Investigating cost behaviour studies


The Rise and Fall of Management Accounting, Johnson and Kaplan (1987) criticised the traditional cost allocation techniques that failed to reflect the production methods and cost patterns of the time. In the decade and a half that followed, a new focus on cost behaviour and patterns has developed. Cost behaviour studies are important due to the influence on the degree of operating risk, break-even point and safety margin, sensitivity, profit

planning and control, and decision making (Correia, Flynn, Uliana and Wormald 2003; Horngren, Datar and Foster 2003). Knowledge of the cost behaviour structures of companies may be applied in other investigations, such as to determine the difference between the cost structure of labour intensive and that of technologically developed companies. This is done in order to draw a comparison between a company's cost structure and its level of technological development, since a technologically developed company is expected to have a higher operating risk than a labour intensive company (Garrison and Noreen 2000:300). Fritzsch (1998) supports the notion that, in the short run, most capital-related inputs are fixed costs, while an input such as labour is a variable cost. La Roy (2000) agrees that costs tend to become fixed if more technology is introduced into the business. Cost classification (into fixed and variable components) nevertheless differs for companies all over the world. Horngren et al (2003:328), and Garrison and Noreen (2000:202) also give examples of different manufacturing companies in different countries classifying similar cost items differently.

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Cost behavior and classification

The relationship between costs and activity is known as cost behavior, while the cost structure of a company refers to the compilation or the nature of its production costs -whether fixed, variable or mixed (semi variable). Variable costs can be divided into true variable cost and step variable cost, whereas fixed costs can be divided into committed and discretionary fixed cost. (In this regard see Horngren et al 2003; Garrison and Noreen 2000; Blocher, Chen and Lin 2002; Hansen and Mowen 2000; Hilton 1997.) Companies with a high fixed cost component and low variable cost component are more sensitive to changes in activity than companies with a low fixed cost component and a high variable cost component (Correia et al 2003). Thus, it is the fixed cost component that is responsible for the operating risk of a company. Benedetti (2000) suggests that, when demand declines, a company should try to shift fixed cost to variable cost by means of flexible contracts, outsourcing, cost-led pricing and pay-for performance plans. Capital intensive companies are at greater risk than labor intensive companies because of their relatively high fixed cost and low variable cost components (Garrison and Noreen 2000:300; La Roy 2000). Thus, compared to labour intensive companies, capital intensive companies have a high contribution margin, high operating leverage and high volatile profit. The degree of technological development can be used to determine whether a company is capital

intensive or labour intensive. In technologically developed companies, production processes are mainly automated and machines perform the bulk of the production processes. Some of these machines are controlled by computers, enabling companies to produce better quality products, deliver better services,

keep a smaller amount of inventory and improve the adaptability of the production process. The costs involved in implementing such automated production processes are high, and therefore result in high fixed costs (Fry, Stoner and Hattwick 1998:465; Hilton 1997).There are a variety of reasons why manufacturing companies classify costs as fixed or variable components. These reasons include price fixing, decreasingcosts, profit planning, cost-benefit analysis, cost-volume-profit analysis and budgeting (Horngren, Foster, Datar and Uliana 1999). Manufacturing companies may also use different methods to classify cost behavior, namely managerial judgment, engineering approach, quantitative analysis (such as the high-low method), visual fit and regression analysis (Horngren et al 2003;Drury 2000). (The sources mentioned could also be consulted for the advantages and disadvantages of each method.) The method used to classify cost behavior may affect the results. Other factors will also play a role, such as the experience of the person doing the classification, the unique nature of the company, social norms, managerial policy, accounting policy, cost object and production level (Oberholzer 1998). With so many variables involved it is quite understandable that different companies classify similar cost items differently. The following may be some of the reasons for this contradiction:

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Accounting policy: Company A has an accounting policy that uses the straight-line method to calculate depreciation. This company will report depreciation as a fixed cost because a fixed amount is written off each period, regardless of the production activity. Company B has a policy to write off depreciation according to the use of the asset. This company will report depreciation as a variable cost.

Cost driver: A company pays a fixed salary to each of its quality controllers. Person A will use the number of units inspected as the cost driver and conclude that it is a fixed cost item, as the total salary cost of the controllers does not vary according to the number of units inspected. Person B will use

the number of controllers as the cost driver and obviously conclude that it is a variable cost, as the total salary cost will change if the number of controllers changes.

Term: Most companies indicated that building occupancy is a fixed cost. This is probably the case if the focus is on the short term, because buildings are not occupied and evacuated on say a weekly, or monthly basis, according to production needs. If the focus is on the long term, building cost will be more variable, because in the long term it is easier to adjust the building space according to a permanent change in the production needs.

Managerial policy: The circumstances of Company A are such that it has a managerial policy to send a vehicle to the supplier on a daily basis to pick up materials. The company will report this part of the material handling cost as fixed, because the number of trips to the supplier is totally independent of Cost behavior classification and cost behaviour structures of manufacturing companies 184 Meditari Accountancy Research Vol. 12 No. 1 2004 : 179-193 the production volume. Company B may have a managerial policy to send avehicle to the supplier every time material is needed for a production unit. It

will report this part of the material handling cost as variable, due to the linear relationship between the production quantity on the one hand and the number of trips and the cost thereof on the other hand.

Utilization level: Company A will report the cost of energy as a variable cost since there is a linear relationship between the production output and the kilowatts used. Company B uses its full capacity every time and consumes the same number of kilowatts during each period. This company will report these costs as fixed, because they remain unchanged from one period to the next. In this case the utilization level therefore influences the classification.

Cost object: Another possible reason why companies reported huge differences in their cost structures is because costs are calculated for different cost objects. Costs can be calculated to determine the expenditure for the whole company, for product (or job) profitability, for customer profitability or for channel profitability. (A channel is for example a specific process, department, selling point, etc., through which a product passes). The following is an example (Table 1) of four cost items classified differently according to the cost object concerned.

Direct labor will probably be a fixed cost for the company as a whole because there are a fixed number of workers who receive a fixed salary every month. Direct labor cost will be assigned to a product and to a customer by multiplying the direct labor rate by the time used, and therefore it will be classified as a variable cost. Direct labor will be fixed with regard to a production department (channel) because it is possible to determine exactly how many workers there are in the department. Rent for buildings is a fixed cost for the company as a whole because the amount is payable, regardless of the production activity. From a product and customer point of view it seems to be a variable cost, as it will be allocated as part as the overhead rate (for example by using direct labor hours as allocation base). The channel will report it as a fixed cost because it is possible to determine the exact floor space of a specific department relative to the whole company. The design cost will be variable to the company as a whole if this job is outsourced and the company pays only for the number of designs, but the cost to design a product is fixed, because only one design is involved. The company as a whole will classify quality controllers' salaries as a fixed cost because there are a fixed number of controllers, each receiving a fixed salary. For a product, customer and channel, this cost will be variable, because the time multiplied by the rate will be charged to each one of these.

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Absorption Costing:

Absorption costing is a process of tracing the variable costs of production and the fixed costs of production to the product. Variable Costing traces only the variable costs of production to the product and the fixed costs of production are treated as period expenses. There are three different types of

Absorption Costing Systems:

Job Order Costing

Process Costing

ABC Costing

In Job Order Costing costs are assigned to the product in Batches or lots.


Furniture manufacturing

Bicycle Manufacturing

In Process Costing, costs are systematically assigned to the product, since there are no discreet batches to assign costs.

Soda Manufacturing

Oil Distilling

ABC Costing assigns cost from cost centers to the product -Best in a multi product firm, where there are different volumes

Consider the following example:

A company is formed to manufacture computers. It starts the year with $2000 in cash and equity. During the year the company incurs $500 in payroll costs, $500 in rent for the plant, and $500 in raw materials. During the year he makes 100 computers.

What will his profits (or loss) be if he sells no computers?

What will his profits be if he sells all 100 computers at $20 per computer?

Job Order Costing is one method of allocating the costs of manufacturing to the product. In Job order costing the manufacturing costs are allocated to the product by batch.Job order costing is appropriate when the firm makes products in small batches, and each batch consumes different amounts of direct labor, direct materials, and processing time/energy.A survey in "Cost and Management Accounting Practices.." in the Management Accounting Research Centre indicate that job order costing is the primary method of costing in the following industries:




Furniture and fixtures

Consider a computer manufacturing company. They have a plant that receives an order for 50 computers. They need to determine how much it costs to manufacture these computers. The batch of 50 computers starts with the introduction of direct materials:

-50 Computer Cases-50 Motherboards-50 CD drives, and floppy drives

Individuals mount equipment, add additional memory etc, to meet the specifications of the job. Special machines are also used to attach the disk drives. In Job order costing the manufacturing costs are allocated to the product by batch. Thus the company allocates manufacturing costs to the 50 Computers ordered. The Job is assigned a Lot #. Lets call this Lot # 1118. When the Parts warehouse provides 50 motherboards, cd roms etc… to the manufacturing group, they allocate the costs of these raw Materials to LOT #1118. The individuals that assemble these computers record the time spent assembling Lot 1118 on their time sheets. The accounting system will allocate the payroll costs at the hourly wage rate to the job. Finally, the cost of the plant, the cost of the specialized machines, the utilities, the accounting system that tracks costs within the plant, the accountant running the system etc must be allocated to the product. This is known as overhead allocation.

In the above case study job order costing is used in order to estimate the total cost for the organization. Activity based costing is also the preferable in the above scenario as in it value advantage could be achieved in the above costing the cost is estimated on the basis of job received with in a organization but if ACB costing would used company would distribute its costs on the basis of activities differ in numbers that give an advantage to distribute maximum cost to the huge processes and minimal cost to the lower ones. Break-even analysis is also the other option for the organization to achieve cost advantage in that company would estimate that on how many units they are able to achieve their cost and after that all the unit sold is their profit, break-even analysis is useful in the industries where items are perishable in the luxury items it is not suitable to implement. The knowledge of the managers for the cost is useful as it gives an edge to attain competitive advantage in the market the understanding of the manager regarding the cost concepts will help organization to achieve their long term objectives.

Task 3

Value Analysis

Value Analysis can be defined as a process of systematic review that is applied to existing product designs in order to compare the function of the product required by a customer to meet their requirements at the lowest cost consistent with the specified performance and reliability needed.

This is a rather complicated definition and it is worth reducing the definition to key points and elements:

Value Analysis (and Value Engineering) is a systematic, formal and organized process of analysis and evaluation.

It is not haphazard or informal and it is a management activity that requires planning, control and co-ordination.

The analysis concerns the function of a product to meet the demands or application needed by a customer. To meet this functional requirement the review process must include an understanding of the purpose to which the product is used.

Understanding the use of a product implies that specifications can be established to assess the level of fit between the product and the value derived by the customer or consumer.

To succeed, the formal management process must meet these functional specification and performance criteria consistently in order to give value to the customer.

In order to yield a benefit to the company, the formal review process must result in a process of design improvements that serve to lower the production costs of that product whilst maintaining this level of value through function.

Defining Cost and Value

Any attempt to improve the value of a product must consider two elements, the first concerns the use of the product (known as Use value) and the second source of value comes from ownership (Esteem value). This can be shown as the difference between a luxury car and a basic small car that each has the same engine. From a use point of view both cars conduct the same function - they both offer safe economical travel (Use value) - but the luxury car has a greater esteem value. The difference between a gold-plated ball pen and a disposable pen is another example. However, use value and the price paid for a product are rarely the same, the difference is actually the esteem value, so even though the disposable pen is priced at X the use value may be far less.

It is important for all managers to understand the nature of costs in the factory and for any given product. Whilst there is no direct relationship between 'Cost' (for the factory) and customer 'Value' in use and esteem, this education process is important. A shocking figure, that is often used as a general measure, is that typically 80% of the manufacturing costs of a product will be determined once the design drawing has been released for manufacturing.

The costs of production are therefore 'frozen' and determined at this point. These costs include the materials used, the technology employed, the time required to manufacture the product and such like. Therefore, the design process creates many constraints for the business and fixes a high degree of the total product cost. It is therefore a process that demands periodic review in order to recover any 'avoidable' costs that can be removed throughout the life of the product (by correcting weaknesses or exploiting new processes, materials or methods) and lowering the costs of production whilst maintaining its Use value to the customer.

Basically, there are three key costs of a product:

Cost of the parts purchased: These are costs associated with the supply of parts and materials.

Cost of direct labour used to convert products.

Cost of factory overheads that recover the expenses of production.

Although there are three elements of total cost accumulation it is traditionally the case that cost reduction activities have focused on the labour element of a product. Activities such as work-study, incentive payments and automation have compressed labour costs and as a result there is little to be gained, for most companies, in attempting to reduce this further. Instead, comparatively greater gains and opportunities lie in the redesign and review of the products

themselves to remove unnecessary materials and overhead costs.

This approach to the 'total costs' of a product involves taking a much broader look at the way costs in the factory accumulate and the relationship between costs and value generation. These new sources of costs and evaluations would therefore include such sources as:

Cost of manufacture

Cost of assembly

Cost of poor quality

Cost of warranty

A detailed understanding of how costs are rapidly accumulated throughout the process of design to the dispatch of the product is key to exploiting the process of VA. All VA activities are aimed at the reduction of avoidable and unnecessary costs, without compromising customer value, and therefore the VA process should target the largest sources of potential cost reduction rather being and indiscriminate or unsystematic process (such as focusing on

labour alone). It is therefore preferable to take the holistic approach to understanding costs and losses in the 'entire system' of design and conversion of value in order to determine how to achieve customer service 'functionality' at a minimal cost per unit.

The Focus of Value Analysis

The key focus of the VA approach is therefore the management of 'functionality' to yield value for the customer. Let us emphasize this point a little. Not that long ago, consumers of electric kettles were offered a variety of different types of metal-based boiling device. The value of a kettle is derived through heating water and therefore its functionality can be determined (temperature, capacity, reliability, safety etc.). Now faced with the same functionality (to boil water), designers would probably look towards a kettle made of plastic. Plastic has the same functionality as metal in terms of containing and boiling water. The action to boil water is conducted by the same part - known as the element. However the switch from metal to plastic does not impair this value and functionality with the customer -

they still want to boil water - but it does result in a cost saving for the manufacturing company. If a company that traditionally made metal kettles did not review its design process then it would be severely disadvantaged when attempting to compete against the lower cost plastic alternative. This is a simple example used only to provide an illustration of the VA concept but it does demonstrate the point of maintaining value whilst reducing costs.

There is a vast importance exist when it comes to costing procedures, managers should need to understand the fact that the use of the costing have a direct impact on the organization profitability and especially on the per unit cost of the products that organization produces. The value analysis helps organization to review their processes that helps the organization best in achieving their overall organization goals. Value analysis helps the organization to charge the extra premium from their clients by incurring some cost that has extra value to the ultimate customers. Managers should need to develop strategies and adopt such methods that helps in attaining optimal performance of their products by incurring limited cost. The selection of the costing method is purely based on the accounting techniques that company is following, traditional or new costing methods are available in the market the need is that manager should have knowledge of its implication and impact of the selected costing method on the ultimate product. If knowledge of costing is with the manager he would be in a better position to adopt the costing technique suitable with his/her environment.

ABC Costing

In the last two decades, competition in the global manufacturing environment has greatly intensified. For companies to survive and maintain profit margins, cost management techniques must constantly be improved (M. Morrow, 1993). Traditional cost accounting practices have been unable to respond to the changing information needs of manufacturing management. Today managers are finding that traditional methods are unable to support decision making in costing. Many companies are finding that traditional accounting methods are too late, too aggregated and too distorted to support decision making in costing (T. Johnson, R.S. Kaplan, 1987). Activity Based Costing (ABC) can help rectify the shortcomings of the traditional cost systems. Although researchers like Cooper, Kaplan and Turney have successfully explored cost theories and the development of ABC (see for example the papers of Cooper and Kaplan, they have not directly addressed the issue of effective transfer of cost technology to the manufacturing environment (J.S. Zuk, G.B. Kleindorfer, W.B. Nordgren, R.D. Moore, D.T. Phillips,1990). Without an appropriate computer model, the number of activity combinations and cost item variations required in ABC are extremely time consuming and costly, making implementation of the ABC difficult (R.B. Troxel,1980). Ideally, a dynamic modeling framework that can include both the operational aspect of a manufacturing system and financial variables needs to be developed for ABC. Only then can management move beyond the traditional static investment analysis of manufacturing systems. ABC systems relate organization spending of resources to the activities and business processes performed by these resources. At the facility level Activity cost drivers are used to collect information that is then driven down to the products, services and customers that create the demand for the facilities activities (R.S. Kaplan, R. Cooper, 1998). Activities can be classified into four general categories [R. Cooper, 1990]:

Unit level performed each time a unit is produced.

Batch level performed each time a batch of goods is produced.

Product level performed as needed to support the production of each type of product.

Facility level performed to sustain the factory performance such as rent, depreciation, insurance etc.

ABC has the conceptual advantage of providing the option of viewing ABCs facility costs as period costs or allocating them at the batch or product level. An example of the use of this classification can be found in (P.B.B. Turney, A.J. Startton, 1992). In ABC, variable overhead costs are traced to individual products, however it is not always

straightforward to assign fixed overhead costs to unit drivers. ABC systems have the advantage of associating many of the costs that are depend in traditional costing systems as Fixed overheads with

changes other than production volume. ABC therefore helps to clarify the relationship between the

causes of cost increase and decrease and the individual products. It is this cause and effect relationship

which allows management to differentiate between value added and non value added activities ABC systems therefore have the potential to be a Strategic Decision making tool for process redesign and continuous improvement (D.R. Hanson, M.M. Mowen, 1997).