Cost is the aggregate of normal non-financial revenue items which are found in revenue statement or profit and loss account of an organisation. What cost accounting aims at is to methodically classify record and analyse such expenses to ascertain the cost of the product or service.
It is possible to re-group the total cost in any fashion according to convenience, for example, function-wise, elements-wise or behavior-wise and so on. One popular way of classifying costs is to re-group them according to their variability in relation to the level of output.
Advantages of Classifying Costs into Fixed and Variable Costs
There are certain advantages of dividing production costs into fixed and variable overhead. They are as follows :—
(1) Fixation of Selling Price – This distinction is very helpful in deter-mining the selling price of the products or services. Sometimes, different prices are charged for the same article in different markets to meet varying degrees of competition. However, the lowest selling of any product should at least cover prime cost + variable expenses, i.e., direct cost. It also helps in determining the price during a slum or a depression or in a special market.
(2) Help in Cost Control – Better control can be exercised over expenses if the estimate of expenses is properly made. Fixed expenses are incurred by management decision and as such can be controlled by the top management while variables expenses can be controlled by lower management.
(3) Helpful in Budgetary Control – This classification of expenses is very helpful in budgeting. Flexible budget for various levels of activities can be prepared with the help of this classification. It helps the management in understanding the behavior of costs.
(4) Marginal Costing and Cost-volume Profit Analysis.- For the technique of marginal costing and break-even analysis, this classification is very essential. It enables the ascertainment of marginal cost, i.e., the cost which can be avoided if a unit of output is given up. It helps in determining the level of output where all the expenses can be met.
(5) Helpful in Management Decisions – The classification of expenses into fixed and variable expenses helps very much in making managerial decisions. Management can decide whether to make a part or to buy it from outside sources. The decision to give up a product or to increase the capacity another product is also made on the basis of difference between the price obtained and the marginal cost.
(B) Non-linear Relationship – When the figures of cost and volume of output are plotted on a graph and they give stepped shape or curvy-linear picture, it is called non-linear relationship of costs with the volume of output. These non-linear relationships are of the following types :
(i) Stepped Relationship – If costs are fixed on constant to a particular level of output and increased with additional level of production at once, it is stepped relationship of costs with the volume of output. Such costs may be termed as “semi-variable costs’ also.
(ii) Curvy-linear Relationship – When changes in costs are very irregular in relation to the changes in volume of output, it is known as curvy-linear, relationship. For example, for first 1000 units, the power cost is $ 1/per unit.; for next 100 units again it goes up to $.1.20 per unit. and for next 1000 units again it goes up to $.1.25 per unit. and so on. Here, the change in cost is not regular. Hence, it is curvy-linear relationship of costs with the level of output.
Assumptions of Cost Behavior
In analysis of cost-volume behavior there are two important assumptions: —(1) The Linear relationship assumption. (2) The full range assumption. But these assumptions are not free from criticism. Hence the managerial utility of cost-behavior of analysis becomes limited.