Prepare a report for the Managing Director of your company explaining how costs may be classified by their behaviour, with particular reference to the effects both on total and on unit costs. Your report should
(i) say why it is necessary to classify costs by their behaviour, and
(ii) be illustrated by sketch graphs within the body of the report.
The correct answer and explanation is :
Report to the Managing Director: Classification of Costs by Their Behaviour
Introduction
Cost classification is crucial in understanding the impact of costs on a company’s profitability, especially as production volumes fluctuate. Classifying costs by their behaviour helps in effective budgeting, pricing decisions, cost control, and profitability analysis. This report outlines why it is necessary to classify costs by their behaviour and explains the effects on total and unit costs with the use of graphs.
(i) Why is it necessary to classify costs by their behaviour?
Classifying costs by their behaviour, specifically into fixed, variable, and semi-variable categories, is vital for several reasons:
- Cost Control: Understanding how costs behave with changes in production volumes helps in planning and controlling costs efficiently. Managers can focus on controlling variable costs, while fixed costs remain constant.
- Decision-Making: When making decisions related to pricing, production volume, or cost reduction strategies, it is important to distinguish between costs that change with activity (variable costs) and those that do not (fixed costs).
- Profitability Analysis: The classification enables accurate profit forecasting, as fixed costs will not change regardless of output, but variable costs will directly impact the profitability based on production levels.
- Budgeting: Knowing which costs are fixed or variable helps in setting budgets, as fixed costs will be incurred regardless of the activity, while variable costs depend on the output.
(ii) Effects on Total and Unit Costs
- Fixed Costs: These costs do not change with the level of production (e.g., rent, salaries). The total fixed cost remains constant regardless of production, but the unit fixed cost decreases as production volume increases because fixed costs are spread over more units.
- Variable Costs: These costs change proportionally with production volume (e.g., raw materials, labor). The total variable cost increases with output, but the unit variable cost remains constant, as it is a cost per unit.
- Semi-Variable Costs: These costs have both fixed and variable components. For example, a salesperson may receive a fixed salary (fixed component) plus a commission (variable component). The total cost behaves similarly to a combination of fixed and variable costs.
Illustrations
Below are graphical representations of cost behaviour:
- Fixed Costs: The total cost line is flat, as it does not change with output, but the unit cost decreases as output increases.
- Variable Costs: Both total and unit costs change with output. The total cost line rises steadily, while the unit cost remains constant.
- Semi-Variable Costs: A mixture of fixed and variable costs results in a line that initially is flat and then rises with production.