases or decreases in response to fairly wide changes in the activity level is known as a step-variable cost. For example, direct labor may be a step-variable cost when workers are only hired on a full-time basis. The difference between a true variable and a step-variable cost is illustrated in Exhibit 5-3 in the text. c. In reality, many costs are curvilinear. Most frequently, costs increase less than proportionately with activity. Nevertheless, within any given narrow band of activity even a curvilinear cost function is approximately linear. This narrow band of activity within which a particular straight line is a reasonable approximation to the true underlying cost function is called its relevant range . Thus, within the relevant range, variable cost per unit can be assumed to be constant. Exhibit 5-4 in the text illustrates a curvilinear cost and the notion of the relevant range. The notion of the relevant range often causes confusion. Some individuals refer to the relevant range as the range of activity within which the company expects to operate or has operated in the recent past. That is not what we mean by the relevant range. The relevant range, as we use the term, is the range of activity within which a

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