3. Cost Behavior Analysis and Use.

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UNIVERSITY OF THE CORDILLERAS
College of Accountancy
Accounting 24c MAS
___________________________________________________________________
Cost Beha!o"# Analys!s an$ Use
Prepared by: Siegfried M. Erorita, cpa, ba c%&'
____________________________________________________________
Re!e( O)*ect!es
1. Understand how fixed and variable costs behave and how to use them to
predict costs.
2. Use a scattergraph plot to diagnose cost behavior.
3. Analyze a mixed cost using the highlow method.
!. "repare an income statement using the contribution format.
#. Analyze a mixed cost using the leasts$uares regression method.
To+!c Su,,a"y
A- Ty+es of Cost Beha!o" .atte"ns- At least three cost behavior patterns%
variable& fixed& and mixed%are found in most organizations. 'f course& many other
types of cost behavior patterns exist& but these three patterns are fairly common
and the mixed cost model can be used to provide approximations to more complex
cost behavior patterns within a relevant range. (t is important for managers to
understand the behavior of each type of cost.
/- Va"!a)le Costs- )he total amount of a variable cost varies in direct proportion
to changes in the activity level. *hen expressed on a per unit basis& variable
costs are constant. +e careful to point out to students that some of these costs
may be fixed in some organizations. )his is particularly true of direct labor and
other employee wages and salaries that may be effectively fixed due to labor
laws in a country& custom& labor contracts& or the organization,s personnel
policies.
a. Activity base -cost driver.. /or a cost to be variable& it must be variable with
respect to some activity base. An activity base is a measure of whatever
causes the incurrence of a variable cost. 0ome of the most common activity
bases are machinehours& units produced& and units sold. A measure of
activity should be used to allocate a cost for decisionma1ing purposes only
if it actually causes the cost.
b. )rue variable and stepvariable costs. 0ome variable costs& such as direct
materials& vary in direct proportion to the level of activity. )hese costs are
called true variable costs. A cost that is obtainable only in large chun1s and
that increases or decreases in response to fairly wide changes in the activity
level is 1nown as a stepvariable cost. /or example& direct labor may be a
stepvariable cost when wor1ers are only hired on a fulltime basis.
c. (n reality& many costs are curvilinear. 2ost fre$uently& costs increase less
than proportionately with activity. 3evertheless& within any given narrow
band of activity even a curvilinear cost function is approximately linear. )his
narrow band of activity within which a particular straight line is a reasonable
approximation to the true underlying cost function is called its "eleant
"ange.
4 )hus& within the relevant range& variable cost per unit can be assumed to
be constant.
4 )he notion of the relevant range often causes confusion. 0ome
individuals refer to the relevant range as the range of activity within
which the company expects to operate or has operated in the recent
past. )hat is not what we mean by the relevant range. )he relevant
range& as we use the term& is the range of activity within which a
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3. Cost Behavior Analysis and Use.doc
particular straight line provides a reasonable approximation to the real
underlying cost function.
0- F!1e$ Costs- A fixed cost remains constant in total dollar amount within the
relevant range. 0ince fixed costs remain constant in total& the amount of cost
computed on a per unit basis becomes smaller as the number of units produced
increases. <are must be exercised in interpreting fixed costs that have been
expressed on a per unit basis= they should not be misinterpreted as variable
costs.
a. /or planning purposes& fixed costs can be viewed as either committed or
discretionary.
4 Co,,!tte$ f!1e$ costs. <ommitted fixed costs relate to investment in
buildings& e$uipment& and the basic organizational structure of a
company. <ommitted fixed costs are longterm and can,t be significantly
reduced even for a short period of time without seriously impairing long
run goals.

4 D!sc"et!ona"y f!1e$ costs. >iscretionary fixed costs are those that
management ad?usts periodically. @xamples of discretionary fixed costs
include advertising& research& and management development programs.
)he planning horizon for discretionary fixed costs is fairly short%usually a
single year. 2anagement may be able to ad?ust these fixed costs as
circumstances change.
b. )he relevant range for a fixed cost is that range of activity over which total
fixed cost does not change.
2- 3!1e$ Costs- A mixed cost contains both variable and fixed cost elements.
2any costs are mixed and can be expressed in terms of the cost formula A B a
C b6& where A is the total estimated cost& a is the estimated total fixed cost& b
is the estimated variable cost per unit of activity& and 6 is the amount of
activity. @ven when the underlying cost is not linear& this formula can provide a
reasonable approximation to the underlying cost function within the relevant
range.
4- Class!f!cat!on of costs- A cost that is considered variable in one organization
may be considered fixed in another due& for example& to differing employment
policies. @xhibit #; in the text shows that there is a lot of variation in how
companies classify costs in terms of behavior.
B- Analys!s of 3!1e$ Costs- /or planning and control purposes& mixed costs
should be bro1en down into variable and fixed components. A number of methods
can be used to analyze mixed costs. Account analysis and the engineering approach
are mentioned briefly in this chapter and are covered in more detail in later
chapters. )his chapter discusses in more depth three techni$ues for analyzing past
records of cost and activity%the scattergraph method& the highlow method& and
leasts$uares regression.
/- The Scatte"g"a+h 3etho$-
a. )he data should be plotted no matter what method is ultimately used to
estimate fixed and variable costs. A graph is constructed with cost on the
vertical axis and activity on the horizontal axis. <osts at various levels of
activity are then plotted on the graph. )his plot will often provide important
insights concerning the underlying relationship and can help in identifying
nonlinearities and outliers -unusual points. that should be ignored.
b. *hile this is not ordinarily done in practice& a line can be fitted to the
plotted points by eye with a straightedge. )he line should be placed so that
approximately e$ual numbers of points fall above and below it. *hile not
strictly necessary& in the text and in problems we always draw the line
through one of the points to simplify calculations. )his line can then be used
to derive what we call D$uic1anddirtyE estimates of the fixed and variable
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3. Cost Behavior Analysis and Use.doc
costs. )he fixed cost can be estimated by the vertical intercept. )he variable
cost per unit can be estimated by computing the slope of the line.
0- The H!gh5Lo( 3etho$- )he highlow method of analyzing mixed costs
focuses exclusively on the high and low levels of activity. )he difference in cost
observed at these two extremes is divided by the change in activity to estimate
the variable cost per unit of activity.
A ma?or defect of the highlow method is that it utilizes only two points and
ignores all of the other data. Fenerally& two points are not enough to produce
accurate results. 2oreover& the periods in which the high and low activity levels
occur are often not typical of most periods.
2- The Least5S6ua"es Reg"ess!on 3etho$- Using mathematical formulas& the
leasts$uares regression method fits a regression line that minimizes the sum
of the s$uared errors.
a. *e don,t go into the details of the computation of the leasts$uares
regression estimates since computer software is widely used for performing
this chore. )he appendix to the chapter shows how to use @xcel to do the
necessary calculations.
b. (n addition to estimates of the slope -variable cost per unit. and the
intercept -total fixed cost.& leasts$uares regression software can produce a
variety of informative statistics. 'ne of the most informative is the G
2
&
which is a measure of the goodness of fit of the regression line. (t tells us
the percentage of the variation in the dependent variable -cost. that is
explained by variation in the independent variable -activity.. *e do not
show in the text how the G
2
is computed& but you may want to discuss its
interpretation with students.
c. 3ult!+le "eg"ess!on analysis should be used when the cost is caused by
more than one factor.
C- The Cont"!)ut!on Fo",at- )wo ma?or approaches can be used to prepare an
income statement. )he difference between these two approaches centers on the
way in which costs are organized.
/- The T"a$!t!onal A++"oach- )he traditional approach to the income statement
organizes data in a functional format& based on the functions of production&
administration& and sales. )he emphasis is on the purposes for which the costs
were incurred. 3o attempt is made to identify the behavior of costs included
under each functional heading. )his approach is used to prepare income
statements for external reporting purposes.
0- The Cont"!)ut!on A++"oach- )he contribution approach to the income
statement organizes costs by behavior& rather than by function.
a. )he contribution approach separates costs into fixed and variable
categories. Hariable expenses are deducted to obtain the contribution
margin. /ixed expenses are then deducted from the contribution margin to
obtain net operating income.
b. )he contribution approach to the income statement ma1es it much easier
for managers to understand the relations between volume and expenses&
and volume and profits. Hariable and fixed costs are not lumped together.
0ince planning and decisionma1ing often involve changes in the level of
activity& contribution income statements can be very useful. Unfortunately&
the contribution approach is seldom used in practice.
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