Cost Behavior: Analysis and Use

Chapter 3

© 2012 McGraw-Hill Education (Asia)

 Learning Objective 1

Understand how fixed and

variable costs behave and
how to use them to predict
costs.

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 Types of Cost Behavior Patterns – Variable
A variable cost is a cost whose total dollar
amount varies in direct proportion to changes
in the activity level.

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 The Activity Base (also called a cost driver)

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours

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 True Variable Cost – An Example

As an example of an activity base, consider

overage charges on a cell phone bill. The activity
base is the number of minutes used above the
allowed minutes in the calling plan.
Charges on Cell
Total Overage

Phone Bill

Minutes Talked
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 Types of Cost Behavior Patterns – Variable

Variable costs remain constant if expressed on

per unit basis.

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 Variable Cost Per Unit – An Example
Referring to the cell phone example, the cost per
overage minute is constant, for example 45 cents per
overage minute.

Overage Charge
Per Minute

Minutes Talked

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 Extent of Variable Costs
The proportion of variable costs differs across organizations.
For example . . .
A public utility like Florida A manufacturing
Power and Light, company
with large investments in like Black and Decker
equipment, will tend to will often have many
have variable costs.
fewer variable costs.
A merchandising company
Some service companies like Wal-Mart
have high variable costs, usually has a high
while other service proportion of variable
companies have high costs,
fixed costs. like cost of sales.
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 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.

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 True Variable Costs
The amount of a true variable cost used during the
period varies in direct proportion to the activity level.
The overage charge on a cell phone bill was one
example of a true variable cost.

Direct material is
Cost

another example
of a cost that
behaves in a true
variable pattern.
Volume

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 Step-Variable Costs
A step-variable cost is a resource that is obtainable only
in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.
Cost

Volume
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 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

Parang electrons HAHA

Volume
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 Step-Variable Costs

Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
Cost

workers employed.

ie. Parking rates

Volume

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 The Linearity Assumption and the Relevant Range

Economist’s A straight line

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

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

Activity
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 Types of Cost Behavior Patterns – Fixed
A fixed cost is a cost whose total dollar amount
remains constant as the activity level changes.

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 Total Fixed Cost – An Example
For example, your cell phone bill probably includes a
fixed amount related to the total minutes allowed in
your calling plan. The amount does not change when
you use more or less allowed minutes.
Cell Phone Bill
Monthly Basic

Number of Minutes Used

within Monthly Plan
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 Types of Cost Behavior Patterns – Fixed
Average fixed costs per unit decrease as the
activity level increases.

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 Fixed Cost Per Unit Example
For example, the fixed cost per minute used
decreases as more allowed minutes are used.

Cost Per Cell Phone Call

Kumbaga, sinulit mo talaga kaya mas
mura per unit

Number of Minutes Used

within Monthly Plan

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 Types of Fixed Costs

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

Examples Examples
Depreciation on Buildings Advertising and
and Equipment and Real Research and
Estate Taxes Development

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 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 of compensating
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.1

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 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.

Within countries managers can view labor costs differently

depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.

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 Fixed Costs and the Relevant Range

90
Rent Cost in Thousands

The relevant range

Relevant of activity for a fixed
of Dollars

60 Range cost is the range of

activity over which
the graph of the
cost is flat.
30

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

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 Fixed Costs and the Relevant Range
For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.

Fixed costs would increase

in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

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 Fixed Costs and the Relevant Range

Step-variable costs can

be adjusted more
How does this quickly as conditions
step-function change and . . .
pattern differ from a The width of the activity
step-variable cost? steps is much wider for
the fixed cost.

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 Quick Check ✓
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within
the relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.

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 Quick Check ✓
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the relevant
range.
d. Total variable costs are constant within the
relevant range.

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 Mixed Costs (also called semivariable costs)

A mixed cost contains both variable and fixed

elements. Consider the example of utility cost.
Y
Total Utility Cost

os t
d c
xe
a l mi
To t
Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge

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 Mixed Costs

Y
Total Utility Cost

o s t
d c
x e
a l mi
To t
Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge

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 Mixed Costs – An 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?

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 Analysis of Mixed Costs

Account Analysis and the Engineering Approach

In account analysis, each account is

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

The engineering approach classifies

costs based upon an industrial engineer’s
evaluation of production methods, and
material, labor and overhead
requirements.

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 Why and how to reduce fixed costs or switch
them to variable costs?
▶ Typical fixed costs: production facilities, rentals, employees
salaries and related benefits and utilities
▶ Converting them into variable may reduce risk of financial commitment
and provide flexibility of capacity utilisation
▶ Outsourcing
◻ Business with fast and regular change and/or large varieties of
products most likely will benefit from this approach e.g. Nike and
Apple
◻ Non-core business functions with lower value-add to majority
customers e.g. call centers for enquiries, 3rd party logistics,
broker-dealers’ securities back office operations

▶ Offshoring
◻ Honda and Toyota Thailand plants
◻ HSBC back office functions in China

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 Learning Objective 2

Use a scattergraph plot to

diagnose cost behavior.

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 The Scattergraph Method
Plot the data points on a graph
(Total Cost Y vs. Activity X).
Y
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

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 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

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 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
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 The Scattergraph Method
Make a quick estimate of variable cost per unit and
determine the cost equation.

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

800
Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

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 Learning Objective 3

Analyze a mixed cost

using the high-low method.

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 The High-Low Method – An Example
Assume the following hours of maintenance work
and the total maintenance costs for six months.

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 The High-Low Method – An Example
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $6.00/hour
400

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 The High-Low Method – An Example

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700
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 The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
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 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

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 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
$4,000 ÷ 40,000 units
= $0.10 per unit

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 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

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 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

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 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.

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 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

Least-squares regression also provides a statistic, called

the R2, which is a measure of the goodness
of fit of the regression line to the data points.

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 Least-Squares Regression Method
R2 is the percentage of the variation in the dependent
variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20
* ** *
Total Cost

* * **
10 * *
R2 varies from 0% to 100%, and
the higher the percentage the better.
0
0 1 2 3 4 X
Activity
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 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 differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.

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 Learning Objective 4

Prepare an income
statement using the
contribution format.

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 The Contribution Format

Let’s put our

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

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 The Contribution Format

The contribution margin format emphasizes cost

behavior. Contribution margin covers fixed costs
and provides for income.
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 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 4).
2.Budgeting (Chapter 10).
3.Segmented reporting of profit data (Chapter 13).
4.Special decisions such as pricing and make-or-buy
analysis (Chapter 14).

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 The Contribution Format

Used primarily for Used primarily by

external reporting. management.

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Least-Squares Regression
Computations
Appendix 3A

© 2012 McGraw-Hill Education (Asia)

 Learning Objective 5

Analyze a mixed cost

using the least-squares
regression method.

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 Simple Regression Analysis – An Example

Matrix, Inc. wants to

know its average
fixed cost and
variable cost per unit.
Using the data to the
right, let’s see how to
do a regression using
Microsoft Excel.

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 Simple Regression Using Excel – An Example
You will need three pieces of
information from your
regression analysis:
1. Estimated Variable Cost Per
Unit (line slope)
2. Estimated Fixed Costs (line
intercept)
3. Goodness of fit, or R2

To get these three pieces

information we will need to
use three Excel functions.
SLOPE, INTERCEPT, and RSQ

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Simple Regression Using Excel – An Example

Place your cursor in

cell F4 and press the
= key. Click on the
pull down menu and
scroll down to “More
Functions . . .”

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Simple Regression Using Excel – An Example

Scroll down to the

“Statistical”,
functions. Now
scroll down the
statistical
functions until you
highlight
“SLOPE”

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Simple Regression Using Excel – An Example

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.

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Simple Regression Using Excel – An Example

Here is the
estimate of the
slope of the line.

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.

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Simple Regression Using Excel – An Example
With your cursor in
cell F5, press the =
key and go to the pull
down menu for
“Special Functions.”
Select Statistical and
scroll down to
highlight the
INTERCEPT function.

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 Simple Regression Using Excel – An Example

Here is the
estimate of the
fixed costs.

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.

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Simple Regression Using Excel – An Example

Finally, we will
determine the
“goodness of fit”,
or R2, by using
the RSQ
function.

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Simple Regression Using Excel – An Example

Here is the
estimate of R2.

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.

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 End of Chapter 3

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