Classifying Costs According to Behavior

In our discussion of fixed, variable, and mixed costs, we concentrated on the defini- tions and took for granted a number of factors that are important for determining whether a cost is fixed or variable. Now it is time to look more closely at the way we can classify costs according to behavior. To assess cost behavior, we must first con- sider the time horizon. Then, we must identify the resources needed and the output of the activity. Finally, we must measure the inputs and outputs and determine the impact of output changes on the activity cost.

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40,000 80,000 120,000 160,000 Cost

Number of Inserts Sold

200,000

$130,000

70,000 50,000 30,000 90,000 110,000

Exhibit 3-3

Mixed-Cost Behavior: Cutting Activity, Reddy Heaters

Time Horizon

Determining whether a cost is fixed or variable depends on the time horizon. According to economics, in the long run, all costs are variable; in the short run, at least one cost is fixed. But how long is the short run? In the Reddy Heaters example, the leasing cost of the cutting machines was fixed for a year, so a year was the length of the short run for that cost. The length of the short run may differ from one cost to another.

Consider a process that takes materials and molds them into the shape of a gar- den hose. The output is the number of feet of hose. As the amount of hose changes, the direct materials used are relatively easy to adjust (acquiring more as the output increases and less as it decreases). For all practical purposes, the firm may treat direct materials as strictly variable even though for the next few hours (or days) the

amount of materials already purchased may be fixed.

What about direct labor? In some settings, a company may be able to hire and lay off its labor relatively quickly—in which case labor could be treated as a variable cost. In other cases, a company may not lay off labor for short-term drops in pro- duction. For example, there may be contracts with labor unions that prohibit layoffs.

Such a contract may make layoffs impossible in the short run even when there have been permanent changes in the need for labor. Only when the contract is renegoti- ated can the level of labor be adjusted. In this case, direct labor is a fixed cost rather than a variable cost. The same observation can be made for other forms of labor. For example, salaries of production line supervisors are also difficult to adjust as the activity output fluctuates. It could take months, or even a year or two, to determine whether a drop in production is permanent and the number of supervisory jobs needs to be reduced. Accordingly, this cost is typically seen as fixed.

The length of the short-run period depends to some extent on management judgment and the purpose for which cost behavior is being estimated. For example, submitting a bid on a one-time, special order may span only a month, long enough to create a bid and produce the order. Other types of decisions, such as dropping a product line or adjusting the product mix, will affect a much longer period of time.

In this case, the costs that must be considered are long-run variable costs, including product design and development, market development, and market penetration.

Resources and Output Measures

Every activity needs resources to accomplish the task it has to do. Resources might include materials, energy or fuel, labor, and capital. These inputs are combined to produce an output. For example, if the activity is moving materials, the inputs could include crates (materials), fuel (energy), a forklift operator (labor), and a forklift (capital). The output would be moved materi- als. But how do we measure this output? One measure is the number of times the activity is performed. For example, suppose that the activity is moving materials from the storeroom to the assembly line. A good measure of output is the number of moves. The more moves that are made, the higher the cost of moving. Therefore, we could say that the number of moves is a good output measure for the activity of moving materials. Exhibit 3-4 illustrates the relationship between inputs, activities, output, and cost behavior.

Another term for output measure is driver. Recall from Chapter 2 that activity drivers are observable causal factors that measure the amount of resources a cost object uses. Activity drivers explain changes in activity costs by measuring changes in activity use or output. Thus, the driver for material handling may be number of moves; the driver for shipping goods may be the units sold; and the driver for laun- dering hospital bedding may be pounds of laundry. The choice of driver is tailored not only to the particular firm but also to the particular activity or cost being meas- ured. Therefore, in order to understand the behavior of costs, we must first deter- mine the underlying activities and the associated drivers that measure activity capac- ity and usage. The need to understand this cost-activity relationship leads us to the determination of an appropriate measure of activity output, or activity driver.

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Activity drivers are divided into two general categories: production (or unit- level) drivers and non-unit-level drivers. Production drivers explain changes in cost as units produced change. Pounds of direct materials, kilowatt-hours used to run production machinery, and direct labor hours are examples of production drivers.

In other words, as pounds of materials used, kilowatt-hours, and direct labor hours increase, output also increases.

Non-Unit-Level Drivers

Non-unit- level drivers explain changes in cost as factors other than units change. For example, setups are a non-unit-level activity. Every time the factory has to stop producing one product in order to set up the production line to produce another product, setup costs are incurred. No matter how many units are in the new batch, the cost to set up

remains the same. You have probably run into this type of activity in your personal life. Let’s consider a common household production activity—making chocolate chip cookies. Suppose that you decide to make two dozen cookies. First, you will have to set up for the cookie baking by taking out a bowl, spoon, baking sheet, and the relevant ingredients. On another occasion, you might decide to make four dozen cookies. You still have to set up, and it will probably take the same amount of time as it took you to set up for two dozen cookies. The point is that setting up is not related to the number of units (cookies). Instead, it is a non-unit-level activity. Other examples of non-unit-level costs include depreciation on the factory, the salary of the factory manager, and the cost of running the purchasing department.

In a functional-based cost system, cost behavior is assumed to be described by unit-level drivers only. In an activity-based system, both unit-level and non-unit-level drivers are used. Thus, the ABC system produces a much richer view of cost behavior than a functional-based system.

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Activities Activity

Output

Cost Behavior Inputs:

Materials

Energy

Labor

Capital

Changes in Input

Cost

Changes in Output

Exhibit 3-4

Activity Cost Behavior Model

The preparation needed to produce a batch of cookies is a good example of a non-unit level activ- ity. It is an activity performed each time a batch is produced, whether one dozen or two dozen cook- ies are baked.

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