Costs that vary in proportion to changes in the level of activity are:

Introduction

Cost-volume-profit (CVP) analysis is a method of cost accounting that looks at the impact that varying levels of costs and volume have on operating profit. CVP evaluates the viability and ability to grow or scale a business and helps company managers make informed decisions about which business prospects to pursue. 

To understand how a business is going to perform over time, it’s important to consider the cost structure of the business. This refers to the various types of expenses a business incurs and its unique attributes and is typically composed of fixed and variable costs. 

Cost Structure of a Business – Fixed and Variable Costs

Variable costs are the costs that vary in direct proportion to changes in the level of activity. This type of cost increases or decreases depending on a company’s production or sales volume. Examples of variable costs include raw materials, sales commissions, packaging, direct label, shipping expenses, etc. 

When analysing variable costs, it is important to consider each cost independently, in order to understand what activity drives the cost. It can relate not only to the number of units produced, but also to labour hours worked, units sold, customers processed, etc. 

Fixed costs are the opposite of variable costs because they don’t vary with changes in the level of activity. They are incurred regularly and are unlikely to fluctuate over time. Examples of fixed costs include administrative salaries, rents, property taxes, security, networking infrastructure support, etc. 

Some fixed costs are classified as committed fixed costs and some as discretionary fixed costs. Committed costs are costs that the management of an organization have a long-term responsibility to pay. The non-payment of committed costs can result in disruption of business activities and legal consequences apply if contractual costs and obligations are not met. Examples include depreciation, rent, insurance, property taxes, etc.  

Discretionary fixed costs are the costs that can be reduced or modified without significant impact on the short-term day to day operations of a company. However, in the long-term their elimination can have a negative impact in the company’s profitability. Examples of discretionary costs are advertising and marketing expenses, employee training, research and development, etc. 

The nature of business defines its inherited fixed cost’s structure. Because airlines have high fixed costs with gates, maintenance, aircrafts, etc, the costs don’t change much with increases of volume. There is not much cost difference in flying a plane empty or full. Which means that in their boom years, airlines could be extremely profitable and in their lean years, they struggled considerably to cover these costs. 

It is important to bear in mind that many fixed costs are only fixed for a certain level of production. Once an activity threshold is met, these costs can increase or decrease according to the new activity level reached by a company. These costs are called step up costs. For example: Sophia operates a company that produces pencils. A machine costing £15,000 is capable of producing up to 1,000 pencils. Considering that Sophia has received an extra order of 2,000 pencils, her company must purchase an additional machine to expand its production capacity. Therefore, the total cost will go up to £ 30,000 (2 machines x £15,000). 

Fixed costs can be spread over large production runs causing a decrease in the per unit fixed cost. On top of that, as the volume goes up, quantity discounts can be applied reducing the variable cost per unit. Companies can achieve economies of scale when production becomes efficient, i.e. cost advantages by increasing production and lowering costs. 

Within designated boundaries, certain revenue or expense levels are likely to occur. Outside that relevant range, they will probably differ from the expected amount. The relevant range is the level of activity, e.g. production or sales, at which a company is expected to perform. If you move outside the relevant range, your cost assumptions are no longer valid. Any pricing data outside of this range is irrelevant and need not be considered. 

Another aspect of cost behaviour that should be considered are the mixed costs. Also called semi variable costs, they contain both fixed and variable components and are hard to evaluate because they change in response to fluctuations in volume. To understand how mixed costs operate, take cell phone agreements as an example. There are companies that charge a monthly fee plus usage charges for excess minutes, which means there is some fixed amount plus a variable component tied to an activity. 

There are two methods to sort out mixed costs: the high-low method and the least squares method. 

The simplest technique to separate mixed costs into variable and fixed portions is the high-low method. It involves taking the highest level of activity and the lowest level of activity and comparing the total costs at each level.

However, there are limitations to the high-low method because it can return an imprecise answer if the data set under analysis has several rogue data points. 

The second technique to separate mixed costs is the Method of Least Squares. It uses statistical regression techniques to estimate a linear total cost function for a mixed cost, based on past cost data. The cost function may then be used to predict the total cost at a given level of activity such as number of units produced. 

Least-squares regression mathematically calculates a line of best fit to a set of data pairs i.e. a series of activity levels and corresponding total-cost at each activity level. The calculation involves minimizing the sum of squares of the vertical distances between the data points and the cost function. 

Considering that the cost varies along y-axis and activity levels along x-axis, the required cost line may be represented in the form of following equation:

y = a + bx

In the above equation, a is the y-intercept of the line and it equals the approximate fixed cost at any level of activity. Whereas b is the slope of the line and it equals the average variable cost per unit of activity. This method can also be used to forecast costs. 

Conclusion

According to the above, by understanding the cost structure of businesses and how variable and fixed costs operate, we can understand the relationship between those costs, business volume, and profitability. 

That’s why the Cost-Volume-Profit analysis is important when it comes to making decisions about what products to offer, how to price them, and how to manage an organization’s cost structure. It is also central to calculating the contribution margin, break-even point, volume levels, income levels, and other cost-related calculations. 

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