Chapter 5

Cost Behavior

ACCT 2200
Professor Allen Huang

Chapter Five Slide 1

 Learning Objectives

1. Identify costs as variable, fixed, step, or mixed.

2. Prepare a scattergraph to illustrate the relationship between total
cost and activity.
3. Use the high-low method to analyze mixed costs.
4. Use least-squares regression to analyze mixed costs.
5. Prepare and interpret a contribution margin income statement.
6. Compare variable costing to full absorption costing.

Chapter Five Slide 2

 Cost Behavior Patterns

Cost behavior describes the way total cost behaves,

or changes, when some measure of activity changes.

The range of activity within which

assumptions about cost behavior hold
true is the relevant range.

Unit variable costs Total fixed costs

remain unchanged. remain unchanged.

Chapter Five Slide 3

 Variable Costs

Total variable costs Variable cost per unit is

increase as constant as
activity increases. activity increases.

Chapter Five Slide 4

 Fixed Costs

Total fixed costs Cost per cup

remain constant as declines as
activity increases. activity increases.
Chapter Five Slide 5
 Cost Behavior Summary

Chapter Five Slide 6

 Step Costs

Step-variable costs Step-fixed costs are fixed

rise in multiple steps over a fairly wide range of
across the relevant range. activities.

Chapter Five Slide 7

 Mixed Costs

Mixed costs contain a fixed portion that is incurred even when

the facility is unused, and a variable portion that increases
with usage. Utilities typically behave in this manner.
Total Utility Cost

Variable
Cost per KW

Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

Chapter Five Slide 8

 Mixed Costs

Total mixed costs Per unit mixed costs

increase as decrease as
activity increases. activity increases.

Chapter Five Slide 9

 Determining Cost Behavior

Camp Rainbow offers overnight summer camp programs for children ages 10-14
every summer during June and July. Each camp session is one week and can
accommodate up to 200 children. Boys attend during the odd-numbered weeks
and girls attend during the even-numbered week. While at the camp, participants
make crafts, participate in various sports, help care for the camp’s resident animals,
have cookouts, and help assemble toys for local underpriviledged children.
The camp provides all food as well as materials for all craft classes and the toys to
be assembled. One cabin can accommodate up to 10 children, and one camp
counselor is assigned to each cabin. Three camp managers are on-site regardless of
the number of campers enrolled.
For each of the following items, identify whether the cost is variable, fixed, mixed,
step-variable, or step-fixed.
a. Cost of meals for campers. b. Cost of camp counselor wages.
c. Cost of crafting materials. d. Depreciation on the cabins.
e. Feed for the camp animals. f. Electricity for the camp.
g. Camp managers’ salary. h. Cost of toys to be assembled by campers.
i. Housekeeping (e.g., cleaning cabins between sessions, laundering bed linens.
Chapter Five Slide 10
 Determining Cost Behavior

a. Cost of meals for campers. Variable

b. Cost of camp counselor wages. Step-variable
c. Cost of crafting materials. Variable
d. Depreciation on the cabins. Fixed.
e. Feed for the camp animals. Variable (with the number of animals);
fixed with respect to the number of
students at the camp)
f. Electricity for the camp. Mixed.
g. Camp managers’ salary. Fixed.
h. Cost of toys to be assembled by Variable (if purchased based on # of
campers. campers expected)
i. Housekeeping (e.g., cleaning cabins Step-variable
between sessions, laundering bed
linens).

Chapter Five Slide 11

 Linear Approaches to Analyzing Mixed Costs

y = Total Costs

a = Intercept

x = Activity

Chapter Five Slide 12

 Linear Approaches to Analyzing Mixed Costs

There are three different methods to analyze mixed costs, all using the
linear assumption as a base.

1. Scattergraph: A graph that provides a visual representation of the

relationship between total cost (y) and activity level (x). It is a useful
first step in analyzing cost behavior.

2. High-low method: A simple approach that uses the two most extreme
data points to determine the slope of the line (variable cost per unit)
and the intercept (total fixed cost).

3. Least-squares regression: A statistical technique for finding the best

fitting line based on historical data. The slope of the line provides an
estimate of the variable cost per unit, while the intercept provides an
estimate of the total fixed cost.

Chapter Five Slide 13

 Scattergraph

A scattergraph is a graph with total cost plotted on the

vertical (Y) axis and some measure of activity on the
horizontal (X) axis.

Chapter Five Slide 14

 Preparing a Scattergraph

A scattergraph can be created by manually plotting data points

on graph-paper, or by using a the following steps in Excel:
1. Enter the data in Excel, and highlight the data.
2. Select Insert from toolbar and then Scatter.
3. Add a chart title and labels for the X and Y axes.

To apply these steps, consider the

following data showing the total
overhead cost (Y) of running our
hypothetical Starbucks location,
along with the number of
customers served (X).

Chapter Five Slide 15

 Preparing a Scattergraph

Chapter Five Slide 16

 High-Low Method

Chapter Five Slide 17

 High-Low Method

February Estimate
_
Total Fixed Cost = $15,750 $0.25 × 15,000
Total Fixed Cost = $12,000

May Estimate
_
Total Fixed Cost = $13,250 $0.25 × 5,000
Total Fixed Cost = $12,000

Chapter Five Slide 18

 High-Low Method

Chapter Five Slide 19

 Least-Squares Regression Method

A statistical method used to analyze mixed costs.

18 000

16 000

14 000
} Error
Total Overhead Cost

12 000

10 000

8 000

6 000

4 000

2 000

-
- 2 000 4 000 6 000 8 000 10 000 12 000 14 000 16 000
Customers Served

The goal of this method is to minimize the sum of the squared errors.

Chapter Five Slide 20

 Least-Squares Regression Method

 Software such as Excel can be

used to fit a regression line
through the data points.
 The cost analysis objective is the
same:
y = a + bx

The output from the regression analysis can be used

to create an equation that enables you to estimate
total costs at any activity level.

Chapter Five Slide 21

 Least-Squares Regression Method

Chapter Five Slide 22

 Least-Squares Regression Method

R2 tell us how closely we

can explain the relationship
between our two variables.
In our example, the number
of customers explains about
64% of the overhead costs.

The intercept and x

coefficient,
respectively, are
estimated total fixed
cost and variable
cost per unit.
Chapter Five Slide 23
 Least-Squares Regression Method

Chapter Five Slide 24

 Least-Squares Regression Method

Total Total Fixed Total Variable Cost

Cost
= Cost
+ (Variable Cost per Unit × X)

Using our regression output, if Starbucks expected to

serve 8,000 customers in July, we would estimate total
overhead costs as follows:

$0.32 × 8,000 =
$11,181 + $2,560
= $13,741

Chapter Five Slide 25

 Summary of Linear Methods

Chapter Five Slide 26

 Determining Cost Behavior
Dove Company manufactures one model of birdbath, which is very popular. Dove
sells all units it produces each month. The relevant range is 0-1,500 units, and
monthly production costs for the production of 500 units follow.

Production Costs Total Cost

Direct materials $1,500
Direct labor 7,500
Utilities ($100 fixed) 650
Supervisor’s salary 3,800
Maintenance ($280 fixed) 480

1.Identify each cost as variable, fixed, or mixed, and express each cost as a
rate per month or per unit (or combination).
2. Determine the total fixed cost per month and the variable cost per unit
for Morning Dove.
3. Calculate Morning Dove’s expected total cost if production increased to
1,200 units per month.
Chapter Five Slide 27
 Determining Cost Behavior

Production Costs Behavior Rate

Direct materials Variable $3.00/unit
Direct labor Variable $15.00/unit
Utilities ($100 fixed) Mixed $100/month (fixed); $1.10/unit (variable)
Supervisor's Salary Fixed $3,800/month
Maintenance ($280 fixed) Mixed $280/month (fixed); $.40/unit (variable)

Direct materials $3.00

Direct labor $15.00 Utilities $ 100
Utilities $ 1.10 Supervisor's Salary $ 3,800
Maintenance $ .40 Maintenance $ 280
Total Variable Cost/unit $19.50 Total Fixed Cost/Month $ 4,180

Total Cost = $4,180 + $19.50(# birdbaths produced)

Total Cost = $4,180 + $19.50(1,200) = $27,580

Chapter Five Slide 28

 Contribution Margin Approach

Contribution margin is the difference between

sales revenue and variable costs.

Chapter Five Slide 29

 Contribution Margin Ratio

Contribution Margin Formula

Contribution Sales Variable

Margin = Revenue ‒ Costs

Contribution Margin Ratio

Contribution Contribution Margin

Margin Ratio = Sales Revenue

Chapter Five Slide 30

 Contribution Margin

Unit contribution margin

Contribution margin ratio

Chapter Five Slide 31
 Contribution Margin

Starbucks is planning on a new ad campaign that

costs $2,000 of advertising expense. The manager
estimate that it will increase sales by $5,000. What
is the new ad campaign’s impact on Starbucks’ net
operating income?

Chapter Five Slide 32

 Preparing a Contribution Margin Income Statement

Sandy’s Socks’ production information for the last eight months follows:
Month Number of Socks Produced Total Cost
January 8,000 $7,000
February 4,500 5,000
March 7,000 6,250
April 8,600 7,750
May 3,750 5,000
June 6,000 6,250
July 3,000 4,250
August 5,000 5,750

1. Using the high-low method, calculate the total fixed cost per month
and the variable cost per sock.
2. Using the results in (1), suppose that Sandy’s expects to sell 4,000
socks during the month of September and that each sock sells for
$2.75. Prepare Sandy’s contribution margin income statement for the
month of September.
Chapter Five Slide 33
 Preparing a Contribution Margin Income Statement

High-low method should be based on April and July:

Variable cost per unit = (Difference in total cost) / (Difference in activity)
= ($7,750 – $4,250) / (8,600 – 3,000)
= $.625 per sock produced
Fixed cost = Total cost – (Variable cost per unit x Activity)
= $7,750 – ($.625 x 8,600)
= $2,375

Sandy’s Socks
Contribution Margin Income Statement
Month of September

Sales revenue (4,000 x $2.75) $11,000.00

Less: Total variable costs (4,000 x $.625) 2,500.00
Contribution margin 8,500.00
Less: Total fixed costs 2,375.00
Net operating income $6,125.00

Chapter Five Slide 34

 Variable Versus Full Absorption Costing

Chapter Five Slide 35

 Reconciling Variable and Full Absorption Costing

Production information in month 1:

Chapter Five Slide 36

 Full Absorption Costing Income Statement
Variable costs only.

All fixed manufacturing overhead is expensed.

Fixed manufacturing cost difference between the two methods:
$200,000 − $200,000/10,000 x 8,000 unit = $40,000
Alternatively, $20 (fixed cost per unit) x 2,000 (diff in units) = $40,000
Chapter Five Slide 37
 Full Absorption Costing Income Statement

In Month 2, the production and sales are both 8,000 units.

Chapter Five Slide 38

 Full Absorption Costing Income Statement

In Month 3, the production is 6,000 and sales are 8,000 units.

$200,000 are overhead in Month 3, allocated to the 6,000 units produced and sold.
$40,000 are overhead from Month 1, allocated to the 2,000 unsold units in Month 1
Chapter Five and sold in Month 3. Slide 39
 Effect of Changes in Inventory Under
Full Absorption and Variable Costing

Chapter Five Slide 40

 Comparing Full Absorption and Variable Costing

Dance Creations manufactures authentic Hawaiian hula skirts that are purchased
for traditional Hawaiian celebrations, costume parties, and other functions. During
its first year of business, the company incurred the following costs:

Dance Creation charges $30 for each skirt that it sells. During the first month of
operation, it made 1,500 skirts and sold 1,375.
Prepare a variable costing income statement and a full absorption costing income
statement. Suppose next month Dance Creations expects to produce 1,200 hula
skirts and sell 1,300. Without any calculation, explain whether variable or full
absorption costing will show a higher profit.
Chapter Five Slide 41
 Comparing Full Absorption and Variable Costing

Chapter Five Slide 42

 Comparing Full Absorption and Variable Costing

When inventory decreases, variable costing will show a

greater income than absorption costing.
Chapter Five Slide 43