In this article we will discuss about the cost classification by behaviour. The categories of classification are: 1. Variable Cost 2. Fixed Cost 3. Semi-Variable or Semi-Fixed Cost.
1. Variable Cost:
The variable cost is a cost that tends to vary in accordance with level of activity within the relevant range and within a given period of time. The prime product costs i.e., direct material, direct labour and direct expenses tend to vary in direct proportion to the level of activity.
An increase in the volume means a proportionate increase in the total variable costs and a decrease in volume will lead to a proportionate decline in the total variable costs. There is a linear relationship between volume and variable costs. They are constant per unit.
Variable costs have an explicit physical relationship with a selected measure of activity and exists an optimum cause and effect relationship between the input and output. Therefore, variable costs are also known as ‘engineered costs’.
All variable costs are not engineered costs. Some of the variable components which are termed as ‘discretionary variable costs’ and such costs will vary with fluctuations in the levels of activity merely because of the policy of the management.
The variable element of research and development or advertisement costs, which are discretionary by nature may increase with increased activity and management may decide to spend more in periods of increased activity.
2. Fixed Cost:
The fixed cost is a cost that tends to be unaffected by changes in the level of activity during a given period of time. The fixed costs remain constant in total regardless of changes in volume up to a certain level of output. They are not affected by changes in the volume of production. There is an inverse relationship between volume and fixed cost per unit.
Fixed costs tend to remain constant for all levels of activity within a certain range. It follows that some fixed costs will continue to be incurred even when the activity comes down to nil. Some fixed costs are liable to change from one period to another. For example salaries bill may go up because of annual increments or due to change in the pay rates and due to pay structure.
2. Semi-Variable or Semi-Fixed Cost:
Many costs fall between these two extremes. They are called as ‘semi-variable costs’ or ‘semi-fixed costs’. They are neither perfectly variable nor absolutely fixed in relation to changes in volume. They change in the same direction as volume, but not in direct proportion thereto.
An example is found in telephone charges. The rental element is a fixed cost whereas charges for calls made are a variable cost. The distinction between fixed and variable costs is important in forecasting the effect of short-run changes in volume upon costs and profits. This distinction has also given rise to the concepts of marginal costing, direct costing, flexible budgeting.
Costs which have neither a linear or curvilinear relationship with output but they move in steps with fluctuations in activity levels. These are called ‘stepped-up costs’. Basically these are fixed costs up to a certain level of activity specified but they change as soon as new range is reached. Such costs are semi-variable in the long-term but fixed in the short-term.
Certain variable costs tend to vary during specific periods for reasons not related to fluctuations in activity level. For example increased maintenance cost during periods of low production, increased costs on air- conditioning in summer. Costs which fluctuate with volume of production but after stage of production has reached, the fluctuations in cost is disproportionate. It changes either of retarded or accelerated rate.
a. Specific and Common Fixed Cost:
The specific fixed cost refers to those costs which can be easily identified with a department, process, product or territory. It follows that such costs which are not identified with a department, process, product or territory would be common fixed cost. This classification of cost is important for the purpose of decision making.
For example, if there is a proposal to discontinue a product, specific fixed cost of the product shall be relevant whereas common fixed cost of this product be irrelevant. Similarly, if there is a proposal to discontinue a territory, the entire specific fixed cost of that territory shall be relevant for above decision.
b. Committed Fixed Cost:
The committed fixed cost is a cost that is primarily associated with maintaining the organization’s legal and physical existence over which management has little discretion. The committed cost is a fixed cost which results from decisions of prior period. The amount of committed cost is fixed by decisions which are made in the past and not subject to managerial control in the short-run.
Since committed cost does not fluctuate with volume and remains unchanged until action is taken to increase or reduce available capacity. Committed cost does not present any problem in cost behaviour analysis. Examples of committed cost are depreciation, insurance premium, rent, etc.
c. Discretionary Fixed Cost:
The discretionary fixed cost refers to those costs which are influenced by the managerial decisions.
These costs will vary depending on the intentions of management. Examples:
(1) Management may decide to pay bonus over and above the minimum bonus.
(2) Instead of engaging the services of employees, it may be decided to outsource the services.
(3) Replacement of labour oriented machine with automatic machine.
d. Engineered Cost:
The engineered costs relates to the inputs like material, labour and expenses, etc., which are directly connected with the product. The quality or material usage or labour hours can be determined for each product or activity.
An item of engineered cost is a type of input that has a definite physical relationship with output. In most of the production processes it is possible to develop standards for both direct materials and direct labour and these standards reflect the relationship between input and output.
Engineered costs can be established with the help of (a) engineering analysis and (b) analysis of historical costs and can be controlled by the management by scheduling production volume, taking proper care of machinery and assigning workers to various jobs.
e. Managed Cost:
The managed cost is a cost that stems from current operations but which must continue to be incurred into the future, its sum level is determined by management, to ensure the continued existence of the enterprise. The managed costs are those which have no direct relationship with the product.
The cost on advertisement, research and development, tool room, drawings and design, etc., cannot be easily associated with the product. The control system starts with annual budgets for these costs.
Comparison of actual costs with budget is made on a monthly basis and variations are ascertained. Managed costs produce an output which benefit the firm in the same manner as engineered costs do but it is difficult to find an exact relationship between the amount of managed costs incurred (input) and its output.
f. Capacity Cost:
The capacity costs are normally fixed costs. A definite relationship between capacity costs and the output of product emerge only in the long-run. The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to enable it to perform its functions are termed as capacity costs.
Capacity costs include the costs of plant, machinery and building for production, warehouses, and vehicles for distribution and key personnel for administration. Capacity costs are in the nature of long-term costs and are incurred as a result of planning decisions.
g. Programmed Cost:
The programmed cost is a cost that is subject to both the management discretion and management control but which has little immediate relevance to current operations although it is generally incurred to ensure long-term survival.
Programmed costs are subject both to management discretion and management control, but which are unrelated to current activities. Advertisement, research and development, sales promotion are good examples and it appears that these costs results from special policy decisions of management.
Importance of Behaviour wise Cost Classification:
The following are the uses of classification of costs into fixed costs and variable costs:
i. Cost Control:
The importance of separating variable from fixed costs stems from the different behaviour patterns of each, which have a significant bearing on their control. Variable costs are controlled in relation to level of activity whilst fixed costs must be controlled in relation to time.
ii. Decision Making:
From decision making point of view it is important to know whether or not a particular cost will vary as a result of a given decision.
iii. Marginal Costing:
The marginal costing technique is based on separate treatment of fixed and variable costs. For this purpose all costs should be segregated into fixed costs and variable costs.
iv. Flexible Budgeting:
A flexible budget takes into account the changes in costs with the changes in activity levels. Flexible budgets cannot be prepared unless the impact of fluctuating activities on variable costs and fixed costs are shown separately.
v. CVP Analysis:
Separation of costs into fixed costs and variable costs is important for cost-volume- profit analysis and break even analysis.
vi. Direct Costing:
The direct costing is a system of costing in which the product is charged only with those costs which vary with volume. Variable or direct costs such as direct materials, direct labour and variable manufacturing expenses are charged to the product cost. For computation of direct cost, all costs should be classified into variable costs and fixed costs.
Diagrammatic Presentation of Cost Behaviour:
The behaviour of costs as discussed above can be represented in the form of diagrams as shown in figure 2.3.: