Cost behavior, cost objects, and cost pools
Learning outcome statements
The learning outcome statements relevant for this section are:
- calculate fixed, variable, and mixed costs, and demonstrate an understanding of the behavior of each in the long and short term and how a change in assumptions regarding cost type or relevant range affects these costs
- identify cost objects and cost pools, and assign costs to appropriate activities
Cost drivers, work-in-process and finished goods accumulation, and actual/normal/standard costing methods are covered in the next measurement concepts chapter, product and period costs, cost drivers, and cost measurement methods.
Cost classification and behavior
Cost behavior refers to how a cost changes in response to variations in activity levels. Understanding cost behavior is essential for managers to predict future costs and make informed decisions. Costs can be classified based on behavior, traceability, and function. The behavioral classification is especially useful for planning, budgeting, and decision-making.
When analyzing cost behavior, it is important to distinguish between how costs behave in total versus how they behave on a per-unit basis.
A classic example is a utility bill: there is a base service fee (fixed) that must be paid regardless of usage, and a variable component that increases based on actual electricity or water consumption.
Mixed costs are also known as semi-variable or semi-fixed costs. To analyze them effectively, companies often separate the fixed and variable components using techniques such as the high-low method or regression analysis.
Example: Separating a mixed cost (high-low method)
A company’s factory overhead was $26,000 at 4,000 machine hours (the low point) and $50,000 at 10,000 machine hours (the high point). Use the high-low method to split this mixed cost into its fixed and variable components, then estimate the cost at 7,000 hours.
- Variable cost per hour: per hour
- Fixed cost:
- Estimated cost at 7,000 hours:
Notice that the $10,000 fixed cost is the same at both activity levels, but its per-unit amount falls from $2.50 per hour at 4,000 hours () to $1.00 per hour at 10,000 hours () - fixed cost per unit shrinks as volume rises, even though total fixed cost doesn’t change.
Answer: Variable cost = $4 per hour; fixed cost = $10,000; estimated cost at 7,000 hours = $38,000
Cost behavior can vary between the short term and long term, which significantly impacts decision-making. In the short term, some costs are often fixed due to contractual obligations or capacity limitations. For example, rental payments or salaried labor may not change even if production increases or decreases within a short period.
In the long term, however, most costs become more variable. Contracts may be renegotiated, operations can be scaled, and labor structures can be altered. This flexibility allows managers to adjust costs in response to strategic goals or changes in market demand.
For example, a factory lease is considered fixed over a one-year period because the terms are locked in, but in the long term, the lease can be renegotiated, terminated, or replaced by a different facility, making the cost variable from a strategic perspective.
An example of relevant range is when a factory may operate efficiently between 10,000 to 20,000 units of production. Within this range, fixed costs like rent remain unchanged, and variable costs per unit stay constant. However, if production exceeds 20,000 units, the company might need to rent additional space or hire another supervisor, increasing fixed costs. Alternatively, if production drops below 10,000 units, equipment may be underutilized, leading to inefficiencies and altered cost behavior.
A step cost stays constant over a band of activity, then jumps to a new level once activity crosses a threshold - unlike a mixed cost, which rises continuously with activity. Hiring a second supervisor once production exceeds 20,000 units is an example of a step cost.
Cost objects and cost pools
Understanding the distinction between cost objects and cost pools is foundational to effective cost allocation and managerial decision-making. In any organization, it is important to know where costs are incurred and how they should be assigned. This allows managers to better control costs, assess departmental performance, price products appropriately, and allocate overhead costs fairly across different segments of the business.
Accurate assignment of costs to cost objects via cost pools supports effective costing systems and internal control. This process enables better budgeting, pricing decisions, and profitability analysis. For instance, utility and supervisory labor costs from the factory cost pool might be allocated to individual products based on machine hours or labor hours used.
This concept becomes especially relevant when dealing with indirect costs, such as overhead, that cannot be traced directly to a single item. While direct materials and direct labor can be directly traced to a product or job, overhead costs must be distributed using cost pools and allocated to cost objects based on appropriate drivers. This is why identifying cost objects and establishing cost pools is critical for accurate product costing, especially in complex or multi-product environments.