Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
11th EditionChapter 5
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Chapter Five
Cost Behavior:Analysis and Use
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit
Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains thesame even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up. relevant range.
Recall the summary of our cost behavior Recall the summary of our cost behavior discussion from an earlier chapter.discussion from an earlier chapter.
Types of Cost Behavior Patterns
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The Activity Base
A measure of what causes the
incurrence of a variable cost
UnitsUnitsproducedproduced
Miles driven
Labor hours
Machine hours
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Minutes Talked
Tota
l Lon
g D
ista
nce
Tele
phon
e B
ill
True Variable Cost Example
A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is based on how many minutes you talk.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit
Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains thesame even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up. relevant range.
Recall the summary of our cost behavior Recall the summary of our cost behavior discussion from an earlier chapter.discussion from an earlier chapter.
Types of Cost Behavior Patterns
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Minutes Talked
Per M
inut
eTe
leph
one
Cha
rge
Variable Cost Per Unit Example
A variable cost remains constant if expressed on a per unit basis. The cost per minute talked is constant. For example, 10 cents per minute.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Extent of Variable Costs
The proportion of variable costs differs across organizations. For example . . .
A public utility withA public utility withlarge investments inlarge investments inequipment will tendequipment will tend
to have to have fewerfewervariable costs.variable costs.
A manufacturing companyA manufacturing companywill often have will often have manymany
variable costs.variable costs.
A merchandising companyA merchandising companyusually will have a usually will have a highhigh
proportionproportion of variable costs of variable costslike cost of sales.like cost of sales.
A service companyA service companywill normally have a will normally have a highhigh
proportionproportion of variable costs. of variable costs.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Volume
Cos
t
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.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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 is known as a step-variable coststep-variable cost.
Volume
Cos
t
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Step-Variable Costs
Small changes in the level of production are not likely to have any effect on the number of
maintenance workers employed.
Volume
Cos
t
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Step-Variable Costs
Only fairly wide changes in the activity level will cause a change in the number of maintenance
workers employed
Volume
Cos
t
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit
Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains thesame even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up. relevant range.
Let’s look at fixed cost behavior on the next Let’s look at fixed cost behavior on the next screens.screens.
Types of Cost Behavior Patterns
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Number of Local Calls
Mon
thly
Bas
ic
Tele
phon
e B
ill
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 probably fixed and does not
change when you make more local calls.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit
Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains thesame even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up. relevant range.
Recall the summary of our cost behavior Recall the summary of our cost behavior discussion from an earlier chapter.discussion from an earlier chapter.
Types of Cost Behavior Patterns
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Number of Local Calls
Mon
thly
Bas
ic T
elep
hone
B
ill p
er L
ocal
Cal
l
Fixed Cost Per Unit Example
Average fixed costs per unit decrease as the activity level increases. The fixed cost per local call
decreases as more local calls are made.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
ExamplesAdvertising and Research and Development
ExamplesDepreciation on Equipment and
Real Estate Taxes
Types of Fixed Costs
DiscretionaryMay be altered in the short-term by current managerial decisions
CommittedLong-term, cannot be significantly reduced
in the short term.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The Trend Toward Fixed Costs
The trend in many industries is toward greater fixed costs relative to variable costs.
As machines take overAs machines take overmany mundane tasksmany mundane taskspreviously performedpreviously performed
by humans, by humans, ““knowledge workersknowledge workers””
are demanded forare demanded fortheir minds rathertheir minds ratherthan their musclesthan their muscles
Knowledge workersKnowledge workerstend to be salaried,tend to be salaried,highly-trained andhighly-trained and
difficult to replace. Thedifficult to replace. Thecost to compensatecost to compensate
these valued employeesthese valued employeesis is relatively fixedrelatively fixed
rather than variable.rather than variable.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Ren
t Cos
t in
Thou
sand
s of
Dol
lars
0 1,000 2,000 3,000 Rented Area (Square Feet)
0
30
60
Fixed Costs and Relevant Range
90
Relevant Range
Total cost doesn’t change for a wide range of activity,
and then jumps to a new higher cost for
the next higher range of activity.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Fixed Costs and Relevant Range
Example:Example: Office space is Office space is available at a rental rate of available at a rental rate of
$30,000 per year in $30,000 per year in increments of 1,000 square increments of 1,000 square feet. As the business grows feet. As the business grows
more space is rented, more space is rented, increasing the total cost.increasing the total cost.
The relevant range of activity for a fixed cost is the range of activity over which the graph of
the cost is flat.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Fixed MonthlyUtility Charge
Variable Cost per KW
Activity (Kilowatt Hours)
Tota
l Util
ity C
ost
X
Y
A mixed cost has both fixed and variablecomponents. Consider the example of utility cost.
Mixed Costs
Total mixed cost
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Fixed MonthlyUtility Charge
Variable Cost per KW
Activity (Kilowatt Hours)
Tota
l Util
ity C
ost
X
Y
Mixed Costs
Total mixed cost
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Mixed Costs Example
If your fixed monthly utility charge is $40, your If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill?what is the amount of your utility bill?
Y = a + bXY = $40 + ($0.03 × 2,000)Y = $100
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Analysis of Mixed Costs
Each account is classified as eitherEach account is classified as eithervariable or fixed based on the analyst’svariable or fixed based on the analyst’s
knowledge of how the account behaves. knowledge of how the account behaves.
Cost estimates are based on an Cost estimates are based on an evaluation of production methods, and evaluation of production methods, and
material, labor and overhead material, labor and overhead requirements.requirements.
Account Analysis and the Engineering ApproachAccount Analysis and the Engineering Approach
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Plot the data points on a graph Plot the data points on a graph (total cost vs. activity).(total cost vs. activity).
0 1 2 3 4
*
Mai
nten
ance
Cos
t1,
000’
s of
Dol
lars
10
20
0
***
**
* **
*
Patient-days in 1,000’s
X
Y
The Scattergraph Method
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The Scattergraph Method
Draw a line through the data points with about anDraw a line through the data points with about anequal numbers of points above and below the line. equal numbers of points above and below the line.
0 1 2 3 4
*
Mai
nten
ance
Cos
t1,
000’
s of
Dol
lars
10
20
0
***
**
* **
*
Patient-days in 1,000’s
X
Y
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The Scattergraph Method
Use one data point to estimate the total level of activity Use one data point to estimate the total level of activity and the total cost. and the total cost.
Intercept = Fixed cost: $10,000
0 1 2 3 4
*
Mai
nten
ance
Cos
t1,
000’
s of
Dol
lars
10
20
0
***
**
* **
*
Patient-days in 1,000’s
X
Y
Patient days = 800Patient days = 800
Total maintenance cost = $11,000Total maintenance cost = $11,000
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The Scattergraph Method
Make a quick estimate of variable cost per unit and Make a quick estimate of variable cost per unit and determine the cost equation. determine the cost equation.
Variable cost per unit = $1,000 800
= $1.25/patient-day$1.25/patient-day
Y = $10,000 + $1.25XY = $10,000 + $1.25X
Total maintenance at 800 patients 11,000$ Less: Fixed cost 10,000 Estimated total variable cost for 800 patients 1,000$
Total maintenance costTotal maintenance cost Number of patient daysNumber of patient days
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The High-Low Method
Assume the following hours of maintenance work and the total maintenance costs for six months.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The High-Low Method
The The variable cost variable cost per hourper hour of of
maintenance is maintenance is equal to the change equal to the change
in cost divided by in cost divided by the change in hours.the change in hours.
= $8.00/hour$8.00/hour$2,400300
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The High-Low Method
Total Fixed Cost = Total Cost – Total Variable CostTotal Fixed Cost = Total Cost – Total Variable Cost
Total Fixed Cost = $9,800 – ($8/hour Total Fixed Cost = $9,800 – ($8/hour × 800 hours)× 800 hours)
Total Fixed Cost = $9,800 – $6,400Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = Total Fixed Cost = $3,400$3,400
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The High-Low Method
Y = $3,400 + $8.00Y = $3,400 + $8.00XXThe Cost Equation for Maintenance
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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 unitb. $0.10 per unit c. $0.12 per unitd. $0.125 per unit
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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 unitb. $0.10 per unit c. $0.12 per unitd. $0.125 per unit $4,000 ÷ 40,000 units
= $0.10 per unit
Units CostHigh level 120,000 14,000$ Low level 80,000 10,000 Change 40,000 4,000$
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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. $ 2,000b. $ 4,000 c. $10,000d. $12,000
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
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. $ 2,000b. $ 4,000 c. $10,000d. $12,000
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Let’s put our knowledge of cost
behavior to work by preparing a
contribution format income statement.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The Contribution Format
Total UnitSales Revenue 100,000$ 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 The contribution margin format emphasizes cost behavior. Contribution margin covers fixed cost behavior. Contribution margin covers fixed
costs and provides for income.costs and provides for income.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Uses of the Contribution Format
The contribution income statement format is used The contribution income statement format is used as an internal planning and decision making tool. as an internal planning and decision making tool.
We will use this approach for:We will use this approach for:
1.1. Cost-volume-profit analysis (Chapter 6).Cost-volume-profit analysis (Chapter 6).
2.2. Budgeting (Chapter 9).Budgeting (Chapter 9).
3.3. Segmented reporting of profit data (Chapter 12).Segmented reporting of profit data (Chapter 12).
4.4. Special decisions such as pricing and make-or-Special decisions such as pricing and make-or-buy analysis (Chapter 13).buy analysis (Chapter 13).
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
The Contribution Format
Used primarily forUsed primarily forexternal reporting.external reporting.
Used primarily byUsed primarily bymanagement.management.
Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
End of Chapter 5