Cost Analysis

Cost classification diagram for pricing the navigation system would as follows:

As the level of business activities changes, some costs change while others do not. The response of a cost to a change in business activity is known as cost behavior. Managers should be able to predict the behavior of a particular cost in response to a change in particular business activity. For this purpose, costs are classified as variable, fixed and semi-variable costs. The three types of costs as well as their response to business activities are:

Variable cost:

A cost that changes, in total dollar amount, with the change in the level of activity is called variable cost. A common example of variable cost is direct materials cost. Consider the following example to understand how variable cost behaves in a manufacturing company.

A radio manufacturing company purchases speakers from another company at a cost of $2 per speaker. The speaker is a direct materials cost for radio manufacturing company. One speaker is used to complete a radio. The total and per unit cost of speakers at various levels of activity is given below:

No. of radios

phones produced Cost of 1

speaker Total cost

of speakers

1 $2.00 $2

50 $2.00 $100

100 $2.00 $200

150 $2.00 $300

200 $2.00 $400

250 $2.00 $500

300 $2.00 $600

Notice that the total cost of speakers increases as the radios produced are increased but per unit cost remains constant.

A cost that does not change, in total, with the change in activity is called fixed cost. A common example of fixed cost is rent. In above example, if radio manufacturing company rents a building for its factory for $5,000 per month, it will have to pay $5,000 for every month even when no radio is produced during the month. The behavior of fixed is shown in the following figure:

Total fixed cost does not change with the change in activity but per unit fixed cost changes with the rise and fall in the level of activity. There is an inverse relationship between per unit fixed cost and activity. If production increases, per unit fixed cost decreases and if production decreases, per unit fixed cost increases. To understand this point, we can use the data from the above example of radio manufacturing company. Consider the following table:

Monthly rent

of the building Number of radios

manufactured Average