Cost Behavior

Article byShrestha Ghosal
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Cost Behavior

Cost behavior is the resulting change in the behavior of cost or expenses of a business due to a change in the business process. The study of how a specific change in a business activity can impact the total cost is known as cost behavior analysis. Its aim is to understand how costs change in relation to changes in an organization’s activity levels.

Cost Behavior

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The management uses cost behavior in accounting to create a budget because it indicates how some activity can impact the cost and increase or decrease it. It can also be used for cost-volume-profit analysis. Additionally, it helps in planning and controlling the expenses of a business.

Key Takeaways

  • Cost behavior is the impact a change in a business activity causes on the operating cost of a business.
  • It indicates how a change in an activity level can cause an increase or decrease in the business’s total operating cost.
  • Certain business activities do not impact the overall production cost, while some business activity levels can significantly change the operating cost. Cost behavior helps in identifying such activities.
  • It is a crucial study that the management considers while making strategic business decisions. It is instrumental in budget creation, cost-volume-profit analysis, and controlling cost.

Cost Behavior Explained

Cost behavior is the behavior change in the total operating cost of an organization as a result of a change in the levels of a specific activity. For example, a business process comprises costs like labor, direct materials, overhead, etc. Cost behavior in accounting is used to study how the total cost will be impacted due to a change in the process.

Several types of expenditures have no impact on the overall business expenses. Some expenditures may remain consistent despite changing the level of that specific activity, while others may significantly affect the overall cost. Analyzing these costs beforehand enables a business to stay prepared for unprecedented changes in the business process.

Cost behavior analysis is an instrumental tool for management to determine how to increase or decrease the cost of production by changing an activity level. It helps to create a budget, control costs, and increase the profit margin. It can also be used for planning and forecasting. The management uses mathematical functions to analyze and study this behavior.

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Types

The types of cost by behavior are as follows:

#1 – Fixed cost

Fixed cost is where the total cost stays the same irrespective of the number of products produced or sold. This type of cost is independent of the production or sales volume. However, despite the total cost remaining the same, the fixed price per unit changes according to the units produced. For example, the rent for manufacturing ten units of a product is the same as for manufacturing a hundred units. However, the cost per unit of producing ten products will be more than that of a hundred products.

#2 – Variable cost

Variable cost is the type of cost where the total cost changes according to the units of a product sold or manufactured. This type of cost is affected by the production or sales volume change. The cost per unit stays the same for each product sold or manufactured unit. For example, the number of raw materials procured for producing a particular product will depend on the units of that product manufactured. Thus, with increased production volume, the total cost of raw materials will also increase.

#3 – Mixed Cost

Mixed cost is the type of cost that comprises both fixed and variable costs. For example, if the transportation cost includes a fixed monthly charge and a per unit charge for every product transported, it is a mixed cost.

#4 – Step cost

Step cost is the type of cost where the fixed cost changes at a particular point in the production process. For example, a warehouse can store 10,000 units of a product. A new warehouse must be rented if more than 10,000 units are produced. The new rent expenses will be added to the total production cost. This type of cost is known as step cost.

Factors

The factors that influence cost behavior are as follows:

  • Raw materials’ availability and quality used for production.
  • The location of the business and its nearness to the market.
  • The transportation cost incurred for the transportation of raw materials and finished products.
  • The power supply used for production and its nearness to the factory where the goods are produced.
  • The labor supply, their skills, and the wages they are given.
  • The source of financing the production process and the business activities.
  • The climate and its impact on raw materials and labor efficiency.
  • The government rules and the taxes imposed.
  • The scope of the business, outsourcing parts of the production process or services to other organizations, and the ability to tap resources.
  • The production size and its suitability.

Formula

The management uses a mathematical cost function to determine cost behavior. It can also be plotted on a graph.

The cost behavior formula is as follows:

Cost Function: y = MX + b

where,

b is the fixed cost

M is the variable cost and,

X is the number of units produced.

The management uses the following assumptions to simplify the use of a cost behavior formula:

  • The variation in the total cost results from the variation in a cost driver.
  • One can summarize the cost behavior into a linear function within a relevant range. The range can imply the field within which the cost and activity level relationship exists.

Examples of Cost Behavior

Let us understand the concept with the help of the following examples:

Example #1

Amacon Company manufactures computers. The rent of the factory where the computers are manufactured is $1,00,000 per month. The cost of raw materials required for one computer unit is $1,000. Every month the company manufactures 100 units of computers. The cost of production every month is $1,00,000 + (1000*100) USD = $1,00,000 + $1,00,000, which is $2,00,000.

After a certain point, Amacon Company decides to expand its monthly production. It starts producing 120 units of computers. Thus, the monthly production cost changes to $1,00,000 + (1000*120) = $1,00,000 + $1,20,000, which is $2,20,000. This is a cost-behavior analysis example.

Example #2

The USA’s fruit and vegetable market size is expected to grow by $25.39 billion in 2027. The rise in veganism is a contributing factor. Since consumers are willing to shift from animal-based products to plant-based products, the production of fruits and vegetables and increasing consumer demands are also increasing. The production cost has recently shifted due to modern technologies being used for higher productivity. Several innovative agricultural tools and methods are being employed, the cost of which is higher than the traditional farming methods. This is a cost behavior analysis example.

Importance

 The importance of cost behavior is discussed below:

#1 – Creating A Budget

The behavior of certain costs is a significant factor the management considers while creating a budget. This budget helps plan future activities and keeps provisions for meeting unprecedented changes in the business process. The budget also helps in forecasting future conditions.

#2 – Controlling Cost

The management uses this cost analysis to control the overall cost of the business. This, in turn, helps the managers in making financial decisions that help increase the profit margin.

#3 – Analyzing Cost-Volume-Profit

Cost-volume-profit is the study of how a shift in production volume can impact a business’s profit. This behavior analysis is instrumental in analyzing cost-volume-profit, a critical factor in strategic business decisions.

Frequently Asked Questions (FAQs)

Do managerial incentives drive cost behavior?

Yes, managerial incentives can drive this behavior. Managerial incentives help employees achieve organizational goals and increase productivity. In addition, the product or service attributes, which affect sales, are also influenced by the managers. As a result, this behavior can be impacted by managerial incentives.

How do organizations identify cost behavior patterns?

The organization or the management studies how the cost behaves as a resultant change in the production process or sales. They also identify the cost type like fixed, variable, mixed, or other.

When is cost behavior analysis used?

Cost behavior analysis is used when the management wants to identify beforehand whether a change in a specific activity will create a rise or fall in the operating cost. For example, if a business wants to expand its production or if it wants to introduce a new item in its product line, the company would need to invest more in the production cost.

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