CHAPTER 3:

Cost Behaviour:
Analysis and Use

Prepared by
Shannon Butler,
CPA, CA
Carleton
University
 Learning Objectives
1 Describe how fixed and variable costs
behave and how to use them to predict
costs.
2 Analyze mixed costs using various
approaches.
3 Prepare an income statement using the
contribution format.
4 (Online Appendix 3A) Analyze a mixed
cost using the least-squares regression
method.
© 2021 McGraw-Hill Limited 3-2
Types of Cost Behaviour Patterns

Recall the summary of our cost behaviour

discussion from a chapter 2.

Behaviour of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

© 2021 McGraw-Hill Limited 3-3

 The Activity Base

Units Machine
produced hours

An activity base is
a measure of
whatever causes
a variable cost to
be incurred.
Miles Labour
Driven Units hours
sold
3-4
 Variable Cost Example
• 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.
Total Long Distance
Telephone Bill

Minutes Talked
© 2021 McGraw-Hill Limited 3-5
Variable Cost Per Unit Example
• 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.
Telephone Charge
Per Minute

Minutes Talked
© 2021 McGraw-Hill Limited 3-6
 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 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.
• A manufacturing company will often have
many variable costs.
© 2021 McGraw-Hill Limited 3-7
 Examples of Variable Costs
Exhibit 3-2 Costs That Are
Normally Variable with
Type of Organization Respect to Volume of Output
Merchandising company Cost of goods (merchandise) sold
Manufacturing company Manufacturing costs:
Direct materials
Variable portion of manufacturing overhead:
Indirect materials, such as lubricants or
supplies
Power
Both merchandising and Selling, general, and administrative costs:
manufacturing companies
Sales commissions
Clerical costs, such as billing
Shipping costs
Service organizations Supplies, travel, clerical, sales commissions‫و‬
part-time employee
3-8
 True Variable 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.
Cost

Volume
© 2021 McGraw-Hill Limited 3-9
 Step-Variable Costs 1
• 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
© 2021 McGraw-Hill Limited 3-10
 Step-Variable Costs 2
• Small changes in the level of production are
not likely to have any effect on the number of
maintenance workers employed.
Cost

Volume
© 2021 McGraw-Hill Limited 3-11
 Step-Variable Costs 3

Only fairly wide

changes in the
activity level will
Cost

cause a change in
the number of
maintenance
workers employed
Volume

© 2021 McGraw-Hill Limited 3-12

The Linearity Assumption and the
Relevant Range
A straight line
Economist’s
closely
Curvilinear Cost
approximates a
Function
curvilinear variable
cost line within the
Total Cost

Relevant relevant range.

Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
© 2021 McGraw-Hill Limited 3-13
 Total Fixed Cost Example
• 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.
Telephone Bill
Monthly Basic

Number of Local Calls

© 2021 McGraw-Hill Limited 3-14
 Fixed Cost Per Unit Example
• Average fixed costs per unit decrease as the
activity level increases. The fixed cost per local
call decreases as more local calls are made.
Monthly Basic Telephone
Bill per Local Call

Number of Local Calls

© 2021 McGraw-Hill Limited 3-15
 Types of Fixed Costs
• Committed Fixed Costs ‫ ھزﯾﻧﮫ ھﺎی ﺛﺎﺑت ﺗﻌﮭد ﺷده‬Long-term,
cannot be significantly reduced in the short term.
Examples are depreciation on equipment and real estate
taxes. ‫ اﺳﺗﮭﻼک ﺗﺟﮭﯾزات و ﻣﺎﻟﯾﺎت‬،‫ ﺑﮫ ﻋﻧوان ﻣﺛﺎل‬.‫در ﮐوﺗﺎه ﻣدت ﻗﺎﺑل ﮐﺎھش ﻧﯾﺳت‬
‫ﺑر اﻣﻼک و ﻣﺳﺗﻐﻼت‬

• Discretionary Fixed Costs ‫ھزﯾﻧﮫ ھﺎی ﺛﺎﺑت اﺧﺗﯾﺎری‬May be

altered in the short-term by current managerial decisions.
Examples are advertising and research and development.
‫ ﺑﮫ ﻋﻧوان ﻣﺛﺎل ﻣﯽ ﺗوان ﺑﮫ‬.‫در ﮐوﺗﺎه ﻣدت ﺗوﺳط ﺗﺻﻣﯾﻣﺎت ﻣدﯾرﯾﺗﯽ ﻓﻌﻠﯽ ﺗﻐﯾﯾر ﮐﻧد‬
‫ﺗﺑﻠﯾﻐﺎت و ﺗﺣﻘﯾﻖ و ﺗوﺳﻌﮫ‬

© 2021 McGraw-Hill Limited 3-16

The Trend Toward Fixed Costs
• The trend in many industries is toward greater
fixed costs relative to variable costs.
• As machines take over many mundane tasks
previously performed by humans,
“knowledge workers” are demanded for their
minds rather than their muscles.
• Knowledge workers tend to be salaried, highly-
trained and difficult to replace. The
cost to compensate these valued employees
is relatively fixed rather than variable.
© 2021 McGraw-Hill Limited 3-17
Fixed Costs & Relevant Range 1

90
Rent Cost in Thousands

Total cost doesn’t

Relevant change for a wide
of Dollars

60 range of activity,
Range and then jumps to a
new higher cost for
the next higher
30 range of activity.

0
0 1,000 2,000 3,000
Rented Area (Square Feet)

© 2021 McGraw-Hill Limited 3-18

Fixed Costs & Relevant Range 2
• The relevant range of activity for a fixed cost is
the range of activity over which the graph of the
cost is flat.
• 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.
• How does this type of fixed cost differ from a
step-variable cost  Step-variable costs can be
adjusted more quickly and the width of the
activity steps is much wider for the fixed cost.
© 2021 McGraw-Hill Limited 3-19
 Quick Check 
Which of the following statements about cost
behaviour are true?

1. Fixed costs per unit vary with the level of

activity.
2. Variable costs per unit are constant within
the relevant range.
3. Total fixed costs are constant within the
relevant range.
4. Total variable costs are constant within the
relevant range.
© 2021 McGraw-Hill Limited 3-20
 Quick Check 
Which of the following statements about cost
behaviour are true?

1. Fixed costs per unit vary with the level of

activity.
2. Variable costs per unit are constant within
the relevant range.
3. Total fixed costs are constant within the
relevant range.

© 2021 McGraw-Hill Limited 3-21

 Mixed Costs Part 1

A mixed cost has both fixed and variable

components. Consider the example of utility cost.

Y
Total Utility Cost

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
© 2021 McGraw-Hill Limited 3-22
 Mixed Costs Part 2
The total mixed cost line can be expressed
as an equation: Y = a + bX

Where: Y = the total mixed cost

a = the total fixed cost (the
Y vertical intercept of the line)
b = the variable cost per unit of
Total Utility Cost

activity (the slope of the line)

X = the level of activity

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
© 2021 McGraw-Hill Limited 3-23
 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
© 2021 McGraw-Hill Limited 3-24
 Analyzing Mixed Costs Part 1
• The fixed portion of a mixed cost represents the
basic minimum cost of having an activity ready
and available for use.
• The variable portion represents the cost incurred
for actual consumption of the activity.
• Common methods used for estimating the fixed
and variable components of a mixed cost are:
• Account analysis
• Engineering approach
• High-low method
• Regression analysis

© 2021 McGraw-Hill Limited 3-25

Analyzing Mixed Costs Part 2
• Account Analysis: Each account is
classified as either variable or fixed
based on the analyst’s knowledge of how
the account behaves.
• Engineering Approach: Cost estimates
are based on an evaluation of production
methods, and material, labour and
overhead requirements.

© 2021 McGraw-Hill Limited 3-26

 Scattergraph Plots Part 1
Plot the data points on a graph
(total cost vs. activity).
Y
20
* *
Maintenance Cost
1,000’s of Dollars

* * * *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

© 2021 McGraw-Hill Limited 3-27

 Scattergraph Plots Part 2
Draw a line through the data points with about an
equal numbers of points above and below the line.
Y
20
* *
Maintenance Cost
1,000’s of Dollars

* * * *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

© 2021 McGraw-Hill Limited 3-28

 Scattergraph Plots Part 3
Use one data point to estimate the total level of activity
and the total cost.
Y Total maintenance cost = $11,000
20
* *
Maintenance Cost
1,000’s of Dollars

* * * *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800
© 2021 McGraw-Hill Limited 3-29
 Scattergraph Plots Part 4
Make a quick estimate of variable cost per unit and
determine the cost equation.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

© 2021 McGraw-Hill Limited 3-30

 The High-Low Method Part 1
• The high-low method is based on the rise-over-
run formula for the slope of a straight line.
• If the relationship between cost and activity can
be represented by a straight line, then the slope
of the straight line is equal to the variable cost
per unit of activity.
• To analyze the mixed cost, you need to identify
the period with the lower level of activity and
the period with the highest level of activity.
• Variable Cost = Change in cost / Change in
activity

© 2021 McGraw-Hill Limited 3-31

 The High-Low Method Part 2
• Assume the following hours of maintenance work
and the total maintenance costs for six months.

© 2021 McGraw-Hill Limited 3-32

The High-Low Method Part 3

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
‫ﺑﯾﺷﺗرﯾن و ﮐﻣﺗرﯾن ھزﯾﻧﮫ ﻣﺎھﺎﻧﮫ رو در ﺳﺎل اﻧﺗﺧب ﻣﯽ ﮐﻧﯾم و اﺧﺗﻼﻓش ﻣﺣﺎﺳﺑﮫ ﻣﯾﮑﻧﯾم‬
© 2021 McGraw-Hill Limited 3-33
 The High-Low Method Part 4

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400 ‫اﯾﻧﺟﺎ ﺑﯾﺷﺗرﯾن ھزﯾﻧﮫ رو اﻧﺗﺧﺎب ﻣﯾﮑﻧﯾم‬
‫ﺑرای ﻣﺣﺎﺳﺑﮫ ﮐﻠﯽ‬

Total Fixed Cost = $3,400

© 2021 McGraw-Hill Limited 3-34
The High-Low Method Part 5
Y= a + bx
a=fixed cost= total high cost - (total high hours)*(high cost-low cost / high hours-low hours)
b= high cost-low cost / high hours-low hours

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
© 2021 McGraw-Hill Limited 3-35
 Quick Check 
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what
is the variable portion of sales salaries and
commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit

© 2021 McGraw-Hill Limited 3-36

 Quick Check 
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what
is the variable portion of sales salaries and
commission?
Units Cost
Answer: High level 120,000 $ 14,000
b. $0.10 per unit Low level 80,000 10,000
Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit
© 2021 McGraw-Hill Limited 3-37
 Quick Check 

Sales salaries and commissions are $10,000 when

80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what
is the fixed portion of sales salaries and
commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000

© 2021 McGraw-Hill Limited 3-38

 Quick Check 

Sales salaries and commissions are $10,000 when

80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what
is the fixed portion of sales salaries and
commissions?
Total cost = Total fixed cost +
Total variable cost
Answer:
$14,000 = Total fixed cost +
a. $ 2,000 ($0.10 × 120,000 units)
Total fixed cost = $14,000 – $12,000
Total fixed cost = $2,000

© 2021 McGraw-Hill Limited 3-39

 Least-Squares Regression
Method
• The two methods just discussed provide slightly
different estimates of the fixed and variable cost
components of the mixed cost.

• This is to be expected because each method

uses differing amounts of the data points to
provide estimates.
• Least-squares regression provides the most
accurate estimate because it uses all the data
points. This method is discussed in the appendix
to this chapter.
© 2021 McGraw-Hill Limited 3-40
The Contribution Format Part 1
‫از اﯾﻧﺟﺎ ﺑﮫ ﺑﻌد ﺧﯾﻠﯽ ﻣﮭﻣﮫ و اﮔر ﯾﺎد ﺑﮕﯾرﯾد ﻣﯾﺗوﻧﯾد ﻧﻣره ﮐﺎﻣل اﻣﺗﺣﺎن ﻧﮭﺎﯾﯽ ﺑﮕﯾرﯾد‬

• Why a New Income Statement Format?

• Traditional format income statement is
organized by function and fixed and
variable costs are not distinguished
• Separating costs into fixed and variable
elements is often crucial in making
decisions
• Contribution format facilitates planning,
control, and decision making
© 2021 McGraw-Hill Limited 3-41
The Contribution Format Part 2
contribution margin=sales revenue-variable cost
net operating income= contribution margin-fixed cost

Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin ‫ﺣد ﻣﺷﺎرﮐت‬ $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000

© 2021 McGraw-Hill Limited 3-42

Uses of the Contribution Format
The contribution income statement format is
used as an internal planning and decision
making tool. We will use this approach for the
following in later chapters:
1.Cost-volume-profit analysis
2.Budgeting
3.Pricing
4.Use of scarce resources
5.Make or buy analysis
© 2021 McGraw-Hill Limited 3-43
The Contribution Format
‫ اﮔر ﻣﺗﻔﺎوت ﺑود ﯾﻌﻧﯽ اﺷﺗﺑﺎه اﻧﺟﺎم دادﯾم‬،‫ھر دو روش ﺟواب ﻧﮭﺎﯾﯽ ﻣﺷﺗرک دارﻧد‬

Used primarily for Used primarily by

external reporting. management.

© 2021 McGraw-Hill Limited 3-44

End of Chapter Summary Part 1

• There are three major classifications of cost:

variable, fixed, and mixed.

• Mixed costs are a combination of variable

and fixed elements and can be expressed in
equation form as Y = a + bX, where Y is the
cost, a is the fixed cost element, b is the
variable cost per unit of activity, and X is the
activity.

© 2021 McGraw-Hill Limited 3-45

End of Chapter Summary Part 2
• The first step in analyzing a mixed cost is to
prepare a scattergraph. Costs are plotted on the
vertical axis and activity levels on the horizontal
axis of the scattergraph.
• The high–low method estimates the variable and
fixed cost components by analyzing the change in
cost between the high and low levels of activity.
• The contribution format income statement
classifies costs by cost behaviour (i.e., variable
versus fixed) rather than by functional areas such
as production, administration, and sales.

© 2021 McGraw-Hill Limited 3-46

 Appendix 3A
Least Squares Regression
Calculations

© 2021 McGraw-Hill Limited 3-47

 Least-Squares Regression
Method Part 1
• 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.
• The goal of this method is to fit a straight line to
the data that minimizes the sum of the squared
errors.
© 2021 McGraw-Hill Limited 3-48
 Least-Squares Regression
Method Part 2
• Software can be used to fit a regression line
through the data points.
• The cost analysis objective is the same:
• Y = a + bX

• Provides a statistic called the R2, which is a

measure of the goodness of fit of the
regression line to the data points.

© 2021 McGraw-Hill Limited 3-49

 Least-Squares Regression
Method Part 3
R2 is the percentage of the variation in total cost explained
by the activity.
Y
20
* ** *
* * **
Total Cost

10 * * R2 varies from 0% to 100%, and

the higher the percentage the better.

0 X
0 1 2 3 4
Activity
© 2021 McGraw-Hill Limited 3-50
 Least-Squares Regression
Method Part 4
• Economic plausibility:
•Does it make sense that a change in the activity
level of the independent variable would cause a
change in the dependent variable ?
• Multiple regression:
•An analytical method used when the
dependent variable (e.g. cost) is caused by
more than one activity.

© 2021 McGraw-Hill Limited 3-51