Question

Questions from Managerial Accounting (16th Edition)

8. Managers often assume a strictly linear relationship between cost and level of activity. How can this practice be defended in light of the fact that many costs are curvilinear?  

9. Only variable costs can be differential costs. Do you agree? Explain.

Answer 1

Linear relationship between cost and level of activity means that there is direct relationship between the cost and the level of activity. If the level of activity falls outside the relevant range, the fixed cost may vary to a certain level and variable cost might change. Cost behavior is an indicator of how a cost will change in total when there is change in some activity. Cost has three elements viz. Variable Cost, Fixed cost and Semi variable Cost or Semi fixed cost. Variable cost change with any change in the volume of production while fixed cost remains same to a certain level and changes if there is a significant change in the Production facilities or utilization.

There are always some costs which are curvilinear . Curvilinear cost can be called nonlinear cost also as the same doesn’t change with every change in production volume. Curvilinear cost may be understood by one example that when the production volume is low you have limited direct labor and there is a direct relationship between the output and the utilization of direct labor. When there is increase in production volume and it is quite high , you need to increase labor for handling the operations. The purpose of this increase is that the existing labor and the additional labor will themselves increase their productivity and get the organization the desired results, but it has been seen that at this stage the productivity is not found and the cost impact is there . It is because that even after having increased number of labor , the individual contribution has got reduced and the organization is not getting optimum level of productivity. These type of costs are curvilinear , where the cost increase , but the production doesn’t increase to that proportion.

Differential cost means when there is increase or decrease in the output by change of sales volume , alternate method of production, make or buy decision ,change in the product mix etc,; there is a change in the cost also .For example, use of machinery instead of manpower will increase the cost and will also increase the production. The differential cost is the difference in cost of machinery and cost of labor which is compared with the output and the difference is called the differential cost.

Under Marginal costing , the costs are calculated on the basis of variable costs and fixed cost but under Differential costing the costs are calculated on the basis of absorption or total costing technique. But if the alternate course of action doesn’t involve any extra fixed cost then the variable cost shall be the differential cost. Total differential revenues are compared with the total differential costs before advocating an alternate source of action.

For making a choice among various alternatives, the alternatives which gives the maximum difference between the incremental revenue and incremental cost is recommended to be adopted.