For budgeting purposes, management need to be able to predict how costs will vary
with differing levels of activity. For example, if a furniture manufacturer expected to
produce 1,000 chairs in a month, what should he budget for the costs of wood,
labour, oil, selling price, factory heating, etc? How would these costs differ, if at all, if
he expected to produce 2,000 chairs?
To make budgeting and forecasting easier, costs are split into the following
categories:
Variable costs – these are costs that vary with the level of production or activity. It is
usually assumed to vary in direct proportion to production. For example, if you make
twice the number of chairs then the assumption is that the amount of wood used
would be doubled.
Fixed costs – these are costs that are not affected by changes in the level of
production or activity, hence costs that don’t vary. For example, rent costs for a
factory. It is assumed that if production increases, the factory rent cost would not be
increasing based on the production volume.
Semi-variable costs – these are costs that have a fixed element and a variable
element. This means that if production were to double, the cost of production will not
double because of the fixed cost element in the production cost, which will remain
the same. For example, the cost of electricity for the factory has a fixed element
relating to lighting and a variable element relating to power used in the production
line.
Stepped costs – these are costs that remain fixed up to a particular level of activity,
but which rise to a higher (fixed) level if activity goes beyond that range. For
example, a business may pay £40,000 per year to rent a factory in which they can
produce up to 1 million units of product per year. However, if demand increases to
more than 1 million units, a second factory may be required – in which case the cost
of factory rent may step up to £80,000 per year and then stay constant until we
want to make 3 million units.