Fixed Costs and Variable Costs
As production volume changes, some costs may increase or decrease and other costs may remain stable, but specific costs behave in predictable ways as volume changes. This concept of predictable cost behaviour based on volume is very important to the effective use of accounting information for managerial decision making.” Do you agree? Justify.
In today’s business world, it is necessary for the organizational managers to manage various business costs in the most effective manner in order to increase the profitability of business. For this reason, cost management is considered as a crucial part of management accounting (Drury, 2013). In the production process, two types of cost can be seen; they are fixed costs and variable cost. The increase and decrease of some costs can be seen due to the change in volume. However, in the production process, some specific costs can be seen that act in predictable manner based on the production volume. These are considered as important costs and the managers are required to take into consideration the effects of these costs as these costs have the ability of influence the managerial decision-making process (Henri, Boiral & Roy, 2016). This essay aims to establish the importance of the underatsding of predictable cost behavior for management decision-making process.
For establishing the importance of predictable cost behavior, it is important to understand the behavior of Fixed Costs and Variable Costs. Fixed costs use to remain the same in total, but variation in them based in per unit can be seen based on the change in production volume (Kinney & Raiborn, 2012). The examples of some major fixed costs are depreciation, rent, salary of the production managers, property taxes, insurance and others. Thus, the fixed expenses remain same in total, but variation on them can be seen when they are expressed in terms of per unit (Kinney & Raiborn, 2012). For example, rent can be taken into consideration. In case the rent of a building is $10,000 per annum and the produced units are 5,000, then the per unit rent is $2 ($10,000/5,000). In case, the production unit becomes 2000, then rent per unit will be $5 ($10,000/2000). On the other hand, in case there is an increase in production volume to 7000 units, the cost per unit will be $1.43 ($10,000/7000 units).
In case of the Variable Costs, variation can be seen among them in case of the change in production volume, but they remain same at the time of expression them in per unit amounts. It needs to be mentioned that the variable costs increase in direct proportion with the change in volume; and their decrease can be seen in direct proportion to the change in production (Banker & Byzalov, 2014). Some of the major examples of variable costs are direct material, direct labor, unit level costs, cost to run factory machinery and others. For example, direct material cost behavior depends on the increase or decrease in the production process (Laitinen, 2014). In case, $25 is the direct material cost for the production of a desk, this direct material cost will be increased or decreased as proportionate with the change in the production volume. For the production of 4000 desks, the total direct material cost will be $100,000 ($25*4000 units). In case of the 50% increase in production volume, that is 6000 units; direct material cost will also be increased by 50% that is $150,000 ($25*6000 units). However, cost per unit remains the same that is $25. In case the production volume decreased by 50% that is 2000, the total material cost will also be decreased by 50% that is $50,000 ($25*2000). However, in this case also, cost per unit remains the same.
The Importance of Predictable Cost Behavior for Decision-making
From the above discussion, it can be observed that there is a requirement of liner relationship between cost and volume for all those costs that vary in direct proportion with the change in volume (Parker, 2012). However, in reality, it can be seen that the reality costs use to behave in a curvilinear manner. The increase in cost per unit or average unit can be seen due to the increase or decrease in total production. In this case, electricity cost per kilowatt-hour can be considered as example as its decrease can be seen due to the increase in production (Fullerton, Kennedy & Widener, 2013). In managerial accounts, the decision-making process of the managers largely depends on the assumption that there is linear relation between the cost and volume within the relevant production range. It implies that, as per the managers’ assumption, the cost per unit uses to remain same over the relevant production range. In this context, relevant range of products refers to the normal production range that the companies expect to produce for a particular product. On the other hand, the relevant range can also be considered as a production volume that establishes the truthfulness of the relationship between fixed and variable costs (Banerjee, 2012).
Figure 1: Curvilinear Costs and the Relevant Range
(Source: Kinney & Raiborn, 2012)
The link between cost and production can be expressed with the assistance of an algebraic equation. The equation is as follows:
Y = a + bx
In the above figure, a refers to the point of intersect to (y) axis and b refers to the slope of the line. The interpretation of the above equation states that one unit decrease or increase in the production leads to the increase or decrease in the material costs. Thus, the variable nature of direct material cost can be seen as they stay on the basis of per unit but increase in the total due to the increase in production. From the above discussion, it can be seen that fixed and variable costs of the companies behave in a particular manner and it is the responsibility of the organizational managers to understand this cost behavior (Lavia López & Hiebl, 2014).
From the above discussion, it can be seen that the concept of predictable cost behavior is an important aspect for the organizational managers as the success of decision-making process largely depends on it. In this context, it is essential to mention the fact that the organizational managers are required to recognize and understand the predictable behavior of production cost as it serves multiple purpose within the business organizations (Berthelot, 2012). In the presence of excellent knowledge for understanding the predictable cost behavior, the management of the companies are able to prepare budget in an effective manner so that the production costs can be minimized and profitability of the organizations can be maximized. Apart from this, business organizations can become beneficial from many different ways by understanding the predictable cost behavior. In the presence of excellent understanding about the predictable cost behavior, organizational managers as well as financial planners can set more realistic goals and objectives for the business organizations. It is easy for the business organizations to achieve realistic goals and objectives. Another important advantage is the analysis of break-even point (Nekarda & Ramey, 2013). It is required for the organizational managers and financial planners to understand the pattern for predictable cost behavior as it is largely helpful for the organizational managers to pinpoint the break-even point of the organizations.
Benefits of Understanding Predictable Cost Behavior
The recognition of breakeven point is helpful for developing effective strategies that are required for development of production process. It can be seen that the management of the companies can get different kinds of production relation information by understanding the predicated cost behaviors of the companies. With the assistance of all these information, the production managers become able to increase he production volume of the organizations (Parker, 2012). At the same time, this information about predictable cost behavior helps the organizational managers in the development of new products and services. It also needs to be mentioned that the organizational managers become aware of the loopholes in the production process with the excellent knowledge in predictable cost behavior (Kinney & Raiborn, 2012). Thus, from the above discussion, it can be observed that the understanding of the predictable cost behavior provides many benefits to the business organizations in different aspects. Most importantly, information regarding the predictable cost behaviors helps the organizational managers in financial decision-making process. It implies that production managers and financial planners can take effective decisions in the areas of production. For this reason, it is required for the financial managers to develop company income statements based on predictable cost behavior. Income statement based on predictable cost behavior taken into consideration the aspects of cost of goods sold and gross margin as they play an integral part for the internal decision-making process of the companies (Drury, 2013).
Conclusion
The above discussion attempts to discuss various aspects of predictable cost behavior. According to the above discussion, it can be seen that the nature of fixed cost is to stay same in total but to vary in case of per unit cost due to the change in production volume. The above discussion also states that the nature of variable cost is to vary at the time of the change in production, but to stay same at the time of expression in terms of cost per unit. From this, it can be observed that both the variable costs and fixed costs have certain predictable behavior associated with the production volume and cost per unit. In addition, from the above discussion, it can also be seen that having excellent knowledge in predictable cost behavior helps the business organizations in various aspects like increase in profitability, increase in production, redaction costs and others. Thus, based on the whole study, it can be concluded that the concept of predictable cost behavior based on volume has major importance for managerial decision-making process
References
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