Cost behaviour analysis is a crucial part of the financial management and decision-making process in all organizations. By examining how various costs respond to changes in activity levels, managers can make an appropriate budgetary decision and set the most efficient prices for their company to achieve maximum profitability.
This article provides an understanding of cost behaviour analysis consisting of key objectives, various types, examples and the practical applications of analysis of cost behaviour.
Cost behaviour is a way in which a firm responds to changes in business volumes, which may include factors such as sales volume, production volume or other equivalent factors. It majorly covers the relationship between variable, fixed and mixed costs and how they change with the changes in operations. Knowledge of cost behaviour is crucial for managing costs and making realistic financial planning.
Cost behaviour analysis means to study the changes in costs with a change in volume of business activity.
In simple terms, it is concerned with identifying if costs go up, down or are even when a firm changes its production or sales volume. Being able to identify the behaviour of the various costs enables the business to forecast the effect the changes in various activity levels are likely to have on the total costs.
There are three primary categories of cost behaviour: They include the fixed costs, variable costs and mixed costs. Every cost category has a different response to changes in business activity, and it is important for managers to understand how to grasp these differences to handle resources efficiently.
Costs that remain the same with the volume of business activity are known as fixed costs. This means that if a company’s production levels rise or even decline, the amount of money it spends on fixed costs remains the same. Examples are rent, insurance and salaries of staff. However, in some situations, fixed costs are nonlinear meaning they may vary with the level of output but remain constant at certain levels.
Variable costs are impacted by changes in the level of task being produced or sold in a given timeframe. Hence, costs such as the cost of the raw material or direct labour will rise as a business organisation manufactures more products. On the other hand, when production is low, the variable costs are also low. Conversely, variable costs are related to the level of business operations.
Variable costs that are partially fixed are referred to as mixed costs or semi-variable costs. This in fact means that some costs are fixed and do not change with the level of production while other costs are directly related with the level of output or work done. costs are directly proportional to the level of production or activity. For example, utility costs are divided into base rate and usage rate which may also be described as a base rate plus a per unit rate.
The identification of cost behaviour at various levels of activity is a fundamental component of financial management. Several methods are employed to analyse cost behaviour, each offering different perceptions of fixed costs, variable costs and mixed costs and how they respond to changes in activity levels.
Below are the primary cost behaviour analysis techniques, along with a relevant formula for those that apply:
This is a very simple method employed to isolate the fixed and variable costs out of mixed costs on the basis of the maximum and minimum activity levels. The formula used to calculate the variable cost per unit is:
Variable Cost per Unit = High Activity Level − Low Activity Level / Cost at High Activity Level − Cost at Low Activity Level
Thus, fixed cost is calculated as total cost subtracted total variable cost at High or Low activity level after identifying variable cost.
This is a visual technique where cost information is displayed graphically with corresponding activity levels for the purpose of observing any patterns and relationships. Unlike the previous method, there is no formula, but this check aids in knowing whether something is a linear or nonlinear cost and whether there are outlying values.
Regression analysis is a statistical technique used for cost estimating to identify the relationship of costs and activity levels. It is more precise than the high-low method and generates a formula of the form:
Total Cost = (Variable Cost per Unit × Activity Level) + Fixed Cost
This technique helps develop a cost predictive formulation based on analytical consideration of past records of the total cost estimate within the firm.
This method covers cost types such as fixed costs, variable costs and the mixed costs which are determined from historical records and estimates. Since there is no specific formula for account analysis, it depends on past records and experience to classify costs properly into its respective heads.
Cost behaviour analysis focuses on several important areas of managerial finance, hence enabling firms to plan and make informed decisions. These focus areas include:
Finding out the instance when the total revenues equal total costs, that is when the company is neither producing a revenue nor a loss. Break-even analysis is important for pricing strategies and understanding the number of sales required to cover costs.
A method of estimating future costs and expenses with the help of historical data and known cost behaviour patterns. This helps managers to estimate the extent to which variation in production or sales will impact costs; hence improving financial planning and budgeting.
Understanding cost behaviour allows businesses to allocate resources effectively, ensuring that funds are spent whether on fixed or variable cost categories where they will have more impact.
By recognising cost behaviours, managers can rely on the scope of activity based, pricing or changing in cost behaviours to increase the profit margin as a means of achieving planned profitability.
Cost behaviour analysis enables one to set a standard and achievable pricing mechanism once the cost per unit of output has been ascertained and set the costs that yield profit.
It helps a business keep costs under control, as well as target areas where costs can be efficiently cut, for example by proportionately reducing production or adjusting variable costs during low-demand periods.
Consider a manufacturing company that manufactures custom furniture sees its variable costs, such as raw materials and direct labour, increase proportionally as orders increase. On the other hand, fixed costs do not differ with production levels, they involve rent and administrative salaries. But when a business expands beyond its means of operation, fixed costs may become nonlinear because of the need for additional resources or to acquire more space.
Understanding these cost behaviours enables the company to predict accurate expenses as well as make informed pricing decisions, and plan for scaling production, resulting in managing the costs and, therefore, profitability.
Cost behaviour analysis applies to several key areas of business management:
Cost behaviour analysis helps businesses to develop better budgets. For instance, knowledge of fixed, variable and mixed costs helps managers forecast how much they will have to spend at different activity levels.
Cost behaviour analysis focuses on enabling the managers to arrive at correct pricing strategies. For instance, by understanding the variable costs related to manufacturing each additional unit, organizations can define the price by which these costs have to be covered, to generate a profit.
The way costs behave at different production volumes is used in predicting the level of profits in a business. Cost behaviour analysis is essential for establishing the sales level to be achieved to attain the desired profit margin.
Cost behaviour analysis is a critical activity in making decisions. Cost behaviour provides managers to predict how costs would react to the changes in business activity. For instance, when a firm expects higher production levels, the cost behaviour analysis can help the managers predict other variable costs and determine whether the business can consume these costs without affecting profit margin.
Also, costs developed which identify what products should cost are called as standard costs. These costs are estimated costs which have been determined at what the product should cost in normal conditions. The understanding of these aspects comes from cost behaviour analysis, which provides the foundations for those standard costs on the basis of historical data and future predictions.
In conclusion, cost behaviour analysis is an essential part of financial strategy and planning. Knowing fixed, variable, and mixed costs as well as the changes they undergo when activity level varies, companies can predict costs, set the price, and make correct operational decisions on profitability. Cost behaviour analysis applies to a wide range of business functions whether determining a company's break-even point or preparing pricing strategies.
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What are the 4 types of cost behaviour?
The four types of cost behaviour are:
Fixed costs: These always stay the same, irrespective of the scale of operation and activity (like rent, insurance etc.).
Variable costs: These vary directly with the volume of output (such as are raw materials, wages depending on the number of hours worked)
Mixed costs: These consist of a part of both fixed and variable costs (for instance, electric power expenses that consist of a fee and a usage component).
Step costs: These are fixed to a certain level of output but rise as production reaches new levels (for example, when additional managers must be hired because of increased production).
What is a cost behavior analysis?
Cost behavior analysis can be described as the identification of the pattern that different costs take when activities change or when the volume of production is altered. This analysis assists businesses in anticipating how costs will behave to fluctuations in production or sales volumes hence planning better.
What is cost concept analysis and behaviour?
Cost concept analysis means that one must categorise various costs that the business entities face. Cost behaviour may be defined as the way in which these costs vary with production or activity levels. Combined, cost concept analysis and behaviour enable firms to anticipate the expenditures, set the prices and allocate the available resources.
What are the three costs of behaviour?
The three main costs of behaviour are:
Fixed costs: Non-variable costs, those expenditures that remain fixed in amounts irrespective of the extent of production.
Variable costs: Expenses that vary proportionately with the activity level of production.
Mixed costs: Costs that share some characteristics of both fixed and variable costs.