Cost Behavior:Analysis and Use

Chapter 5

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Summary of Variable and Fixed Cost Behavior

Cost 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.

Fixed Total fixed cost remains the Fixed cost per unit goessame even when the activity down as activity level goes up.

level changes within therelevant range.

Recall the summary of our cost behavior discussion from Chapter 2.

Types of Cost Behavior Patterns

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The Activity Base

A measure of the event that causes the incurrence of a

variable cost – a cost driver

A measure of the event that causes the incurrence of a

variable cost – a cost driver

Unitsproduced

Unitsproduced

Miles driven

Miles driven

Labor hours

Labor hours

Machine hours

Machine hours

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Minutes Talked

To

tal L

on

g D

ista

nce

Tel

eph

on

e B

ill

True Variable Cost Example

Your total long distance telephone bill is based on how many minutes you talk.

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Minutes Talked

Per

Min

ute

Tel

eph

on

e C

har

ge

Variable Cost Per Unit Example

The cost per minute talked is constant. For example, 10 cents per minute.

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Step-Variable Costs

Activity

Co

st

Total cost remainsconstant within anarrow range of

activity.

Total cost remainsconstant within anarrow range of

activity.

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Step-Variable Costs

Activity

Co

st

Total cost increases to a new higher cost for the

next higher range of activity.

Total cost increases to a new higher cost for the

next higher range of activity.

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RelevantRange

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

Activity

To

tal

Co

st

Economist’sCurvilinear Cost

Function

The Linearity Assumption and the Relevant Range

Accountant’s Straight-Line Approximation (constant

unit variable cost)

Exh.5-4

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Number of Local Calls

Mo

nth

ly B

asic

T

elep

ho

ne

Bill

Total Fixed Cost Example

Your monthly basic telephone bill is probably fixed and does not change when

you make more local calls.

Exh.5-5

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Number of Local Calls

Mo

nth

ly B

asic

Tel

eph

on

e B

ill p

er L

oca

l Cal

l

Fixed Cost Per Unit Example

The fixed cost per local call decreases as more local calls are made.

Exh.5-5

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Cost Behavior

MerchandisersCost of Goods Sold

MerchandisersCost of Goods Sold

ManufacturersDirect Material, Direct Labor, and Variable

Manufacturing Overhead

ManufacturersDirect Material, Direct Labor, and Variable

Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Merchandisers and Manufacturers

Sales commissions and shipping costs

Service Organizations Supplies and travel

Service Organizations Supplies and travel

Examples of normally variable costsExamples of normally variable costs

Examples of normally fixed costsExamples of normally fixed costs

Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salariesDepreciation, Advertising

Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salariesDepreciation, Advertising

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ExamplesAdvertising and Research and Development

ExamplesAdvertising and Research and Development

ExamplesDepreciation on Buildings and

Equipment

ExamplesDepreciation on Buildings and

Equipment

Types of Fixed Costs

DiscretionaryMay be altered in the short-term by current managerial decisions

DiscretionaryMay be altered in the short-term by current managerial decisions

CommittedLong-term, cannot be reduced in the short

term.

CommittedLong-term, cannot be reduced in the short

term.

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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.

Fixed Costs and Relevant Range

Continue

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Ren

t C

ost

in

T

ho

usa

nd

s o

f D

oll

ars

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.

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.

Exh.5-6

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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.

Fixed Costs and Relevant Range

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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.

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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Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal

Uti

lity

Co

st

X

Y

A mixed cost has both fixed and variablecomponents. Consider the example of utility cost.

A mixed cost has both fixed and variablecomponents. Consider the example of utility cost.

Mixed Costs

Total mixed cost

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Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal

Uti

lity

Co

st

X

Y

Mixed Costs

Total mixed cost Y

= a + bX

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The Analysis of Mixed Costs

Engineering Approach

Account Analysis

High-Low Method

Least-Square Regression Method

Scattergraph Plot

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Account Analysis & Engineering Estimates

Each account is classified as eithervariable or fixed based on the analyst’s

knowledge of how the account behaves.

Each account is classified as eithervariable or fixed based on the analyst’s

knowledge of how the account behaves.

Cost estimates are based on an evaluation of production methods, and material, labor and overhead

requirements.

Cost estimates are based on an evaluation of production methods, and material, labor and overhead

requirements.

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WiseCo recorded the following production activity and maintenance costs for two months:

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.

The High-Low Method

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Changein costChange in units

The High-Low Method

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

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The High-Low Method

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

= $0.80 per unit

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The High-Low Method

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

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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

The High-Low Method

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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

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

Quick Check

$4,000 ÷ 40,000 units = $0.10 per unit

Units Cost

High level 120,000 14,000$

Low level 80,000 10,000

Change 40,000 4,000$

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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

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

Quick Check

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Let’s put our knowledge of cost

behavior to work by preparing a

contribution format income statement.

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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. Contribution margin covers fixed costs

and provides for income.

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The Contribution Format

Used primarily forexternal reporting.

Used primarily bymanagement.

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End of Chapter 5