[Music] I'm Larry Walter this is principles of accounting dot-com chapter 18 in this first module we will look at cost behavior patterns and the implications for managing a business cost can be generally described as variable in nature or fixed in nature variable costs are those that vary in direct proportion to changes in the level of activity examples are direct material direct labor sales force commissions things of this nature each additional unit of production produces another uniform increment in cost fixed cost for those that do not fluctuate with changes in levels of activity examples include management salaries that are fixed in nature rent for a facility property tax amounts no matter the level of volume for the business those costs are stable let's look at a variable cost example NGO sound produces portable music players and each unit produced requires a digital chip that cost NGO sound 11 dollars and so if we produce 100,000 units we can expect to incur at $11 per unit a total cost of 1 million 100,000 and you can see as volume increases we also increase our variable cost at the constant rate of $11 per unit graphically I plotted on the Left the total variable cost the total variable cost is rising as production increases but if we look at on the right variable cost per unit we can see its constant at $11 per unit variable cost needs to be associated with the activity base that is the activity base is the item or event that causes the incurrence of a variable cost the best example being units produced each unit produced requires one more chip for example each variable cost needs to be considered independently in other words a business's variable cost will not all vary in the same fashion some may vary with production some may vary with sales some may vary on some other activity bass and so we have to associate each variable cost with its activity bass or the thing that causes it to vary let's turn to fixed cost go sound also leases their manufacturing facility for a total rent of 1 million two hundred thousand dollars no matter the level of production so in this table on the Left I've kept the same number of units 100,000 125 150 and so forth however the factory rent the middle column is the same no matter the level of production importantly notice that the rent per unit decreases the more we produce the lower is the fixed cost per unit graphically I plotted on the left the total fixed cost it's the same no matter the number of units produced but I've plotted on the right the fixed cost per unit and you can see how it's decreasing with increases in production continuing on considering a business's cost structure that is what proportion of its costs are fixed and what proportion of its cost or variable is very important in evaluating the business and managing the business and it varies a lot from business to business for example airlines have a high fixed cost in terms of their aircraft and the fuel they consume that they fly whether the plane is full or empty this causes them to struggle during years when the economy's slow and they cannot fill their airplanes on the other hand during boom years they can be extremely profitable because many of their costs are fixed and don't vary so additional passengers the revenue mostly goes to the bottom line to control for fixed cost many businesses have attempted to outsource much of their for example tech support paying on a per unit call basis rather than having a fixed staff that charges the same no matter how many calls will receive it's a way to avoid fixed costs or the business will fluctuate a business's profitability can fluctuate with its volume more so than being volatile as it can be for the airlines consideration of the fixed cost of a business also gives one to consider economies of scale certain efficiencies are achieved as production levels rise because as we've already seen fixed costs can be spread over a greater also one might consider that even certain variable cost and fluctuate you might get a quantity discount for a large or during larger volumes of a particular raw material that's needed in production all of these need to be considered in managing a business but what's important for cost behavior analysis is to consider the relevant range the relevant range is the level of activity for which cost and volume assumptions are expected to hold true any pricing data outside of the relevant range is irrelevant and need not be considered adopting a business strategy that results in operating levels outside of the relevant range can upset business results via significant deviations between actual and expected performance now let's consider how relevant range matters in the context of ordering parts a cost typically regarded as a variable here I have a pricing table and notice that I can either order in quantities of 1 or 10 or 100 or 1000 and the price varies considerably based on the quantity that I order if I order 10 units that cost is 30 cents per unit or 3 dollars for 10 if I order instead 100 units that price drops down to 13 cents per unit and even a bigger drop if it drops to 1,000 units if I need 250 units I need to study that table and very clearly determine what my correct ordering strategy would be rather than ordering 10 units at a time 25 times it would be much cheaper to order in units of 100 in this case although I only need 250 units I'm actually going to determine that it's much cheaper to order 300 units at 13 cents a unit or $13 per hundred or in other words a total of 39 dollars that's my cheapest option to get access to 250 units no other combination would give me a lower total cost for the units that I need so the variable cost per unit over my relevant range would be regarded as 13 cents per unit based on these calculations graphically one can consider the relevant range in this fashion here I show the variable cost per unit and it declines as we increase production significantly there's some very low price points out here but we're not going to produce at that level nor there's a higher price point but we're not going to produce at that level we have to think about our pricing structure within our relevant range so despite the decreasing variable cost per unit within the relevant range the cost is stable a step cost is a type of fixed cost that increases in increments fixed costs are only fixed over a relevant range at some point capacity fixed capacity would need to be increased and so I'm showing units of production and we have a fixed cost and then at a higher level of production we incur another fixed cost and yet another fixed cost for example if we're manufacturing something on an assembly line the assembly line can only produce say a thousand units a day if we need to increase production to two thousand units we'll need to add another assembly line add that additional fixed cost and so it would go for successively higher levels of production so once again in evaluating fixed cost for a business we have to think about the fixed cost that are applicable or relevant over the range of activity in which we expect to operate when we consider the relevant range and step cost it makes sense that we would want to operate at the rightmost edge of a step cost graphically speaking because that's where we have full capacity utilization we're fully utilizing a fixed cost without having to step up another level and move to a higher step of fixed cost or higher grades of course in some cases full capacity utilization is simply not possible there may be some idle capacity for which we're going to have to incur the fixed cost for a period of time when we think further about these concepts we also need to think about fixed cost as potentially committed in nature they arise from an organization's commitment to engage in operations depreciation rent insurance property taxes these costs were not going to avoid they relate to our desired long-run positioning for the firm and they're not easily adjusted other fixed cost however are discretionary in nature so we talk about discretionary fixed cost as those that originate from top management's yearly spending plans this could include an annual advertising budget employee training program and so forth these fixed costs tend to have a short-term orientation or a short-term focus and they can be adjusted or affected with proper planning if the business cycle is turning down we may eliminate certain fixed cost in order to maintain some efficiency in our biz this model certain variable costs are also subject to adjustment we saw an example of this with the part where we could order 10 units or a hundred units or a thousand units and get a different price per part basically what we need to do is optimize our purchasing in our order there's an economic order quantity formula that we introduced later in the book so economic order quantities are used to balance out the carrying and order cost for inventory and perhaps achieve a lower price point on the order also direct labor can be adjusted for overtime premiums we think of labor as a variable cost but if we cause our employees to work overtime we may pay them a premium say one and a half times their normal hourly rate and so proper planning can allow us to try to avoid those overtime premiums by better balancing our workload so all of these thought processes are necessary to effectively run a profitable business