Cost Behavior

Cost Behavior Analysis

 Learning objectives
1. Cost behaviour.
2. Variable, fixed, and mixed costs, and
separate mixed costs into their variable and
fixed components.
3. Cost-volume-profit (CVP) analysis.
4. Breakeven point(BEP)
 Cost Behaviour
Cost behaviour is the way costs respond
to changes in volume or activity.

• Is a factor in almost every decision

managers make
• Used to analyse alternative courses of
action
• Select the course that will
– Generate income for owners
– Maintain liquidity for creditors
The use of Cost Behaviour in the
Management Cycle
 Cost Behaviour
• Cost behaviour can be observed
– As it relates to products and services
– In selling, administrative, and general activities

! If managers can predict how costs will

behave, then costs become manageable.
 Cost Behaviour
• Variable costs
– Vary with volume or operating activity
• Fixed costs
– Remain fixed as volume changes
• Mixed costs
– Exhibit characteristics of both variable and fixed
costs
 Variable Costs
Variable cost are total costs that change in direct
proportionn to changes in productive output or any other
measure of volume.

Number of Total Cost of

Vehicles Cost of Tires per
Produced Tires Vehicle Operating capacity is the upper
1 $ 192 $192
2 384 192 limit of an organization’s
3 576 192 productive output
4 768 192
5 960 192 capacity,
10 1,920 192
given its existing resources.
 Fixed costs
• Fixed costs are total costs that remain
constant within a relevant range
of volume or activity
• Fixed costs behave differently from
variable costs
The Manufacturer of aluminum cans needs one supervisor for an 8-
hour work shift. Production can range from zero to 500,000 units
per month per shift. The supervisor’s salary is $ 4,000 per month.

•The relevant range is from zero to 500,000 units

– Any output above 500,000 units would require another work
shift and another supervisor.
 Fixed costs
Fixed unit costs vary inversely with activity or
volume.
On a per unit basis, fixed costs go down as
volume goes up
Volume of Activity Cost per Unit
100,000 units $4,000 ÷ 100,000 = $.0400
300,000 units $4,000 ÷ 300,000 = $.0133
500,000 units $4,000 ÷ 500,000 = $.0080
600,000 units $8,000 ÷ 600,000 = $.0133

At 600,000 units, the activity is above the relevant range, which means
another shift must be added and another supervisor hired
 Mixed costs
… have both variable and fixed components
– Part of a mixed cost changes with volume or usage
– Part is fixed over a particular period
• For planning and control purposes, mixed costs
must be divided into their variable and fixed
components
– These components can then be grouped with other
variable and fixed costs for analysis
 The High-Low Method
….identifies a linear relationship between
activity level and cost by analysing the highest
and lowest volumes in an accounting period
and their related costs.
 The High-Low Method (cont’d)
• Three steps
1. Calculate the variable cost per activity base
2. Calculate the total fixed costs
3. Calculate the formula to estimate the total costs
within the relevant range
 The High-Low Method (cont’d)
• Step 1
– Calculate the variable cost per activity base
• Select the periods of highest and lowest activity
within the accounting period
• Find the difference between the highest and lowest
amounts for both machine hours and their related
electricity costs
The High-Low Method (cont’d)
Month Machine Hours Electricity Costs
January 6,250 $ 24,000
February 6,300 24,200
March 6,350 24,350
April 6,400 24,600
May 6,300 24,400
June 6,200 24,300
July 6,100 23,900
August 6,050 23,600
September 6,150 23,950
October 6,250 24,100
November 6,350 24,400
December 6,450 24,700
Totals 75,150 $290,500

Volume Month Activity Level Cost

Highest December 6,450 machine hours $24,700
Lowest August 6,050 machine hours 23,600
Difference 400 machine hours $ 1,100
 The High-Low Method (cont’d)
Variable cost per machine hour
Difference in cost divided by difference in machine
hours
Difference in Cost
Variable Cost per Machine Hour 
Difference in Machine Hours
The variable cost per machine $1,100
hour will be used to calculate 
400 Machine Hours
total fixed costs in Step 2 and
total cost per month in Step 3  $2.75 per Machine Hour (MH)
 The High-Low Method (cont’d)

Step 2
Calculate the total fixed costs
Total Fixed Costs  Total Costs  Total Variable Costs

Select the information from the month with

either the highest or lowest volume
 The High-Low Method (cont’d)
• December
– Total Costs = $24,700
– Total Variable Costs = 6450 MH x $2.75 per MH

Total fixed Costs= $24700 – (6450 x2.75 per MH)=$6962.50

• August
– Total Costs = $23,600
– Total Variable Costs = 6050 MH x $2.75 per MH

Total fixed Costs = $23600 – (6050 MH x $2.75 per MH) = $6962.50

The total fixed costs in Step 2 will

be used to calculate total cost per
month in Step 3
 The High-Low Method (cont’d)
Step 3
Calculate the formula to estimate the total
costs within the relevant range

Total Cost per Month  Total Fixed Costs  Total Variable Costs

From Step 2 From Step 1

Total Cost per Month  $6,962.50  $2.75 per MH * MH

 The High-Low Method (cont’d)
• The cost formula will work only within the
relevant range
– In this case, for amounts between 6,050 and
6,450 machine hours
• To estimate electricity costs for amounts
outside of this range, a new formula must be
calculated
 Cost-Volume-Profit Analysis
… is
an examination of the cost behavior patterns
that underlie the relationships among cost, volume
of output, and profit

Sales Revenue  Variable Costs  Fixed Costs  Profit

S  VC  FC  P
 Cost-Volume-Profit Analysis (cont’d)
• CVP is a tool for
– Short-range planning
• Calculate net income when sales volume is known
• Decide the level of sales needed to reach a targeted amount of
income
• Budgeting
– Control
• Compare actual costs with expected costs
• Measure the effects of alternate courses of action
– Changing variable or fixed costs
– Expanding or contracting sales volume
– Increasing or decreasing selling prices
 Cost-Volume-Profit Analysis (cont’d)

• Useful only under certain conditions and

when certain assumptions hold true:
1. The behavior of variable and fixed costs can be
measured accurately
2. Costs and revenues have a close linear
approximation
3. Efficiency and productivity hold steady within the
relevant range of activity
Cost-Volume-Profit Analysis (cont’d)
4. Cost and price variable also do not change
during the period being planned
5. The sales mix does not change during the period
being planned
6. Production and sales volume are roughly equal

If one or more of these conditions and assumptions are absent, the

CVP analysis may be misleading
 Break-even Point Analysis
…uses the basic elements of cost-volume-profit
analysis to determine the breakeven point
• Break-even point
– The point at which
• Total revenues equal total costs
• The company begins to earn a profit
• Margin of safety
– The number of sales units or amount of sales EUR by
which actual sales can fall below planned sales without
resulting in a loss
 Break-even Point Analysis (cont’d)
General equation for finding the break-
even point

Sales  Variable Costs  Fixed Costs  0

S  VC  FC  0
 Break-even Point Analysis (cont’d)
Metal Products, Inc. makes ornamental iron plant stands.
Variable costs are $50 per unit, and fixed costs average $20,000
per year. Each plant stand sells for $90

$90x  $50x  $20,000  0

$40x  $20,000
x  500 units
Compute the break-even point in sales dollars
$90  500 units  $45,000
Breakeven Point Analysis (cont’d)
 Breakeven Point Analysis (cont’d)

Contribution margin (CM)

Is the amount that remains after all variable costs are
subtracted from sales

S  VC  CM
A product line’s contribution margin represents its net
contribution to paying off fixed costs and earning a
profit
Profit is what remains after fixed costs are paid and subtracted from
contribution margin
CM  FC  P
 Breakeven Point Analysis (cont’d)
Units Produced and Sold
Symbols 250 500 750
S Sales revenue ($90 per unit) $22,500 $45,000 $67,500
VC Less variable costs ($50 per unit) 12,500 25,000 37,500
CM Contribution margin ($40 per unit) $10,000 $20,000 $30,000
FC Less fixed costs 20,000 20,000 20,000
P Profit (loss) ($10,000) — $10,000

• Breakeven point (BEP)

– Can be expressed as the point where
• Contribution margin minus total fixed costs equals zero
• Contribution margin equals fixed costs

(CM per Unit  BEP Units)  FC  0

FC
BEP Units 
CM per Unit
 Break-even Point Analysis (cont’d)

Compute the breakeven point in units for Metal

Products
FC $20,000 $20,000
BEP Units     500 Units
CM per Unit $90  $50 $40

Compute the break-even point in sales dollars using

the CM Ratio
CM $40
CM Ratio    0.444, or 4/9
SP $90
FC
BEP $  $20,000
CM Ratio   $45,045 *
0.444 * Difference due to
rounding up