Cost - Behavior-Analysis and Use

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Cost- Behavior-Analysis and

Use
Chapter 5

Garrison, Noreen , Brewer


Thirteenth edition

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INTRODUCTION :

A cost, in its widest meaning, is an amount of


expenditure on a defined activity. The word ‘cost’
needs other words added to it, to give it a specific
meaning. Managers in almost any organization
want to know how costs will be effected by changes
in the organization’s activity. Different elements of
costs whether they are either manufacturing or
administrative or selling behave differently with
changes in the volume of activity.

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The relationship between cost and activity called
cost behavior, is relevant to management
functions of planning, control, and decision
making. This behavior of costs may have
impacts on the managerial decisions relating to
volume of activity, selection of markets, selection
of products, selection of machineries etc. Without
the knowledge of cost behaviors, budgets and
other forecasting tools can be inaccurate and
unreliable.

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Mixed Costs:
As already mentioned, 'mixed costs' are cost
items which have both fixed and variable
elements. For helping management, these two
components should be segregated. The process of
segregation is termed as analysis.
Mixed cost is an item of cost containing both fixed
and variable elements.
Also known as semi-variable costs, a mixed cost is
an item of cost containing both fixed and variable
elements.

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Methods of Analyzing Mixed Costs

The following are the methods used to


separate fixed and variable parts of mixed
costs:
(a) Scatter Diagram
(b) High-Low Method
(c) Regression Method
(d) Miscellaneous Methods: Account
Analysis and Engineering Approach

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(a).Scatter Diagrams:
Scatter diagrams are merely graphs showing, in
two-dimensional space, the pairs of values (xi, yi).
This is a statistical technique of identifying the form of
functional relationship between xi, the independent
variable and yi, the dependent variable. This technique
can be used to segregate mixed costs into fixed and
variable components.

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(b).High-Low Method:
If a scatter diagram confirms that the
relationship is approximately linear, attempts
must be made to segregate fixed and variable
costs. This can be done by using the
"high-low method".

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(c)The Least Square Regression Method
The High-Low method of separating fixed and variable costs
in mixed cost is limited for its consideration of two points
instead of all data. The least square regression is a method of
separating a mixed cost into its fixed and variable
components that uses all of the data.
A regression line of the form y = a +bx is fitted to the data,
where y represents total mixed cost, ‘a’ represents the total
fixed cost and ‘b’ represents the variable cost per unit of the
activity, ‘x’ represents the level of activity.

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Example: Production level Maintenance Costs
2,000 units Tk.13,000
5,000 " 28,000
6,000 " 35,000
4,000 " 25,000
8,000 " 40,000
10,000 " 45,000
In the above example,
Lowest point : 2,000 units Cost : Tk.13,000.00
Highest point : 10,000 Units Cost : 45,000.00

Variable cost Tk.45,000–Tk.13,000 Tk.32,000


per unit : ------------------------- = ------------------- = Tk.4 / unit
10,000 – 2,000 8,000
Fixed Cost : Tk.13,000 - (Tk.4×2,000) = Tk.5,000
Cost Function: Y = a + bx
Total costs y = Tk.5,000 + Tk.4x

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The Least Square Regression Method(Cont)
The High-Low method of separating fixed and variable
costs in mixed cost is limited for its consideration of two
points instead of all data. The least square regression is a
method of separating a mixed cost into its fixed and
variable components that uses all of the data.
A regression line of the form y = a +bx is fitted to the data,
where y represents total mixed cost, ‘a’ represents the
total fixed cost and ‘b’ represents the variable cost per
unit of the activity, ‘x’ represents the level of activity.
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Example: Calculation of variation and co-variation

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Calculation of 'a' and 'b'

In a regression analysis, two unknown a &


b can be found using the normal
equations:
Where,

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(d).Miscellaneous Methods:
In practice, the following methods are very
much popular:
(i) Account analysis
(ii) Engineering analysis
(i)Account Analysis: Each account under
consideration is classified as either fixed or
variable based on the analyst's prior
knowledge of how the figures of the account
behave with the changes in the volume of
activity.
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(d).Miscellaneous Methods (Cont)

(ii)The Engineering Analysis: This type of


analysis involves a detailed analysis of
what cost behavior should be, based on
an individual industrial engineer's
evaluation of the production methods to be
used, material specifications, labor
requirement equipment usages, efficiency
of production, power consumption and so
on.
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Format of Income Statement

(i)Traditional Approach/ Format


of Income Statement

(ii) Contribution Format of


Income Statement: [Variable
Costing Income Statement]

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(i)Traditional Approach/ Format of Income Statement

Under this approach, revenues are recorded as and


when earned and costs are classified on the basis of
functions irrespective of their behavior in relation to the
volume of production and sale. Thus, costs are
classified as follows:
(i) Manufacturing Costs: Both fixed and variable
(ii) General and Administrative Costs: Both fixed and
variable
(iii) Selling and Distribution Costs: Both fixed and
variable
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Traditional Approach/ Format of Income
Statement(Cont)

Under traditional approach, all operating expenses are


treated as periodic charges, whereas, manufacturing costs
are matched to periodic sale to find out gross profit.
Under traditional approach, all operating expenses i.e.
general and administrative costs and selling and
distribution costs are treated as periodic charges,
whereas, manufacturing costs are matched to periodic
sale to find out gross profit.
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Income Statement
For the Period
[Under Traditional Approach/Functional
Format ]

Sales Tk xxxxxx
Less Cost of Goods sold . xxxx
Gross Profit / Margin xxxx
Less Operating Expenses:
Administrative Costs Tk xxxx
Selling Costs . xxxx xxxx
Net Operating Income Tk xxxx
.

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(ii) Contribution Format of Income Statement: [Variable
Costing Income Statement]

Although an income statement prepared in the functional


format under traditional approach may be useful for external
reporting, it has serious limitations when used for internal
purposes. Internally, management needs data for planning,
control and decision making. More useful data can be
generated if income statements can be prepared based on
behavioral classification of costs.
The excess of sales over the variable costs (manufacturing,
administrative and selling) is known as contribution margin.

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Income Statement
For the Period ......
[Contribution Format/Behavioral Format ]

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COMPARISON

Used primarily for Used primarily by


external reporting. management.
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Contribution Format of Income Statement:
[Variable Costing Income Statement]
(Cont)
It is claimed that this approach furnishes data for
internal planning and decision making. More
specifically, these data can be used for the following
purposes:
(i) Cost-volume-profit analysis
(ii) Appraising management performance
(iii) Segment reporting of profit data
(iv) Budgeting
(v) Product line profitability analysis
(vi) Special pricing
(vii) Use of scarce resources
(viii)Make or buy decisions

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