Activity Cost Behavior

Prepared by

Douglas Cloud
Pepperdine University

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Objectives
1. Define and describe fixed, variable, and After studying this mixed costs. chapter, you should 2. Explain the use of beresources able to: and activities and their relationship to cost behavior. 3. Separate mixed costs into their fixed and variable components using the high-low method, the scatterplot method, and the method of least squares.
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Objectives
4. Evaluate the reliability of the cost formula. 5. Explain how multiple regression can be used to assess cost behavior. 6. Define the learning curve, and discuss its impact on cost behavior. 7. Discuss the use of managerial judgment in determining cost behavior.

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Fixed Costs
Fixed costs are costs that in total are constant within the relevant range as the level of the activity driver varies.

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Fixed Costs
Two production lines can process 10,000 computers per year each. The workers on each line are supervised by a production-line manager who is paid $24,000 per year. For production up to 10,000 units, only one supervisor is needed. When production is between 10,001 and 20,000 computers being produced, two supervisors are required.

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Total Fixed Cost Graph

$60,000 $50,000 $40,000 $30,000 F = $24000 $20,000 $10,000 0 4 8 10 12 16 Units Produced (000) Total Costs

Fixed Costs

Supervision $24,000 24,000 24,000 48,000 48,000 48,000

Computers Processed 4,000 8,000 10,000 12,000 16,000 20,000

Unit Cost $6.00 3.00 2.40 4.00 3.00 2.40

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Total Fixed Cost Graph

$60,000 $50,000 $40,000 $30,000 F = $24000 $20,000 $10,000 0 4 8 10 12 16 Units Produced (000) Total Costs

Fixed Costs

Supervision $24,000 24,000 24,000 48,000 48,000 48,000

Computers Processed 4,000 8,000 10,000 12,000 16,000 20,000

Unit Cost $6.00 3.00 2.40 4.00 3.00 2.40

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Total Fixed Cost Graph

$60,000 $50,000 $40,000 $30,000 $20,000 $10,000 Total Costs F = $48,000

Fixed Costs

0 4 8 10 12 16 Units Produced (000)

Supervision $24,000 24,000 24,000 48,000 48,000 48,000

Computers Processed 4,000 8,000 10,000 12,000 16,000 20,000

Unit Cost $6.00 3.00 2.40 4.00 3.00 2.40

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Total Fixed Cost Graph

$60,000 $50,000 $40,000 $30,000 $20,000 $10,000 Total Costs F = $48,000

Fixed Costs

0 4 8 10 12 16 Units Produced (000)

Supervision $24,000 24,000 24,000 48,000 48,000 48,000

Computers Processed 4,000 8,000 10,000 12,000 16,000 20,000

Unit Cost $6.00 3.00 2.40 4.00 3.00 2.40

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Variable costs are costs that in total vary in direct proportion to changes in an activity driver.

Variable Cost

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Variable Cost
A 3-inch disk drive is added to each computer at a cost of $30 per computer. The total cost of disk drives for various levels of production is a follows:
Total Cost of Disk Driver
$120,000 240,000 360,000 480,000 600,000

Number of Computers Produced

4,000 8,000 12,000 16,000 20,000

Unit Cost of Disk Drives

$30 30 30 30 30
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Variable Cost
Y v = VX Y v = Total variable costs V = Variable cost per unit X = Number of units of the driver

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Variable Cost
Cost (in thousands)

$600
480 360 240 120

Y v = $30X

4,000 8,000 12,000 16,000 20,000 Number of Computers Processed

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Nonlinearity of Variable Cost

Cost ($)

Relevant Range

Units of Activity Driver

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Mixed costs are costs that has both a fixed and a variable component.

Mixed Costs

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Y = Fixed cost + Total variable cost Y = F + VX where

Y = Total cost

Mixed Costs

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Mixed Costs
For Days Computer, the selling cost is represented by the following equation: Y = $300,000 + $50X

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Mixed Costs
Fixed Cost of Selling

Days Computers, Inc. Variable Cost Total Cost Computers Selling Cost of Selling Sold Per Unit $ 200,000 400,000 600,000 800,000 1,000,000 $ 500,000 700,000 900,000 1,100,000 1,300,000 4,000 8,000 12,000 16,000 20,000 $125.00 87.50 75.00 68.75 65.00

$300,000 300,000 300,000 300,000 300,000

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Mixed Cost Behavior

Cost (in thousands) $1,500 1,300 1,100 900 700 500 300 Fixed Cost 4,000 8,000 12,000 16,000 20,000 Number of Computers Sold
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Variable Costs

Basic Terms
When a firm acquires the resources needed to perform an activity, it is obtaining activity capacity.
The amount of activity capacity needed which corresponds to the level where the activity is performed efficiency is called practical capacity.
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Flexible Resources
Flexible resources are supplied as used and needed. They are acquired from outside sources, where the terms of acquisition do not require any long-term commitment for any given amount of the resource.

Example: Materials and energy

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Committed Resources
Committed resources are supplied in advance of usage. They are acquired by the use of either an explicit or implicit contract to obtain a given quantity of resource, regardless of whether the amount of the resource available is fully used or not. Committed resources may have unused capacity.
Example: Buying or leasing a building or equipment

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Committed Resources
Committed fixed expenses are costs incurred for the acquisition of long-term capacity.
Example: Plant, equipment, warehouses, vehicles, and salaries of top employees

Discretionary fixed expenses are shorter-term committed resources.

Example: The hiring of new receiving clerks

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Step-Cost Behavior
A step cost function displays a constant level of cost for a range of output and then jumps to a higher level of cost at some point.

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Step-Cost Behavior
Cost

$500 400 300 200 100

20

40

60

80

100

120

Activity Output (units)

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Step-Fixed Costs
Cost

$150,000
100,000 50,000 Normal Operating Range (Relevant Range)

2,500

5,000

7,500
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Activity Usage

Step-Fixed Costs
Cost of orders supplied = Cost of orders used + Cost of unused orders 7,500($20) = 6,000($20) + 1, 500($20) $150,000 = $120,000 + $30,000

The $30,000 of excess engineering capacity means that a new product could be introduced without increasing current spending on engineering.
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Methods for Separating Mixed Costs

The High-Low Method

The Scatterplot Method

The Method of Least Squares

Variable Component Fixed Component

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The Scatterplot Method

Material Handling Cost

Graph A--Anderson Company

$9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000

5 8 10 6 7 2 1 9

3 4

| 100

| 400

| 500
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200 300 Number of Moves

The Scatterplot Method

Material Handling Cost $9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000

Graph B--High-Low Line

5 8 10 6 7 2 1 9

3 4

| 100

| 400

| 500
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200 300 Number of Moves

The Scatterplot Method

Material Handling Cost $9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000

Graph COne Possible Scattergraph LIne

5 8 10 6 7 2 1 9

3 4

| 100

| 400

| 500
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200 300 Number of Moves

The Scatterplot Method

Graph A--Nonlinear Relationship
Activity Cost

0 Activity Output
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The Scatterplot Method

Graph B--Upward Shift in Cost Relationship
Activity Cost

0 Activity Output
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The Scatterplot Method

Graph C--Presence of Outliers
Activity Cost

Outlier

Outlier

Activity Output
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The Method of Least Squares

Annual Cost Predicted Cost Deviation 0 790 -120 -1,10 700 $3,090 900 - 2,300 500 700 -900 340 Deviation Squared 0 624,100 14,400 1,464,100 790 x 790 490,000 810,000 250,000 490,000 810,000 115,600 5,068,200
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$2,000 $2,000 3,090 2,300 2,780 2,900 1,990 3,200 7,500 6,800 5,300 4,400 4,300 3,800 6,300 5,600 5,600 6,500 6,240 5,900 Total measure of closeness

The Method of Least Squares

Material Handling Cost $9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0

Line Deviations

8 6 7 2 1 3 10 9

| 100

| 400

| 500
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200 300 Number of Moves

The Method of Least Squares

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

Spreadsheet Data for Anderson Company

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The Method of Least Squares

SUMMARY OUTPUT Regression Statistics Multiple R 0.92894908 R. Square 0.862946394 Adjusted R 0.845814693 Square Standard Error Observations ANOVA Regression Residual Total df 1 8 9 Coefficient 854.4993582 12.3915276 SS 29903853.98 4749346.021 34653200 Standard Error 569.7810263 1.745955536 MS 29903853.98 593668.2526 F 50.37132077

Regression Output for Anderson Company

770.4987038 10

Intercept X Variable 1

t-Stat 1.49967811 7.097275588

P-value 0.172079925 0.000102268

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The Method of Least Squares

The results give rise to the following equation:
Material handling = $854.50 + ($12.39 x number of items) cost

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Coefficient of Correlation
Positive Correlation r approaches +1

Machine Utilities Hours Costs

Machine Utilities Hours Costs

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Coefficient of Correlation
Negative Correlation r approaches 1

Hours of Industrial Safety Accidents Training

Hours of Industrial Safety Accidents Training

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Coefficient of Correlation
No Correlation r~0

Hair Accounting Length Grade

Hair Accounting Length Grade

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Multiple Regression
Y = F + V1 X1 + V2 X2 X1 = Number of moves X2 = The total distance

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Multiple Regression
Month
January February March April May June July August September October Material Handling Cost $2,000 3,090 2,780 1,990 7,500 5,300 4,300 6,300 5,600 6,240 Number of Moves 100 125 175 200 500 300 250 400 475 425 Pounds Moved 6,000 15,000 7,800 600 29,000 23,000 17,000 25,000 12,000 22,400
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Multiple Regression
Y = $507 + $7.84X 1 + $0.11X 2 = $507 + $7.84(350) + $0.11(17,000) = $507 + $2.744 + $1,870

= $5,121

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The Learning Curve and Nonlinear Behavior

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Cumulative Cumulative Cumulative Individual Units Number Average Time Total Time: Time for nth of Units per Unit in Hours Labor Hours Unit-Labor Hours (1) (2) (3) = (1) x (2) (4) 1 100 100 100 2 80 (0.8 x 100) 160 60 3 70.21 50.63 Data for Cumulative Average210.63 Time Learning Curve 4 64 (0.8 x 80) 256 45.37 with 80 Percent Learning Rate 5 59.57 297.85 41.85 6 56.17 337.02 39.17 7 53.45 374.15 37.13 8 51.20 (0.8 x 64) 409.60 35.45 16 40.96 655.36 28.06 32 32.77 1,048.64
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Graph of Cumulative Total Hours Required and the Cumulative Average time per Unit
1,200 1,000 800 600 400 200 0 1 5 10 15 20 Units 25 30 35 36
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Cumulative Individual Unit Cumulative Cumulative Number Time for nth Unit Total Time: Average Time per of Units in Labor Hours Labor Hours Unit-Labor Hours (1) (2) (3) (4) = (3)/(1) 1 100 100 100 2 80 (0.8 x 100) 180 90 3 70.21 259.21 Learning 83.40 Data for an Incremental Unit-Time Curve 4 64 (0.8 x 80) 314.21 78.55 with an 80 Percent Learning Rate 5 59.57 373.78 74.76 6 56.17 429.95 71.66 7 53.45 483.40 69.06 8 51.20 (0.8 x 64) 534.60 66.83 16 40.96 892.00 55.75

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Managerial Judgment
Managerial judgment is critically important in determining cost behavior and is by far the most widely used method in practice.

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Chapter
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End of

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