Cost Types: 3 Main Types of Cost

This article throws light upon the three main types of costs. The types are: 1. Fixed Costs 2. Variable Costs 3. Semi-Variable Costs.

Type # 1. Fixed Costs:

Fixed Costs also referred to as non-variable costs, stand-by costs, period costs or capacity costs are those costs which do not vary with changes in volume of output over a given period of time and within a relevant range of activity. Fixed costs, thus, remain constant in total amount whether there is any increase or decrease in level of activity or output.

The examples of fixed costs are rent and taxes of building; insurance charges and depreciation of plant, machinery and building; salaries of foremen, works manager, permanent staff and executives, etc.

For instance, if the factory building is rented for, say, Rs. 10,000 per month, this cost remains the same whether 1,000 units are produced in a month, 2,000 units are produced or any other numbers of units are produced upto the full capacity of the plant.

However, it should be observed that while fixed costs remains the same in total when the volume of output changes, fixed cost per unit of production decreases with increase in volume of output. Conversely, when there is a decrease in the volume of output, the fixed cost per unit increases. Thus, there is an inverse relationship between volume of output and fixed cost per unit.

The following table illustrates the behaviour of fixed costs in relation to the volume of output:

The behaviour of cost relationships between:

(i) Volume of output and total fixed costs; and

(ii) Volume of output and fixed costs per unit can also be plotted on a graph as below:

From the above figures it can be observed that total fixed cost remains constant at Rs. 10,000 regardless of level of output whether it is O or 10,000 units. However, fixed cost per unit decreases from Rs. 10 per unit at a level of 1,000 units of production to Rs. 5 per unit at 2,000 units and further to Re. 1per unit at 10,000 units of production.

Another important feature of the behaviour of fixed costs is that fixed costs are not always wholly fixed in nature. One should not form an opinion that fixed costs will remain constant for all times to come. In fact, these costs remain fixed only for a given period of time, and like all other costs, fixed costs are also subject to change over a period of time.

For instance, factory rent may increase or salaries of foremen and managers may increase with passage of period of time. But these increases in fixed costs are not due to increase in the volume of output. It is for this reason that fixed costs are also referred to as ‘period costs’.

In the same manner, fixed costs tend to remain constant with changes in the volume of output within a relevant range only. The fixed costs may also change before and beyond that range of activity.

For example, an expansion of plant beyond the present capacity may require additional building, machinery, foremen and supervisors resulting into additional fixed costs in the form of increased depreciation and salaries. Thus, the fixed cost remains fixed only in a given period in which no change in capacity takes place and it is for this reason that fixed costs are also sometimes called as ‘capacity costs’.

Such a behaviour of fixed costs has been shown in the diagram:

From the point of view of profit planning and control, fixed costs can be further classified into two categories:

(a) Commited Fixed Costs; and

(b) Discretionary, programmed or managed Costs

(a) Committed Fixed Costs:

Committed costs are those fixed costs which are caused by investments in fixed assets, such as building, plant or equipment, for providing production facilities. Depreciation, insurance, rent, property, taxes, etc. are the examples of committed fixed costs. Once a firm purchases building, plant or equipment, it commits itself to depreciation charge, insurance charges, property tax, etc. for fairly a long period.

These costs are called committed costs because the firm has committed itself to incur such costs for a long period. In the short period, such costs are non-controllable and hence ignored for short-term decisions. Committed fixed costs can be reduced by change in the commitment, for example by disposing of the building or some plant the depreciation charge will decrease.

(b) Discretionary Fixed Costs:

Discretionary costs, also referred to as programmed or managed costs, are those fixed costs the amount of which is decided by the management. Such costs can be reduced substantially at any period of time at the discretion of the management.

The examples of discretionary fixed costs are research and developmental costs, advertising costs, expenses incurred on human resource development, public relations, etc. Generally, the benefit of such cost does not accrue in the same period when these are incurred.

Type # 2. Variable Costs:

Variable costs are those costs which fluctuate, in total, in direct proportion to the volume of output. Such costs increase in aggregate as the output increases and decrease in the same proportion when the output falls. A variable cost, thus, in total, changes in the same direction and in direct proportion to changes in production activity, sales activity or some other measure of volume.

The costs of direct material, direct labour, supplies and direct expenses like sales commission are perfect Examples of variable costs. However, it must be noted that variable costs fluctuate, in total amount, in direct proportion to the volume but tend to remain constant per unit of production.

In fact, there is a linear relationship between volume of output and variable costs. The following table illustrates the relationship between volume of output and variable costs.

The above table shows that total variable cost increases proportionately with every increase in volume of production, but variable cost per unit remains constant at Rs. 20 per unit regardless of the volume of production. It is because of this behaviour of variable costs that they are, sometimes, called ‘engineered costs’.

We can depict the behaviour or relationship of variable costs with volume of production as below:

Type # 3. Semi-Variable Costs:

Semi-variable costs are a combination of fixed and variable cost and are, thus, also known as mixed costs. Such costs are neither perfectly variable nor absolutely fixed in relation to changes in the volume of output ‘The Fixed component of such costs represents the cost of providing capacity and the variable component is caused by using the capacity.’

A part of the fixed costs, comprising of the fixed cost component, is not expected to respond to the changes in the volume of activity, and another part of these costs, comprising of variable costs, is expected to change in response to changes in the volume of activity.

Thus, semi-variable costs fluctuate.in the same direction but not in direct proportion to the changes in volume of output. They go up with volume but not in the same proportion as volume. Hence, these costs should be plotted on a graph as a curved line.

Utility bills, such as power costs, telephone charges, repair and maintenance costs, etc. are the examples of semi-variable costs. For example, power costs include a fixed portion of ‘minimum charge’ that will be charged even if you do not consume power and-variable charge based on consumption of power. Thus, power cost increases with an increase in production activity but not in the same proportion.

Another example of semi-variable costs could be supervisory salaries which remain constant for any production volume from zero to the maximum that could be produced on a single shift basis but then increase in lumpsum if another shift is added.

These, then, remain fixed at this level till the third shift is introduced.