Chapter 5

Cost Behavior:
Analysis and Use

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2

Learning Objective 1

Understand how fixed and

variable costs behave and how
to use them to predict costs.
5-3

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.
5-4

The Activity Base

Units
Machine
produce
hours
d
A measure of what
causes the
incurrence of a
variable cost.

Miles Labor
driven hours
5-5

True Variable Cost Example

A variable cost is a cost whose total dollar

amount varies in direct proportion to
changes in the activity level.
Total Long Distance

Your total long

Telephone Bill

distance telephone bill

is based on how many
minutes you talk.

Minutes Talked
5-6

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.
5-7

Variable Cost Per Unit Example

A variable cost remains constant if

expressed on a per unit basis.

Telephone Charge
The per minute cost

Per Minute
of long distance calls
is constant, for
example, 10¢ per
minute.
Minutes Talked
5-8

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.
5-9

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.
5-10

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
5-11

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.
Cost

Volume
5-12

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
5-13

Step-Variable Costs

Only fairly wide changes in the activity

level will cause a change in the number
of maintenance workers employed.
Cost

Volume
5-14
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
Total Cost

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

Activity
5-15

Types of Cost Behavior Patterns

Let’s turn our attention to fixed cost behavior.

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.
5-16

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
Monthly Basic
Telephone Bill

probably fixed and does

not change when you
make more local calls.

Number of Local Calls

5-17

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.
5-18

Fixed Cost Per Unit Example

Average fixed costs per unit decrease

as the activity level increases.

Monthly Basic Telephone

The fixed cost per

Bill per Local Call

local call decreases
as more local calls
are made.

Number of Local Calls

5-19

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
5-20

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.
5-21

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.

Most companies in the United States continue

to view direct labor as a variable cost.
5-22

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)
5-23

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.
5-24

Fixed Costs and Relevant Range

Step-variable costs
can be adjusted
How does this type more quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is
cost? much wider for the
fixed cost.
5-25

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.
5-26

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.
5-27

This is just a review:

Types of Cost Behavior Patterns

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.
5-28

THANK YOU...
5-29

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
5-30

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
5-31

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, the
amount of your utility bill is:

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
5-32

Analysis of Mixed Costs

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, labor and overhead
requirements.
5-33

Learning Objective 2

Use a scattergraph plot

to diagnose cost behavior.
5-34

The Scattergraph Method

Plot the data points on a graph

Y (total cost vs. activity).
20
Maintenance Cost
1,000’s of Dollars

* * * ** *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
5-35

The Scattergraph Method

Draw a line
through the
Y
data points
20
Maintenance Cost
1,000’s of Dollars

* * * ** * with about
an equal
** number of
10 * * points above
and below
the line.
0 X
0 1 2 3 4
Patient-days in 1,000’s
5-36

The Scattergraph Method

Use one
Y Total maintenance cost = $11,000 data point
20 to estimate
Maintenance Cost
1,000’s of Dollars

* * * ** * the total
** level of
10 * * activity
Intercept = Fixed cost: $10,000 and the
0 X
total cost.
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800
5-37

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

5-38

Learning Objective 3

Analyze a mixed cost

using the high-low method.
5-39

The High-Low Method

Assume the following hours of maintenance work

and the total maintenance costs for six months.
5-40

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
5-41

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
5-42

The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
5-43

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
5-44

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
5-45

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
5-46

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
5-47

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 The goal of this method is
mixed cost. to fit a straight line to the
data that minimizes the
sum of the squared errors.
5-48

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.
5-49

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 of the
data points.
5-50

Learning Objective 4

Prepare an income statement

using the contribution format.
5-51

The Contribution Format Income Statement

Let’s put our

knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
5-52

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, by separating costs into fixed and
variable categories. Contribution margin covers
fixed costs and provides for income.
5-53

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).
5-54

The Contribution Format

Used primarily for Used primarily by

external reporting. management.
 Appendix 5A

Variable Costing

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
5-56

Learning Objective 5

Use variable costing to prepare a

contribution format income statement
and contrast absorption costing and
variable costing.
(Appendix 5A)
5-57
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
5-58

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.
5-59

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.
5-60

Unit Cost Computations

Harvey Company produces a single product

with the following information available:
5-61

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.
5-62
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 is no beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
5-63

Absorption Costing
5-64

Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (25,000 × $10) 250,000
manufacturing
Goods available for sale 250,000
overhead is
Less ending inventory (5,000 × $10) 50,000
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
5-65
Comparing Absorption and
Variable Costing
Let’s compare the methods.
5-66
Comparing Absorption and
Variable Costing

We can reconcile the difference between absorption

and variable net operating 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
5-67

Extended Comparison of Income Data

Here is information about the operation

of Harvey Company for the second year.
5-68

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.
5-69

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.
5-70

Variable Costing Variable

manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
5-71
Comparing Absorption and
Variable Costing

We can reconcile the difference between absorption

and variable net operating 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
5-72
Comparing Absorption and
Variable Costing
5-73

Summary of Key Insights

NOI = net operating income

5-74

End of Chapter 5