When analyzing costs, it is helpful to divide them into three categories: fixed, variable, and semi-variable. Analyzing costs is necessary when a business is evaluating how to maximize profit and minimize loss through its decision-making. These decisions are made with the company’s future in mind.
Looking at cost and revenue data from the past can be helpful but management must seek to make estimates predicting the future. This type of evaluation also involves opportunity costs which cannot be measured in accounting records. Opportunity cost is the income sacrificed by not choosing the best alternative.
These costs do not change regardless of the level of business activity. Fixed costs are fixed only in the context of existing operations. The management’s decisions to operate the business in a particular way causes the costs to remain fixed until the context of operation alters.
Most costs vary to some extent. Factory costs, materials, overhead and direct labor vary with the volume of production. Selling costs differ with sales volume. Administrative costs and utility costs differ as well depending on a variety of factors.
These are costs that vary but contains a fixed-cost element as well. The variable component of the cost is payable proportionate to the level of activity. Many semi-variable costs increase in proportion over most levels of activity but out of proportion at very low and high levels.