Cost behavior is the changes and trends that occur to the total cost as a result of a change in any business activity. The main ideal behind any business entity is to earn profits. Businesses are faced with ever changing environments and therefore it is important to have a clear understanding of the various cost behavior patterns that face businesses. Additionally, these cost behavior patterns are important in predicting trends in expenses that arise due to change in volume of sale and the general production process. Further, having good knowledge about the concepts of costing is important in determining when and how the concepts are to be used in an organization.
This paper seeks to explain the various types of cost behavior patterns that are present in a business setup. Further, the paper classifies the various costs incurred by Eddison Electronic Company resulting from its operations and assets. Additionally, the paper analyses the various costing methods and their applicability to different business environments.
Type of costs
Various types of costs exist and they are classified depending on its association with sales and how they are affect by changes in sales volume. The costs are broadly classifies as fixed costs, variable costs and mixed cost;
Fixed costs are costs incurred by a business entity which are fully independent on the volume sales (Upton, 1953). This cost will be incurred even in situations where the business temporarily closes down. They include rents, long term leases, buildings, machinery, and equipment. This cost is further categorized into discretionary fixed cost and committed fixed cost depending on the level of control that managers have over the cost. Discretionary fixed costs are the cost that managers have control and can therefore be minimized in case of economically hard times (Upton, 1953). On the other hand, committed fixed costs are the costs that managers have very little control over. Graphically it is represented as shown below.
These are costs that are dependent on the volume of output, they either increase or decrease depending on the changes that occur in the volume of output (Hendriksen, 1977). It increases with an increase in output because the costs are influenced by the amount of units produced; examples are raw materials, utilities, salaries and wages. Taking an example of raw material, an increase in output volumes may be as a result of an increase in the volume of raw material used in the production. Graphically it is represented as shown by the graph below.
An interpretation from the graph implies that an increase output lead to an increase in the variable cost.
These are cost that show characteristics that is partially similar to that of fixed cost while at the same time showing the characteristics similar to those of variable cost (Hendriksen, 1977). The cost implies that in case there is no production the cost will be incurred and an increase in production increases the cost, examples are electricity bills, water bills and sewage bills. In the example of electricity bill, if there is no production the there is a minimum bill to settle for the supply of power while if the production increases the cost of electricity also increases.
A Review of Eddison Electronic Company
Eddison Electronic Company is involved in the production and sale business and therefore the various cost behaviors patterns apply to the company. Among the fixed costs that exist in the company include; land, plant and equipment, maintenance expenses, direct labor, bonds and notes expenses, these are the bills that the company must settle regardless of the output volume (Upton, 1953). On the other hand, the variable cost for the company include; indirect labor, utilities, factory supplies and cost of raw material, those cost is influenced by output volume. Finally, the mixed cost of the company include; insurance, administrative expense, salaries, and income tax.
Relationship between Sales Volume and Cost Behavior Patterns
Unit fixed cost is the arithmetical expression of the total fixed cost divided by total sales units. This cost is inversely proportional to the volume of sale implying that an increase in sales volume leads to a reduction in the unit fixed cost. This is because the fixed cost has been spread over a large number of units hence lowering the average cost of each unit.
The total fixed cost is not affected by a change in the volume of output, therefore, it remains constant. This implies that an increase or decrease in the volume of sales does not lead to any change in the total fixed cost; therefore it remains constant throughout the production process. The total variable cost increases with an increase in output volume, the relationship is directly proportional. Finally, the unit variable cost remains constant with change in sales volume; it is not affected by an increase or decrease in the volume of output (Howard & Upton, 1953).
Different costing methods exist depending on the type of production and the strategies that exist in the production process. Job costing is a type of costing in which a company values its products depending on the value of individual job component performed on the product. This method is mostly applicable where clients make orders for products. Secondly, service costing is a type that t is applied on untouchable services rather that goods. Thirdly, unit costing is the type which involves costing of products that are identical countable, therefore allowing the products to be valued individually. Finally, contracting costing is the where different contracts are treated separately and therefore the value of the whole production process is the summation of the individual contract cost (Howard & Upton, 1953). This type of costing is mainly applied for civil and engineering work which is usually of large magnitude.
Target Costing Concept
This is a system in which the cost of products is derived from the existing and prevailing market standards(Hendriksen, 1977). In the concept, the cost of commodities is established by working backwards form the market price so as to set the required price (Howard & Upton, 1953). Mathematically it is expressed as;
Target cost= Expected selling price- required profit.
Eddison Electronic Company can apply the concept in order to earn more profit , however, adequate market research must be done to ensure the correct market price is established. The company can then meet the target cost by reducing wastage, simplifying its designs in order to cut waste and reduce the cost of direct labor and materials.
In conclusion, to be able to maintain and increase profits, it is important to increase sales while at the same time minimizing both fixed and variable cost. Further, understanding the cost behavior patterns and concepts helps in analyzing making informed decisions about a business. The cost behavior patterns include the trends that exists in the fixed cost, variable costs and mixed cost.
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Howard, B. B., & Upton, M. (1953). Introduction to business finance.McGraw-Hill.
Upton, M. (1953). Introduction to Business Finance.McGraw-Hill.