Chapter 3

Chapter 3
Cost Behavior
Text Book: Chapter 2 (P. 60-62; 76); Chapter 3 (P. 104-123)
TABLE OF CONTENTS
CHAPTER 2
PART I – An Introduction to Management Accounting, Cost Terms and Cost

Behavior
Chapter 3. Cost Behavior
1. Types of Cost Behaviour Patterns

2. The Analysis of Mixed Costs
3. The Contribution Format
Managerial Accounting
1-3-2020 | 2
1. TYPES OF COST BEHAVIOUR PATTERNS
VARIABLE, FIXED, MIXED
▪ Three cost behaviour pattern
1. Variable Costs
2. Fixed Costs
3. Mixed Costs
▪ A firm’s cost structure is the relative proportion of fixed, variable and mixed costs found
within an organization. A firm's cost structure can have a significant impact on decisions
➔ Important for managers to understand the behaviour of each type of cost.
1-3-2020 | 3
VARIABLE COSTS
Total variable cost is Variable cost per unit

proportional to the remains the same over
activity wide ranges of activity
1-3-2020 | 4
EXAMPLES OF NORMALLY VARIABLE COSTS
▪ The number of variable costs present in an
organization will depend in large part on the
organization’s structure and purpose.
▪ Companies with large investments in

equipment (such as a utility company or an
airline company), will tend to have few
variable costs
▪ A manufacturing company (such as

Coca-Cola Company) will often have many
variable costs
▪ A merchandising company (such as Ikea)

will usually have a high proportion of
variable costs
▪ Service companies have diverse cost

structures
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VARIABLE COSTS: THE ACTIVITY BASE – COST DRIVERS
▪ Costs are caused by many

different activities within an
? ? organization
▪ For a cost to be variable, it

must be variable with
A measure of whatever respect to its activity
? base/cost driver
? Miles causes the incurrence of a
drivenvariable cost – a cost driver
▪ A cost driver should be
used to allocate a cost for
decision-making purposes
? only if it actually causes the
?
cost!
1-3-2020 | 6
VARIABLE COSTS: THE ACTIVITY BASE – COST DRIVERS
▪ Costs are caused by many

different activities within an
Units Machine organization
produced hours
▪ For a cost to be variable, it
must be variable with
A measure of whatever respect to its activity
Number of
Kilos of base/cost driver
laundy Miles causes the incurrence of a occupied
beds
drivenvariable cost – a cost driver
▪ A cost driver should be
used to allocate a cost for
decision-making purposes
Miles Labour only if it actually causes the
driven hours cost!
1-3-2020 | 7
TRUE VARIABLE VERSUS STEP-VARIABLE COSTS
▪ True or proportionately variable costs (such as Total cost increases to a

DM) are costs that vary in direct proportion to new higher cost for the
next higher range of
the level of production activity. activity.
▪ Step-variable costs (such as the cost of a

maintenance worker) are costs that increase and
decrease only in response to fairly wide changes
in the activity level because the resources are
Cost
obtainable only in indivisible chunks
Total cost remains Volume

constant within a
narrow range of
activity.
1-3-2020 | 8
TRUE VARIABLE VERSUS STEP-VARIABLE COSTS
What is the challenge in dealing with step-variable costs?
1-3-2020 | 9
STEP-VARIABLE COSTS
For decisions where the range of activity is limited to a single step of the cost function, we
consider the cost a fixed cost. For decisions where the range of activity encompasses many
steps, the cost behaves more like a variable cost.
Step cost treated as a fixed cost Step cost treated as a variable cost
1-3-2020 | 10
THE LINEARITY ASSUMPTION AND THE RELEVANT RANGE
▪ In dealing with variable costs, accountants and

managers often assume a linear relationship
between cost and cost driver. Linear-cost
behavior can be graphed with a straight line
▪ In reality, many costs behave in a curvilinear

fashion.
▪ Nevertheless, within the relevant range even a

curvilinear cost function is approximately linear
▪ Often a single cost driver is used to describe each

cost even though many have multiple causes.
Careful use of linear-cost behavior with a single
cost driver often provides cost estimates that are
accurate enough for most decisions, though each
cost may have a different cost drivers. The use of
linear cost behavior may be justified on cost-
benefit grounds.
1-3-2020 | 11
FIXED COSTS
Total fixed cost

remains the same Fixed cost per unit goes
even when the down as activity level goes
activity level changes up
within the relevant
range
1-3-2020 | 12
EXAMPLES OF NORMALLY FIXED COSTS
Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising
▪ Fixed costs are sometimes referred to as capacity costs, since they result from outlays
made for buildings, equipment, skilled professional employees and other items needed to
provide the basic capacity for sustained operations
▪ For planning purposes, fixed costs can be viewed as either committed or discretionary
1-3-2020 | 13
TYPES OF FIXED COSTS
▪ Committed fixed costs

▪ Costs arising from the possession of facilities, equipment, and a basic organization
▪ 1) Long-term in nature and 2) they cannot be reduced to zero even for short periods of
time without seriously impairing the profitability or long-run goals of the organization.
▪ Examples include depreciation of buildings and equipment, taxes on real estate,

insurance, salaries of top management
1-3-2020 | 14
▪ Discretionary fixed costs (managed fixed costs)

▪ Costs determined by management as part of the periodic planning process in order to
meet the organization’s goals. They have no obvious relationschip with levels of capacity or
output activity
▪ Each planning period, management will determine how much to spend on discretionary
items. These costs then become fixed until the next planning period
▪ 1) planning horizon is short term and 2) they can be reduced for short periods of time with
minimal damage to the long-run goals of the organization
▪ Examples include advertising, research, PR, internships for students

promotion costs, public relations, research and development costs, charitable donations, employee training programs, and management
consulting services
1-3-2020 | 15
TYPES OF FIXED COSTS: SUMMARY
1-3-2020 | 16
Can the company reduce or eliminate any of these costs?
1-3-2020 | 17
THE TREND TOWARD FIXED COSTS
The trend in merchandising and manufacturing companies is

toward greater fixed costs relative to variable costs
1-3-2020 | 18
FIXED COSTS AND THE RELEVANT RANGE
Example: 90
Rent Cost in Thousands of

Total cost doesn’t
Office space is available change for a wide
at a rental rate of £30,000 Relevant range of activity, and
60 then jumps to a new
pounds
per year in increments of Range
higher cost for the
1,000 square metres. As next higher range of
activity.
the business grows more 30
space is rented,
increasing the total cost.
0
0 1,000 2,000 3,000
Rented Area (Square metres)
1-3-2020 | 19
FIXED COSTS AND THE RELEVANT RANGE
Step-variable costs
can be adjusted
How does this more quickly
type of fixed cost and . . .
differ from a step- The width of the
variable cost? activity steps is
much wider for the
fixed cost.
1-3-2020 | 20
MIXED COSTS
▪ A mixed cost has both fixed and

variable components
▪ Also known as semi-variable costs
1-3-2020 | 21
MIXED COSTS
The total mixed cost line can be expressed

as an equation: Y = a + bX
Where: Y = the total mixed cost

Y = 25000 + 3X
a = the total fixed cost (the
vertical intercept of the line)
Suppose 800 pony treks
b = the variable cost per unit of
activity (the slope of the line) are expected. What
X = the level of activity
would be the total fee?
1-3-2020 | 22
MIXED COSTS
▪ The fixed portion of a mixed cost

represents the minimum cost of
having a service ready and available
for use. office salaries where there is a core of long-term secretarial staff plus employment
of temporary staff when activity levels rise;
Suppose one supervisor can manage up to 20 employees. Cost of supervision will be fixed for the level of activity from 1 to
20 employees. Beyond that level a second supervisor will be needed, causing a sudden increase in fixed cost
▪ The variable portion represents the

cost incurred for actual consumption
of the service, thus it varies in
proportion to the amount of service
actually consumed.
1-3-2020 | 23
2. THE ANALYSIS OF MIXED COSTS
COST FUNCTIONS
▪ Managers will use cost functions often as a planning and control tool
▪ Planning and controlling the activities of an organization require useful and accurate
estimates of future fixed and variable costs
▪ Cost measurement involves estimating or predicting costs as a function of

appropriate cost drivers.
1-3-2020 | 24
COST FUNCTIONS
The first step in estimating or predicting

costs is measuring cost behavior as a
function of appropriate cost drivers.
The second step is to use these cost

measures to estimate future costs at
expected levels of cost-driver activity.
1-3-2020 | 25
FORM OF COST FUNCTIONS
The total mixed cost line can be expressed

as an equation: Y = a + bX
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
1-3-2020 | 26
DEVELOPING COST FUNCTIONS
▪ Plausibility
▪ The cost function must be believable
▪ A cause-and-effect relationship is desirable for cost functions
▪ Reliability
▪ A cost function’s estimates of costs at actual levels of activity must reliably conform
with actually observed costs
▪ “goodness of fit”
▪ How do managers construct plausible and reliable cost functions?

→ choosing the right cost drivers through activity analysis
1-3-2020 | 27
ACTIVITY ANALYSIS – CHOICE OF COST DRIVERS
▪ Activity analysis: the process of identifying appropriate

cost drivers and their effects on the costs of making a
product or service
▪ The final product or service may have a number of cost

drivers because a number of separate activities may
be involved
▪ Activity: Production of the soundboard

Cost Driver: labor cost
Upright piano requires 40 labor hours

Blue jumper requires 20 labor hours
1-3-2020 | 28
METHODS OF MEASURING COST FUNCTIONS
Account Analysis
Engineering Approach
High-Low Method
Scattergraph/Visual-Fit Method
Least-Square Regression Method
1-3-2020 | 29
ACCOUNT ANALYSIS
▪ A method for analyzing cost behaviour in which each account under consideration is
classified as either variable or fixed based with respect to a selected cost driver on the
analyst’s prior knowledge of how the cost in the account behave
Monthly Cost : 3,700 patient-days January Month
Supervisor's salary and benefits € 3.800

Hourly workers' wages and benefits 14.674
Equipment depreciation and rentals 5.873
Equipment repairs 5.604
Cleaning Supplies 7.472
Total facilities maintenance cost 37.423
1-3-2020 | 30
ACCOUNT ANALYSIS
Monthly Cost : 3,700 patient-days Amount Fixed Variable
Supervisor's salary and benefits € 3.800 3.800

Hourly workers' wages and benefits 14.674 14.674
Equipment depreciation and rentals 5.873 5.873
Equipment repairs 5.604 5.604
Cleaning Supplies 7.472 7.472
Total facilities maintenance cost 37.423 9.673 27.750
Y = FC + (UVC*X)
Y = 9 673 + (27 750/ 3 700) * X
Y = $9 673 + $7,50 x
1-3-2020 | 31
ACCOUNT ANALYSIS
▪ Benefits?
▪ Relatively inexpensive and easy
▪ Works best when analyzing costs at a fairly aggregated level
▪ Drawbacks?
▪ Subjective
▪ Inaccurate (based on 1 observation)
▪ Does not recognize that some of the accounts are mixed costs
1-3-2020 | 32
ENGINEERING ANALYSIS
▪ A detailed analysis of cost behaviour based on an industrial engineer’s evaluation of the inputs
that are required to carry out a particular activity and of the prices of those inputs
▪ It involved a detailed analysis of what cost behaviour should be, not by what costs have been
▪ Engineering analysis entails a systematic review of materials, supplies, labor, support

services, and facilities needed for products and services
▪ How?
▪ personnel interviews Existing products
-
▪ observation of activities
▪ experiments with prototypes
▪ experience of competitors New products
▪ management consultants
1-3-2020 | 33
▪ Pizza hut might use the engineering approach to estimate

the cost of serving a particular pizza
▪ The cost of the pizza would be estimated by carefully

costing:
▪ the specific ingredients used to make the pizza

▪ the power consumed to cook the pizza
▪ the cost of the container the pizza is delivered in
1-3-2020 | 34
▪ Benefits?
▪ Prevents recording of past inefficiencies
▪ If the cost analysts are experienced and understand the activities of the organization, then
their engineering cost predictions may be quite useful and reliable for decision making
▪ Drawbacks?
▪ Time consuming
▪ Expensive
▪ Subjective
1-3-2020 | 35
METHODS OF MEASURING COST FUNCTIONS
High-Low, Visual-Fit, and Least-Squares methods all use historical data

over several periods.
➔ more objective than

- Engineering analysis (↔ hard evidence)
- Account analysis (↔ more than one period)
➔ Historical data :
- could be obsolete
- may hide past inefficiencies
1-3-2020 | 36
HIGH-LOW METHOD
▪ Is a simple way to get estimates of the slope and intercept of

a mixed cost functions by focusing on the highest-activity
and lowest-activity points, and fitting a line through these
two points
▪ A major deficiency of the high-low method is that it utilizes

only two points and ignores all of the other data. Generally,
two points are not enough to produce accurate results.
▪ Moreover, the periods in which the high and low activity levels
occur are often not typical of most periods.
1-3-2020 | 37
HIGH-LOW METHOD
1-3-2020 | 38
HIGH-LOW METHOD
Using these two levels of activity,
compute:
 The variable cost per unit;
 The fixed cost;
 Express the costs in equation form
Change in cost
1. Unit variable cost = = £2,400 ÷ 3,000 = £0.80 per patient day
Change in units
2. Fixed cost = Total cost – Total variable cost
= £9,800 – (£0.80 per patient day × 8,000 patient days) = £9,800 – £6,400 = £3,400
3. Y = £3,400 + £0.80X
1-3-2020 | 39
HIGH-LOW METHOD
1-3-2020 | 40
SHORT QUIZ
QUESTION 1
If sales salaries and commissions are £10,000 when 80,000 are sold and
£14,000 when 120,000 units are sold, what is the variable portion of sales
salaries and commissions?
a. £0,08 per unit
b. £0,10 per unit
c. £0,12 per unit
d. £0,125 per unit
1-3-2020 | 41
SCATTERGRAPH / VISUAL-FIT METHOD
▪ Under this method, a regression line is visually fitted through a plot of all of the
available data, not just between the high point and the low point, making it more
reliable than the high-low method
▪ Some would argue a scattergraph should be the beginning point in all cost analyses, due
to the benefits to be gained from having the data visually
▪ 2 major drawbacks:
▪ Subjective
▪ Extimate of fixed costs are not precise as they are with other methods, since it is
difficult to measure precisely the mount where the regression line intersects the
vertical cost axis.
1-3-2020 | 42
How?
2. THE ANALYSIS OF MIXED COSTS 1. Plot the data points on a graph (total cost vs. activity)
SCATTERGRAPH / VISUAL-FIT METHOD 2. Draw a line through the data points with about an
equal numbers of points above and below the line
3. Estimated fixed cost
4. Determine Variable costs
Y
20
1,000s of pounds
* ** *
Total Cost in
* *
** 1. Plot the data points on a graph
10 * * (total cost vs. activity).
0 X
0 1 2 3 4
Activity, 1,000s of Units Produced
1-3-2020 | 43
How?
Y
20
1,000s of pounds
* ** *
Total Cost in
* * 2. Draw a line through the data points

** with about an equal numbers of points
10 * * above and below the line.
0 X
0 1 2 3 4
1-3-2020 | 44
How?
Y
20 4. The slope of this line is the variable unit cost. (Slope is
1,000s of pounds
* * the change in total cost for a one unit change in activity).

Total Cost in
18
* * * * 18 000 = 10 000 + UVC * 3 000
** UVC = (18 000 - 10 000) / 3 000
10 * * UVC = 2,67
3. Estimated fixed cost = 10,000
Y = 10 000 + 2,67*X
0 X
0 1 2 3 4
1-3-2020 | 45
THE LEAST-SQUARES REGRESSION METHOD
▪ Regression analysis measures a cost function by using

statistics to fit a cost function to all the data
▪ Regression analysis measures cost behavior more

reliably, objectively and precisely than other cost
measurement methods
▪ Regression analysis computes the regression line that

minimizes the sum of these squared errors
▪ Simple versus Multiple Regression
1-3-2020 | 46
• Least-squares regression also provides a statistic, called the (adjusted) R², that is a measure of the
goodness of fit of the regression line to the data points
• The coefficient of determination measures how much of the fluctuation of a cost is explained by
changes in the cost driver
• The R² varies from 0% to 100%, and the higher the percentage, the better. A low R² would be an
indication of a poor fit
• Example: a R² of 0,90 indicates that 90% of the variation in costs is explained by the variation in cost
driver
1-3-2020 | 47
Y
20
Total Cost
* ** *
* * **
10 * * R2 for this relationship is near
100% since the data points are
very close to the regression line.
0 X
0 1 2 3 4
Activity
1-3-2020 | 48
3. THE CONTRIBUTION FORMAT
Any additional capacity of limited resource should be applied toward the product with higher
INTRODUCTION contribution margin per unit of limited resource.
Contribution margin is the amount of revenue remaining after deducting variable costs.
The contribution approach is a
profit statement format that is Total Unit
geared to cost behaviour in that costs Sales £ 100.000 £ 50
are separated into variable and Less: Variable expenses 60.000 30
fixed catergories rather than being Contribution margin £ 40.000 £ 20
separated according to the functions
Less: Fixed costs 30.000
of production, sales, and
Operating profit £ 10.000
administration. The unique thing
about the contribution approach is
that it provides the manager with The contribution margin format emphasizes cost
a profit statement geared directly behaviour. Contribution margin covers fixed costs
to cost behaviour. and provides for profit.
1-3-2020 | 49
WHY A NEW STATEMENT OF PROFIT OR LOSS FORMAT?
▪ There are two major approaches to preparing a statement of profit and loss. The difference
between these two approaches centres on the way in which costs are organized:
✓ The traditional approach:

- Organizes costs in a ‘functional’ format
- Used for external reporting
✓ The contribution approach:

- Organizes costs by behaviour (variable and fixed costs)
- Helps manager to understand relations between volume and expenses and volume and profit
- Since planning and decision making often involve changes in the level of activity, contribution
profit statements facilitate planning, control and decision making
1-3-2020 | 50
TRADITIONAL VERSUS CONTRIBUTION APPROACH
Product cost Some product cost,

(some variable, some fixed) Some period costs
Period cost
(some variable, some fixed)
Some product cost,

Some period costs
Used primarily for Used primarily by Managerial Accounting

external reporting. management. 1-3-2020 | 51
contribution margin per unit= Unit Selling -Unit Variable
contribution margin ratio= contribution margin per unit / by the unit selling price
SHORT QUIZ $200 / $500= 40% The contribution margin ratio of 40% means that Vargo generates 40 cents of
QUESTION 2 contribution margin with each dollar of sales.
Every dollar of sales will increase income by the contribution margin Ratio
A cost that changes abruptly at interval of activity because the resources

and the costs in indivisible chunks is called a(n) ______ cost.
a. Indivisble
b. Mixed
c. Activity
d. Step
1-3-2020 | 52
SHORT QUIZ
QUESTION 3
The limits of cost-driver activity within which a specific relationship between

costs and the cost driver is valid is called _____.
a. Relevant range
b. Variable range
c. Total range
d. Valid range
1-3-2020 | 53
SHORT QUIZ
QUESTION 4
The cafeteria department at Tonka Center incurred the following costs for September 20x7:
Monthly Cost September 20x7 Amount ($)

Manager’s salary 9,000
Hourly workers’ wages and benefits 28,000
Food 12,000
Equipment depreciation and rental 11,000
Supplies 4,000
Total cafeteria costs 64,000
The cafeteria served 12,500 meals during the month. Using an account analysis to classify
costs, the cost function for Olmstead’s cafeteria department is _____ per meal.
a. $20,000 + $1.62
b. $20,000 + $3.52
c. $44,000 + $1.60
d. $44,000 + $3.52
1-3-2020 | 54
SHORT QUIZ
QUESTION 5
Bolt Corp. used regression analysis to predict the annual cost of indirect materials.
The results were as follows:
Regression Output:
Constant 21,890
Std Err of Y Est 4,560
R Squared 0.7832
Number of Observations 22
X Coefficient(s) 11.75
Std Err of Coef. 2.1876
What is the linear cost function?
a. Y = $20,100 + $4.60X
b. Y = $21,890 + $11.75X
c. Y = $21,300 + $2.1876X
d. Y = $ 4,560 + $5.15X
1-3-2020 | 55

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Chapter 3

PART I – An Introduction to Management Accounting, Cost Terms and Cost

Chapter 3. Cost Behavior

1. Types of Cost Behaviour Patterns

▪ Three cost behaviour pattern

➔ Important for managers to understand the behaviour of each type of cost.

Total variable cost is Variable cost per unit

▪ Companies with large investments in

▪ A manufacturing company (such as

▪ A merchandising company (such as Ikea)

▪ Service companies have diverse cost

▪ Costs are caused by many

▪ For a cost to be variable, it

▪ Costs are caused by many

▪ True or proportionately variable costs (such as Total cost increases to a

▪ Step-variable costs (such as the cost of a

Total cost remains Volume

What is the challenge in dealing with step-variable costs?

▪ In dealing with variable costs, accountants and

▪ In reality, many costs behave in a curvilinear

▪ Nevertheless, within the relevant range even a

▪ Often a single cost driver is used to describe each

Total fixed cost

Merchandisers, manufacturers, and service organizations

▪ Committed fixed costs

▪ Examples include depreciation of buildings and equipment, taxes on real estate,

▪ Discretionary fixed costs (managed fixed costs)

▪ Examples include advertising, research, PR, internships for students

Can the company reduce or eliminate any of these costs?

The trend in merchandising and manufacturing companies is

Rent Cost in Thousands of

▪ A mixed cost has both fixed and

The total mixed cost line can be expressed

Where: Y = the total mixed cost

▪ The fixed portion of a mixed cost

▪ The variable portion represents the

▪ Cost measurement involves estimating or predicting costs as a function of

The first step in estimating or predicting

The second step is to use these cost

The total mixed cost line can be expressed

Where: Y = the total mixed cost

▪ How do managers construct plausible and reliable cost functions?

▪ Activity analysis: the process of identifying appropriate

▪ The final product or service may have a number of cost

▪ Activity: Production of the soundboard

Upright piano requires 40 labor hours

Least-Square Regression Method

Monthly Cost : 3,700 patient-days January Month

Supervisor's salary and benefits € 3.800

Monthly Cost : 3,700 patient-days Amount Fixed Variable

Supervisor's salary and benefits € 3.800 3.800

Y = 9 673 + (27 750/ 3 700) * X

▪ Relatively inexpensive and easy

▪ Works best when analyzing costs at a fairly aggregated level

▪ Inaccurate (based on 1 observation)

▪ Engineering analysis entails a systematic review of materials, supplies, labor, support

▪ Pizza hut might use the engineering approach to estimate

▪ The cost of the pizza would be estimated by carefully

▪ the specific ingredients used to make the pizza

▪ Prevents recording of past inefficiencies