In evaluating a business decision, it is essential to understand how the costs associated with a given course of action will change over a range of activity levels. When managers talk about cost behavior, they are referring to how total costs change in response to changes in the activity level. Cost behavior consists of
- Variable Cost
Any total cost that varies in proportion to business activity is variable. The activity can be any repetitive event that serves as a measure of output or usage, such as units sold, units produced, minutes talked, or miles are driven. As the level of activity increases, the total cost increases by the same proportion. Conversely, as the level of activity decreases, the total cost decreases by the same proportion. So a 10% increase in volume results in a 10% increase in total variable cost, and a 10% decrease in volume results in a 10% decrease in total variable cost. Variable costs have two main characteristics: (a) The total cost varies in proportion to changes in the level of activity (b) The cost per unit remains constant, regardless of the activity level. 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.
- Fixed Cost
In contrast to a variable cost, the total amount of a fixed cost does not change with the activity level. However, the cost per unit does change. The higher the level of activity, the lower the fixed cost per unit. Fixed costs have two main characteristics: (a) The total cost remains fixed, regardless of changes in the level of activity; (b) The cost per unit varies inversely with changes in the level of activity. Examples include property taxes, insurance, rent, supervisory salaries, and straight-line depreciation on buildings and equipment.
- Mixed Cost
Mixed costs are costs that contain both variable-cost and fixed-cost components. Mixed costs, therefore, change in total but not proportionately with changes in the activity level. For example, each month, the electric bill includes a flat service fee plus a usage charge.
Sources:
- Google Image. (2022).
- Charles E. D. and Davis E. (2020). Managerial Accounting. 4th Edition. Wiley.
- Paul D. Kimmel, Jerry J. Weygandt, Jill E. Mitchell. (2021). Accounting: Tools for Business Decision Making. 8th Edition. Wiley.
Costs that do not change in direct proportion to increasing levels of activity
What are Step Costs?
Step costs, also called stair-step costs, are costs that do not change in direct proportion to increasing levels of activity. In other words, step costs are constant at a certain activity level but increase or decrease when an activity threshold is met.
Understanding Step Costs
Step costs are extremely important to consider when a company is about to reach a new activity level. If neglected, they can cause a business to miss out on profits.
John operates a company that produces pens. A machine costing $15,000 is capable of producing up to 1,000 pens. Assume that there are no additional costs related to producing pens (no raw materials, labor, etc.). As such, the cost of machinery is an example of a step cost. The information is illustrated below:
As shown in the illustration, the cost of machinery closely resembles steps. At a production of 500 or 750 pens, only one machine is required. The total cost is, therefore, $15,000. However, at the production of 1,500, the company must purchase an additional machine to expand its production capacity. At a production of 1,500 pens, the total cost is $30,000 ($15,000 x 2 machines). Therefore, it is an example of a step cost: costs that are constant at a certain level of activity and rise or decrease when a certain activity threshold is met.
Importance of Step Costs
Step costs are extremely important to consider when a company is about to reach a new activity level. If neglected, they can cause a business to lose unnecessary profits.
Continuing with the example above. Assume that John initially forecasted that the demand for pens would be 1,050 next year. Additionally, assume that each pen can be sold for $20.
To an individual who does not understand step costs, they may recommend purchasing two machines to meet the demand for 1,050 pens. The revenues generated from 1,050 pens are $21,000 (1,050 x $20). However, total costs (two machines) are $30,000. The purchase of the second machine that would only generate revenue for the sale of 50 additional pens would make the company much less profitable.
To an individual who understands step costs, they would recommend purchasing one machine and producing 1,000 pens and not 1,050. The revenues generated from 1,000 pens are $20,000 (1,000 x $20) and the total costs (one machine) are $15,000. The company would be generating $5,000 in profits at the given production level.
As shown above, investing in an additional machine would cause the company to lose profits! Therefore, it is key to consider whether incurring a step cost would be accretive to profits or not. In the example above, an additional 50 pens (revenues of $100) would be generated through a second machine costing $15,000. In such a scenario, it would not be worthwhile for the company to incur the additional cost to produce an additional 50 pens.
Example
Consider a company with a cost structure in the production of widgets as follows:
Assuming that the sale price of widgets is $30 and the company currently utilizes three machines and sells 125 widgets. Would you recommend the company to continue utilizing three machines or to cut down to two and only sell 100 widgets (the production capacity for two machines)?
Three machines with sales of 125 widgets
The total costs for the three machines are $3,000. The sales generated from 125 widgets are $3,750 (125 x $30). Therefore, the profit is $750.
Two machines with sales of 100 widgets
The total costs for the two machines are $2,000. The sales generated from 100 widgets are $3,000 (100 x $30). Therefore, the profit is $1,000.
Therefore, the company should only operate two machines and produce 100 widgets.
Step Costs in the News
Step costs are common – the cost of a new production facility, the cost of a new machine, supervision costs, marketing costs, etc., are all step costs.
For example, on July 17, 2019, FortisBC announced the completion of a $400-million expansion project that increased the company’s capacity from 35,000 a ton to 250,000 a ton. As such, the facility expansion project by FortisBC is a step cost.
Related Readings
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:
- Activity-Based Costing
- Cost of Goods Manufactured (COGM)
- Fixed and Variable Costs
- Target Costing