Cost Classifications for

Predicting Cost Behavior

• Cost behavior refers to how a cost reacts to
changes in the level of activity. As the activity
level rises and falls, a particular cost may rise
and fall as well—or it may remain constant.
• For planning purposes, a manager must be
able to anticipate which of these will happen;
and if a cost can be expected to change, the
manager must be able to estimate how much
it will change.
• To help make distinctions, costs are often
categorized as variable, fixed, or mixed.
• The relative proportion of each type of cost in
an organization is known as its cost structure .
 Variable Cost
• A variable cost varies, in total, in direct
proportion to changes in the level of activity.
• Common examples of variable costs include cost
of goods sold for a merchandising company,
direct materials, direct labor, variable elements
of manufacturing overhead, such as indirect
materials, supplies, and power, and variable
elements of selling and administrative expenses,
such as commissions and shipping costs.
• An activity base is a measure of whatever
causes the incurrence of a variable cost. An
activity base is sometimes referred to as a cost
driver.
• Some of the most common activity bases are
direct labor-hours, machine-hours, units
produced, miles driven, and units sold.
• To provide an example of a variable cost,
consider Nooksack Expeditions, a small
company that provides daylong whitewater
rafting excursions on rivers in the North
Cascade Mountains.
• The behavior of this variable cost, on both a
per unit and a total basis, is shown below:
 Fixed Cost
• A fixed cost is a cost that remains constant, in
total, regardless of changes in the level of
activity.
• Examples of fixed costs include straight-line
depreciation, insurance, property taxes, rent,
supervisory salaries, administrative salaries,
and advertising. Unlike variable costs, fixed
costs are not affected by changes in activity.
• To continue the Nooksack Expeditions example,
assume the company rents a building for $500
per month to store its equipment.
• The total amount of rent paid is the same
regardless of the number of guests the
company takes on its expeditions during any
given month.
• The concept of a fixed cost is shown graphically
on the right-hand side of Exhibit 2–2 .
Note that as the number of guests increase, the average fixed cost per
guest drops.
• For planning purposes, fixed costs can be viewed as
either committed or discretionary.
• Committed fixed costs represent organizational
investments with a multiyear planning horizon that
can’t be significantly reduced even for short periods
of time without making fundamental changes.
Examples include investments in facilities and
equipment, as well as real estate taxes, insurance
expenses, and salaries of top management.
• Discretionary fixed costs (often referred to as managed
fixed costs ) usually arise from annual decisions by
management to spend on certain fixed cost items.
• Examples of discretionary fixed costs include
advertising, research, public relations, management
development programs, and internships for students.
• Discretionary fixed costs can be cut for short periods of
time with minimal damage to the long-run goals of the
organization.
 Mixed Costs
• A mixed cost contains both variable and fixed cost elements.
Mixed costs are also known as semi-variable costs.
• To continue the Nooksack Expeditions example, the company
incurs a mixed cost called fees paid to the state. It includes a
license fee of $25,000 per year plus $3 per rafting party paid
to the state’s Department of Natural Resources.
• If the company runs 1,000 rafting parties this year, then the
total fees paid to the state would be $28,000, made up of
$25,000 in fixed cost plus $3,000 in variable cost. Exhibit 2–5
depicts the behavior of this mixed cost.
 Cost Estimation
• Managers can use a variety of methods to
estimate the fixed and variable components of
a mixed cost such as account analysis, the
engineering approach, the high-low method,
and least-squares regression analysis.
• In account analysis , an account is classified as
either variable or fixed based on the analyst’s
prior knowledge of how the cost in the
account behaves.
• For example, direct materials would be
classified as variable and a building lease cost
would be classified as fixed because of the
nature of those costs.
• The engineering approach to cost analysis
involves a detailed analysis of what cost
behavior should be, based on an industrial
engineer’s evaluation of the production
methods to be used, the materials
specifications, labor requirements, equipment
usage, production efficiency, power
consumption, and so on.
• The high-low and least-squares regression
methods estimate the fixed and variable
elements of a mixed cost by analyzing past
records of cost and activity data.
The High-Low Method
• The total maintenance cost, Y, is plotted on
the vertical axis. Cost is known as the
dependent variable because the amount of
cost incurred during a period depends on the
level of activity for the period.
• The activity, X is known as the independent
variable because it causes variations in the
cost.
• Consequently, the following formula can
be used to estimate the variable cost:
To analyze mixed costs with the high-low
method , begin by identifying the period with
the lowest level of activity and the period with
the highest level of activity.
The Contribution Format Income Statement

• Separating costs into fixed and variable

elements helps to predict costs and provide
benchmarks.
• The unique thing about the contribution
approach is that it provides managers with an
income statement that clearly distinguishes
between fixed and variable costs and therefore
facilitates planning, control, and decision
making.
Notice that the contribution approach
separates costs into fixed and variable
categories, first deducting variable expenses
from sales to obtain the contribution margin.
The contribution margin is the amount
remaining from sales revenues after variable
expenses have been deducted. This amount
contributes toward covering fixed expenses
and then toward profits for the period.
 traditional approach
• is organized in a “functional” format—
emphasizing the functions of production,
administration, and sales. No attempt is made
to distinguish between fixed and variable
costs.
• Under the heading “Administrative expense,”
for example, both variable and fixed costs are
lumped together.