How Costs Behave

Management accounting versus financial accounting

Financial accounting reports to outsiders under prescribed rules, historically, for the whole entity. Management accounting informs internal decisions: no prescribed format, forward-looking as well as historic, at whatever level of detail is useful, and timely rather than precise. A management report that is exact but arrives three weeks late has failed; one that is approximately right on the second working day is valuable.

Classifying cost by behaviour

• Variable — changes in proportion to activity: materials, piece-rate labour, commission, consumables. Constant per unit; total varies.
• Fixed — unchanged by activity within a range: rent, insurance, salaried staff, depreciation. Constant in total; per unit falls as volume rises.
• Semi-variable — a fixed element plus a variable one: a standing charge plus usage, or basic pay plus overtime.
• Stepped fixed — fixed within a band, then jumping: an additional supervisor, another shift, a second machine. Most costs described as fixed are really stepped, and the step is where the decision lies.

The relevant range matters: cost behaviour holds only within the activity range observed. Extrapolating a variable rate far beyond it produces confidently wrong answers.

Separating mixed costs

The high-low method takes the highest and lowest activity levels: the difference in cost divided by the difference in activity gives the variable rate per unit, and substituting back gives the fixed element. It is quick and it relies on two points, so an unrepresentative month distorts it. Regression across all observations is more robust and is easily done in a spreadsheet.

Other classifications

• Direct — traceable to a specific product, job or service. Indirect (overhead) — shared, requiring allocation.
• Product — attached to inventory and charged to profit when sold. Period — charged when incurred.
• Controllable by a particular manager, or uncontrollable by them. Holding a manager accountable for costs they cannot influence produces resentment and no improvement.
• Avoidable — disappears if the activity stops. Unavoidable — continues regardless. This distinction decides most closure and outsourcing questions.

Cost units and cost centres

A cost unit is what cost is measured against — a tonne, a job, a passenger-kilometre, a patient episode, a training day. A cost centre is where cost is collected — a department, a machine, a site. Choosing a meaningful cost unit is the first design decision in any costing system, and a poorly chosen one makes every subsequent number uninformative.