Production Management

The Relationship of Cost to Volume and their Assumptions

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.

This classification of cost is based on the behavior of cost in relation to the volume of output. Broadly, this behavior can be of two types : (A) Linear Relationship – Such relationship is also called Straight-line Relationship of cost to the volume of output. When the values of cost and volume of output are plotted on a graph paper, they give a straight-line curve. B) Non-Linear Relationship. Here we are going to discuss the linear relationship.

Types of Costs According to Linear Relationship

According to Linear Relationship, the cost may be of three types :

(1) Fixed-constant or Non-Variable Cost – This is the cost that does not vary with the level of production or volume of output. Such expenses remain constant irrespective of the level of output.

For example, if the output goes up or comes down, there will be no change in the rent of the factory or in the salary of sales manager. By constant, it is not meant that they do not change at all. They change according to time and not according to level of output. As such, fixed costs are not affected by any variation in the volume of output.

Examples of such expenses are : rent, rates and insurance of the factory premises, pay and allowance of managers, secretary and accountant, and certain other office expenses.

(2) Variable Cost – Expenses that vary almost in direct proportion to the volume of production are called variable expenses. The examples of such expenses are the cost of direct material, direct labor and direct chargeable expenses, such as electric power, full and consumable stores, etc. If the production goes high these expenses also go high; if production comes down, they also come down.

Thus, they vary almost proportionately in relation to the production, While fixed expenses remain constant per unit of time, variable expenses remain constant per unit of output. Fixed expenses are said to be uncontrollable because the money must he spent irrespective of the level of output while variable expenses are said to be controllable as they are incurred only when production takes place, otherwise not.

(3) Semi-Variable Costs – These expenses change in the same direction in which output changes, i.e., they go up when the output rises and come down when the output declines, but they do not change in the same production as they change in the level of output. Such expenses remain fixed up to a particular limit.

After the limit is reached, they became variable. But the rate of their variability is slow. For example, depreciation of plant and machinery is not doubled even if the production is doubled.

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