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Question: Cost Behaviour

Conventionally, it is often assumed that cost can be easily separated into fixed and
variable elements, and that the variable element behaves linearly and is affected
only by changes in the level of activities. Yet cost behaviour in practice is much more
complex than this simple model suggests.
You are required:
1. To explain the above statement.
2. To describe other possible approaches to analyse this problem of cost
behaviour.

Question 1
Costing is the process of arriving at an amount or figures that has to be paid or given
up in order to achieve an input/output.
This may be analysed in terms of two measurements;
- A physical quantity
- Price measurement
Traditionally, production was more labour intensive, so was quite a straightforward
process to use direct labour hours, machine hours and units produced to arrive at
costing figures.
However currently, to arrive at any product and/or service, (considering that
machines are used a lot more and a number of things are automated) a number of
hidden operations or processes are involved. These are known as activities or cost
pools, and have an impact on the cost of any production.
Within these cost pools are the many minute details called cost drivers, which
influence changes in the cost of a production with changes in the level of
occurrence.
Fixed costing is one which is not affected by changes in the level of activity, over a
defined period of time. Examples include; administrative salaries, rent, property
taxes, advertising in trade journals, depreciation of machinery based on a straight line basis.
It is important to note that, fixed costs are unchanged over a defined period of time
but may vary in the longer term.

Variable costing is one which varies directly with changes in the level of activity,
over a defined period of time. Examples include; direct material, direct labour, sales
commissions, fuel used by haulage trucks.
There is also semi-variable costing which is partly fixed and partly varies with
changes in the level of activity over a defined period of time. An example is with
office salaries, where there is a core of long-term staff on a pay-roll plus
employment of temporary staff in times of increased level of activity in the business.
It is also not quite the case that every costing can strictly fit the above definitions of
fixed and variable because in real life theres usually a mixture of the two occurring
concurrently and influenced by the time frame being captured. So the annual rent of
a production unit would be the same (fixed) for a given year, but increases in steps
in subsequent years (step cost).
The traditional method of costing will only be applicable and useful if the production
process is overly simplified and there are no hidden components (machine set-up,
machine scheduling, production line advertising, research and development,
material handling, component costs, packaging, sales and distribution) to the
process of arriving at the product or service.
A total cost is thus a summation of the effect of a products cost pools, influenced by
the cost drivers plus an eventual interplay of technology, the option to outsource or
otherwise, competition and the purchasing power of the consumer. No one variable
component can be used effectively and in isolation linearly to determine the cost
of a product or service rendered; the activities involved must be assessed and
costed.

Question 2
Cost has been traditionally classified as fixed cost (not affected by changes in the
level of activity in a specified period/time) and variable cost (varies directly with
changes in the level of activity in a specified period/time).
A cost that has both a fixed and variable component is called a semi variable cost
whilst a cost which is fixed over a specified period of activity, then changes because
an additional fixed cost has to be added, is a step cost.
Cost behaviour can also be looked at in terms of it being a direct cost (can be
specifically and exclusively identified with a given cost object/service) or an indirect
cost (cannot be specifically and exclusively identified with a given cost
object/service). Indirect costs are also called overhead costs.
It is always very important to remember that the terminology (direct or indirect) is
always with respect to a particular object or service. An item which is a direct cost
for a department may end up being an indirect cost for a product or service churned
out by the same department.
An example: electricity meter readings will be a direct cost for running a department
as a whole, but this same reading will be an indirect cost with regards to different
services that are rendered by the department, since it will be shared among those
services.
Another approach for looking at cost behaviour is to distinguish it into product cost
and period cost.
Product costs are those costs associated with goods or services purchased or
produced for sale to the customer. These costs belong to the product or service

intended for the customer whether they are completed, uncompleted or still part of
inventory.
A product cost will include both the direct and indirect costs of production. The total
of direct costs is described as the prime cost.
Period costs are those costs which are treated as expenses in the period in which
they are incurred. Examples include insurance premium for a factory premise, rental
of warehouse storage space, depreciation of machinery.
In a service organisation, all costs incurred up to the point of completion of the
service are regarded as product costs. All other costs such as advertising collecting
cash from the customers would be period costs.
Costs can also be looked at as avoidable cost (costs that can be saved if an activity
or business did not exist) and unavoidable costs (costs that cannot be saved/and
would be incurred whether or not an activity existed in a business). These also are
alternative terms to describe relevant or irrelevant costs.
Another approach is the Activity-based costing (ABC) which is a methodology for
more precisely allocating overhead costs to those items that actually use it. The
fundamental advantage of using an ABC system is to more precisely determine how
overhead is used.
Costs are divided into cost pools and individual cost drivers are assessed for their
contributions to the total cost.
ABC works best in complex environments, where there are many machines and
products, and tangled processes that are not easy to sort out.