Cambrige AS and A Level Accounting Notes (9706)/ ZIMSEC  Advanced Accounting Level Notes: Cost Behaviour: Fixed Costs, Variable Costs and Semi-Variable Costs

  • Costs can be classified in a number of ways
  • One way to classify costs is by behaviour
  • This involves determining how certain costs will vary according to the organisation’s level of activity
  • For example how rentals change when the organisation produces say 500 units compared to 1000 units
  • This knowledge would be essential for decision making
  • Often managers do what if analysis:
    • What would happen if the business increased it’s output to 3000 units
    • How many kilograms do we need to sell in order to break even at the current price
    • What if we reduced the price by 10% what would be the overall effect on things
  • All this would not be possible without classifying costs by behaviour
  • When it comes to classification by behaviour all costs are traditionally divided into three:
    1. Variable Costs
    2. Fixed Costs
    3. Semi-variable costs

Variable Costs

Variable Costs

  • Variable cost refer to costs that vary in proportion to the level of activity
  • That is these costs increase whenever the level of activity (units produced etc) increases
  • For example if output is doubled the expectation is that variable costs will double
  • For this reason if a total variable cost graph were to be created it would be a linear graph with a constant gradient much like the one shown above
  • This means that the variable costs per unit is constant i.e. fixed
  • Examples of variable costs include:
  • Labour for example when assembly line workers are paid per unit produced ( Piece Rate System)
  • Direct materials i.e. the cost of raw materials used in production
  • Let’s say each table produced requires wood worth $50
  • If the business in question produces 1000 tables the cost of wood would be $50 000
  • If they produce double the number of tables they would need 20000 x $50 = $100 000 worth of materials
  • As can be seen the cost of direct materials varies with the level of activity,
  • The more is produced the higher the costs and vice versa

Fixed Costs

Fixed Costs

  • Fixed Costs are those costs that remain constant over wide ranges of activity for a specified time period
  • They are not affected by the changes in levels of activity
  • When plotted on a graph as shown above you get a straight line that is parallel to the x-axis
  • Examples of fixed costs include:
  • Depreciation of machinery,
  • Salaries of supervisors
  • Leasing costs for equipment e.g. Delivery vehicle leasing costs
  • Fixed Costs per unit decrease as the level of activity increases
  • With each unit produced they approach zero
  • Consider a company that leases a truck for $3 000 per year to use when making deliveries
  • If they produce 0 tables they still have to pay the leasing company $3 000
  • If they produce 1 000 tables they still have to pay $3 000
  • In fact it does not matter if they produce 2 000 tables for whatever they produce they still are required to pay the leasing fee of $3 000
  • However on a per unit basis if they produce 1 000 tables the fixed cost attributable to each table would be:
  • \dfrac{\$3 000}{1000}
  • That is $3 per table
  • If the business produces 30 000 tables the fixed cost attributable to each table becomes:
  • \dfrac{\$3 000}{30000}
  • That is 10 cents per table
  • As already pointed out the fixed cost per unit approaches zero as the level of activity increases
  • In mathematical terms the graph of fixed cost per unit would produce a curve that is asymptomatic to the x-axis

Semi-variable costs

Semi Variable Costs

  • In the real world there are costs that are neither variable nor fixed
  • There are costs for example that remain constant within the borders of certain levels of activity
  • When the level of activity is increased beyond a certain level the costs increase but not in a linear fashion
  • Such costs usually increase in a stepped fashion as shown in the graph above
  • An example would be warehouse rental costs
  • A company could pay $1 000 to rent a warehouse which would be adequate to store between 0 and 5 000 units
  • Any increase in units produced and stored in this warehouse would within these confines would not affect the payable rentals
  • However any increase to 5 0001 units might require the business to rent an additional warehouse with a capacity to store up to 5 000 more units for an additional $1 000 bringing the total warehouse rentals to $2 000
  • Another example would be supervisor salaries at some point if the level of activity is increased an additional supervisor would be necessary
  • All these costs are examples of semi fixed/ semi variable costs

NB

  • The distinction between fixed and variable costs is made in the short run
  • Short run- is a period period during which only some factors or variables can be changed because there is not enough time to change the others
  • In the long run all costs are can be varied
  • The exact duration of what constitutes the short run varies from entity to entity depending on the entity’s nature of operations as well as other factors

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