 Cost behavior refers to how cost behaves when

there is a change in the level of activity. There

is the need for managers to know whether cost
changes as the level of activity changes or
remains constant irrespective of a change in
output. This calls for understanding of variable
cost, fixed cost and semi variable cost

 As managers, you have to understand also the

cost structure of your organization. You must,
for instance, understand what the direct and
indirect components of your cost are. This can
help managers to have greater control over the
resources of the firm and help in making better
decisions.
 A knowledge of how cost and revenue will vary with
different levels of activity ( or volume) is essential for
decision-making
 Activity or volume may be measured in terms of units
of production or sales, hours worked, miles travelled,
students enrolled etc.
 Sometimes managers may want to take decisions in
respect of the following:
. 1. Quantity to produce in order to break even.
2. Quantity to sell in order to earn a desired profit
3. Shut down a segment
4 make or buy a product
 Cost behaviour tends to classify costs as one
of the following :
 Variable cost
 Fixed costs
 Semi-variable costs.
 VARIABLE COSTS
 A variable cost is a cost in which the total
cost tends to change in direct proportion to
changes in the volume of production. while
the unit cost or cost per unit remains
constant for each unit produced
 Variable cost can be shown graphically as
follows.
 FIXED COST
Fixed cost is a cost in which the total cost
remains constant in the volume of
production over a relevant range of output. A
fixed cost remains fixed only in relation to a
given period and a given range of activity .
Examples of fixed cost are:
Rent per annum on factory building
Insurance premium.
Executives salaries
 SEMI VARIABLE COST.
 Semi variable or semi fixed cost contains the
characteristics of both variable and fixed cost
and are therefore referred to as mixed costs.
 For planning, control and decision making , semi
variable cost should be separated into fixed and
variable contents. Examples of semi variable
cost are electricity bills and telephone charges.
Semi variable costs can be shown diagrammatically
below.
 Fixed cost, variable cost, and marginal cost
 .
 Costs that vary directly with activity are known as
variable cost and those that do not change with
activity are known as fixed cost.
 As managers, because some costs are fixed, we are
more concerned about the additional cost that an
activity will generate. This additional cost is referred to
as marginal cost or incremental cost.
 The importance and interrelationships of these
concepts will be revealed in our discussion on
contribution analysis
 CVP analysis refers to interrelationship
between cost, volume and profit at various
levels of activities.
 It is also called cost, volume, profit(CVP)
analysis
 Break even sales is the level of sales at which
total revenue equals total cost
 i. All cost can be categorized into fixed and
variable cost. This may not be true because
there are semi variable cost or mixed cost
 ii. Total fixed cost would remain unchanged
over the relevant volume. Fixed cost may
increase when output increase. Example is in
the long run.
 iii. Total variable costs are directly
proportional to volume over the relevant
range.
 iv. The only factor that affects cost and
revenue is volume (output). Macro economic
factors like inflation, interest rate and
exchange rate may affect cost and revenue
 v. All quantities produced are sold.
Sometimes there may be closing inventory
 vi. Selling price is to remain unchanged.
 . Cost and revenue behave in a linear fashion
over the activity range.
 Single product or constant sales mix
 Contribution is sales minus variable cost or
selling price per unit minus variable cost per
unit
 Contribution is used to cover fixed cost
 Assumptions:
 This approach of contribution analysis is based on the following
assumptions:
1. Total cost can be split between fixed cost and variable cost
2. Fixed cost remain constant irrespective of the level of
activity
3. Fixed cost do not bear any relationship to specific units
4. Variable cost vary in direct proportion to activity.
 Contribution and net income analysis:

PRODUCTS Total
A B C
Sales revenue 100 120 80 300
Less: variable cost 35 68 70 173
Contribution 65 52 10 127
Less: fixed cost 90
Profit 37

 From this, you can do sensitivity analysis to see what the impact of
management decisions, such as increasing or decreasing price or
volume of products, varying quality of products to change variable
cost, will have on the profits.
 Application: sale price/unit=GHC50 and vc/unit=GHC30,
 Changes in variable cost

One unit 100 units 1000 units

Sales revenue 50 5,000 50,000
Less: Variable costs 30 3,000 30,000
Contribution 20 2,000 20,000
 This illustrates that variable cost increases in direct proportion
with increase in number of units. Every unit sold contributes
GH¢20 to fixed assets. If fixed assets are covered, then every
extra unit sold will increase profit by GH¢20 as illustrated below:
FC=GHC40,000
 Changes in profit
100 units 1000 units 2000 units 3000 units 4000 units
Sales revenue 5,000 50,000 100,000 150,000 200,000
Less: Variable costs 3,000 30,000 60,000 90,000 120,000
Contribution 2,000 20,000 40,000 60,000 80,000
Less: Fixed costs 40,000 40,000 40,000 40,000 40,000
Profit / Loss (38,000) (20,000) 0 20,000 40,000

 We need to sell 2,000 units to cover our fixed cost. Beyond that,
every extra unit sold will add GH¢20 to profits
 Break even point in quantity
Fixed cost
Contribution/unit

 Break even point in sales value

= Fixed cost x selling price

Contribution/unit
Level of sales in unit at target profit
= Fixed cost + target profit

Contribution/unit

Level of sales in value at target profit

= fixed cost + target profit
contribution/unit
 Sales = total cost plus + profit
 Sales = fixed cost + variable cost + profit
 Let x, p, v and fc represent a unit of quantity
sold, selling price per unit, variable cost per
unit and fixed cost respectively
 Px = fc + vx + profit
 X(p – v) = fc +profit
 X = fc + profit
p -v
 The Margin of Safety is the difference between the
expected level of sales and break-even sales.

 Margin of safety = actual sales – break-even point

 Illustrations:
 The following information relates to Billz Ltd for the year 2011.

Units sold = 20,000 Per unit(GH¢) Total(GH¢)

Sales 50 1,000,000
Less: Variable cost 38 760,000
Contribution 12 240,000
Less: Fixed costs 156,000
 InProfit
value and unit terms compute: 84,000
1. The break-even position
2. margin of safety
 Billz Ltd in January 2012 spent 100,000 on fixed costs and have the following budget for
2012.

Budget unit sales = 25,000 Per unit(GH¢) Total(GH¢)

Sales 58 1,450,000
Less: Variable cost 48 1,200,000
Contribution 10 250,000
Less: Fixed costs 256,000
 ManagementProfit
would want to at least maintain 2011 profit levels and -6,000
have the following
options:
1. Reduce the selling price of each unit by GH¢5
2. Increase the selling price of each unit by GH¢5
3. Improve the quality of the product, which will increase variable cost by GH¢2
 For each proposal calculate: i. break even position in units and value terms. ii. number of
units required to be sold in order to meet the profit target
 Criticisms:
 The main criticism of the use of marginal cost in
contribution analysis are as follows:
 Cost cannot be easily divided into fixed and variable cost.
There may be semi-fixed costs.
 Variable costs do not necessarily vary in direct proportion to
sales revenue at all levels of operations. For instance, market
forces and bulk purchase may change the cost of direct
materials.
 Fixed costs may also change when activity falls out side of a
certain range. Very high levels of activity may call for
additional fixed cost investments.
 Sometimes more than one product may be produced and
where there are two products sales mix may not be constant.