Cost behavior analysis is the study of how specific costs respond to changes in the level of business activity. As you might expect, some costs change, and others remain the same. For example, for an airline company such as Southwest or United, the longer the flight, the higher the fuel costs. On the other hand, Massachusetts General Hospital’s costs to staff the emergency room on any given night are relatively constant regardless of the number of patients treated. A knowledge of cost behavior helps management plan operations and decide between alternative courses of action. Cost behavior analysis applies to all types of entities.
The starting point in cost behavior analysis is measuring the key business activities. Activity levels may be expressed in terms of sales dollars (in a retail company), miles driven (in a trucking company), room occupancy (in a hotel), or dance classes taught (by a dance studio). Many companies use more than one measurement base. A manufacturer, for example, may use direct labor hours or units of output for manufacturing costs, and sales revenue or units sold for selling expenses.
For an activity level to be useful in cost behavior analysis, changes in the level or volume of activity should be correlated with changes in costs. The activity level selected is referred to as the activity (or volume) index. The activity index identifies the activity that causes changes in the behavior of costs. With an appropriate activity index, companies can classify the behavior of costs in response to changes in activity levels into three categories: variable, fixed, or mixed.
Variable costs are costs that vary in total directly and proportionately with changes in the activity level. If the level increases 10%, total variable costs will increase 10%. If the level of activity decreases by 25%, variable costs will decrease 25%. Examples of variable costs include direct materials and direct labor for a manufacturer; cost of goods sold, sales commissions, and freight‐out for a merchandiser; and gasoline in airline and trucking companies. A variable cost may also be defined as a cost that remains the same per unit at every level of activity.
To illustrate the behavior of a variable cost, assume that Damon Company manufactures tablet computers that contain $10 cameras. The activity index is the number of tablet computers produced. As Damon manufactures each tablet, the total cost of cameras used increases by $10. As part (a) of Illustration 18-1 shows, total cost of the cameras will be $20,000 if Damon produces 2,000 tablets, and $100,000 when it produces 10,000 tablets. We also can see that a variable cost remains the same per unit as the level of activity changes. As part (b) of Illustration 18-1 shows, the unit cost of $10 for the cameras is the same whether Damon produces 2,000 or 10,000 tablets.
ILLUSTRATION 18-1 Behavior of total and unit variable costs
Companies that rely heavily on labor to manufacture a product, such as Nike or Reebok, or to perform a service, such as Hilton or Marriott, are likely to have many variable costs. In contrast, companies that use a high proportion of machinery and equipment in producing revenue, such as AT&T or Duke Energy Co., may have few variable costs.