Cost Behavior: Analysis and Use

Chapter 5

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 1

Understand how fixed and

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

McGraw-Hill/Irwin Slide 2
 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.

McGraw-Hill/Irwin Slide 3
 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
McGraw-Hill/Irwin Slide 4
 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
McGraw-Hill/Irwin Slide 5
 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.

McGraw-Hill/Irwin Slide 6
 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

McGraw-Hill/Irwin Slide 7
 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.

McGraw-Hill/Irwin Slide 8
 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.

McGraw-Hill/Irwin Slide 9
 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

McGraw-Hill/Irwin Slide 10
 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
McGraw-Hill/Irwin Slide 11
 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
McGraw-Hill/Irwin Slide 12
 Step-Variable Costs

Only fairly wide changes

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

workers employed.

Volume

McGraw-Hill/Irwin Slide 13
 The Linearity Assumption and the Relevant Range

AA straight
straight line
line
Economist’s
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
McGraw-Hill/Irwin Slide 14
 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.

McGraw-Hill/Irwin Slide 15
 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
McGraw-Hill/Irwin Slide 16
 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.

McGraw-Hill/Irwin Slide 17
 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

McGraw-Hill/Irwin Slide 18
 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
McGraw-Hill/Irwin Slide 19
 The Trend Toward Fixed Costs

The trend in many industries is toward greater

fixed costs relative to variable costs.

As machines take over Knowledge workers

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

McGraw-Hill/Irwin Slide 20
 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.

McGraw-Hill/Irwin Slide 21
 Fixed Costs and the Relevant Range

90
Rent Cost in Thousands

The relevant range

Relevant of activity for a fixed
60
of Dollars

cost is the range of

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

0
0 1,000 2,000 3,000
Rented Area (Square Feet)

McGraw-Hill/Irwin Slide 22
 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.

McGraw-Hill/Irwin Slide 23
 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.

McGraw-Hill/Irwin Slide 24
 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.

McGraw-Hill/Irwin Slide 25
 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.

McGraw-Hill/Irwin Slide 26
 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
xe
al mi
t
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

McGraw-Hill/Irwin Slide 27
 Mixed Costs

Y
Total Utility Cost

os t
d c
x e
al mi
t
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

McGraw-Hill/Irwin Slide 28
 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?

McGraw-Hill/Irwin Slide 29
 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.

McGraw-Hill/Irwin Slide 30
 Learning Objective 2

Use a scattergraph plot to

diagnose cost behavior.

McGraw-Hill/Irwin Slide 31
 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

McGraw-Hill/Irwin Slide 32
 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

McGraw-Hill/Irwin Slide 33
 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
McGraw-Hill/Irwin Slide 34
 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.

To tal m ain tenan ce at 800 patien ts $ 11,000

Less: Fixed cost 10,000
E stim ated to tal variab le cost for 800 patients1,000
$

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

800
Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

McGraw-Hill/Irwin Slide 35
 Learning Objective 3

Analyze a mixed cost

using the high-low method.

McGraw-Hill/Irwin Slide 36
 The High-Low Method – An Example
Assume the following hours of maintenance work and the total maintenance costs for six months.

McGraw-Hill/Irwin Slide 37
 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

McGraw-Hill/Irwin Slide 38
 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
McGraw-Hill/Irwin Slide 39
 The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
McGraw-Hill/Irwin Slide 40
 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

McGraw-Hill/Irwin Slide 41
 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 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

McGraw-Hill/Irwin Slide 42
 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

McGraw-Hill/Irwin Slide 43
 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

McGraw-Hill/Irwin Slide 44
 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.

McGraw-Hill/Irwin Slide 45
 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 R2, which is a measure of the goodness
of fit of the regression line to the data points.

McGraw-Hill/Irwin Slide 46
 Least-Squares Regression Method
R2 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
McGraw-Hill/Irwin Slide 47
 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.

McGraw-Hill/Irwin Slide 48
 Learning Objective 4

Prepare an income
statement using the
contribution format.

McGraw-Hill/Irwin Slide 49
 The Contribution Format

Let’s put our

knowledge of cost
behavior to work
by preparing a
contribution
format income
statement.

McGraw-Hill/Irwin Slide 50
 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.
McGraw-Hill/Irwin Slide 51
 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).

McGraw-Hill/Irwin Slide 52
 The Contribution Format
Comparison of the Contribution Income Statement
with the Traditional Income Statement

Traditional Approach Contribution Approach

(costs organized by function ) (costs organized by behavior )

Sales $ 100,000 Sales $ 100,000

Less cost of goods sold 70,000 Less variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating expenses 20,000 Less fixed expenses 30,000
Net operating income $ 10,000 Net operating income $ 10,000

Used primarily for Used primarily by

external reporting. management.

McGraw-Hill/Irwin Slide 53
Least-Squares Regression
Computations
Appendix 5A

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 5

Analyze a mixed cost

using the least-squares
regression method.

McGraw-Hill/Irwin Slide 55
 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.

McGraw-Hill/Irwin Slide 56
 Simple Regression Using Excel – An Example
You will need three pieces of
information from your
regression analysis:
1. Estimated Variable Cost Per
Unit (line slope)
2. Estimated Fixed Costs (line
intercept)
3. Goodness of fit, or R2

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

McGraw-Hill/Irwin Slide 57
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 .. .. .”.”

McGraw-Hill/Irwin Slide 58
Simple Regression Using Excel – An Example

Scroll down to the

“Statistical”,
functions. Now
scroll down the
statistical
functions until you
highlight
“SLOPE”

McGraw-Hill/Irwin Slide 59
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.

McGraw-Hill/Irwin Slide 60
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.

McGraw-Hill/Irwin Slide 61
Simple Regression Using Excel – An Example
With your cursor in
cell F5, press the =
key and go to the pull
down menu for
“Special Functions.”
Select Statistical and
scroll down to
highlight the
INTERCEPT function.

McGraw-Hill/Irwin Slide 62
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.

McGraw-Hill/Irwin Slide 63
Simple Regression Using Excel – An Example

Finally, we will
determine the
“goodness of
fit”, or R2, by
using the RSQ
function.

McGraw-Hill/Irwin Slide 64
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.

McGraw-Hill/Irwin Slide 65
 End of Chapter 5

McGraw-Hill/Irwin Slide 66