Core Concepts of Accounting - Numbers and People Week 4: Andout OST Ehavior

Core Concepts of Accounting – Numbers and People Week 4
HANDOUT 4.2
COST BEHAVIOR
COSTS – AN INTRODUCTION
Cost – the Idea

The key concept of managerial accounting – cost – is defined as the amount of resources
foregone to achieve a specific objective. As has been mentioned above (see Handout 4.1)
the idea of cost is closely linked with the objective and with a certain “thing” it is referred to.
The Cost Object

In order to make decisions, managers have to answer the fundamental question: “How much
does this thing cost?”
This “thing” is called the cost object – that is anything for which we would specifically like to
measure the cost.
Examples of cost objects include:
▪ Product
▪ Service
▪ Project
▪ Customer
▪ Activity
▪ Department
▪ Program
The Cost Driver – the Idea

Costs associated with the cost object may be affected by many factors to a different extent.
Any factor that influences cost is called a cost driver (or cost generator or cost determinant).
We study cost drivers more thoroughly in Week 5 of this Course. For now, it is important for
us to recognize that a change in the level of the cost driver causes a change in the level of
cost of a related cost object.
VARIABLE COSTS AND FIXED COSTS

If a company increases the production output, the corresponding amount of resources
necessary to produce more products should also increase. However, in many cases this
increase of resources required is not proportional to the growth in production. In order to
understand why this happens we will consider the concepts of variable and fixed costs.
Strictly speaking, the concepts of variable and fixed costs are linked to the corresponding
cost driver:
▪ A variable cost is a cost that changes in proportion to the change in a cost driver
▪ In our discussion we consider the production output quantity as the only cost driver –
then a clear example of a variable cost will be the cost of raw materials used
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▪ A fixed cost is a cost that does not change with the change in a cost driver
▪ An example of a fixed cost in our discussion will be the rental payments for the
production premises
▪ Fixed costs may change over time but this change has nothing to do with the change
in a cost driver (in our case, the change in production output)
TOTAL COST
The sum of the variable cost and the fixed cost is the total cost for a certain object. In what
follows we will discuss the charts displaying the behavior of variable, fixed, and total costs as
functions of the production volume (the only cost driver in our case).
The analysis, although quite straightforward, reveals important relationships and provides
information for potential efficiency improvements.
The Total Cost Chart

In Fig. 4.2-1 (A, B, and C) the charts for variable, fixed, and total costs are shown. The total
cost may be represented by the following formula:
TC = FC + UVC  Q
where
▪ TC – Total cost
▪ FC – Fixed cost
▪ UVC – Unit variable cost
▪ Q – Quantity of output
1200
Total (USD)
Variable Cost
1000
800
600
400
200
0
0 50 100 150 200
Production Volume (Units)
Fig. 4.2-1A. Variable Cost and Output
5
1200
1000
Total (USD)
800
Fixed Cost
600
400
200
0
0 50 100 150 200
Fig. 4.2-1B. Fixed Cost and Output
Fixed
Total Costs
Cost
1200
1000
Total (USD)
800
600
400
200
0
0 50 100 150 200
Fig. 4.2-1C. Total Cost and Output
Unit Cost as a Function of Output Quantity

With the growth in output quantity Q the total fixed cost FC does not change while the Total
Cost increases. On a per unit basis, the variable cost component does not change with the
growth in output quantity while the fixed cost component gets progressively smaller.
The lower limit of the unit cost is clearly the unit variable cost (UVC).
The dependence of unit cost on the output quantity is an important factor in pricing. The
overall analysis is called CVP (cost-volume-profit) analysis.
In what follows we perform the simple CVP analysis for the following inputs (see Fig. 4.2-2):
▪ FC = $400
▪ UVC = $6
▪ Then for the total cost per unit (TUC) we have:
TUC = FC/Q + UVC = 400/Q + 6
The TUC has the meaning only when the output quantity is defined.
6
Fig. 4.2-2. Total Unit Cost and Output Quantity
Revenue and Profit

The CVP analysis is represented in Fig. 4.2-3.
Fig. 4.2-3. The Cost-Volume-Profit Chart
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We have added another important input – the unit selling price (USP) in the amount of $8.50:
▪ FC = $400
▪ UVC = $6
▪ USP = $8.50
▪ Then for the total revenue (R) we have:
R = USP  Q
Combining with the expression for the total cost
TC = FC + UVC  Q
and setting R = TC we obtain an expression for the break-even point (BEP):
R = USP  Q = FC + UVC  Q = TC,
𝐹𝐶
𝑄(𝐵𝐸𝑃) =
𝑈𝑆𝑃 − 𝑈𝑉𝐶
For the above inputs (FC = $400, USP = $8.50, UVC = $6) we get Q(BEP) = 160 units.
Contribution Margin
By definition, the contribution margin (CM) per each unit sold is the difference between the
unit selling price and the unit variable cost:
UCM = USP – UVC
Therefore, the expression for the break-even point volume in the previous section can be
rewritten as follows:
Q(BEP) = FC/UCM
A funny chart on the next page illustrates the core idea of the contribution margin.
Each droplet USP that falls from the “Revenue” pipe is the revenue from each unit sold.
A part of this revenue goes to cover variable costs – this is exactly UVC. They leave the
distribution funnel. The remainder – the amount equal to the USP – UVC is exactly the
contribution margin per unit (UCM). The UCM is the amount that goes to fill up the reservoir
labeled “Fixed Costs”.
When UCM droplets fill up the Fixed Costs reservoir the break-even point is reached (see the
equation above). After that (but only after that!) every next UCM falls to the “Profit” cup.
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Fig. 4.2-4. The Contribution Margin Concept
The Use of CVP Analysis

The CVP analysis clearly indicates four basic ways of improving efficiency:
▪ Increasing USP
▪ Reducing UVC
▪ Reducing fixed costs (FC)
▪ Increasing output volume (Q)
The mentioned factors are rarely independent. For example, increasing USP often leads to
the reduced production output due to the smaller demand.
As a result, in the use of CVP analysis considerable attention should be paid to the
interdependence of various contributing factors.

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Core Concepts of Accounting – Numbers and People Week 4

Cost – the Idea

The Cost Object

The Cost Driver – the Idea

VARIABLE COSTS AND FIXED COSTS

The Total Cost Chart

Fig. 4.2-1A. Variable Cost and Output

Fig. 4.2-1B. Fixed Cost and Output

Fig. 4.2-1C. Total Cost and Output

Unit Cost as a Function of Output Quantity

Fig. 4.2-2. Total Unit Cost and Output Quantity

Revenue and Profit

Fig. 4.2-3. The Cost-Volume-Profit Chart

Fig. 4.2-4. The Contribution Margin Concept

The Use of CVP Analysis

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