COST BEHAVIOR ANALYSIS

COST BEHAVIOR ANALYSIS

Learning Objectives

1. Explain the meaning of cost behavior, and define and describe fixed
and variable costs.
2. Define and describe mixed and step costs.
3. Separate mixed costs into their fixed and variable components using
the high-low method, the scattergraph method, and the method of
least squares.

COST BEHAVIOR ANALYSIS

Basics of Cost Behavior

▪ Cost behavior is the relationship between cost and activity – as to

how costs react to changes in an activity like production. As
production increase, some costs remain the same (i.e. fixed) while
some costs increase or decrease (i.e. variable).
▪ Cost behavior is the foundation upon which managerial accounting is
built.
▪ Describes whether a cost changes when the level of output changes.
▪ Costs can be variable, fixed, or mixed.
▪ A cost that does not change in total as output changes is a fixed cost.

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Basics of Cost Behavior (cont.)

▪ A variable cost, on the other hand, increases in total with an increase in

output and decreases in total with a decrease in output.
▪ Knowing how costs change as output changes is essential to planning,
controlling, and decision making.

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Measures of Output and the
Relevant Range
▪ Fixed and variable costs have meaning only when related to some
output measure.
▪ A cost driver is a causal factor that measures the output of the activity
that leads (or causes) costs to change.
▪ Identifying and managing drivers helps managers better predict and
control costs.

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Relevant Range and
Cost Relationships
▪ Relevant range is the range of output over which the assumed cost
relationship is valid for the normal operations of a firm.
▪ Limits the cost relationship to the range of operations that the firm
normally expects to occur.

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Relevant Range and Cost
Relationships (cont.)

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COST BEHAVIOR ASSUMPTIONS AND
LIMITATIONS
▪ RELEVANT RANGE Assumption
Relevant range refers to the range of activity within which the cost
behaviour patterns are valid. Any level of activity outside this range
may show a different cost behavior pattern.
▪ TIME Assumption
The cost behavior patterns identified are true only over a specified
period of time. Beyond this, the cost may show a different cost
behavior pattern.
▪ LINEARITY Assumption
The cost is assumed to manifest a linear relationship over a relevant
range despite its tendency to show otherwise over the long run.

COST BEHAVIOR ANALYSIS

Fixed Costs

▪ Fixed costs are costs that in total are constant within the relevant range
as the level of output increases or decreases.

▪ Example: The rental cost of warehouse space by a wholesaler is fixed for

the term of the lease. If the wholesaler’s sales go up or down, the cost
of the leased warehouse stays the same.

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COST BEHAVIOR ANALYSIS
To illustrate fixed cost behavior, consider a factory operated by
Colley Computers, Inc., a company that produces unlabeled
personal computers for small computer stores across the
Midwest. The assembly department of the factory assembles
components into a completed personal computer. Assume that
Colley Computer wants to look at the cost relationship between
supervision cost and the number of computers processed and
has the following information:

COST BEHAVIOR ANALYSIS

▪ The assembly department can process up to 50,000
computers per year.
▪ The assemblers (direct labor) are supervised by a
production-line manager who is paid $32,000 per year.
▪ The company was established 5 years ago.
▪ Currently, the factory produces 40,000 to 50,000
computers per year.
▪ Production has never fallen below 20,000 computers in a
year.

COST BEHAVIOR ANALYSIS

Fixed Costs (cont.)

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Fixed Costs (cont.)

▪ The number of computers produced is called the output measure, or

driver.
▪ Even though fixed costs may change, this does not make them variable.
▪ They are fixed at a new higher (or lower) rate.

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Fixed Costs (cont.)

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Discretionary Fixed Costs and
Committed Fixed Costs
▪ Two types of fixed costs: discretionary fixed costs and committed fixed
costs.
▪ Discretionary fixed costs are fixed costs that can be changed or avoided
easily at management discretion.
▪ Committed fixed costs, on the other hand, are fixed costs that cannot
be easily changed.

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Discretionary Fixed Costs and
Committed Fixed Costs

▪ Advertising is a discretionary fixed cost, because it depends on a

management decision.
▪ Lease cost is a committed fixed cost because it involves a long-term
contract.

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COST BEHAVIOR ANALYSIS
Variable Costs

▪ Variable costs are costs that vary in direct proportion to changes in

output within the relevant range.
▪ Variable costs can also be represented by a linear equation.
▪ Total variable costs depend on the level of output.

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Variable Costs (cont.)

Total variable costs = Variable rate x Amount of output

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Mixed Costs

▪ Mixed costs are costs that have both a fixed and a variable component.
For example, sales representative often are paid a salary plus a
commission on sales.

The formula for a mixed cost is as follows:

Total cost = Total fixed cost + Total variable cost

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Step Costs: Narrow Steps

▪ Some cost functions may be discontinuous.

▪ Known as step costs (or semi-fixed).
▪ Displays a constant level of cost for a range of output and then jumps to a higher
level (or step) of cost at some point, where it remains for a similar range of
output.

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Step Costs: Narrow Steps (cont.)

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Step Costs: Wide Steps

▪ Step cost with wide steps are more characteristic of fixed costs.
▪ Example: A company may have to lease production machinery.
▪ If the machine can only produce 1,000 units and the company grows, they will
have to lease additional machines for each 1,000 units of production needed

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Step Costs: Wide Steps (cont.)

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Accounting Records and
Need for Cost Separation
▪ Only through a formal effort to separate costs can all costs be classified
into the appropriate cost behavior categories.
▪ If mixed costs are a very small percentage of total costs, formal cost
separation may be more trouble than it’s worth.

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Accounting Records and
Need for Cost Separation (cont.)
▪ Mixed costs could be assigned to either the fixed or variable cost
category without much concern for the classification error or its effect
on decision making.
▪ Alternatively, the total mixed cost could be divided between the two
cost categories. (This is rarely done and not a good option.)
▪ Typically, mixed costs for many firms are large enough to call for
separation.

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Separating Mixed Costs into Fixed
and Variable Components
▪ Three methods of separating a mixed cost into its fixed and variable
components:
▪ high-low method
▪ scattergraph method
▪ method of least squares
▪ Each method requires the simplifying assumption of a linear cost
relationship.

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Separating Mixed Costs into Fixed, Variable
Components (cont.)
▪ Expression of cost as an equation for a straight line is:
Total cost = Fixed cost +
(Variable rate x Output)
▪ The dependent variable is a variable whose value depends on the value
of another variable.
▪ Total cost is the dependent variable; it is the cost we are trying to
predict.

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Methods for Separating Mixed Costs
into Fixed, Variable Components (cont.)
▪ The independent variable measures output and explains changes in the
cost or other dependent variable.
▪ A good independent variable is one that causes or is closely associated with the
dependent variable.
▪ Many managers refer to an independent variable as a cost driver.
▪ The intercept corresponds to fixed cost.
▪ The slope of the cost line corresponds to the variable rate.

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 COSTS TOTAL AMOUNT PER UNIT AMOUNT

1. FIXED constant decreases as production

increases
2. VARIABLE Increases as production constant
increases
3. MIXED Increases less decreases less
proportionately as proportionately as
production increases production increases

COST BEHAVIOR ANALYSIS

FIXED COST (a)
VARIABLE COST (bX)

Y = a + bX
[Y] – the total costs (dependent variable)
[a] – the total fixed costs (vertical/ y-axis intercept)
[b] – the variable cost per unit (slope of the line)
[X] – the activity or cost driver (independent variable)
[bX] – the total variable cost

COST BEHAVIOR ANALYSIS

Creating and Using A Cost Formula

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Creating and Using A Cost Formula
(cont.)

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The High-Low Method

▪ Given two points, the slope and the intercept can be determined.
▪ The high-low method is method of separating mixed costs into fixed and
variable components by using just the high and low data points.

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The High-Low Method (cont.)

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The High-Low Method

▪ Four steps must be taken in the high-low method:

▪ Step 1: Find the high point and the low point for a given data set.
▪ Step 2: Using the high and low point, calculate the variable rate.

Variable rate =
(High point cost - Low point cost) ÷ (High point output - Low point
output)

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Variable cost per unit (b) = Change in Costs (YH-YL)
Change in Activity (XH-XL)

COST BEHAVIOR ANALYSIS

The High-Low Method (cont.)

▪ Step 3: Calculate the fixed cost using the variable rate (from Step 2) and either
the high point or low point.

Fixed cost = Total cost at high point -

(Variable rate x Output at high point)

▪ Step 4: Form the cost formula for materials handling based on the high-low
method.

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High-Low Method to Calculate Fixed
Cost, Variable Rate and Cost Formula

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High-Low Method to Calculate Fixed
Cost, Variable Rate and Cost Formula

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Calculate Predicted Total Variable
Cost and Total Cost for Budgeted Output
Recall that BlueDenim Company constructed the following formula for monthly electricity cost.

Total electricity = $440 + ($6.10 x machine hours)

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Variable Cost. Total Cost for A Time
Period that Differs from the Data Period
Recall that BlueDenim Company constructed the following formula for monthly electricity cost.

Total electricity = $440 + ($6.10 x machine hours)

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Advantages of high-low method
▪ Objectivity – any two people using the high-low method on a
particular data set will arrive at the same answer.
▪ Quick overview – the high-low method allows a manager to get
a quick fix on a cost relationship by using only two data points.
For example, a manager may have only two months of data.
Sometimes this will be enough to get a crude approximation of
the cost relationship.
▪ Ease of use – the high-low method is simple, inexpensive and
easily communicated to other individuals, even those who are
not comfortable with numerical analyses.

COST BEHAVIOR ANALYSIS

Disadvantags
▪ Occurrence of outliers – the high and low points can be what are known
as outliers. They may represent a typical cost-activity relationship.
▪ Potential for misrepresentative data – Even if the high and low points
are not outliers, other pairs of points may be more representative.

COST BEHAVIOR ANALYSIS

COST BEHAVIOR ANALYSIS
 Scattergraph Method
▪ The scattergraph method is a way
to see the cost relationship by
plotting the data points on a graph.
▪ The first step is to plot the data
points so that the relationship
between materials handling costs
and activity output can be seen.

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Scattergraph Method (cont.)

▪ Inspect the scattergraph to see

if it reveals one or more points
(outliers) that do not seem to fit
the pattern of behavior.
▪ This might justify their
elimination and perhaps lead to
a better estimate of the
underlying cost function.

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Scattergraph Method (cont.)

▪ Is the line determined by the

high and low points is
representative of the overall
relationship.
▪ Notice that three points lie
above the high-low line, but five
points lie below it.

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Scattergraph Method (cont.)

▪ This does not give us confidence

in the high-low results for fixed
and variable costs. We wonder
if the variable cost (slope) is
somewhat higher than it should
be and the fixed cost is
somewhat lower than it should
be.

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Scattergraph Method (cont.)

▪ Finally, we can use the

scattergraph to visually fit a line
to the data points on the graph.
▪ The manager or cost analyst will
choose the line that appears to
fit the points the best.

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Scattergraph Method (cont.)

▪ An infinite number of lines

might go through the data, but
this one goes through the point
for January (100, $2,000) and
intersects the y-axis at $800.

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Scattergraph Method (cont.)

▪ Our two points are (100, $2,000) and (0, $800). Next, use these two
points to compute the variable rate (the slope):

▪ Variable rate = ($2,000 - $800)

= $100 - 0
= $1,200/100
= $12

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Scattergraph Method (cont.)

▪ The variable rate is $12 per material move.

▪ The fixed cost and variable rate for materials handling cost have now
been identified.
▪ The cost formula for the materials handling activity can be expressed as:

Total cost = $800 + ($12 x Number of moves)

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Using the Formula from the
Scattergraph Method (cont.)
▪ Using this formula, the total cost of materials handling for between 100
and 500 moves can be predicted and then broken down into fixed and
variable components.
▪ For example, assume that 350 moves are planned for November.

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Using the Formula from the
Scattergraph Method
▪ Using the cost formula, the predicted cost is:
$5,000 = $800 + ($12 x 350)
▪ Of this total cost, $800 is fixed, and $4,200 is variable.
▪ Unfortunately, the scattergraph method suffers from the lack of any
objective criterion for choosing the best-fitting line.
▪ The quality of the cost formula depends on the quality of the subjective
judgment of the analyst.

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SCATTERGRAPH (Scatter Diagram) Method

▪ All observed costs at various activity levels are plotted on a graph. Based
on sound judgment, a regression line is then fitted to the plotted points
to represent the line function.

COST BEHAVIOR ANALYSIS

The Method of Least Squares

▪ The method of least squares (regression) is a statistical way to find the

best-fitting line through a set of data points.
▪ One advantage is that for a given set of data, it will always produce the
same cost formula.
▪ The best-fitting line is the one in which the data points are closer to the
line than to any other line.

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LEAST-SQUARE REGRESSION Method

Least-square method is a statistical technique that investigates

the association between dependent and independent variables.
This method determines the line of best fit for a set of
observations by minimizing the sum of the squared deviations
between cost line and data points.
▪ If there is only one independent variable, the analysis is known
as SIMPLE REGRESSION.
▪ If the analysis involves multiple dependent variable, it is known
as MULTIPLE REGRESSION

COST BEHAVIOR ANALYSIS

LEAST-SQUARE REGRESSION Method

▪ Equation 1 Y = a + bx
▪ Equation 2 ∑y = na + b∑x
▪ Equation 3 ∑xy = ∑xa + b∑x2

COST BEHAVIOR ANALYSIS

Comparison of Methods for Separating Fixed
Costs into Fixed and Variable Components

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Other Cost Estimation Methods:

A) Industrial Engineering Method – based on the relationship

between inputs and outputs in physical forms; engineering
estimates indicate what and how much costs should be.
B) Account Analysis Method – each account is classified as
either fixed or variable based on experience and judgment of
accounting and other qualified personnel in the organization.
C) Conference Method – costs are classified based on opinions
from various company departments such as purchasing,
process engineering, manufacturing, employee relations and
so on.

COST BEHAVIOR ANALYSIS

CORRELATION ANALYSIS

CORRELATION ANALYSIS is used to measure the strength

of linear relationship between two or more variables.
The correlation between two variables can be seen by
drawing a scatter diagram:
▪ If the points seem to form a straight line, there is high
correlation
▪ If the points form a random patter, there is low
correlation or no correlation at all.

COST BEHAVIOR ANALYSIS

CORRELATION ANALYSIS

COEFFICIENT OF CORRELATION (r) measure the relative strength of

linear relationship between two (2) variables. Its value ranges from
-1.0 to +1.0
▪ If r = -1.0, there is perfect inverse linear relationship between X and Y.
▪ If r = 0, no linear relationship
▪ If r = +1.0, there is perfect direct relationship between X and Y.

COST BEHAVIOR ANALYSIS

CORRELATION ANALYSIS

COEFFICIENT OF DETERMINATION (r2 ) is the proportion of the total

variation in Y that is accounted for by the regression equation,
regardless of whether the relationship between X and Y is direct or
inverse. It is a measure of ‘goodness of fit’ in the regression. The
higher the r , the more confidence can have in the estimated cost
formula.

COST BEHAVIOR ANALYSIS

Managerial Judgment

▪ Managerial judgment is critically important in determining cost behavior

and is by far the most widely used method in practice.
▪ Many managers simply use their experience and past observation of
cost relationships to determine fixed and variable costs.

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Managerial Judgment (cont.)

▪ This method may take a number of forms.

▪ Some managers simply assign some costs to the fixed category and others to the
variable category and ignore the possibility of mixed costs.
▪ Other managers may identify mixed costs and divide these into fixed and variable
components.

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Managerial Judgment (cont.)

▪ Management may use experience and judgment to refine statistical

estimation results.
▪ The experienced manager might ‘‘eyeball’’ the data and throw out
several points as being highly unusual or revise the results of estimation
account for projected changes in cost structure or technology.

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Managerial Judgment (cont.)

▪ The advantage of using managerial judgment to separate fixed and

variable costs is its simplicity.
▪ In situations in which the manager has a deep understanding of the firm
and its cost patterns, this method can give good results.
▪ However, if the manager does not have good judgment, errors will
occur.

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Ethical Decisions

▪ There are ethical implications to the use of managerial judgment.

▪ Managers use their knowledge of fixed and variable costs to make
important decisions, such as whether to switch suppliers, expand or
contract production, or lay off workers.
▪ These decisions affect the lives of workers, suppliers, and customers.
▪ Ethical managers will make sure that they have the best information
possible when making these decisions.

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