Chapter 5

Cost Behavior: Analysis and Use

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Types of Cost Behavior Patterns

Recall the summary of our cost behavior discussion from Chapter 2.
Summary of Variable and Fixed Cost Behavior
Cost Variable In Total Total variable cost is proportional to the activity level within the relevant range. Total fixed cost remains the same even when the activity level changes within the relevant range. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed cost per unit goes down as activity level goes up.

Fixed

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The Activity Base

Units produce d A measure of the event that causes the incurrence of a variable cost a cost driver Machine hours

Miles driven
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Labor hours
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True Variable Cost Example

Your total long distance telephone bill is based on how many minutes you talk.
Total Long Distance Telephone Bill Minutes Talked
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Variable Cost Per Unit Example

The cost per minute talked is constant. For example, 10 cents per minute.
Per Minute Telephone Charge Minutes Talked
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Step-Variable Costs
Total cost remains constant within a narrow range of activity. Cost Activity
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Step-Variable Costs
Total cost increases to a new higher cost for the next higher range of activity.

Activity
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Cost

The Linearity Assumption and the Relevant Range

Exh. 5-4

A straight line Economists closely Curvilinear Cost approximates a Function curvilinear

Total Cost

Relevant Range

variable cost line within the relevant range.

Accountants Straight-Line Approximation (constant unit variable cost) Activity

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Exh. 5-5

Total Fixed Cost Example

Your monthly basic telephone bill is probably fixed and does not change when you make more local calls.
Monthly Basic Telephone Bill Number of Local Calls
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Exh. 5-5

Fixed Cost Per Unit Example

The fixed cost per local call decreases as more local calls are made.
Monthly Basic Telephone Bill per Local Call Number of Local Calls
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Cost Behavior
Examples of normally variable costs
Merchandisers
Cost of Goods Sold

Service Organizations
Supplies and travel

Manufacturers
Direct Material, Direct Labor, and Variable Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Examples of normally fixed costs

Merchandisers, manufacturers, and service organizations
Real estate taxes, Insurance, Sales salaries Depreciation, Advertising
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Types of Fixed Costs

Committed
Long-term, cannot be reduced in the short term.

Discretionary
May be altered in the short-term by current managerial decisions

Examples
Depreciation on Buildings and Equipment
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Examples
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Fixed Costs and Relevant Range

Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost.
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Fixed Costs and Relevant Range

Rent Cost in Thousands of Dollars

Exh. 5-6

90 Relevant
Range
Total cost doesnt change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

60

30

00
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1,000 2,000 3,000 Rented Area (Square Feet)

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Fixed Costs and Relevant Range

How does this type of fixed cost differ from a step-variable cost?

Step-variable costs can be adjusted more quickly and . . .

The width of the activity steps is much wider for the fixed cost.
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Quick Check
Which of the following statements about cost behavior are true?
a Fixed costs per unit vary with the level of activity. b Variable costs per unit are constant within the relevant range. c Total fixed costs are constant within the relevant range. d Total variable costs are constant within the relevant range.
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Mixed Costs
A mixed cost has both fixed and variable components. Consider the example of utility cost.
Total Utility Cost Y

Variable Cost per KW

Activity (Kilowatt Hours)

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Fixed Monthly Utility Charge

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Mixed Costs
The total mixed cost line can be expressed as an equation: Y = a + bX Where: Y = the total mixed cost a = the total fixed cost (the vertical intercept of the line) b = the variable cost per unit of activity (the slope of the line) X = the level of activity

Total Utility Cost

Variable Cost per KW

Activity (Kilowatt Hours)

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Fixed Monthly Utility Charge

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The Analysis of Mixed Costs

Account Analysis Engineering Approach Scattergraph Plot High-Low Method Least-Square Regression Method
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Account Analysis & Engineering Estimates

Each account is classified as either variable or fixed based on the analysts knowledge of how the account behaves.

Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements.

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The Scattergraph Method

Y Plot the data points on a graph (total cost vs. activity).

Total Cost in 1,000s of Dollars

20

10

* * * *

* ** * **
X

0 1 2 3 4 Activity, 1,000s of Units Produced

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Quick-and-Dirty Method
Draw a line through the data points with about an equal numbers of points above and below the line. Y

Total Cost in 1,000s of Dollars

20

10

* * * * Intercept is the estimated

fixed cost = $10,000

* ** * **
X

0 1 2 3 4 Activity, 1,000s of Units Produced

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Quick-and-Dirty Method The slope is the estimated variable cost per unit.
Slope = Change in cost Change in units Y

Total Cost in 1,000s of Dollars

20

10

* * * * Horizontal
distance is the change in activity.

* ** * **
Vertical distance is the change in cost.

0 1 2 3 4 Activity, 1,000s of Units Produced

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The High-Low Method

WiseCo recorded the following production activity and maintenance costs for two months:
High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Using these two levels of activity, compute: the variable cost per unit; the fixed cost; and then express the costs in equation form Y = a + bX. The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Change in cost Variable cost per unit = Change in cost change in units
Change in units

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The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Variable cost per unit = $2,400 3,000 units

= $0.80 per unit

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The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Variable cost = $2,400 3,000 units = $0.80 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)

Fixed cost = $9,800 $6,400 = $3,400

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The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Variable cost = $2,400 3,000 units = $0.80 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)

Fixed cost = $9,800 $6,400 = $3,400 Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $3,400 + $0.80X
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Quick Check
Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? Units Cost 120,000 $ 14,000 a. $0.08 per unit High level 80,000 10,000 b. $0.10 per unit Low level Change 40,000 $ 4,000 c. $0.12 per unit $4,000 40,000 units d. $0.125 per unit = $0.10 per unit
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Quick Check
Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? Total cost = Total fixed cost + Total variable cost a. $ 2,000 $14,000 = Total fixed cost + ($0.10 120,000 units) b. $ 4,000 c. $10,000 Total fixed cost = $14,000 - $12,000 d. $12,000 Total fixed cost = $2,000
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Least-Squares Regression Method

Software can be used to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bx
Least-squares regression also provides a statistic, called the R2, that is a measure of the goodness of fit of the regression line to the data points.
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Least-Squares Regression Method

R2 is the percentage of the variation in total cost explained by the activity. Y 20 Total Cost

10

* * * * R2 for this relationship is near

100% since the data points are very close to the regression line. 0 1 2 3 Activity 4 X

* ** * **

0
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Lets put our knowledge of cost behavior to work by preparing a contribution format income statement.

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The Contribution Format

Sales Revenue Less: Variable costs Contribution margin Less: Fixed costs Net operating income Total $ 100,000 60,000 $ 40,000 30,000 $ 10,000 Unit $ 50 30 $ 20

The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.
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The Contribution Format

Used primarily for external reporting.

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Used primarily by management.

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End of Chapter 5

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