Cost Behavior

Chapter
5
Cost Behaviour:
Analysis and Use
5-2
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain the effect of a change in activity on
both total variable costs and per unit variable
costs.
2. Explain the effect of a change in activity on
both total fixed costs and fixed costs
expressed on a per unit.
3. Use a cost formula to predict costs at a new
level of activity.
4. Analyze a mixed cost using the high-
low method.
© McGraw-Hill Ryerson Limited., 2001

5-3
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5. Analyze a mixed cost using the scattergraph

method.
6. Explain the least-squares regression method of
analyzing a mixed cost.
7. Prepare an income statement using the
contribution format.
8. (Appendix 5A) Analyze a mixed cost using the
least-squares regression method.

5-4
Types of Cost Behaviour Patterns

Recall the summary of our cost behaviour
discussion from Chapter 2.
Summary of Variable and Fixed Cost Behaviour

Cost In Total Per Unit
Variable Total variable cost i s Variable cost per unit remains

proportional to the activity the same over w ide ranges
level w ithin the relevant range. of activity.
Fixed Total fixed cost remains the Fixed cost per unit goes
same even w h e n the activity dow n a s activity level goes up.
level changes w ithin the
relevant range.

5-5
Total Variable Cost Example
Your total long distance telephone bill is

based on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked
5-6
Variable Cost Per Unit Example
The cost per minute talked is constant. For

example, 10 cents per minute.
Telephone Charge
Per Minute
Minutes Talked
5-7
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

5-8
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
5-9
Cost Behaviour
Examples of normally variable costs
Merchandisers Service Organizations
Cost of Goods Sold Supplies and travel
Manufacturers Merchandisers and

Direct Material, Direct Manufacturers
Labour, and Variable Sales commissions and
Manufacturing Overhead shipping costs
Examples of normally fixed costs

Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Amortization, Advertising
5-10
The Activity Base

Units Machine
produced hours
A measure of the event

causing the occurrence of a
variable cost – a cost driver
Miles Labour
driven hours
5-11
Step-Variable Costs
Total cost remains

constant within a
narrow range of
activity.
Cost
Activity

5-12
Step-Variable Costs
Total cost increases to a
new higher cost for the
next higher range of
activity.
Cost
Activity

5-13
The Linearity Assumption and the

Relevant Range
Economist’s
Curvilinear Cost
Function
Total Cost
Activity
5-14

Relevant Range
Economist’s
Curvilinear Cost
Function
Total Cost
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
5-15

Relevant Range A
A straight
straight line
line
closely
closely
approximates
approximates
Economist’s aa curvilinear
curvilinear
Curvilinear Cost variable
variable cost
cost
Function line
line within
within the
the
relevant
relevant
Relevant range.
range.
Total Cost
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
5-16
Types of Fixed Costs

Fixed Costs
Committed Discretionary
Long-term, cannot be May be altered in the
reduced in the short short-term by current
term. managerial decisions
Examples Examples
Amortization on Advertising and
Buildings and Research and
Equipment Development
5-17
Trend Toward Fixed Costs
Increased automation.
Increase in salaried “knowledge” workers
who are difficult to train and replace.
Implications
Implications
Managers
Managers are more“locked-in”
are more “locked-in”with
withfewer
fewerdecision
decision
alternatives.
alternatives.
Planning
Planning becomes
becomes more
morecrucial
crucial because
because fixed
fixed costs
costsare
are
difficult
difficultto
to change
change with
withcurrent
currentoperating
operatingdecisions.
decisions.

5-18
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. Continue

5-19
90
Thousands of Dollars
Total cost doesn’t

Rent Cost in
Relevant change for a wide

60 range of activity,
Range
and then jumps to a
new higher cost for
30 the next higher
range of activity.
00 1,000 2,000 3,000

Rented Area (Square Feet)
5-20
Step-variable costs
can be adjusted more
How does this type quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is much
cost? wider for the fixed
cost.

5-21
Mixed Costs
A mixed cost
has both fixed
and variable
components.
Consider the
following electric
utility example.

5-22
Mixed Costs
Y
Total Utility Cost
Variable
Utility Charge
Fixed Monthly
X Utility Charge
Activity (Kilowatt Hours)
5-23
Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Y
Where: Y = the total mixed cost
bX
Total Utility Cost
a+ a = the total fixed cost (the

Y= vertical intercept of the line)
ost
Variable
b = the variable cost per unit of
activity (the slope of the line)
Utility Charge
X = the level of activity
Fixed Monthly
X Utility Charge
5-24
Mixed Costs
Y
Total Utility Cost
Variable
bX
Utility Charge
Fixed Monthly
a
X Utility Charge
5-25
The Analysis of Mixed Costs
Account Analysis
Engineering Approach
High-Low Method
Scattergraph Method
Least-Square Regression Method

5-26
Account Analysis
Each account is classified as either

variable or fixed based on the analyst’s
knowledge of how the account behaves.
5-27
Engineering Estimates
Cost estimates are based on an evaluation

of production methods, and material, labour
and overhead requirements.

5-28
The High-Low Method

WiseCo recorded the following production activity
and maintenance costs for two months:
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600
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.
5-29
The High-Low Method

Units Cost
Change 4,000 $ 3,600

5-30
The High-Low Method

Units Cost
Change 4,000 $ 3,600
Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

5-31
The High-Low Method

Units Cost
Change 4,000 $ 3,600

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600

5-32
The High-Low Method

Units Cost
Change 4,000 $ 3,600

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = $1,600 + $0.90X

5-33
The High-Low Method
IfIf 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 unitsunits are
are sold,
sold, 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

5-34
The High-Low Method
IfIf 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
are sold,
sold, 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 Units Cost
b.
b. $0.10
$0.10 per
per unit
unit High level 120,000 $ 14,000
c.
c. $0.12
$0.12 per
per unit
unit Low level 80,000 10,000
Change 40,000 $ 4,000
d. $0.125 per
d. $0.125 per unit unit
$4,000 ÷ 40,000 units
= $0.10 per unit

5-35
The High-Low Method
IfIf sales
sales salaries
salaries and commissions are
and commissions are $10,000
$10,000
when
when 80,000
80,000 units
units are sold and
are sold and $14,000
$14,000 when
when
120,000
are sold,
sold, 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

5-36
The High-Low Method
IfIf sales
sales salaries
salaries and commissions are
and commissions are $10,000
$10,000
when
when 80,000
80,000 units
units are sold and
are sold and $14,000
$14,000 when when
120,000
120,000 units
units are
are sold,
sold, what
what isis the
the fixed
fixed portion
portion
of
of sales
salessalaries
salariesand
and commissions?
commissions?
Tota l cost = Tota l fixed cost +
Tota l va riable cost
a. $ 2,000
a. $ 2,000
$14,000 = Tota l fixed cost +
b. $ 4,000
b. $ 4,000 ($0.10 × 120,000 units)
c.
c. $10,000
$10,000 Tota l fixed cost = $14,000 - $12,000
d.
d. $12,000
$12,000 Tota l fixed cost = $2,000

5-37
The Scattergraph Method

Plot the data points on a
graph (total cost vs. activity).
Y
20
* *
(000’s of Dollars)
* * *
*
Total Cost
**
10 * *
0 X
0 1 2 3 4
Activity (000’s of Units Produced)

5-38

Draw a line through the data points with about an
equal numbers of points above and below the line.
Y
20
* *
* * *
*
Total Cost
**
10 * *
0 X
0 1 2 3 4

5-39

The slope of this line is the variable unit
cost. (Slope is the change in total cost
Y for a one unit change in activity).
20
* *
* * *
*
Total Cost
**
10 * *
Estimated fixed cost = $10,000
0 X
0 1 2 3 4

5-40

Change in cost
Slope =
Change in units
Y
20
* *
Vertical
*
* * *
Total Cost
distance
** is the
10 * * change
in cost.
Horizontal distance is
the change in activity.
0 X
0 1 2 3 4

5-41
Least-Squares Regression Method

 Accountants and managers
may use computer software
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 alsoalso provides
provides aa statistic,
statistic, called
called
the adjusted R 22, that is a measure of the goodness
the adjusted R , that is a measure of the goodness
of
offit
fitof
ofthe
theregression
regression line
lineto
tothe
thedata
datapoints.
points.
5-42
Least-Squares Regression Method

R2 is the percentage of the variation
in total cost explained by the activity.
Y
20
* * *
*
Total Cost
* * * *
10 * *2
R for this relationship is near
100% since the data points are
very close to the regression line.
0
0 1 2 3 4 X
Activity
5-43
The Contribution Format
Let’s put our

knowledge of cost
behaviour to work
by preparing a
contribution format
income statement.

5-44

Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net income $ 10,000
The contribution margin format emphasizes cost

behaviour. Contribution margin covers fixed costs
and provides for income.

5-45

Comparison of the Contribution Income Statement
with the Traditional Income Statement
Traditional Approach Contribution Approach

(costs organized by function) (costs organized by behavior)
Sales $100,000 Sales $100,000

Less cost of goods sold 70,000 Less variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating expenses 20,000 Less fixed expenses 30,000
Net income $ 10,000 Net income $ 10,000
Used primarily for Used primarily by

external reporting. management.

Appendix
5A
Least-Squares Regression
Calculations
5-47
This method provides the most objective and precise
breakdown of mixed costs into variable and fixed
components.
This method also uses the most complex calculations.

However, most business calculators and several
computer software programs can quickly complete the
calculations required.
This method mathematically places the line in the most

favourable location by ensuring that the total of the
squares of all points off the line is minimized.

5-48
Calculations:
b = n(XY-(X)(Y)
n(X2) - (X)2
a = (Y) - b(X)
n
where X= the level of activity (Independent variable)
Y= the total mixed cost (dependent variable)
a = the total fixed cost (vertical intercept of line)
b = the variable cost per unit of activity (slope of
line)
n = number of observations
 = sum across all n observations
5-49
End of Chapter 5

Cost Behavior

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Chapter

© McGraw-Hill Ryerson Limited., 2001

5. Analyze a mixed cost using the scattergraph

© McGraw-Hill Ryerson Limited., 2001

Types of Cost Behaviour Patterns

Summary of Variable and Fixed Cost Behaviour

Variable Total variable cost i s Variable cost per unit remains

© McGraw-Hill Ryerson Limited., 2001

Total Variable Cost Example

Your total long distance telephone bill is

Variable Cost Per Unit Example

The cost per minute talked is constant. For

Total Fixed Cost Example

Number of Local Calls

Fixed Cost Per Unit Example

Monthly Basic Telephone

Manufacturers Merchandisers and

Examples of normally fixed costs

The Activity Base

A measure of the event

Total cost remains

© McGraw-Hill Ryerson Limited., 2001

© McGraw-Hill Ryerson Limited., 2001

The Linearity Assumption and the

The Linearity Assumption and the

The Linearity Assumption and the

Types of Fixed Costs

Trend Toward Fixed Costs

© McGraw-Hill Ryerson Limited., 2001

Fixed Costs and Relevant Range

Example: Office space

© McGraw-Hill Ryerson Limited., 2001

Fixed Costs and Relevant Range

Total cost doesn’t

Relevant change for a wide

00 1,000 2,000 3,000

Fixed Costs and Relevant Range

© McGraw-Hill Ryerson Limited., 2001

© McGraw-Hill Ryerson Limited., 2001

a+ a = the total fixed cost (the

The Analysis of Mixed Costs

Least-Square Regression Method

Each account is classified as either

Cost estimates are based on an evaluation

© McGraw-Hill Ryerson Limited., 2001

The High-Low Method

Using these two levels of activity, compute:

The High-Low Method

© McGraw-Hill Ryerson Limited., 2001

The High-Low Method

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

© McGraw-Hill Ryerson Limited., 2001

The High-Low Method

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

© McGraw-Hill Ryerson Limited., 2001

The High-Low Method

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

© McGraw-Hill Ryerson Limited., 2001

The High-Low Method

© McGraw-Hill Ryerson Limited., 2001

The High-Low Method

© McGraw-Hill Ryerson Limited., 2001

The High-Low Method

© McGraw-Hill Ryerson Limited., 2001