Separation of Cost into Fixed Cost and Variable Cost

The following methods are used in separation of such costs into fixed cost and variable cost. They are: 1. Industrial Engineering Method 2. Account Inspection Method 3. Scatter Graph Method 4. High and Low Method.

1. Industrial Engineering Method:

This method is used to collect cost information that is not available in an organization’s records and is particularly relevant when an organization is just beginning a new activity. Every productive process involves employing a particular mix of materials, labour and capital equipment in order to yield physical output.

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When the relationship between the input and output is established by an engineer or technical expert e.g., 2 kgs. of materials + 3 hours of labour = 1 unit of output. The material and labour costs can be estimated by imputing material prices and wage rates to physical input needs. It is important to note that these costs are estimates because of possible uncertainty with regard to wastage in material usage and changes in labour efficiency in production process.

The engineering method is particularly useful when applied to material and labour costs which represent a large proportion of the total output cost. If the relationship between material and labour inputs and outputs remain static over time, then these cost estimates can be used in the future without significant adjustment. When costing new products, the engineering method is the only approach that can be used due to lack of historic data.

However, there are three main disadvantages of the engineering method:

(1) It is expensive as work measurement involves detailed analysis of the physical movements required in each task, in order to produce one unit of output.

(2) There are other costs incurred in the production process e.g., machine maintenance and supervision which cannot be associated with specific units of output, but may be direct costs of the department. The engineering method cannot be applied to these costs, whose equations will have to be derived from an analysis of past data or from subjective evaluation.

(3) Different mixes of materials and skills may be used to produce the same unit of output, leading to several conflicting cost estimates.

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Although the engineering method is usually associated with production, work study techniques are applied to other areas, such as selling and administrative functions of the organization.

2. Account Inspection Method:

This method is a fast and inexpensive way of estimating costs as it simply involves examining each account and subjectively classifying the account’s total cost into either fixed or variable elements. This requires that the Management Accountant inspect each item of expenditure within the ledgers at a given level of output to determine whether a cost is fixed, variable or semi-variable.

Limitations:

This technique has the following limitations:

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(a) It depends heavily on the initial decision to classify an account as fixed or variable.

(b) It fails to recognize that semi-variable costs exist.

(c) It relies on a single observation of the account to determine the cost equation rather than using an average based on several observations of each account.

(d) It assumes that transactions have been correctly charged to one account or another. The account inspection method should be used only when a crude approximation of cost behaviour is sufficient for making decisions.

3. Scatter Graph Method:

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In this method, it involves plotting several observed levels of cost and their associated levels of activity on a scatter-graph and then applying statistical analysis to fit the best line through these points.

Illustration:

The point at which the line of best fit touches the ordinate indicates fixed component of the cost i.e., Rs. 9,500 in this case. The slope of the line indicates the degree of variability of costs.

The scatter-graph as shown in figure 2.4 can be drawn with the help of the above data:

Scattergraph

The line of best fit is relatively simple to apply and it does attempt to use all the information in the relevant range of production to arrive at the estimated cost function. However, it remains rather crude and does not adequately handle data points which are far away from the main body of points (called out liners).

Another problem with this method is that each accountant using the same cost data to estimate the cost of equation may draw different total cost lines by eye, to describe the relationship between cost and activity. Despite the short-coming, the method may be sufficient for the small company that does not possess the expertise to use complicated statistical technique.

4. High and Low Method:

Under this method, the highest and lowest volumes of output and the relevant cost figures are taken into consideration. The difference of cost between volumes, i.e., incremental cost for incremental output will be arrived at. The incremental cost will be further divided by the incremental output. This will give the variable cost per unit.

Total variable cost for any level of output can be determined easily. Now, the total cost of the volume of output less the total variable cost at that level of output gives the fixed cost which will remain for all levels of activity.

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