Cost Behavior: Analysis and Use

Learning Objective 1

Understand how fixed and

variable costs behave and
how to use them to predict
costs.
 Types of Cost Behavior Patterns – Variable
A variable cost is a cost whose total dollar
amount varies in direct proportion to changes
in the activity level.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
The Activity Base (also called a cost driver)

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours
True Variable Cost – An Example

As an example of an activity base, consider

overage charges on a cell phone bill. The activity
base is the number of minutes used above the
allowed minutes in the calling plan.
Charges on Cell
Total Overage

Phone Bill

Minutes Talked
Types of Cost Behavior Patterns – Variable

Variable costs remain constant if expressed on

a per unit basis.

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
Variable Cost Per Unit – An Example
Referring to the cell phone example, the cost per
overage minute is constant, for example 45 cents per
overage minute.

Overage Charge
Per Minute

Minutes Talked
Extent of Variable Costs
The proportion of variable costs differs across organizations.
For example . . .
A public utility like Florida A manufacturing company
Power and Light, like Black and Decker
with large investments in will often have many
equipment, will tend to have variable costs.
fewer variable costs.

Some service companies A merchandising company

have high variable costs, like Wal-Mart
while other service usually has a high
companies have high proportion of variable costs,
fixed costs. like cost of sales.
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.
True Variable Costs
The amount of a true variable cost used during the
period varies in direct proportion to the activity level.
The overage charge on a cell phone bill was one
example of a true variable cost.

Direct material is
Cost

another example
of a cost that
behaves in a true
variable pattern.
Volume
Step-Variable Costs
A step-variable cost is a resource that is obtainable
only in large chunks (such as maintenance workers)
and whose costs change only in response to fairly
wide changes in activity.
Cost

Volume
Step-Variable Costs

Small changes in the level of production are not

likely to have any effect on the number of
maintenance workers employed.
Cost

Volume
Step-Variable Costs

Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
Cost

workers employed.

Volume
The Linearity Assumption and the Relevant Range

Economist’s AA straight
straight line
line
closely
closely
Curvilinear Cost approximates
approximates aa
Function curvilinear
curvilinear
variable
variable cost
cost
line
line within
within the
the
Relevant
relevant
relevant range.
range.
Total Cost

Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
Types of Cost Behavior Patterns – Fixed
A fixed cost is a cost whose total dollar
amount remains constant as the activity level
changes.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed costs remain the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.
Total Fixed Cost – An Example
For example, your cell phone bill probably includes a
fixed amount related to the total minutes allowed in
your calling plan. The amount does not change when
you use more or less allowed minutes.
Cell Phone Bill
Monthly Basic

Number of Minutes Used

within Monthly Plan
Types of Cost Behavior Patterns – Fixed
Average fixed costs per unit decrease as the
activity level increases.

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed costs remain the
same even when the activity Average fixed costs per unit
Fixed level changes within the decrease as the activity
relevant range. level increases.
Fixed Cost Per Unit Example
For example, the fixed cost per minute used
decreases as more allowed minutes are used.

Cost Per Cell Phone Call

Number of Minutes Used

within Monthly Plan
Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in short-term by current
the short term. managerial decisions

Examples Examples
Depreciation on Buildings Advertising and
and Equipment and Real Research and
Estate Taxes Development
The Trend Toward Fixed Costs

The trend in many industries is toward greater

fixed costs relative to variable costs.

As
As machines
machines take
take over
over Knowledge
Knowledge workersworkers
many
many mundane
mundane tasks
tasks tend
tend to to be
be salaried,
salaried,
previously
previously performed
performed highly-trained
highly-trained and and
by
by humans,
humans, difficult
difficult toto replace.
replace. The
The
““knowledge
knowledge workers
workers”” cost
cost of of compensating
compensating
are
are demanded
demanded for for these
these valued
valued employees
employees
their
their minds
minds rather
rather is
is relatively
relatively fixed
fixed
than
than their
their muscles.
muscles. rather
rather than
than variable.1
variable.1
 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.

Within countries managers can view labor costs differently

depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.
Fixed Costs and the Relevant Range

90
Rent Cost in Thousands

The
The relevant
relevant range
range
Relevant of
of activity
activity for
for aa fixed
fixed
60
of Dollars

cost
cost is
is the
the range
range of of
Range activity
activity over
over which
which
the
the graph
graph ofof the
the
cost
cost is
is flat.
flat.
30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)
Fixed Costs and the Relevant Range
For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.

Fixed costs would increase

in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.
Fixed Costs and the Relevant Range

Step-variable costs
can be adjusted more
How does this quickly as conditions
step-function change and . . .
pattern differ from a The width of the activity
step-variable cost? steps is much wider for
the fixed cost.
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.
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.
Mixed Costs (also called semivariable costs)

A
A mixed
mixed cost
cost contains
contains both
both variable
variable and
and fixed
fixed
elements.
elements. Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Y
Total Utility Cost

os t
d c
ixe
al m
t
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
Mixed Costs

Y
Total Utility Cost

os t
d c
ixe
al m
t
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
Mixed Costs – An 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, what is
the amount of your utility bill?
Analysis of Mixed Costs

Account Analysis and the Engineering Approach

In
In account
account analysis
analysis,, each
each account
account isis
classified
classified as
as either
either variable
variable or
or fixed
fixed based
based
on
on the
the analyst’s
analyst’s knowledge
knowledge of of how
how
the
the account
account behaves.
behaves.

The
The engineering
engineering approach
approach classifies
classifies
costs
costs based
based upon
upon an
an industrial
industrial
engineer’s
engineer’s evaluation
evaluation of
of production
production
methods,
methods, and
and material,
material, labor
labor and
and
overhead
overhead requirements.
requirements.
Learning Objective 2

Use a scattergraph plot to

diagnose cost behavior.
The Scattergraph Method
Plot
Plot the
the data
data points
points on
on aa graph
graph
(Total
(Total Cost
Cost YY vs.
vs. Activity
Activity X).
X).
Y
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
The Scattergraph Method
Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about anan
equal
equal numbers
numbers of of points
points above
above and
and below
below the
the line.
line.
Y
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
The Scattergraph Method
Use
Use one
one data
data point
point to
to estimate
estimate thethe total
total level
level of
of activity
activity
and
and thethe total
total cost.
cost.
Y Total maintenance cost = $11,000
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800
The Scattergraph Method
Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per unit
unit and
and
determine
determine the
the cost
cost equation.
equation.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

Variable cost per unit = $1,000 = $1.25/patient-day

800
Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

Learning Objective 3

Analyze a mixed cost

using the high-low method.
The High-Low Method – An Example
Assume the following hours of maintenance work and the total maintenance costs for six months.
The High-Low Method – An Example
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $6.00/hour
400
The High-Low Method – An Example

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700
The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions areare $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is the
the
variable
variable portion
portion of
of sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit
Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions areare $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what isis the
the
variable
variable portion
portion of
of sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit Units Cost
b.
b. $0.10
$0.10 per
per unit
unit High level 120,000 $ 14,000
c.
c. $0.12
$0.12 per
per unit
unit Low level 80,000 10,000
d.
d. $0.125
$0.125 per
per unit
unit Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit
Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions areare $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions areare $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000
Least-Squares Regression Method

A method used to analyze mixed costs if a

scattergraph plot reveals an approximately linear
relationship between the X and Y variables.

This method uses all of the

data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
Least-Squares Regression Method

 Software can be used to fit

a regression line through
the data points.
 The cost analysis objective
is the same: Y = a + bX

Least-squares regression also provides a statistic, called

the R22, which is a measure of the goodness
of fit of the regression line to the data points.
Least-Squares Regression Method
R22 is the percentage of the variation in the dependent
variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20
* ** *
Total Cost

* * **
10 * *
R2 varies from 0% to 100%, and
the higher the percentage the better.
0 X
0 1 2 3 4
Activity
Comparing Results From the Three Methods

The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates ofof the
the fixed
fixed and
and
variable
variable cost
cost components
components of of the
the mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses differing
differing amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because itit uses
uses all
all the
the data
data
points.
points.
Learning Objective 4

Prepare an income
statement using the
contribution format.
The Contribution Format

Let’s put our

knowledge of cost
behavior to work
by preparing a
contribution
format income
statement.
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
The contribution
contribution margin
margin format
format emphasizes
emphasizes cost
cost
behavior.
behavior. Contribution
Contribution margin
margin covers
covers fixed
fixed
costs
costs and
and provides
provides for
for income.
income.
Uses of the Contribution Format

The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning andand decision-making
decision-making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.Cost-volume-profit
1.Cost-volume-profit analysis
analysis (Chapter
(Chapter 6).
6).
2.Budgeting
2.Budgeting (Chapter
(Chapter 9).
9).
3.Segmented
3.Segmented reporting
reporting of
of profit
profit data
data (Chapter
(Chapter 12).
12).
4.Special
4.Special decisions
decisions such
such as
as pricing
pricing and
and make-or-
make-or-
buy
buy analysis
analysis (Chapter
(Chapter 13).
13).
The Contribution Format

Used primarily for Used primarily by

external reporting. management.
Least-Squares Regression
Computations
Appendix 5A
Learning Objective 5

Analyze a mixed cost

using the least-squares
regression method.
 Simple Regression Analysis – An Example

Matrix,
Matrix, Inc.
Inc. wants
wants to
to
know
know itsits average
average
fixed
fixed cost
cost and
and
variable
variable cost
cost per
per unit.
unit.
Using
Using the
the data
data to
to the
the
right,
right, let’s
let’s see
see how
how toto
do
do aa regression
regression using
using
Microsoft
Microsoft Excel.
Excel.
Simple Regression Using Excel – An Example
You
You will
will need
need three
three pieces
pieces of
of
information
information from
from your
your
regression
regression analysis:
analysis:
1.
1. Estimated
Estimated Variable
Variable Cost
Cost Per
Per
Unit
Unit (line
(line slope)
slope)
2.
2. Estimated
Estimated Fixed
Fixed Costs
Costs (line
(line
intercept)
intercept)
3.
3. Goodness
Goodness of of fit,
fit, or
or R
R22

To
To get
get these
these three
three pieces
pieces
information
information we
we will
will need
need to
to
use
use three
three Excel
Excel functions.
functions.
SLOPE,
SLOPE, INTERCEPT,
INTERCEPT, and
and RSQ
RSQ
Simple Regression Using Excel – An Example

Place
Place your
your cursor
cursor in in
cell
cell F4
F4 and
and press
press the the
== key.
key. Click
Click on
on the the
pull
pull down
down menu
menu and and
scroll
scroll down
down toto “More
“More
Functions
Functions .. .. .”.”
Simple Regression Using Excel – An Example

Scroll
Scroll down
down toto the
the
““Statistical
Statistical”,”,
functions.
functions. NowNow
scroll
scroll down
down thethe
statistical
statistical
functions
functions until
until you
you
highlight
highlight
““SLOPE
SLOPE””
Simple Regression Using Excel – An Example

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.
Simple Regression Using Excel – An Example

Here is the
estimate of the
slope of the line.

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.
Simple Regression Using Excel – An Example
With
With your
your cursor
cursor in in
cell
cell F5,
F5, press
press the
the ==
key
key and
and gogo to
to the
the pull
pull
down
down menu
menu forfor
“Special
“Special Functions.”
Functions.”
Select
Select Statistical
Statistical and
and
scroll
scroll down
down to to
highlight
highlight the
the
INTERCEPT
INTERCEPT function.
function.
Simple Regression Using Excel – An Example

Here is the
estimate of the
fixed costs.

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.
Simple Regression Using Excel – An Example

Finally,
Finally, we we willwill
determine
determine the the
““goodness
goodness of of
fit
fit”,
”, or
or R
R22,, by
by
using
using the the RSQ
RSQ
function.
function.
Simple Regression Using Excel – An Example

Here is the
estimate of R2.

1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.
End of Chapter 5