In a bid to enhance its quality production and sustain its operation costs, the company’s management relies on partly external financing valued in the form of notes and bonds. The external source of financing attracts annual interest expense payable at 10% and 8% respectively until the expiration of the maturity period. Finally, the firm is accountable for a 30% income tax as a federal obligation that would be deducted from the gross profit.
ECC’s Cost Behavior
While every firm incurs various expenses for its daily operations, there exists clear distinction on the extent to which the costs influence the overall financial performance of a company. Hence necessitates the importance of cost behavior analysis techniques that categorizes the expenses into fixed, variable and mixed or rather semi-variable costs. The cost behavior analysis evaluates how various costs change in value as the company performs its manufacturing and operation activities.
Fixed costs refer to the expenses catered by a firm and are non-influenced by the changes in the level of production. Such costs will feature in the firm’s statement of accounts regardless of whether the activities are taking place or not. The total fixed costs remain constant all through the operation period, and any realizable change would only be affected by other exogenous variables (Horngren, Sundem, Stratton, Burgstahler & Schatzberg, 2002). For instance, Rent on factory premises is a fixed cost; however it could turn upwards in future due to government influence on rent levy. Notably, while total fixed cost remains constant all throughout the operation period, total fixed costs per unit of production is inversely proportional to the change in the quantity of units produced. In that case, the higher the production output, the lower the rate of fixed cost per unit.
In the ECC electronic company, there are various activities recorded in the journal entry whose cost remains unaffected by the company’s daily operations. They include:
Insurance factory is a type of cost that a company incurs to shield the continuity of the firms in case of unforeseen events such as fire or other related hazards. The assumption informs this conclusion that the insurance premium is entitled to cover the factory premises thus excludes the operation machines, the quantity of electronic goods produced, and compensation of workers. The accounting standards of cost valuation and behavioral analysis argue that the company accountants would have the discretion to point out the independent variable to enable categorizes the nature of the pertinent costs. Hence, ECC company net income reduces by $ 920,000 to insure the company premises against hazardous events.
Factory depreciation expense.
These refer to the accumulated loss of value of the company’s machines and manufacturing equipment. The expenses lead to reduced value of the assets until they attain their intended useful life upon which they are disposed and replaced with new ones. As a precautionary measure to assert the clarity of our classification, it will be assumed that the company applied a straight-line method of determining depreciation cost of $3726, 0000 that subsequently increases the annual operation cost and the value of the company’s fixed assets.
Factory property tax
Factory property tax is a fixed cost of $173,000 that the firm remits to the government as part of the tax obligations. In most cases, the expense remains constant as long as the firm continues in operation.
A land is a type of fixed asset that a firm purchases to erect the factory premises. Therefore, the cost incurred to procure the asset is a one-off expense that featured in the company’s first financial statement. In the subsequent periods, it is categorized in the balance sheet as a fixed asset subject to increase in value on appreciation. The Eddison electronic company’s land was valued at $2760, 000 by the end of 2005 financial period.
According to the international accounting standards, variable costs include those expenses that are directly proportional to the degree of company production (Horngren, Sundem, Stratton, Burgstahler & Schatzberg, 2002). That is, if a firm decides to increase their current units of production to replenish the market demand gap, the total variable cost would subsequently increase proportionately. However, variable cost incurred per unit of production remains constant throughout. It is paramount for the production managers to enhance production efficiency during production to retain the desired level of profitability. The core variable cost incurred by the Eddison electronic company include
Administrative expenses are likely to change due to exogenous variables such as economic fluctuations or the firm’s expansion strategy. For example, currency depreciation could lead to an increase in banking rates due to inflation.
Selling expenses vary could vary upwards as a result of aggressive marketing as well as increased fuel consumption cost on delivery vehicles.
Increased taxes on local and imported supply materials could lead to varying amount of expensed amount.
Maintenance factory expenses
As the factory machines continue to depreciate and portray slowed performance, the ECC Company would have to bear extra maintenance cost or opt to dispose the old machines in replacement of high efficient machines.
The company utilities would include among others, water and electricity bills whose billing varies based on a determination by the relevant organizations. The cost of consumption rise with the rate of usage and, therefore, a variable cost.
Purchases of raw materials
The cost of raw materials is subject to exogenous influencing factors such as scarcity and government imposition of tax duties on local and imported inputs. The company expense of $17250, 000 on raw materials is subject to change due to increased market demand for electronic goods, scarcity or imposition of duties.
Direct labor factory
Direct labor factor encompasses individual workers that participate in the immediate production process of goods. On the other hand, indirect labor includes research personnel and managers salaries that are subject to change based on the level of production.
In this case, it would be cautious to lay the assumption that insurance premium if it covers the change in production capacity or workers’ compensation. In that case, the $920,000 expense of factory insurance could also be categorized as a variable cost subject to change in the ensuing period as the firm expands its production process.
Others include indirect labor and factor utilities that are subject to change based on the firm’s rate of production.
In a different perspective, there are costs that feature in both fixed and variable categories. Such cost is defined as semi-variable or mixed costs. For example, water billing is calculated on a fixed amount up to a certain consumption level after which a constant charge rate is introduced on the extra units above the threshold. The accounting experts advises companies to employ cost behavior analysis techniques such as high-low method, scatter diagram or the least-square regression analysis method to ascertain correctly the fixed and variable cost ratios of particular expenses (Horngren, Sundem, Stratton, Burgstahler & Schatzberg, 2002). All methods endeavor to create a boundary between the fixed and variable cost of firm’s expense as a cautionary approach to avoid double counting or over-estimation of operation cost.
Expenses such as water, electricity and phone billing apply a fixed charge on a stated amount and then a cap a constant unit expense on any unit consumed above the set limit. Such cost would be rationed as fixed and variable expense on the ECC income statement.
Based on the level of consumption, the firm may opt to increase or reduce the number of workforces hence affecting the level of the salary cost. The management could consider employing few workers who would be paid fixed monthly salaries as well as an agreed hourly payment upon working overtime to regulate the exaggeration of cost.
What effect would a sales volume increase or decrease have on a unit fixed cost, unit variable cost, total fixed costs, and total variable cost?
Sales volume refers to the number of units that a firm produces in a given operation period. Changes in the level sales volume would have an impact on the firm’s production costs as well as the total sales.
A change in the sales volume would have an inverse impact on the unit fixed cost of production. That is, an increase in the volume of production will cause a decrease in fixed cost per unit output and vice versa (Horngren, Sundem, Stratton, Burgstahler & Schatzberg, 2002). The operating income will change due to change in unit fixed cost.
Change in sales volume will not influence the variable cost on any unit produced. The variable costs will remain constant throughout. The variation will have no impact on the contribution margin of the ECC Company.
Total fixed cost
In case a firm opts to increase sales volume to meet the market demand, the variation will have no impact on the total fixed costs because the expenses are independent of the company’s daily operations. Ultimately, the net operation income will remain unaffected by the adjustments to the sales volume.
Total fixed cost
Total variable cost
Change in sales volume results in a direct proportionate change in the total expense of variable cost. Subsequently, an impact would be evident in the company’s cash flow as well as the net operating income.
Total variable cost
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. (2002). Introduction to Management Accounting: Chapters 1-17. Prentice Hall.