Chapter 5

Cost Behavior: Analysis and Use

Mar 3, 2004

Cost Behavior
How a cost will react or change as the level of business activity changes Cost can be either variable, fixed or mixed Understanding cost behavior allows managers to predict what costs will be at various business activity levels This information is essential for managing your business efficiently

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Types of Cost Behavior Patterns

Recall the summary of our cost behavior discussion from Chapter 2.
Summary of Variable and Fixed Cost Behavior
Cost Variable In Total Total variable cost is proportional to the activity level within the relevant range. Total fixed cost remains the same even when the activity level changes within the relevant range. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed cost per unit goes down as activity level goes up.

Fixed

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The Activity Base

Units produce d A measure of the event that causes the incurrence of a variable cost a cost driver Machine hours

Miles driven
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Labor hours
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True Variable Cost Example

Your total long distance telephone bill is based on how many minutes you talk.
Total Long Distance Telephone Bill Minutes Talked
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Variable Cost Per Unit Example

The cost per minute talked is constant. For example, 10 cents per minute.
Per Minute Telephone Charge Minutes Talked
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Step-Variable Costs

Total cost remains constant within a narrow range of activity. Cost Activity
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Step-Variable Costs
Total cost increases to a new higher cost for the next higher range of activity. i.e., hiring an additional supervisor or maintenance worker.

Activity
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Cost

Relevant Range
A range of business activity within which the assumptions made about cost behavior are valid. Variable costs on a per unit basis remain the same within the relevant range, and in total vary directly with the level of activity Fixed costs in total remain fixed within the relevant range, but will change on a per unit basis as the level of activity changes
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Exh. 5-5

Total Fixed Cost Example

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
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Exh. 5-5

Fixed Cost Per Unit Example

The fixed cost per local call decreases as more local calls are made.
Monthly Basic Telephone Bill per Local Call Number of Local Calls
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Cost Behavior - Examples

Examples of normally variable costs
Merchandisers
Cost of Goods Sold

Service Organizations
Supplies and travel

Manufacturers
Direct Material, Direct Labor, and Variable Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Examples of normally fixed costs

Merchandisers, manufacturers, and service organizations
Real estate taxes, Insurance, Sales salaries, Depreciation, Advertising
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Types of Fixed Costs

Committed
Long-term, cannot be reduced in the short term.

Discretionary
May be altered in the short-term by current managerial decisions

Examples
Depreciation on Buildings and Equipment, Property Taxes
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Examples
Advertising and Research and Development
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Fixed Costs and Relevant Range

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.
Continue
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Fixed Costs and Relevant Range

Rent Cost in Thousands of Dollars

Exh. 5-6

90 Relevant
Range
Total cost doesnt change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

60

30

00
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1,000 2,000 3,000 Rented Area (Square Feet)

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Fixed Costs and Relevant Range

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.
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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
A mixed cost has both fixed and variable components. Consider the example of utility cost. Total Utility Cost Y

Variable Cost per KW

Activity (Kilowatt Hours)

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Fixed Monthly Utility Charge

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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 vertical intercept of the line) b = the variable cost per unit of activity (the slope of the line) X = the level of activity

Total Utility Cost

Variable Cost per KW

Activity (Kilowatt Hours)

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Fixed Monthly Utility Charge

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Separating Variable and Fixed Costs

There are a number of methods for separating variable and fixed costs for a mixed cost total Scattergraph High-Low Method Least Squares Regression

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The Scattergraph Method

Y Plot the data points on a graph (total cost vs. activity).

Total Cost in 1,000s of Dollars

20

10

* * * *

* ** * **
X

0 1 2 3 4 Activity, 1,000s of Units Produced

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Quick-and-Dirty Method
Draw a line through the data points with about an equal numbers of points above and below the line. Y

Total Cost in 1,000s of Dollars

20

10

* * * * Intercept is the estimated

fixed cost = $10,000

* ** * **
X

0 1 2 3 4 Activity, 1,000s of Units Produced

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Quick-and-Dirty Method
The slope is the estimated variable cost per unit. Slope = Change in cost Change in units Y

Total Cost in 1,000s of Dollars

20

10

* * * * Horizontal
distance is the change in activity.

* ** * **
Vertical distance is the change in cost.

0 1 2 3 4 Activity, 1,000s of Units Produced

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Calculating the Total Cost

Y = a + bX a is the intersection of the slope line and the y axis (fixed cost) To find b, find a data point on the slope line, and determine the level of activity (x axis) and total cost (y axis) Solve for b using the above equation See example on page 204-05 Disadvantages: Outliers, accuracy of line drawn through the dots
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The High-Low Method

(Use example on page 204)
WiseCo recorded the following production activity and maintenance costs for two months:

High activity level Low activity level Change

Units 8,000 5,000 3,000

Cost $ 9,800 7,400 $ 2,400

Using these two levels of activity, compute: the variable cost per unit; the fixed cost; and then express the costs in equation form Y = a + bX.
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The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Change in cost Variable cost per unit = Change in cost change in units
Change in units

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The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Variable cost per unit = $2,400 3,000 units

= $0.80 per unit

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The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Variable cost = $2,400 3,000 units = $0.80 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)

Fixed cost = $9,800 $6,400 = $3,400 (or do the same calculation with the low activity level)

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The High-Low Method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

Variable cost = $2,400 3,000 units = $0.80 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)

Fixed cost = $9,800 $6,400 = $3,400 Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $3,400 + $0.80X
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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 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
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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 Total cost = Total fixed cost + Total variable cost b. $ 4,000 c. $10,000 $14,000 = Total fixed cost + ($0.10 120,000 units) d. $12,000
Total fixed cost Total fixed cost
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= $14,000 - $12,000 = $2,000

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Mixed Cost Equation

If variable cost per unit is $.10 and fixed cost is $2,000 then what is the Total cost equation? Y = $2,000 + $.10(X)

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Hi-Lo Disadvantages
Utilizes only two data points out of the entire data base; not enough for accurate results in cost analysis Outliers could cause a major discrepancy if they are selected as a high or low

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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, that 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 total cost explained by the activity. Y 20 Total Cost

10

* * * * R2 for this relationship is near

100% since the data points are very close to the regression line. 0 1 2 3 Activity 4 X

* ** * **

0
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Total Cost Formula using Least Squares Method

Use the data provided by the least squares for points a and b See example on page 210 Result of least squares method: Y = $3,431 + $0.759(X)

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Least Squares Disadvantages

Outliers can also cause least squares to come up with a wrong answer. Always use least squares on conjunction with scatter grade to identify, and eliminate if necessary, outliers that may erroneously impact the results.

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Comparison of Methods
Scatter Graph Y = $3,300 + $0.79(X) High Low Y = $3,400 + $0.80(X) Least Squares Y = $3,431 + $0.759(X) Which one would you choose? Why?
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Lets put our knowledge of cost behavior to work by preparing a contribution format income statement.

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Contribution Margin Approach

Provides the internal manager with an income statement geared directly to cost behavior; can predict future results Contribution margin is what is left after you subtract variable costs from sales This allows you to determine if you are selling enough product to cover your fixed costs and, therefore, earn a profit Provides ability to analyze profitability by product line, operation, etc.
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The Contribution Format

(Requires Segregation of variable and fixed cost)

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

The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.
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The Contribution Format

Used primarily for external reporting.

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Used primarily by management. Not GAAP

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End of Chapter 5

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