Cost Behavior: Analysis and Use: Chapter Five

Cost Behavior:
Analysis and Use

Chapter Five
McGrawHill/Irwin
Copyright2008,TheMcGrawHillCompanies,Inc.
5-2
Learning Objective 1
Understand how fixed and

variable costs behave and
how to use them to predict
costs.
McGrawHill/Irwin
5-3
Types of Cost Behavior Patterns

Recall the summary of our cost behavior
discussion from an earlier chapter.
McGrawHill/Irwin
5-4
The Activity Base

Units
Units
produced
produced
Machine
Machine
hours
hours
A
Ameasure
measure of
of what
what
causes
causes the
the
incurrence
incurrence of
of aa
variable
variable cost
cost
Miles
Miles
driven
driven
McGrawHill/Irwin
Labor
Labor
hours
hours
5-5
True Variable Cost Example
Total Long Distance

Telephone Bill
A variable cost is a cost whose total dollar amount

varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is
based on how many minutes you talk.
Minutes Talked
McGrawHill/Irwin
5-6

McGrawHill/Irwin
5-7
Variable Cost Per Unit Example
Per Minute
Telephone Charge
A variable cost remains constant if expressed on

a per unit basis. The cost per minute talked is
constant. For example, 10 cents per minute.
Minutes Talked
McGrawHill/Irwin
5-8
Extent of Variable Costs

The proportion of variable costs differs across
organizations. For example . . .
A public utility with
large investments in
equipment will tend
to have fewer
variable costs.
A manufacturing company
will often have many
variable costs.
A service company
will normally have a high
proportion of variable costs.
A merchandising company
usually will have a high
proportion of variable costs,
like cost of sales.
McGrawHill/Irwin
5-9
Examples of Variable Costs

1. Merchandising companies cost of goods sold.
2. Manufacturing companies direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies
commissions, shipping costs, and clerical costs,
such as invoicing.
4. Service companies supplies, travel, and
clerical.
McGrawHill/Irwin
5-10
True Variable Cost
Cost
Direct materials is a true or proportionately variable

cost because the amount used during a period will
vary in direct proportion to the level of production
activity.
Volume
McGrawHill/Irwin
5-11
Step-Variable Costs
Cost
A resource that is obtainable only in large chunks (such

as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a step-variable cost.
cost
Volume
McGrawHill/Irwin
5-12
Step-Variable Costs
Cost
Small
Small changes
changes in
in the
the level
level of
of production
production are
are
not
not likely
likely to
to have
have any
any effect
effect on
on the
the number
number of
of
maintenance
maintenance workers
workers employed.
employed.
Volume
McGrawHill/Irwin
5-13
Step-Variable Costs
Cost
Only fairly wide changes in the activity level will

cause a change in the number of maintenance
workers employed
Volume
McGrawHill/Irwin
5-14
The Linearity Assumption and the Relevant Range
Total Cost
A
A straight
straight line
line
Economists
closely
closely
Curvilinear Cost approximates
approximates aa
Function
curvilinear
curvilinear
Relevant
Range
variable
variable cost
cost
line
line within
within the
the
relevant
relevant range.
range.
Accountants Straight-Line
Approximation (constant
unit variable cost)
Activity
McGrawHill/Irwin
5-15

Lets look at fixed cost behavior on the next
screens.
McGrawHill/Irwin
5-16
Total Fixed Cost Example
Monthly Basic
Telephone Bill
A fixed cost is a cost whose total dollar amount remains

constant as the activity level changes. Your monthly
basic telephone bill is probably fixed and does not
change when you make more local calls.
Number of Local Calls

McGrawHill/Irwin
5-17

McGrawHill/Irwin
5-18
Fixed Cost Per Unit Example
Monthly Basic Telephone

Bill per Local Call
Average fixed costs per unit decrease as the activity

level increases. The fixed cost per local call
decreases as more local calls are made.
Number of Local Calls

McGrawHill/Irwin
5-19
Types of Fixed Costs
Committed
Committed
Discretionary
Discretionary
Long-term,
Long-term, cannot
cannot be
be
significantly
significantly reduced
reduced
in
in the
the short
short term.
term.
May
May be
be altered
altered in
in the
the
short-term
short-term by
by current
current
managerial
managerial decisions
decisions
Examples
Examples
Examples
Depreciation on
Equipment and
Real Estate Taxes
Advertising
Advertising and
and
Research
Research and
and
Development
Development
McGrawHill/Irwin
5-20
The Trend Toward Fixed Costs

The trend in many industries is toward
greater fixed costs relative to variable costs.
As
As machines
machines take
take over
over
many
many mundane
mundane tasks
tasks
previously
previously performed
performed
by
by humans,
humans,
knowledge
knowledge workers
workers
are
are demanded
demanded for
for
their
their minds
minds rather
rather
than
than their
their muscles.
muscles.
McGrawHill/Irwin
Knowledge
Knowledge workers
workers
tend
tend to
to be
be salaried,
salaried,
highly-trained
highly-trained and
and
difficult
difficult to
to replace.
replace. The
The
cost
cost to
to compensate
compensate
these
these valued
valued employees
employees
is
is relatively
relatively fixed
fixed
rather
rather than
than variable.
variable.
5-21
Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can
differ across countries, depending on labor
regulations, labor contracts, and custom.
In France, Germany, China, and Japan, management has
little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
In the United States and the United Kingdom, management
has greater latitude. Labor costs are more variable in nature.
McGrawHill/Irwin
Fixed Costs and Relevant Range
Rent Cost in
Thousands of Dollars
5-22
McGrawHill/Irwin
90
Relevant
60
Range
30
0
Total
Total cost
cost doesnt
doesnt
change
change for
for aa wide
wide
range
range of
of activity,
activity,
and
and then
then jumps
jumps to
to
aa new
new higher
higher cost
cost
for
for the
the next
next higher
higher
range
range of
of activity.
activity.
1,000
2,000
3,000
Rented Area (Square Feet)
5-23

The relevant range of activity for a fixed cost
is the range of activity over which the graph of
the cost is flat.
Example:
Example: Office
Office space
space is
is
available
available at
at aa rental
rental rate
rate of
of
$30,000
$30,000 per
per year
year in
in
increments
increments of
of 1,000
1,000 square
square
feet.
feet. As
As the
the business
business grows,
grows,
more
more space
space is
is rented,
rented,
increasing
increasing the
the total
total cost.
cost.
McGrawHill/Irwin
5-24
How does this

type of fixed cost
differ from a stepvariable cost?
McGrawHill/Irwin
Step-variable costs
can be adjusted
more quickly and . . .
The width of the
activity steps is
much wider for the
fixed cost.
5-25
Quick Check
Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
McGrawHill/Irwin
5-26
Quick Check
Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
McGrawHill/Irwin
Cost Behavior:
Analysis and Use
Chapter Five
McGrawHill/Irwin
5-28
Mixed Costs
A
A mixed
mixed cost
cost has
has both
both fixed
fixed and
and variable
variable
components.
components. Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Total Utility Cost
ta
o
T
xe
i
lm
os
c
d
t
Variable
Cost per KW
Activity (Kilowatt Hours)

McGrawHill/Irwin
Fixed Monthly
Utility Charge
5-29
Mixed Costs
Total Utility Cost
ta
o
T
xe
i
lm
os
c
d
t
Variable
Cost per KW
Activity (Kilowatt Hours)

McGrawHill/Irwin
Fixed Monthly
Utility Charge
5-30
Mixed Costs Example

If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours,
what is the amount of your utility bill?
Y = a + bX
Y = $40 + ($0.03 2,000)
Y = $100
McGrawHill/Irwin
5-31
Analysis of Mixed Costs

Account Analysis and the Engineering Approach
Each
Each account
account is
is classified
classified as
as either
either
variable
variable or
or fixed
fixed based
based on
on the
the analysts
analysts
knowledge
knowledge of
of how
how the
the account
account behaves.
behaves.
Cost
Cost estimates
estimates are
are based
based on
on an
an
evaluation
evaluation of
of production
production methods,
methods, and
and
material,
material, labor
labor and
and overhead
overhead
requirements.
requirements.
McGrawHill/Irwin
5-32
Use a scattergraph plot to

diagnose cost behavior.
McGrawHill/Irwin
5-33
The Scattergraph Method

Plot
Plot the
the data
data points
points on
on aa graph
graph
(total
(total cost
cost vs.
vs. activity).
activity).
Maintenance Cost
1,000s of Dollars
Y
20
* *
* *
10
* ** *
**
Patient-days in 1,000s
McGrawHill/Irwin
5-34
Maintenance Cost
1,000s of Dollars
Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about an
an
equal
equal numbers
numbers of
of points
points above
above and
and below
below the
the line.
line.
Y
20
* *
* *
10
* ** *
**
McGrawHill/Irwin
5-35
Maintenance Cost
1,000s of Dollars
Use
Use one
one data
data point
point to
to estimate
estimate the
the total
total level
level of
of activity
activity
and
and the
the total
total cost.
cost.
Y Total maintenance cost = $11,000
20
* ** *
**
* *
* *
10
Intercept = Fixed cost: $10,000
Patient days = 800
McGrawHill/Irwin
5-36

Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per unit
unit and
and
determine
determine the
the cost
cost equation.
equation.
Variable cost per unit =
$1,000
800
= $1.25/patient-day
Y = $10,000 + $1.25X
Total maintenance cost
McGrawHill/Irwin
Number of patient days

5-37
Analyze a mixed cost

using the high-low method.
McGrawHill/Irwin
5-38
The High-Low Method

Assume the following hours of maintenance work and the total maintenance costs for six months.
McGrawHill/Irwin
5-39
The High-Low Method

The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $8.00/hour
300
McGrawHill/Irwin
5-40
The High-Low Method
Total Fixed Cost = Total Cost Total Variable Cost

Total Fixed Cost = $9,800 ($8/hour 800 hours)
Total Fixed Cost = $9,800 $6,400
Total Fixed Cost = $3,400
McGrawHill/Irwin
5-41
The High-Low Method
The Cost Equation for Maintenance
Y = $3,400 + $8.00X
McGrawHill/Irwin
5-42
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the variable
variable portion
portion of
of sales
sales salaries
salaries and
and
commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit
McGrawHill/Irwin
5-43
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the variable
variable portion
portion of
of sales
sales salaries
salaries and
and
commission?
commission?
Units
Cost
a.
a. $0.08
$0.08 per
per unit
unit High level
120,000
$ 14,000
b.
80,000
10,000
b. $0.10
$0.10 per
per unit
unit Low level
40,000
$ 4,000
c.
c. $0.12
$0.12 per
per unit
unit Change
d.
d. $0.125
$0.125 per
per unit
unit
$4,000 40,000 units
= $0.10 per unit
McGrawHill/Irwin
5-44
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
McGrawHill/Irwin
5-45
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
McGrawHill/Irwin
5-46
Least-Squares Regression Method

A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.
McGrawHill/Irwin
The goal of this method is

to fit a straight line to the
data that minimizes the
sum of the squared errors.
5-47

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
Least-squares regression
regression also
also provides
provides aa statistic,
statistic,
called
called the
the R
R22,, which
which is
is aa measure
measure of
of the
the goodness
goodness
of
of fit
fit of
of the
the regression
regression line
line to
to the
the data
data points.
points.
McGrawHill/Irwin
5-48

2
R
R2 is
is the
the percentage
percentage of
of the
the variation
variation in
in total
total cost
cost
explained
explained by
by the
the activity.
activity.
Y
Total Cost
20
10
R2 varies from 0% to 100%, and

the higher the percentage the better.
0
McGrawHill/Irwin
* *
* *
* ** *
**
2
3
Activity
5-49
Comparing Results From the Three Methods

The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates of
of the
the fixed
fixed and
and
variable
variable cost
cost components
components of
of the
the mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses differing
differing amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because itit uses
uses all
all the
the data
data
points.
points.
McGrawHill/Irwin
5-50
Prepare an income
statement using the
contribution format.
McGrawHill/Irwin
5-51
The Contribution Format
Lets put our

knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
McGrawHill/Irwin
5-52
The
The contribution
contribution margin
margin format
format emphasizes
emphasizes
cost
cost behavior.
behavior. Contribution
Contribution margin
margin covers
covers fixed
fixed
costs
costs and
and provides
provides for
for income.
income.
McGrawHill/Irwin
5-53
Uses of the Contribution Format

The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning and
and decision
decision making
making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.
1. Cost-volume-profit
Cost-volume-profit analysis
analysis (Chapter
(Chapter 6).
6).
2.
2. Budgeting
Budgeting (Chapter
(Chapter 9).
9).
3.
3. Segmented
Segmented reporting
reporting of
of profit
profit data
data (Chapter
(Chapter 12).
12).
4.
4. Special
Special decisions
decisions such
such as
as pricing
pricing and
and make-ormake-orbuy
buy analysis
analysis (Chapter
(Chapter 13).
13).
McGrawHill/Irwin
5-54
Used primarily for

external reporting.
McGrawHill/Irwin
Used primarily by
management.
5-55
McGrawHill/Irwin
End of Chapter 5

Cost Behavior: Analysis and Use: Chapter Five

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Cost Behavior: Analysis and Use: Chapter Five

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Cost Behavior:

Analysis and Use

Understand how fixed and

Types of Cost Behavior Patterns

The Activity Base

True Variable Cost Example

Total Long Distance

A variable cost is a cost whose total dollar amount

Types of Cost Behavior Patterns

Variable Cost Per Unit Example

A variable cost remains constant if expressed on

Extent of Variable Costs

Examples of Variable Costs

True Variable Cost

Direct materials is a true or proportionately variable

A resource that is obtainable only in large chunks (such

Only fairly wide changes in the activity level will

The Linearity Assumption and the Relevant Range

Types of Cost Behavior Patterns

Total Fixed Cost Example

A fixed cost is a cost whose total dollar amount remains

Number of Local Calls

Types of Cost Behavior Patterns

Fixed Cost Per Unit Example

Monthly Basic Telephone

Average fixed costs per unit decrease as the activity

Number of Local Calls

Types of Fixed Costs

The Trend Toward Fixed Costs

Is Labor a Variable or a Fixed Cost?

Fixed Costs and Relevant Range

Fixed Costs and Relevant Range

Fixed Costs and Relevant Range

How does this

Activity (Kilowatt Hours)

Total Utility Cost

Activity (Kilowatt Hours)

Mixed Costs Example

Analysis of Mixed Costs

Use a scattergraph plot to

The Scattergraph Method

The Scattergraph Method

The Scattergraph Method

Intercept = Fixed cost: $10,000

The Scattergraph Method

Variable cost per unit =

Number of patient days

Analyze a mixed cost

The High-Low Method

The High-Low Method

The High-Low Method

Total Fixed Cost = Total Cost Total Variable Cost

The High-Low Method

The Cost Equation for Maintenance

Least-Squares Regression Method

The goal of this method is

Least-Squares Regression Method

Least-Squares Regression Method

R2 varies from 0% to 100%, and

Comparing Results From the Three Methods

The Contribution Format

Lets put our