Chapter 5

Cost Behavior:
Analysis and Use
 Learning Objective
LO1

To understand how fixed and

variable costs behave and
how to use them to predict
costs.
 Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from Chapter 1.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 The Activity Base
Units
Machine
produce
hours
d
A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours
 True 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
 Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from Chapter 1.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 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¢ per minute.

Telephone Charge
Per Minute

Minutes Talked
 Extent of Variable Costs
The proportion of variable costs differs across
organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
proportion of variable costs.
like cost of sales.
 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.
 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
 Step-Variable Costs
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
 Step-Variable Costs

Small changes in the level of production are

not likely to have any effect on the number of
maintenance workers employed.
Cost

Volume
 Step-Variable Costs
Only fairly wide changes in the activity level will
cause a change in the number of maintenance
workers employed
Cost

Volume
The Linearity Assumption and the
Relevant Range

Economist’s A straight line

closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
line within the
Relevant
relevant range.
Total Cost

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

Activity
 Types of Cost Behavior Patterns
Let’s look at fixed cost behavior on the next
screens.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 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.
Monthly Basic
Telephone Bill

Number of Local Calls

 Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from Chapter 1.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
 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

 Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced short-term by current
in the short-term. managerial decisions

Examples Examples
Depreciation on Advertising and
Buildings and Research and
Equipment and Development
Real Estate Taxes
 The Trend Toward Fixed Costs
The trend in many industries is toward
greater fixed costs relative to variable costs.
As machines take over Knowledge workers
many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost to compensate
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.
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.
 Fixed Costs and Relevant Range

90
Thousands of Dollars

Total cost doesn’t

Rent Cost in

Relevant change for a wide

60 range of activity, and
Range
then jumps to a new
higher cost for the
30 next higher range of
activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
Fixed Costs and Relevant Range
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.
Fixed Costs and Relevant Range

Step-variable costs
can be adjusted
How does this more quickly and . . .
type of fixed cost The width of the
differ from a step- activity steps is
much wider for the
variable cost? fixed cost.
 Quick Check 
Which of the following statements about
cost behavior 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.
 Quick Check 
Which of the following statements about
cost behavior 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.
 Mixed Costs
A mixed cost has both fixed and variable
components. Consider your utility costs.

Y
Total Utility Cost

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
 Mixed Costs
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
 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
 Analysis of Mixed Costs
Account Analysis and the Engineering Approach

Each account is classified as either

variable or fixed based on the analyst’s
knowledge of how the account behaves.

Cost estimates are based on an

evaluation of production methods, and
material, labor and overhead
requirements.
 Learning Objective
LO2

To use a scattergraph plot

to diagnose cost behavior.
 The Scattergraph Method
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
 The Scattergraph Method
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
 The Scattergraph Method
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
 The Scattergraph Method
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

 Learning Objective
LO3

To analyze a mixed cost

using the high-low method.
 The High-Low Method
Assume the following hours of maintenance work
and the total maintenance costs for six months.
The High-Low Method
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
Hours Total Cost
High 800 $ 9,800
Low 500 7,400
Change 300 $ 2,400

$2,400
= $8.00/hour
300
 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
 The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
 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
 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
Units Cost
b. $0.10 per unit High level 120,000 $ 14,000
c. $0.12 per unit Low level 80,000 10,000

d. $0.125 per unit Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit
 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
 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 Total cost = Total fixed cost +
Total variable cost
b. $ 4,000
$14,000 = Total fixed cost +
c. $10,000 ($0.10 × 120,000 units)
d. $12,000 Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000
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.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
Least-Squares Regression Method
 Software can be used
to fit a regression line
through the data points.
 The cost analysis
objective is the same:
Y = a + bX

The output from the regression analysis can be

used to create an equation that enables you to
estimate total costs at any activity level.
Comparing Results From the Three Methods
The three 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 different amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.
 Learning Objective
LO4

To prepare an income
statement using the
contribution format.
The Contribution Format Income Statement

Let’s put our

knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
 The Contribution Format
Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000

The contribution margin format emphasizes

cost behavior. Contribution margin covers fixed
costs and provides for income.
 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:
1. Cost-volume-profit analysis (Chapter 6).
2. Budgeting (Chapter 7).
3. Special decisions such as pricing and make-or-
buy analysis (Chapter 11).
 The Contribution Format

Used primarily for Used primarily by

external reporting. management.
 Learning Objective
LO5

To use variable costing to

prepare a contribution format
income statement and
contrast absorption costing
and variable costing.
(Appendix 5A)
Appendix
Chapter5A
5

Variable Costing
 Overview of Absorption
and Variable Costing

Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses
 Quick Check 
Which method will produce the highest values
for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
 Quick Check 
Which method will produce the highest values
for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
 Unit Cost Computations
Harvey Company produces a single product
with the following information available:
 Unit Cost Computations
Unit product cost is determined as follows:

Selling and administrative expenses are

always treated as period expenses and deducted
from revenue as incurred.
 Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional
information for Harvey Company.
 20,000 units were sold during the year at a
price of $30 each.
 There were no units in beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
Absorption Costing
 Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10) 250,000
All fixed
Goods available for sale 250,000
manufacturing
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000 expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Contribution margin 340,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
 Income Comparison of
Absorption and Variable Costing
Let’s compare the methods.
 Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
Extended Comparison of Income Data
Here is information about the operation of Harvey Company
for the second year.
 Unit Cost Computations

Since there was no change in the variable costs

per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
 Absorption Costing
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Goods available for sale 480,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

These are the 25,000 units

produced in the current period.
Variable Costing
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
 Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
Income Comparison
Summary of Key Insights
End of Chapter 5