Chapter 5

Cost Behavior: Analysis and Use

McGraw-Hill /Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Understand how fixed and variable costs behave and how to use them to predict costs.

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Types of Cost Behavior Patterns

Summary of Variable and Fixed Cost Behavior

Cost Variable In Total Per Unit

Fixed

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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.

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Fixed Costs and Relevant Range

Rent Cost in Thousands of Dollars

90 Relevant
Range
Total cost doesnt change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

60

30

1,000 2,000 3,000 Rented Area (Square Feet)

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The Activity Base= Cost Driver

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

Miles driven

Labor hours

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True Variable Cost Example

Total Long Distance Telephone Bill

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

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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 Telephone Bill

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

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Variable Cost Per Unit Example

A variable cost remains constant if expressed on a per unit basis.

The per minute cost of long distance calls is constant, for example, 10 per minute.
Per Minute Telephone Charge

Minutes Talked

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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, etc

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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

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Step-Variable Costs
A resource that is obtainable only in large chunks and whose costs increase or decrease only in response to fairly wide changes in activity.

Cost

Volume

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Step-Variable Costs
Small changes in the level of activity are not likely to have any effect on that certain cost at that level.

Cost

Volume

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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.

Monthly Basic Telephone Bill

Number of Local Calls

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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.

Monthly Basic Telephone Bill

Number of Local Calls

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Types of Cost Behavior Patterns

Summary of Variable and Fixed Cost Behavior

Cost Variable In Total Total variable cost is proportional to the activity level within the relevant range. Total fixed cost remains the same even when the activity level changes within the relevant range. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed cost per unit goes down as activity level goes up.
(inversely proportional to activity)

Fixed

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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.
Monthly Basic Telephone Bill per Local Call

Number of Local Calls

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Types of Fixed Costs

Committed
Long-term, cannot be significantly reduced in the short-term.

Discretionary
May be altered in the short-term by current managerial decisions

Examples
Depreciation on Buildings and Equipment and Real Estate Taxes

Examples
Advertising and Research and Development

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The Trend Toward Fixed Costs

The trend in many industries is toward greater fixed costs relative to variable costs.
As machines take over many routine tasks previously performed by humans, knowledge workers are demanded for their minds rather than their muscles. Knowledge workers tend to be salaried, highly-trained and difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable.

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Quick Check
Which of the following statements about cost behavior is true (more than one could be true)?
1.

2.

3.

Fixed costs per unit vary with the level of activity. Variable costs per unit are constant within the relevant range. Total fixed costs are constant within the relevant range. Total variable costs are constant within the relevant range.

4.

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Quick Check
Which of the following statements about cost behavior is true (more than one could be true)?
1.

2.

3.

4.

Fixed costs per unit vary with the level of activity. Variable costs per unit are constant within the relevant range. Total fixed costs are constant within the relevant range. Total variable costs are constant within the relevant range.

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Mixed Costs
A mixed cost has both fixed and variable components. Consider your utility costs.
Y Total Utility Cost

Variable Cost per KW

X
Activity (Kilowatt Hours)

Fixed Monthly
Utility Charge

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Mixed Costs
The total mixed cost line can be expressed as an equation: Y = a + bX

Y Total Utility Cost

Where:

Y = the total mixed cost a = the total fixed cost (the vertical intercept of the line) b = the variable cost per unit of activity (the slope of the line) X = the level of activity

Variable Cost per KW

X
Activity (Kilowatt Hours)

Fixed Monthly
Utility Charge

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Mixed Costs Example

If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, what is the equation to get the mixed cost:

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Mixed Costs Example

If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, what is the equation to get the mixed cost:

Y = a + bX

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Mixed Costs Example

If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, what is the equation to get the mixed cost:

Y = a + bX

Y = $40 + $0.03X

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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 X

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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

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Using a Scattergraph plot to diagnose cost behavior.

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The Scattergraph Method

Plot the data points on a graph (total cost vs. activity).

Y
Maintenance Cost 1,000s of Dollars

20

10

* * * *
0 1 2

* ** * **
X

Machine-Hours (in 1,000s)

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The Scattergraph Method

Draw a line through the data points with about an equal number of points above and below the line.

Y
Maintenance Cost 1,000s of Dollars

20

10

* * * *
0 1 2

* ** * **
X

Machine-Hours (in 1,000s)

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The Scattergraph Method

Use one data point to estimate the total level of activity and the total cost.

Maintenance Cost 1,000s of Dollars

Y Total maintenance cost = $11,000 20

10

* * * *
0 1 2

* ** * **
X

Machine-Hours (in 1,000s) Machine-Hours= 800

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The Scattergraph Method

Make a quick estimate of variable cost per unit and determine the cost equation.
$ 11,000 10,000 Estimated total variable cost for 800 machine-hours $ 1,000
Variable cost per unit = $1,000 800 = $1.25/machine-hour

Total maintenance at 800 machine-hours Less: Fixed cost

Y = $10,000 + $1.25X
Total maintenance cost Number of machine-hours

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Analyzing a mixed cost using the high-low method.

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The High-Low Method

related to the Activity level

Assume the following hours of maintenance work and the total maintenance costs for six months.

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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
$2,400 300 = $8.00/hour

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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

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The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X

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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

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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 40,000 $ 4,000 d. $0.125 per unit Change
$4,000 40,000 units = $0.10 per unit

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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

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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? Total cost = Total fixed cost + a. $ 2,000 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

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Preparing an income statement using the contribution format.

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The Contribution Format

Total $ 100,000 60,000 $ 40,000 30,000 $ 10,000 Unit $ 50 30 $ 20

Sales Revenue Less: Variable costs Contribution margin Less: Fixed costs Net operating income

The contribution margin format emphasizes cost behavior, by separating costs into fixed and variable categories. Contribution margin covers fixed costs and provides for income.

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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-orbuy analysis (chapter 11).

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The Contribution Format

Used primarily for external reporting.

Used primarily by management.

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End of Chapter 5