Chapter 16

The Behavior
of Costs

McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Cost-Volume
Relationships
Higher volume causes higher costs.
However, percentage increase in costs
is usually less than increase in volume.
Depends on behavior of costs.
Variable costs.
Fixed costs.
Semivariable costs.
Part variable, part fixed.
Also called semifixed costs or mixed costs.
16-2

Variable Costs
In TOTAL, varies directly and
proportionately with volume of activity.
Cost PER UNIT of activity remains
constant.
Examples:
Material costs varies with units sold.
Vehicle fuel costs varies with miles driven.
Salespersons commissions varies with
sales dollars generated.
16-3

Fixed Costs
In TOTAL, does not change with
volume of activity.
However, are fixed for a range of
activity and a limited period of time.
Cost PER UNIT of activity decreases
as the level of activity increases.
Examples:
Building rent.
Property taxes.
Management salaries.
16-4

Semivariable Costs
Part variable cost, part fixed cost.
In TOTAL, varies less than
proportionately with volume of activity.
Example: Electricity cost in a factory.
Variable component: Cost of powering
production equipment.
Fixed component: Cost of lighting.

To effectively analyze, will need to

break down into variable and fixed
components.
16-5

Cost-Volume (C-V)
Diagram

Illustrations 16-1 and 16-2.

Y or vertical axis reflects total cost.
X or horizontal axis reflects volume.
y = mx + b.
Total cost = total variable cost + total fixed
cost.
y is the total cost at a volume of x.
m is the rate of cost change per unit of volume
change, or the slope (i.e., variable costs).
b is the vertical intercept, which represents the
fixed cost component.
16-6

TC = TFC +(UVC*X)
TC = total cost;
TFC = total fixed cost (per time period),
UVC = Unit variable cost (per unit of
volume),
X = volume.

Equations for:
Variable cost line: TC = (UVC*X).
Fixed cost line: TC = TFC.
Semivariable cost: TC = TFC +
(UVC*X).
16-7

Unit Costs
Average cost per unit.
Total cost volume of activity.

As volume goes up
Type of
Cost
Variable

Total Cost

Fixed

Stays the
same
Increases

Semivariabl

Increases

Cost Per
Unit
Stays the
same
Decreases
Decreases

16-8

Inherent Conditions of
C-V Analysis
Relevant range.
A straight line approximates cost
behavior only within a certain range of
volume.
When volume approaches zero,
management takes steps to reduce
fixed costs.
When volume exceeds relevant range,
fixed costs increase.
16-9

Inherent Conditions of
C-V Analysis
Relevant time period.
Amount of variable costs depends
on the time period over which
behavior is estimated.
If the time period is one day, few
costs are variable.
Over an extremely long time
period, no costs are fixed.
16-10

Inherent Conditions of
C-V Analysis
Sticky Costs.
Many costs considered variable actually
fall less with decreases of activity than
they rise with increases.
Why? Managers tend to increase
resources more quickly than they
decrease.
Examples:
Sales commissions with minimum guarantees.
Managers slower to fire employees than to hire.

16-11

Inherent Conditions of
C-V Analysis
Environment.
C-V analysis only shows how costs
vary with volume.
Many other environmental
influences affecting cost.
E.g., changes in wage rates, fringe
benefits, material prices,
technology.
16-12

Inherent Conditions of
C-V Analysis
Linear assumption.
C-V relationship is often not linear.
Some cost functions are curved or occur
in steps (i.e., curvilinear, step-function).
Solution? Segments of the C-V
relationship can be approximated by a
straight line, each with its own relevant
range.

16-13

Step-Function Costs
Incurred when costs are added in discrete
chunks.
E.g., a supervisor is needed for every 10 workers.

Adding the new step or chunk of costs

increases capacity.
Height of step (riser) indicates the cost of
adding incremental capacity.
Width of step (tread) shows how much
additional volume of activity can be serviced
by the new step up in cost.
16-14

Step Function Costs

If steps are small, then relationship
can be approximated by a variable
cost line.
If steps are wider, then relationship
can be approximated by a fixed
cost line (but only if activity is
within relevant range and relevant
time period).
16-15

Estimating The C-V

Relationship
1. Judgment.
Also called account-by-account
method.
Each account in cost structure is
estimated and divided between
fixed and variable costs.

16-16

Estimating The C-V

Relationship
2. High-Low method.
Estimate total costs for two volume levels,
preferably one high level and one low level.
To determine slope or variable cost per unit:
(Change in total cost between the two
points) (change in units of activity).
To determine fixed costs:
Take total cost at either point and
subtract out variable cost (i.e., variable
cost per unit multiplied by units of
activity).
16-17

Estimating The C-V

Relationship
3. Scatter diagram
Plot actual costs and volume on C-V diagram.
Visually draw a line of best fit.
Read across on diagram to determine total
cost for any level of activity.

4. Linear regression
A statistical method to determine line of best
fit.
Best to eliminate outliers or unusual
observations (e.g., a period during which
there was a strike).
16-18

Potential Problems
with Estimating The CV
Relationship
Use of past data to predict the future.
Other factors (other than volume) may
be affecting cost.
E.g., may be due to trend (or drift) of cost
over time, not relationship of cost to volume.

Linear approximations can hide step

function characteristics.
Costs may appear to be fixed in short
run, but are actually variable in long run
(i.e., long-term variable costs).
16-19

Measures of Volume
Best measure is one that is the
cause of the change in cost.
Units produced?

Can be reliable when considering a

single-product.
Not as reliable when producing multiple
products with different cost structures.

Common measures used:

Labor hours, labor dollars, machine

hours, weight/volume measures (e.g.,
tons, barrels), sales value.
16-20

Questions to Consider
in Selecting a Volume
Measure
Input measure (resources used)
or output measure (goods or
services produced)?
Monetary measure (e.g., labor
dollars) or Nonmonetary
measure (e.g., labor hours)?

16-21

Input vs. Output

Measures
Input measures (resources used).
E.g., labor hours worked, labor cost, machine
hours, kilowatt hours of electricity, pounds of
material.
Commonly used in manufacturing settings.

Output measures (goods/services

produced).
E.g., units of product/service sold, revenue
dollars.
Commonly used in retail/service settings.
16-22

Monetary vs.
Nonmonetary Measures
Nonmonetary measure is
unaffected by price changes.
However, if price changes affect all
costs equally, use of dollars as an
activity measure implicitly allows
for price changes (e.g., labor
costs).

16-23

Selecting a Volume
Measure: General
Considerations

Practicality (i.e., the availability of data

on volume measure).
Causality (i.e., the volume measure
causes the cost to be incurred).
Scope (i.e., the more items of cost that
are combined in the cost function the
more difficult it is to relate causality to a
single measure).
Appropriateness (i.e., changes in
conditions may change current usefulness
of a measure).
16-24

Profitgraph
Add revenue line to C-V diagram.
Assumes constant selling price.
UP = unit selling price.
TR = total revenue.

16-25

Break-even Analysis
TR = (UP*X).
TC = TFC + (UVC*X).
At break-even: TR = TC.
Break-even volume:
(UP*X) = TFC + (UVC*X), or
X = TFC (UP - UVC).
16-26

Break-even Analysis
Unit contribution.
Amount each unit contributes to covering
fixed costs (first) and toward generating profit
(second).
(Unit selling price) (variable cost per unit).
UP - UVC.
Constant (unchanging) for all volumes within
relevant range.
Also known as unit contribution margin or
marginal income.
16-27

Break-even Analysis
Contribution margin percentage.
Contribution as a percentage of
revenues.
(UP - UVC) UP.

Break-even in units:
Fixed costs unit contribution.

Break-even in revenue dollars:

Fixed costs contribution percentage.
16-28

Related Analysis
Target Profit.
Calculate volume needed to achieve a target (T)
level of profit.
(UP*X) = TFC + (UVC*X) + T, or
X = (TFC+T) (UP - UVC).

Operating Leverage.
% change in profit caused by a % change in volume.
Caused by degree (%) of fixed cost in company.
Higher operating leverage means higher changes in
profit.

16-29

Using the Profitgraph

Contribution profitgraph.
Replace total cost/revenue on vertical
axis with income.
Focuses on activity above break-even.

Cash amounts vs. accrual amounts.

Depends on desired focus (i.e., adequate
cash flow vs. adequate profitability).
Consistency is crucial (i.e., sales volume
should equal production volume).
16-30

Using the Profitgraph

Determine how each of the following
improves profitability:

Increase selling price per unit (UR).

Decrease variable cost per unit (UVC).
Decrease fixed costs (TFC).
Increase volume (X).

Margin of safety.
The amount or ratio by which current
volume exceeds breakeven volume.
16-31

C-V-P with Multiple

Products
Analysis is similar if:
Each product has a similar contribution
margin percentage.
Product mix (proportion of each product
in sales total) remains relatively constant.
Use weighted-average unit contribution.

If conditions above do not exist:

Calculate C-V-P for each product
individually.
Requires allocation of fixed costs to individual
products.
16-32

Other Influences on
Costs
Changes in input prices.
Rate at which volume changes.
E.g., rapid changes in volume may
make it more difficult to change
personnel costs.

Direction of change in volume.

Tends to be a lag in cost changes.

Duration of change.
Temporary changes affect costs less
than long-term changes.
16-33

Other Influences on
Costs
Prior knowledge of change.
Allows planning to occur.

Productivity.
As productivity changes costs change.

Management discretion.
Learning curves.
Unit production costs decrease as a
company gains experience producing a
new product.
16-34