Management accounting contains a number of decision-making tools that require the conversion of all operating costs and expenses into fixed and variable components. The responsibility for providing this cost behavior information falls squarely upon the shoulders of the management accountant. The conversion of ordinary financial data as typically found in the general ledger accounts requires that the management accountant have a thorough understanding of cost behavior theory. The identification and measurement of fixed and variable costs is somewhat complicated by the fact that some costs are fixed or variable at the discretion of management, while other costs are not.
Furthermore, for those expenditures that are inherently variable, management has the ability, within limits, to control the magnitude of the variable cost factors. In order to exercise this control, management also needs a solid understanding of the nature of cost behavior. In management accounting, the classification and measurement of fixed and variable cost is based on a body of knowledge that involves a number of assumptions. In many cases, the usefulness of fixed and variable cost data depends on the validity of these assumptions. In order to avoid poor operating results and faulty decision making that is likely to occur when false cost assumptions are made, the ability to recognize and measure cost behavior is essential.
The most volatile variable in any business is volume; that is, units produced or units sold. A change in volume has an immediate impact on variable costs. Variable costs are those costs that increase or decrease with corresponding changes in volume. However, the exact relationship between total variable cost and volume in practice is not always easy to describe or measure. Therefore, in both management accounting and economic theory, the relationship between volume and total variable cost is often determined by assumption. An important point that needs understanding is that some costs are not inherently fixed or variable but become one or the other by management exercising its decision-making powers. Management has the discretionary power to make some costs either variable or fixed. For example, sales people compensation can be either fixed or variable.
If management decides to reward sales people on the basis of a commission, then sales people’s compensation is variable. If the basis for rewarding sales effort is a salary, then sales people’s compensation is a fixed expense. If factory workers are paid a wage rate, then factory workers’ compensation is variable. The decision to pay workers a salary would make the factory labor compensation a fixed cost in the short- run. In management accounting, the relationship between activity and total variable cost is assumed to be linear. If the cost per unit of output sharply changes outside of this range of activity, then the use of a constant average cost per unit values should be avoided.