Chapter

3
Cost Behavior:
Analysis and Use
 5-2

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain the effect of a change in activity on
both total variable costs and per unit variable
costs.
2. Explain the effect of a change in activity on
both total fixed costs and fixed costs
expressed on a per unit.
3. Use a cost formula to predict costs at a new
level of activity.
4. Analyze a mixed cost using the high-
low method.

© McGraw-Hill Ryerson Limited., 2001

 5-3

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

5. Analyze a mixed cost using the scattergraph

method.
6. Explain the least-squares regression method of
analyzing a mixed cost.
7. Prepare an income statement using the
contribution format.
8. (Appendix 5A) Analyze a mixed cost using the
least-squares regression method.

© McGraw-Hill Ryerson Limited., 2001

 5-4

Types of Cost Behaviour Patterns

Summary of Variable and Fixed Cost Behaviour

Cost In Total Per Unit

Variable Total variable cost i s Variable cost per unit remains

proportional to the activity the same over w ide ranges
level w ithin the relevant range. of activity.
Fixed Total fixed cost remains the Fixed cost per unit goes
same even w h e n the activity dow n a s activity level goes up.
level changes w ithin the
relevant range.

© McGraw-Hill Ryerson Limited., 2001

 5-5

Total 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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 5-6

Variable Cost Per Unit Example

The cost per minute talked is constant. For

example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
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 5-7

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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 5-8

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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 5-9

Cost Behaviour
Examples of normally variable costs
Merchandisers Service Organizations
Cost of Goods Sold Supplies and travel

Manufacturers Merchandisers and

Direct Material, Direct Manufacturers
Labour, and Variable Sales commissions and
Manufacturing Overhead shipping costs

Examples of normally fixed costs

Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Amortization, Advertising
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 5-10

The Activity Base

Units Machine
produced hours

A measure of the event

causing the occurrence of a
variable cost – a cost driver

Miles Labour
driven hours
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 5-16

Types of Fixed Costs

Fixed Costs

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

Examples Examples
Amortization on Advertising and
Buildings and Research and
Equipment Development
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 5-18

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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 5-19

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

00 1,000 2,000 3,000

Rented Area (Square Feet)
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 5-21

Mixed Costs

A mixed cost
has both fixed
and variable
components.
Consider the
following electric
utility example.

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 5-22

Mixed Costs

Y
Total Utility Cost

Variable
Utility Charge

Fixed Monthly
X Utility Charge
Activity (Kilowatt Hours)
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 5-23

Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Y
Where: Y = the total mixed cost
bX
Total Utility Cost

a+ a = the total fixed cost (the

Y= vertical intercept of the line)
ost
Variable
b = the variable cost per unit of
activity (the slope of the line)
Utility Charge
X = the level of activity

Fixed Monthly

X Utility Charge
Activity (Kilowatt Hours)
© McGraw-Hill Ryerson Limited., 2001
 5-24

Mixed Costs

Y
Total Utility Cost

Variable
bX
Utility Charge

Fixed Monthly
a
X Utility Charge
Activity (Kilowatt Hours)
© McGraw-Hill Ryerson Limited., 2001
 5-25

The Analysis of Mixed Costs

Account Analysis

Engineering Approach

High-Low Method

Scattergraph Method

Least-Square Regression Method

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 5-26

Account Analysis

Each account is classified as either

variable or fixed based on the analyst’s
knowledge of how the account behaves.
© McGraw-Hill Ryerson Limited., 2001
Steps in Account Analysis
1. Review each cost account used to record
the costs that are of interest. Each cost is
identified as either fixed or variable
depending on the relationship between the
cost and some activity.
2. Each major class of manufacturing
overhead or other mixed cost is itemized.
Each cost is then divided into its estimated
variable and fixed components. This is
done on the basis of the experience and
judgment of accounting and other
personnel.
Account Analysis: Advantage and
Disadvantage

• Advantage
It involves a detailed examination of the
data base by accountants and managers who
are familiar with it.

• Disadvantage
It uses subjective, judgmental approach
so that different analysts may provide different
estimates of cost behavior.
 5-27

Engineering Estimates

Cost estimates are based on an evaluation

of production methods, and material, labour
and overhead requirements.

© McGraw-Hill Ryerson Limited., 2001

Steps in applying the Engineering
Method of Estimating Costs
1. A study of the physical relation between the
quantities of inputs (material, labor, etc.)
and each unit of output (finished product) is
done. This involves the ff activities.
a. A detailed step-by-step analysis of each
phase of each manufacturing process
together with the kinds of work performed,
and time to perform each step is done.
(time-and-motion study).
b. Engineering estimates of the materials
required for each unit of production are
obtained from drawings and specifications
sheets.
Steps in applying the Engineering
Method of Estimating Costs
2. Costs are then assigned to each of the
physical inputs (wages, material price,
insurance charges, etc.) to estimate the
cost of the outputs.
Industrial Engineering Method:
Advantages and Disadvantages

Advantages
• It can detail each step required to perform
an operation.
• It enables the company to review its
manufacturing productivity and identify
specific strengths and weaknesses.
• It can be used to estimate costs for totally
new activities because it does not require
data from prior activities in the organization.
Industrial Engineering Method:
Advantages and Disadvantages

Disadvantages
• It can be quite expensive to use because
each activity is using engineering norms
and expert engineers which are costly.
• Engineering estimates are often based on
optimal condition. It is also difficult to
estimate the indirect costs of production.
 5-28

The High-Low Method

WiseCo recorded the following production activity
and maintenance costs for two months:
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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.
© McGraw-Hill Ryerson Limited., 2001
 5-29

The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

© McGraw-Hill Ryerson Limited., 2001

 5-30

The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

© McGraw-Hill Ryerson Limited., 2001

 5-31

The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600

© McGraw-Hill Ryerson Limited., 2001

 5-32

The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = $1,600 + $0.90X

© McGraw-Hill Ryerson Limited., 2001

 5-33

The High-Low Method

IfIf sales
sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold
sold and
and $14,000
$14,000 when
when
120,000
120,000 unitsunits are
are sold,
sold, what
what is
is the
the variable
variable
portion
portion of of sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit

© McGraw-Hill Ryerson Limited., 2001

 5-34

The High-Low Method

IfIf sales
sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000
when
when 80,000
80,000 units
units are
are sold
sold and
and $14,000
$14,000 when
when
120,000
120,000 unitsunits are
are sold,
sold, what
what is is the
the variable
variable
portion
portion of of sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit Units Cost
b.
b. $0.10
$0.10 per
per unit
unit High level 120,000 $ 14,000
c.
c. $0.12
$0.12 per
per unit
unit Low level 80,000 10,000
Change 40,000 $ 4,000
d. $0.125 per
d. $0.125 per unit unit
$4,000 ÷ 40,000 units
= $0.10 per unit

© McGraw-Hill Ryerson Limited., 2001

 5-35

The High-Low Method

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

© McGraw-Hill Ryerson Limited., 2001

 5-36

The High-Low Method

IfIf sales
sales salaries
salariesand
andcommissions
commissionsare are $10,000
$10,000
when
when 80,000
80,000units
unitsare
are sold
sold and
and$14,000
$14,000when when
120,000
120,000 unitsunits are
are sold,
sold,whatwhatisisthe
thefixed
fixed portion
portion
of
of sales salariessand
salessalarie and commissions?
commissions?
Tota l cost = Tota l fixed cost +
Tota l va riable cost
a. $ 2,000
a. $ 2,000
$14,000 = Tota l fixed cost +
b.
b. $$ 4,000
4,000 ($0.10 × 120,000 units)
c.
c. $10,000
$10,000 Tota l fixed cost = $14,000 - $12,000
d.
d. $12,000
$12,000 Tota l fixed cost = $2,000

© McGraw-Hill Ryerson Limited., 2001

 5-37

The Scattergraph Method

Plot the data points on a
graph (total cost vs. activity).
Y
20
* * *
(000’s of Dollars)

* * *
Total Cost

**
10 * *

0 X
0 1 2 3 4
Activity (000’s of Units Produced)

© McGraw-Hill Ryerson Limited., 2001

 5-38

The Scattergraph Method

Draw a line through the data points with about an
equal numbers of points above and below the line.
Y
20
* * *
(000’s of Dollars)

* * *
Total Cost

**
10 * *

0 X
0 1 2 3 4
Activity (000’s of Units Produced)

© McGraw-Hill Ryerson Limited., 2001

 5-39

The Scattergraph Method

The slope of this line is the variable unit
cost. (Slope is the change in total cost
Y for a one unit change in activity).
20
* * *
(000’s of Dollars)

* * *
Total Cost

**
10 * *
Estimated fixed cost = $10,000

0 X
0 1 2 3 4
Activity (000’s of Units Produced)

© McGraw-Hill Ryerson Limited., 2001

 5-40

The Scattergraph Method

Change in cost
Slope =
Change in units
Y
20
* * *
(000’s of Dollars)

Vertical
* * *
Total Cost

distance
** is the
10 * * change
in cost.
Horizontal distance is
the change in activity.
0 X
0 1 2 3 4
Activity (000’s of Units Produced)

© McGraw-Hill Ryerson Limited., 2001

 5-41

Least-Squares Regression Method

 Accountants and managers
may use computer software
to fit a regression line
through the data points.
 The cost analysis objective
is the same: Y = a + bx

Least-squares
Least-squares regression
regression alsoalso provides
provides aa statistic,
statistic, called
called
the adjusted R 22, that is a measure of the goodness
the adjusted R , that is a measure of the goodness
of
offit
fitof
ofthe
theregression
regression line
lineto
tothe
thedata
datapoints.
points.
© McGraw-Hill Ryerson Limited., 2001
 5-42

Least-Squares Regression Method

R2 is the percentage of the variation
in total cost explained by the activity.

Y
20
* * *
*
Total Cost

* * * *
10 * *2
R for this relationship is near
100% since the data points are
very close to the regression line.
0
0 1 2 3 4 X
Activity
© McGraw-Hill Ryerson Limited., 2001
 Appendix

3A
Least-Squares Regression
Calculations
 5-47

Least-Squares Regression
This method provides the most objective and precise
breakdown of mixed costs into variable and fixed
components.

This method also uses the most complex calculations.

However, most business calculators and several
computer software programs can quickly complete the
calculations required.

This method mathematically places the line in the most

favourable location by ensuring that the total of the
squares of all points off the line is minimized.

© McGraw-Hill Ryerson Limited., 2001

 5-48

Least-Squares Regression
Calculations:
b = n(XY-(X)(Y)
n(X2) - (X)2

a = (Y) - b(X)
n
where X= the level of activity (Independent variable)
Y= the total mixed cost (dependent variable)
a = the total fixed cost (vertical intercept of line)
b = the variable cost per unit of activity (slope of
line)
n = number of observations
 = sum across all n observations
© McGraw-Hill Ryerson Limited., 2001
 5-49

End of Chapter 3

© McGraw-Hill Ryerson Limited., 2001