PALAWAN STATE UNIVERSITY

College of Business and Accountancy

Department of Accountancy
Puerto Princesa City

MODULE 3:
COST BEHAVIOR
BA2002: COST AND MANAGEMENT ACCOUNTING
2ND Semester | SY: 2020-2021

BSBA-MM 1

LARA CAMILLE C. CELESTIAL, CTT, CMA

College of Business and Accountancy
Palawan State University
 TABLE OF CONTENTS

Title Page of Module 1

Table of Contents 2

Overview 3
Course Outcome 3
Learning Outcomes 3
Summary of Topics 3
Content
Topic 1: Basics of Cost Behaviour 4
1.1 Fixed Cost 4
1.2 Variable Cost 5
1.3 Mixed Cost 6
Topic 2: Quantitative Methods for Separating Mixed Cost 7 2.1
High-Low Method 7
2.2 Method of Least Squares 8
Topic 3: Learning Curve 10
3.1: Cumulative Average Time Learning Curve 11
3.2: Incremental Unit-time Learning Curve 12
3.3: Factors limit the Learning Curve 12
Reference 14

MODULE 3 |
COST BEHAVIOR
BA2002: Cost and Management Accounting| Module 3: Cost Behavior 2
Overview
Costs can display variable, fixed, or mixed behaviour. Knowing how
costs change as activity changes is essential to planning, controlling,
and decision-making. For example, budgeting, deciding to keep or
drop a product line, and evaluating the performance of a segment all
depend on an understanding of cost behaviour. Not knowing and
understanding cost behaviour can lead to poor – and even disastrous –
decisions.

Cost-volume-profit analysis and variable costing systems, for example,

require that all costs be classified as fixed or variable. This module
describes ways of separating costs into fixed and variable categories,
discusses the assumptions and limitations underlying these methods,
and assess the reliability of these procedures.

Intended Learning Outcomes:

 Define and describe fixed, variable, and mixed costs.
 Explain the use of resources and activities and their relationship to cost behavior
 Explain how several methods of cost estimation can be used.
 Separate mixed costs into their fixed and variable components using the high-low
method, the scatterplot method, and the method of least squares.
 Evaluate the reliability of the cost formula
 Define the learning curve and discuss its impact on cost behaviour

Topics:
1: Basics of Cost Behaviour
1.1 Fixed Cost
1.2 Variable Cost
1.3 Mixed Cost
2: Quantitative methods for separating mixed cost
2.1: High-Low Method
2.2 Method of Least Squares
3: Learning Curve
3.1: Cumulative Average Time Learning Curve
3.2: Incremental Unit-time Learning Curve
3.3: Factors limit the Learning Curve

Topic #1: Basics of Cost Behavior

Cost behaviour is the term used to describe whether a cost changes when the level of
output changes. A cost that does not change as output changes is a fixed cost. A variable cost
on the other hand, increases in total with an increase in output and decreases in total with a
decrease in output. While economics may assume the fixed and variable costs are known, in
BA2002: Cost and Management Accounting| Module 3: Cost Behavior 3
the real world, management accountants must determine them. Let’s first review the basics of
cost and output measures. Then, we will look at fixed, variable, and mixed costs. Finally, we
will assess the impact of time horizon on cost behaviour.

COST OBEJCTS

Recall from Module 2 that a cost object is the item for which managers want cost
information. So the first step is to determine appropriate cost objects. This is relatively easy in
manufacturing firm; the cost object is typically the tangible product. For service firms, the
logical cost object is the service. For example, hospitals may view particular services such as
blood tests or radiology services as primary cost objects. There are, however, a variety of cost
objects for which managers may need to know cost behaviour.

MEASURES OF ACTIVITY OUTPUT

The terms fixed cost and variable cost only have meaning when related to some output
measure or driver. Therefore, we must first determine the underlying activities and the
associated drivers that measure the capacity of an activity and its output. For example,
shipping goods may be measured by the units sold; materials handling may be measured by
the number of moves; and laundering hospital linen may be measured by the pounds of
laundry. The choice of driver is tailored not only to the particular firm but also to the particular
activity or cost being measured.

Activity drivers explain changes in activity costs by measuring changes in activity output
(usage). The two general categories of activity drivers are unit-level drivers and non-unit-level
drivers. Recall the drivers are factors that cause changes in resource usage, activity usage,
costs, and revenues. Unit-level drivers explain changes in cost as units produced change.
Pounds of direct materials, kilowatt-hours used to run production machinery, and direct labor
hours are example of unit-based activity drivers. While none of these drivers is equal to the
number of units produced, each does vary proportionately with the number of units produced.
Non-unit-level drivers explain how costs change as factors other than the number of units
produced changes.

1.1 FIXED COST

Fixed costs are those that stay the same in total regardless of the number of units
produced or sold. Although total fixed costs are the same, fixed costs per unit changes as
fewer or more units are produced. Straight‐line depreciation is an example of a fixed cost. It
does not matter whether the machine is used to produce 1,000 units or 10,000,000 units in a
month, the depreciation expense is the same because it is based on the number of years the
machine will be in service.

Graphically, the total fixed cost looks like a straight horizontal line. Although total fixed
costs are constant, the fixed cost per unit changes with the number of units.

BA2002: Cost and Management Accounting| Module 3: Cost Behavior 4

1.2 VARIABLE COST

Variable costs are the costs that change in total each time an additional unit is
produced or sold. With a variable cost, the per unit cost stays the same, but the more units
produced or sold, the higher the total cost. Direct materials is a variable cost. If it takes one
yard of fabric at a cost of $5 per yard to make one chair, the total materials cost for one chair
is $5. The total cost for 10 chairs is $50 (10 chairs × $5 per chair) and the total cost for 100
chairs is $500 (100 chairs × $5 per chair).

When cost behavior is discussed, an assumption must be made about operating levels.
At certain levels of activity, new machines might be needed, which results in more
depreciation, or overtime may be required of existing employees, resulting in higher per hour
direct labor costs. The definitions of fixed cost and variable cost assumes the company is
operating or selling within the relevant range (the shaded area in the graphs) so additional
costs will not be incurred.

BA2002: Cost and Management Accounting| Module 3: Cost Behavior 5

LINEARITY ASSUMPTION

A linear cost function is used to approximate the underlying cost function within a
relevant range because it is less time consuming and less expensive to estimate. A relevant
range is the range of activity for which the assumed cost relationship is valid.

1.3 MIXED COST

Some costs, called mixed costs, have characteristics of both fixed and variable costs.
For example, a company pays a fee of $1,000 for the first 800 local phone calls in a month
and $0.10 per local call made above 800. During March, a company made 2,000 local calls. Its
phone bill will be $1,120 ($1,000 + (1,200 × $0.10)).

To analyse cost behavior when costs are mixed, the cost must be split into its fixed and
variable components. Several methods are used to identify the variable and fixed portions of a
mixed cost, which are based on the past experience of the company. Each method requires us
to make the simplifying assumption of a linear cost relationship. Therefore, before we examine
each of these methods more closely, let's review the expression of cost as an equation for a
straight line.

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 Y = F+VX
Where:
Y = Total Cost (the dependent variable)
F = Fixed cost component (the intercept parameter)
V = Variable cost per unit (the slope parameter)
X = Measure of output (the independent variable)

a) The dependent variable is a variable whose value depends on the value of another
variable. In the preceding equation, total cost is the dependent variable; it is the cost we
are trying to predict.

b) The independent variable is a variable that measures output and explains changes in
the activity cost. It is an activity driver. A good independent variable causes or is closely
associated with the dependent variable.

c) The intercept parameter corresponds to fixed cost. Graphically, the intercept

parameter is the point at which the mixed cost line intercepts the cost (vertical) axis.

d) The slope parameter corresponds to the variable cost per unit of activity. Graphically,
this represents the slope of the mixed cost line.

Since the accounting records reveal only X and Y, those values must be used to estimate
the parameters F and V. With estimates of F and V, the fixed and variable components can be
estimated, and the behavior of the mixed cost can be predicted as output changes.

Topic #2: Quantitative Methods for Separating Mixed Cost

Two methods will be described for estimating F and V:

a) the high-low method
b) the method of least squares

2.1 HIGH-LOW METHOD

Basic geometry tells us that two points determine a line. F, the fixed cost component, is the
intercept of the total cost line, and V, the variable cost per unit, is the slope of the line. Given
two points, the slope and the intercept can be determined. The high-low method preselects the
two points that are used to compute the parameters F and V. The high point is defined as the
point with the highest activity level. The low point is defined as the point with the lowest activity
level. Note that the high and low points are determined by the independent variable, not the
dependent (typically cost) variable.
Variable Cost per unit = (High cost - Low cost)
(High units - Low units)

Fixed cost = Total cost - (Variable rate x Units)

BA2002: Cost and Management Accounting| Module 3: Cost Behavior 7

EXAMPLE:

Anderson Company had the following 10 months of data on materials handling cost and
number of moves:

Month Materials Handling Cost Number of Moves

January 2,000 100
February 3,090 125
March 2,780 175
April 1,990 200
May 7,500 500
June 5,300 300
July 4,300 250
August 6,300 400
September 5,600 475
October 6,240 425

Required:
1) Determine the high point and the low point.
2) Calculate the variable cost per unit for materials handling based on the number of
moves.
3) Calculate the fixed monthly cost of materials handling.

SOLUTION:

1) High point = 500 moves (May)

Low point = 100 moves (January)
2) Variable Cost per unit = (7,500 – 2000) = 13.75 per move
(500 – 100)

3) HP: Fixed Cost = 7,500 – (13.75 per move x 500 moves) = 7,500 – 6,875 = 625
LP: Fixed Cost = 2,000 – (13.75 per move x 100 moves) = 2,000 – 1,375 = 625

2.2 METHOD OF LEAST SQUARES

The use of linear regression (least squares method) is the most accurate method in
segregating total costs into fixed and variable components. The total fixed cost and variable
cost per unit are determined mathematically through a series of computations.

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Like the other methods of cost segregation, the least squares method follows the same cost
function:

Y = a+bx
Where:
Y = Total Cost
F = Total Fixed Cost
V = Variable cost per level of activity
X = Level of activity

Using the normal equations above, a formula for b can be derived. The variable cost per unit
or slope is computed using the following formula:

Variable Cost per unit (b): b = n∑xy – (∑x)(∑y)

n∑x² – (∑x) ²
Once b has been determined, the total fixed cost or a can be computed using the formula:

Total Fixed Cost (a): a = ∑y – b∑x

n
EXAMPLE:
Anderson Company had the following 10 months of data on materials handling cost and
number of moves:

Month Mat. Handling Cost (y) # of Moves (x) XY X2

January 2,000 100 200,000 10,000
February 3,090 125 386,250 15,625
March 2,780 175 486,500 30,625
April 1,990 200 398,000 40,000
May 7,500 500 3,750,000 250,000
June 5,300 300 1,590,000 90,000
July 4,300 250 1,075,000 62,500
August 6,300 400 2,520,000 160,000
September 5,600 475 2,660,000 225,625
October 6,240 425 2,652,000 180,625

45,100 2,950 15,717,750 1,065,000

Required:

BA2002: Cost and Management Accounting| Module 3: Cost Behavior 9

1) Calculate the variable cost per unit for materials handling based on the number of moves.
2) Calculate the total fixed cost
3) What is the cost function?
4) Calculate the total cost at activity levels of 600 and 700 moves

SOLUTION:
1. b = n∑xy – (∑x)(∑y) = 10(15,717,750) – (2,950)(45,100)
n∑x² – (∑x) ² 10 (1,065,000) – (2,950) ²
= 12.39 moves

2. a = ∑y – b∑x = 45,100 – (12.39)(2,950) = 8,549.5 = 854.95

n 10 10

3. Y = 854.95 + 12.39x

4. Y = 854.95 + 12.39 (600) = 8,288.95

Y = 854.95 + 12.39 (700) = 9,527.95

Topic #3: Learning Curve

A number of cost behavior patterns do not follow a linear pattern. We have

already seen that total cost can increase at a decreasing rate, as is the case when there are
discounts for large purchases of materials. An important type of nonlinear cost curve is the
learning curve. The learning curve shows how the labor hours worked per unit decrease as the
number of units produced increases. The basis of the learning curve is almost intuitive—as
we- perform an action over and over, we improve, and each additional performance takes less
time than the -preceding ones. We learn how to do the task, become more efficient, and
smooth out the rough spots. In a manufacturing firm, learning takes place throughout the
process: workers learn their tasks and agers learn to schedule production more efficiently and
to arrange the flow of work. Each time cumulative volume doubles, costs fall by a constant
and-predictable percentage. This effect was first documented in the aircraft industry.

Managers can see that the ideas behind the learning curve can extend to the service
industry as well as to manufacturing firms. Costs in marketing, distribution, and service after
BA2002: Cost and Management Accounting| Module 3: Cost Behavior 10
the sale also decrease as the number of units produced and sold. When used in this way, the
learning curve is often called the experience curve. The experience curve relates cost to
increased efficiency, such that the more often a task is performed, the lower will be the cost of
doing it. The experience curve can be applied to any task, including: production, selling,
distribution, post-sales service, and so on.

The learning curve model takes two common forms (The difference between the two lies in the
assumption made about the speed of learning):

a) the cumulative: average-time learning curve model

b) the incremental unit-time learning curve model

3.1 CUMULATIVE AVERAGE TIME LEARNING CURVE

The cumulative average-time learning curve model states that the cumulative average
time per unit decreases by a constant percentage, or learning rate, each time the cumulative
quantity of units produced doubles. The learning rate is expressed as a percent, and it gives
the percentage of time needed to make the next unit, based on the time it took to make the
previous unit.

The learning rate is determined through experience and must be between 50 and 100
percent. A 50 percent learning rate would eventually result in no labor time per unit—an
absurd result. A 100 percent learning rate implies no learning (since the amount of decrease is
zero). An 80 percent learning curve is often used to illustrate this model, possibly because the
original learning curve work the aircraft industry found an 80 percent learning curve. Illustration
below shows how to calculate the amount of time needed for producing successive units given
an 80 percent learning rate and 100 direct labor hours for the first unit.

EXAMPLE:

Propeller Inc. plans to manufacture a newly designed high-technology propeller for airplanes.
Propeller forecasts that as workers gain experience, they will need less time to complete the
job. Based on prior experience, Propeller estimates a 70% cumulative learning curve and has
projected the following costs.

What is the total manufacturing cost for Propeller if it manufactures eight propellers?

Cumulative number Manufacturing Projections

of units produced Average cost per unit Total
costs

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 1 $20,000 $20,000

2 14,000 28,000

4 9,800 39,200
8 6,860 54,880

Total Manufacturing Cost for 8 propellers = (6,860 x 8) = 54,880

3.2 INCREMENTAL UNIT-TIME LEARNING CURVE

The incremental unit-time learning curve model decreases by a constant percentage

each time the cumulative quantity of units produced doubles. The same general assumptions
for the learning curve hold; however, the learning rate is assumed to apply to the last unit
produced, not to the cumulative average of all units to date. For an 80 percent learning rate,
the cumulative average-time learning model assumes that the cumulative average time for
every unit produced is just 80 percent of the amount for the previous output level. Thus, when
we look at the time to produce two units, the average time for each of the units is assumed to
be 80 percent of the time for the first unit. However, the incremental unit-time learning model
assumes that only the last (incremental) unit experiences the decrease in time, so the second
unit takes 80 hours, but the first still takes 100 hours. Thus, the total time is 180 (100 + 80)
hours. Further explanation of the incremental unit-time learning curve be left for more
advanced courses.

The use of the learning curve concepts permits management to be more accurate in
budgeting and performance evaluation for processes in which learning occurs while the
learning curve was originally developed manufacturing processes, it can also apply in service
industries. For example, insurance companies develop new policies and new methods of
selling policies. There is a learning component to each new policy as employees discover
glitches that were unexpected in the development process and then learn how to fix those
glitches and become more efficient.

3.3 FACTORS LIMIT THE LEARNING CURVE

The workers will keep improving their skills as the more the units produce; however, it
does not mean the improvement will go forever. At any specific time (output level) it will stop
due to some specific factors such as:

The workers may keep improving their

skills and spend less time, but the
Machine machine will not be able to reduce its

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 working hours. So it will become
the bottleneck.
Even the workers try to improve work
efficiency and reduce time spent, they
are still the human who has the
physical limit.
Physical Limitation
The learning curve will slow down as it
reaches the bottom, we cannot reduce
the spending time to an impossible
level.
The company expects the workers to
improve their work; however, some
Staff Turnover workers will resign. As the new
workers come, the cycle of learning
curve needs to restart. The high staff
turnover will
harm the learning curve.
The team spirit is the internal power
Team Spirit that will motivate the staff to complete
the tasks and continue improvement.
For example, they will not work hard if
they have any conflict with their direct
managers.
The workers will improve themselves
when they do the same task over and
Work Rotation over. If the company require them to
rotate their job so often, it also impacts
their learning curve. They need to start
over from the beginning when learning
new tasks.

REFERENCES|
Leonardo E. Aliling, CPA, MBA and Ma. Flordeliza L. Anastacio, CPA, PhD, Management Accounting
1 (2015) Rex Publishing

BA2002: Cost and Management Accounting| Module 3: Cost Behavior 13