3.

1 DEFINITION AND APPLICATION OF COST BEHAVIOUR CONCEPT

Cost behaviour is the way in which costs are affected by the changes
in the volume of output. Management decisions are often based on how costs
and revenues vary at different activity levels.

3.2 COST BEHABIOUR AND LEVELS OF ACTIVITY

Although there are many factors which may influence costs, the major influence is
the volume of output or the level of activity. The term level of activity may refer to one of
the following:
 number of units produced;
 value of items sold;
 number of items sold;
 number of invoices issued;
 number of units of electricity consumed.

3.3 COST BEHAVIOUR PATTERNS

Cost behaviour analysis is concerned with how costs change with level of activity
and by how much. Individual items of cost can be classified according to their cost
behaviour. There are many cost behavior patterns but many costs can be classified
according to behaviour as:
 fixed costs;
 variable costs;
 semi-variable costs;
 step costs.

3.4 FIXED COSTS

A fixed cost is a cost which tends to be unaffected in total by increases or decreases
in the volume of output. An example of fixed cost is the rent of a factory which is a constant
amount each period regardless of how much or how little is manufactured inside it. The
factory rent will be 10 million whether you produce 2 units or 100 units of a product.
In reality there must be a level of activity at which more than one factory would be
required for production. At that point rent is no longer a fixed cost. Therefore, fixed costs
are constant within a reasonable range of activity.
A sketch of a fixed cost would look like this:
Graph of Fixed cost
Cost –
(Pesos)
(x)

Fixed cost

Volume of output (level of activity)(y)

Examples of fixed costs would be:
  The salary of a managing director per year.
 The rent of a single factory building per year or month.
 Straight-line depreciation of a single machine.

3.5 VARIABLE COSTS

A variable cost is a cost which tends to vary directly with the volume of output. The
variable cost per unit is the same amount for each unit produced. A constant variable cost
per unit implies that the price per unit of say, material purchased is constant and that the
rate of material usage is also constant.
A sketch of a fixed cost would look like this:

Cost Total Variable cost Graph

Pesos(y)

Volume of output(x)

EXAMPLES OF VARIABLE COSTS

 Cost of raw materials.
 Direct labour costs.
 Sales commission.
 Bonus payment.

3.6 SEMI-VARIABLE COSTS

A semi-variable cost is cost which contains both fixed and variable components and
so is partly affected by changes in the level of activity.
Examples of semi-variable costs include:
 Electricity bills
 Salesman’s salary
 Costs of running a car

3.7 DETERMINING THE FIXED AND VARIABLE ELEMENTS OF SEMI-VARIABLE COSTS

It is generally assumed that costs are one of the following:
 Variable
 Fixed
 Semi-variable

3.7.1 Methods of Splitting Semi-Variable Costs

 HIGH-LOW METHOD
Semi-variable costs are often separated into fixed and variable
components. One of the methods used to split the cost is the high-low method
which works as follows:

1
 Step 1. Review records the costs in the past periods

 Select the period with the highest activity level

 Select the period with the lowest activity level

Step 2. Determine the following;

 Total cost at high level of activity

 Total cost at low level of activity
 Total units at high level of activity
 Total units at low level of activity

Step 3. Calculate the variable cost per unit by dividing the difference
between the total cost at the lowest activity and total cost at
high activity by the difference between the highest and lowest
activity.

Step 4. Calculate the fixed cost by subtracting variable costs from the
total cost at either the lowest or highest activity.

Cost Function : Y = a + b x
Y= Total Cost; a = fixed cost ; b= variable cost per unit x= No. of activity level

Illustrative Example:
Dolfin Ltd has recorded the following total costs during the last five years

Year Units Produced(X) Total cost (Y)pesos

2000 65,000 145,000
2001 80,000 162,000
2002 90,000 170,000
2003 60,000 140,000
2004 75,000 160,000

Required:
Calculate the total costs that should be expected in 2005 if output is 95,000 units.

SOLUTION:

Step Period with highest

1 activity 2002 (90,000)
Period with lowest
activity 2003 (60,000)

Step
2 Total cost at high activity P 170,000
Total cost at low activity P 140,000
Total units at high
activity 90,000
Total units at low
activity 60,000

Step Variable cost per unit

2
3
Total cost at high activity - total cost at low activity
Total units at high activity - total units at low activity

b= P170,000 - P140,000 = P30,000

30,000uni
90,000 - 60,000 ts =P1/unit

Step Fixed cost = Total cost @ high activity - total units @ high activity x variable cost
4 per unit

P170,000 - P(90,000 x 1)
= P80,000

Therefore total cost at 95,000 units are as follows

Cost Function : Y=(a + bx)
Y= Total Cost; a = fixed cost ; b= variable cost per unit
x= No. of activity level
Total Cost (y)
Variable cost = 95,000 x
1 95,000
Fixed costs 80,000
Total costs 175,000

Cost Function : Y = a + b x
Y = 80,000 + P1(x)
Y= 80,000 + P 1 (95,000)
Total Cost= P175,000

3
 LEAST SQUARE METHOD

Illustrative Example:
Dolfin Ltd has recorded the following total costs during the last five years

Year Units Produced(x) Total cost (y)pesos

2000 65,000 145,000
2001 80,000 162,000
2002 90,000 170,000
2003 60,000 140,000
2004 75,000 160,000
Required:
Calculate the total costs that should be expected in 2005 if output is 95,000 units.

Step 1. Compute the total number of data (n), x ² and x(y)

Step 2. Use the following equation:

Equation 1 Y= a+ b x
Equation 2 ∑Y = na + b∑x
Equation 3 ∑XY = ∑xa + b ∑x²

Step 3. Calculate the variable cost per unit by using equation 2 and
3, using the elimination method.

Step 4. Calculate the fixed cost by choosing any of the equation 2

and 3 and substituting the data provided in the problem.

Solution:

Units Total cost

Year Produced(X) pesos (Y) x ² (000) X(Y)
(000) (000)

2000 65 145 4,225 9,425

2001 80 162 6,400 12,960
2002 90 170 8,100 15,300
2003 60 140 3,600 8,400
2004 75 160 5,625 12,000
n=5 ∑x= 370 ∑Y= 777 ∑x²= 27,950 ∑XY= 58,085

Step 1. Compute the total number of data (n), x ² and x(y)

Step 2. Equation 2 ∑Y = n a + b ∑x

4
 777 = 5 (a) + b (370)

Equation 3 ∑XY = ∑xa + b ∑x²

58,085 = 370a + b 27,950

74 (777 = 5 (a) + b (370)) 74

58,085 = 370a + b 27,950

Next: 57,498 = 370 a + b (27,380)

58,085= 370a + b (27,950)
587 = 0 + b (570)
b = 587/570
b = P1.03/u

Step 3. Substituting the value for either using equation 2 or 3, we can

compute for as follows:
777 = 5 (a) + b (370)
777= 5 (a) + P1.03 (370)
777= 5 (a ) + 381.1
777-381.1= 5 (a)
79.18 = a

Cost Function : Y = a + b x
Y = 79, 180 + 1.03 x
Y= 79, 180 +1.03 (95,000)
Total Cost= P177, 030

Note: Though the given data are the same, using HLM and least square
method usually do not arrive at exactly the same answer. Why?
In the HLM, we are only using two data (highest and the lowest) while the
least square method are using all the data given. Now, which do you think is
more accurate, is it the LHM or the LSM?