In evaluating a business decision, it is essential to understand how the costs associated with a given course of action will change over a range of activity levels. When managers talk about cost behavior, they are referring to how total costs change in response to changes in the activity level. Cost behavior consists of
- Variable Cost
Any total cost that varies in proportion to business activity is variable. The activity can be any repetitive event that serves as a measure of output or usage, such as units sold, units produced, minutes talked, or miles are driven. As the level of activity increases, the total cost increases by the same proportion. Conversely, as the level of activity decreases, the total cost decreases by the same proportion. So a 10% increase in volume results in a 10% increase in total variable cost, and a 10% decrease in volume results in a 10% decrease in total variable cost. Variable costs have two main characteristics: (a) The total cost varies in proportion to changes in the level of activity (b) The cost per unit remains constant, regardless of the activity level. 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.
- Fixed Cost
In contrast to a variable cost, the total amount of a fixed cost does not change with the activity level. However, the cost per unit does change. The higher the level of activity, the lower the fixed cost per unit. Fixed costs have two main characteristics: (a) The total cost remains fixed, regardless of changes in the level of activity; (b) The cost per unit varies inversely with changes in the level of activity. Examples include property taxes, insurance, rent, supervisory salaries, and straight-line depreciation on buildings and equipment.
- Mixed Cost
Mixed costs are costs that contain both variable-cost and fixed-cost components. Mixed costs, therefore, change in total but not proportionately with changes in the activity level. For example, each month, the electric bill includes a flat service fee plus a usage charge.
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