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Chapter 3

Cost Behavior:
Analysis and Use

Types of Cost Behavior


Patterns
Recall the summary of our cost behavior
discussion from Chapter 2.
Summary of Variable and Fixed Cost Behavior
Cost

In Total

Per Unit

Variable

Total variable cost is


proportional to the activity
level within the relevant range.

Variable cost per unit remains


the same over wide ranges
of activity.

Fixed

Total fixed cost remains the


same even when the activity
level changes within the
relevant range.

Fixed cost per unit goes


down as activity level goes up.

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The Activity Base


Units
Units
produced
produced

Machine
Machine
hours
hours
A
Ameasure
measure of
of the
the
event
event that
that causes
causes
the
the incurrence
incurrence of
of aa
variable
variable cost
cost aa
cost
cost driver
driver

Miles
Miles
driven
driven
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Labor
Labor
hours
hours

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True Variable Cost Example

Total Long Distance


Telephone Bill

Your total long distance telephone bill is


based on how many minutes you talk.

Minutes Talked
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Variable Cost Per Unit Example

Per Minute
Telephone Charge

The cost per minute talked is constant. For


example, 10 cents per minute.

Minutes Talked
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Step-Variable Costs

Cost

Total
Totalcost
cost remains
remains
constant
constantwithin
withinaa
narrow
narrow range
rangeof
of
activity.
activity.

Activity
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Step-Variable Costs

Cost

Total
Totalcost
costincreases
increasesto
toaa
new
new higher
highercost
cost for
for the
the
next
next higher
higherrange
rangeof
of
activity.
activity.

Activity
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The Linearity Assumption and


the Relevant Range

Exh.
5-4

Total Cost

AAstraight
straightline
line
Economists
closely
closely
Curvilinear Cost approximates
approximates aa
Function
curvilinear
curvilinear

Relevant
Range

variable
variablecost
cost
line
linewithin
withinthe
the
relevant
relevant range.
range.

Accountants Straight-Line
Approximation (constant
unit variable cost)
Activity

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Total Fixed Cost Example

Exh.
5-5

Monthly Basic
Telephone Bill

Your monthly basic telephone bill is


probably fixed and does not change when
you make more local calls.

Number of Local Calls


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Fixed Cost Per Unit Example

Exh.
5-5

Monthly Basic Telephone


Bill per Local Call

The fixed cost per local call decreases as


more local calls are made.

Number of Local Calls


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Cost Behavior
Examples
Examples of
of normally
normally variable
variable costs
costs
Merchandisers
Merchandisers

Service
ServiceOrganizations
Organizations

Cost
Costof
ofGoods
GoodsSold
Sold

Supplies
Suppliesand
andtravel
travel

Manufacturers
Manufacturers

Merchandisers
Merchandisers and
and
Manufacturers
Manufacturers

Direct
DirectMaterial,
Material,Direct
Direct
Labor,
Labor,and
andVariable
Variable
Manufacturing
ManufacturingOverhead
Overhead

Sales
Salescommissions
commissionsand
and
shipping
shippingcosts
costs

Examples
Examples of
of normally
normally fixed
fixed costs
costs
Merchandisers,
Merchandisers, manufacturers,
manufacturers, and
and
service
serviceorganizations
organizations

Real
Realestate
estatetaxes,
taxes,Insurance,
Insurance,Sales
Salessalaries
salaries
Depreciation,
Depreciation,Advertising
Advertising
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Types of Fixed Costs

Committed
Committed

Discretionary
Discretionary

Long-term,
Long-term, cannot
cannot be
be
reduced
reducedin
in the
theshort
short
term.
term.

May
Maybe
bealtered
altered in
inthe
the
short-term
short-term by
bycurrent
current
managerial
managerial decisions
decisions

Examples
Examples

Examples
Examples

Depreciation
Depreciationon
on
Buildings
Buildingsand
and
Equipment
Equipment

Advertising
Advertisingand
and
Research
Research and
and
Development
Development

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Fixed Costs and Relevant


Range
Example: Office space
is available at a rental
rate of $30,000 per year
in increments of 1,000
square feet. As the
business grows more
space is rented,
increasing the total
cost.
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Continue

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Rent Cost in
Thousands of Dollars

Fixed Costs and Relevant


Range

Exh.
5-6

90

60

30
00

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Relevant
Range

Total
Totalcost
costdoesnt
doesnt
change
changefor
foraawide
wide
range
rangeof
ofactivity,
activity,
and
andthen
thenjumps
jumpsto
toaa
new
newhigher
highercost
costfor
for
the
thenext
nexthigher
higher
range
rangeof
ofactivity.
activity.

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

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Fixed Costs and Relevant


Range

How does this type


of fixed cost differ
from a step-variable
cost?

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Step-variable costs
can be adjusted more
quickly and . . .
The width of the
activity steps is much
wider for the fixed
cost.

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Quick Check
Which
Which of
of the
the following
following statements
statements about
about
cost
cost behavior
behavior are
are true?
true?
Fixed
Fixedcosts
costsper
perunit
unitvary
varywith
withthe
the level
levelof
of activity.
activity.
bb Variable costs per unit are constant within the
Variable costs per unit are constant within the
relevant
relevantrange.
range.
cc Total fixed costs are constant within the relevant
Total fixed costs are constant within the relevant
range.
range.
dd Total variable costs are constant within the
Total variable costs are constant within the
relevant
relevantrange.
range.
aa

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Mixed Costs
AAmixed
mixedcost
cost has
hasboth
bothfixed
fixed and
andvariable
variable
components.
components. Consider
Consider the
the example
example of
of utility
utilitycost.
cost.
Total Utility Cost

ta
o
T

xe
i
lm

os
c
d

t
Variable
Cost per KW

Activity (Kilowatt
Hours)
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Fixed Monthly
Utility Charge

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Mixed Costs

Total Utility Cost

ta
o
T

xe
i
lm

s
o
dc

a
=
Y

X
b
+

Variable
Cost per KW

Activity (Kilowatt
Hours)
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Fixed Monthly
Utility Charge

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The Analysis of Mixed Costs


Account Analysis
Engineering Approach
Scattergraph Plot
High-Low Method
Least-Square Regression Method
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Account Analysis &


Engineering Estimates
Each
Each account
accountis
isclassified
classifiedas
aseither
either
variable
variableor
or fixed
fixedbased
based on
on the
theanalysts
analysts
knowledge
knowledgeof
ofhow
how the
theaccount
account behaves.
behaves.

Cost
Costestimates
estimatesare
arebased
basedon
onan
an
evaluation
evaluationof
ofproduction
productionmethods,
methods,
and
and material,
material, labor
labor and
andoverhead
overhead
requirements.
requirements.
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The Scattergraph Method


Plot
Plot the
thedata
datapoints
pointson
onaa
graph
graph(total
(totalcost
cost vs.
vs. activity).
activity).

Total Cost in
1,000s of Dollars

Y
20

10

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* *
* *

* ** *
**
X

0
1
2
3
4
Activity, 1,000s of Units Produced

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Quick-and-Dirty Method
Draw
Draw aaline
linethrough
throughthe
thedata
datapoints
pointswith
withabout
aboutan
an
equal
equalnumbers
numbersof
ofpoints
points above
aboveand
and below
below the
the line.
line.
Total Cost in
1,000s of Dollars

Y
20

10

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* ** *
**

* *
*
* Intercept
is the estimated

Intercept is the estimated


fixed
fixedcost
cost==$10,000
$10,000

0
1
2
3
4
Activity, 1,000s of Units Produced

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Quick-and-Dirty Method
The
Theslope
slopeis
isthe
theestimated
estimatedvariable
variable cost
cost per
per unit.
unit.
Slope
Slope==Change
Changein
in cost
cost Change
Changein
inunits
units
Total Cost in
1,000s of Dollars

Y
20

10

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* *
*
*Horizontal
Horizontal

distance
distanceis
is
the
thechange
changein
in
activity.
activity.

* ** *
**
Vertical
Verticaldistance
distanceis
is
the
thechange
changein
incost.
cost.

0
1
2
3
4
Activity, 1,000s of Units Produced

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The High-Low Method


WiseCo recorded the following production activity and
maintenance costs for two months:

Using these two levels of activity, compute:


the variable cost per unit;
the fixed cost; and then
express the costs in equation form Y = a + bX.

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The High-Low Method

cost in units
Variable cost per unit = Change Changein
in cost change
Change in units

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The High-Low Method

Variable cost per unit = $2,400 3,000 units


= $0.80 per unit

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The High-Low Method

Variable cost = $2,400 3,000 units = $0.80 per unit


Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)
Fixed cost = $9,800 $6,400 = $3,400

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The High-Low Method

Variable cost = $2,400 3,000 units = $0.80 per unit


Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)
Fixed cost = $9,800 $6,400 = $3,400

Total cost = Fixed cost + Variable cost (Y = a + bX)


Y = $3,400 + $0.80X
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Quick Check
Sales
Salessalaries
salariesand
and commissions
commissions are
are $10,000
$10,000when
when
80,000
80,000units
unitsare
aresold,
sold, and
and$14,000
$14,000when
when120,000
120,000units
units
are
aresold.
sold. Using
Using the
thehigh-low
high-low method,
method,what
what is
is the
the
variable
variable portion
portion of
of sales
salessalaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08per
perunit
unit
Units
Cost
b.
b. $0.10
$0.10per
perunit
unit
High level
120,000
$ 14,000
c.
c. $0.12
$0.12per
perunit
unit
Low level
80,000
10,000
d.
d. $0.125
$0.125per
perunit
unit Change
40,000
$ 4,000
$4,000 40,000 units
= $0.10 per unit
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Quick Check
Sales
Salessalaries
salariesand
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000units
unitsare
aresold,
sold, and
and$14,000
$14,000 when
when 120,000
120,000units
units
are
aresold.
sold. Using
Usingthe
thehigh-low
high-low method,
method,what
whatis
isthe
the
fixed
fixed portion
portionof
of sales
salessalaries
salariesand
andcommissions?
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

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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
Least-squaresregression
regressionalso
alsoprovides
providesaa statistic,
statistic,
22
called
the
R
called the R ,,that
that is
is aameasure
measure of
of the
thegoodness
goodness
of
of fit
fitof
ofthe
theregression
regression line
lineto
tothe
thedata
data points.
points.
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Least-Squares Regression
Method
RR22 is
isthe
thepercentage
percentage of
ofthe
the variation
variation in
in total
total cost
cost
explained
explainedby
bythe
theactivity.
activity.
Y
Total Cost

20

* ** *
**

* *
* * R2 for this relationship is near

10

0
McGraw-Hill/Irwin

100% since the data points are


very close to the regression line.
X
2
3
4
Activity

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Cost Estimation Methods


Regression Analysis
A
Astatistical
statistical method
method used
used to
to create
create an
an
equation
equation relating
relating independent
independent (or
(or X)
X)
variables
variables to
to dependent
dependent (or
(or Y)
Y) variables.
variables.
Past
Past data
data is
is used
used to
to estimate
estimate relationships
relationships
between
between costs
costs and
and activities.
activities.
Independent
Independent variables
variables
are
arethe
thecost
costdrivers
driversthat
that
are
arecorrelated
correlatedwith
withthe
the
dependent
dependent variables.
variables.
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Dependent
Dependent variables
variablesare
are
caused
caused by
bythe
the
independent
independentvariables.
variables.

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Cost Estimation Methods


Regression Analysis
The
The simple
simple cost
cost model
model is
is actually
actually aa
regression
regression model:
model:
TC
TC == FF ++ VX
VX
This
Thismodel
model will
willonly
only
be
beuseful
usefulwithin
withinaa
relevant
relevantrange
rangeof
of
activity.
activity.

McGraw-Hill/Irwin

Caution:
Caution: Before
Before doing
doing
the
theanalysis,
analysis,take
taketime
time
to
todetermine
determineifif aa
logical
logicalrelationship
relationship
between
betweenthe
thevariables
variables
exists.
exists.

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Cost Estimation Methods


Regression Analysis
A
Aset
set of
of data
data can
can be
be regressed
regressed using
using several
several
techniques:
techniques:
Manual
Manual computations
computations
SPSS
SPSS or
or SAS
SAS Statistical
Statistical Software
Software
Excel
Excel or
or other
other spreadsheet
spreadsheet
The
Theresult
result of
of the
the
regression
regressionprocess
processis
isaa
regression
regression model:
model:

TC
TC == FF ++ VX
VX
McGraw-Hill/Irwin

Each
Each regression
regressionmodel
model
22
has
an
R-square
(R
has an R-square (R ))
measure
measure of
of how
how good
good the
the
model
modelis.
is.
2
Range
Rangeof
ofRR2 == 00to
to1.0
1.0

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Simple Regression Analysis


Example
Fasco
Fascowants
wantsto
to
know
know its
itsaverage
average
fixed
fixedcost
cost and
and
variable
variablecost
cost per
per
unit.
unit.
Using
Usingthe
thedata
datato
to
the
theright,
right,lets
letssee
see
how
how to
todo
doaa
regression
regressionusing
using
Excel.
Excel.
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Simple Regression Analysis


Example
You
Youwill
willneed
needthree
threepieces
pieces
of
ofinformation
informationfrom
fromyour
your
regression
regressionanalysis:
analysis:
1.
1. Estimated
EstimatedVariable
VariableCost
Cost
per
perUnit
Unit(line
(lineslope)
slope)
2.
2. Estimated
EstimatedFixed
FixedCosts
Costs
(line
(lineintercept)
intercept)
2
3.
3. Goodness
Goodnessof
offit,
fit,or
orRR2
To
Toget
getthese
thesethree
threepieces
pieces
of
ofinformation
informationwe
wewill
will
need
needto
touse
useTHREE
THREE
different
differentexcel
excelfunctions.
functions.
LINEST,
LINEST,INTERCEPT,
INTERCEPT,&&RSQ
RSQ
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Simple Regression Using Excel 2000

First,
First, open
open
the
the excel
excel file
file
with
with your
your
data
data and
and
click
click on
on
Insert
Insert and
and
Function
Function

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Simple Regression Using Excel 2000

When
When the
the
function
function box
box
opens,
opens, click
click
on
on
Statistical,
Statistical,
then
then on
on
LINEST
LINEST

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Simple Regression Using Excel


2000
By
Byclicking
clickingon
onthe
the
buttons
buttonsto
tothe
the
left,
left,you
youcan
can
highlight
highlightthe
the
desired
desiredcells
cells
directly
directlyfrom
fromthe
the
spreadsheet.
spreadsheet.

1.
1. Enter
Enterthe
thecell
cellrange
rangefor
for the
thecost
cost amounts
amountsin
inthe
the
Known_ys
Known_ysbox.
box.
2.
2.Enter
Enterthe
thecell
cellrange
rangefor
for the
thequantity
quantityamounts
amountsin
in
the
theKnown_xs
Known_xsbox.
box.
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Simple Regression Using Excel 2000

The
TheSlope,
Slope,or
orestimated
estimatedvariable
variable cost
cost per
perunit,
unit, is
is
identified
identified here.
here. Click
ClickOK
OKto
toput
put this
thisvalue
value on
on your
your
spreadsheet.
spreadsheet.

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Simple Regression Using Excel 2000

Repeat
Repeat the
the
procedure
procedure
using
using
Intercept,
Intercept,
to
to estimate
estimate
fixed
fixed cost.
cost.

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Simple Regression Using Excel 2000

The
Theestimated
estimated fixed
fixed cost
cost is
is
identified
identified here.
here.

McGraw-Hill/Irwin

As
Aspreviously,
previously,
enter
enter the
the
appropriate
appropriatecell
cell
ranges
ranges in
intheir
their
appropriate
appropriate
places.
places.

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Simple Regression Using Excel 2000


Finally,
Finally,
determine
determine the
the
goodness
goodness of
of
22
fit,
or
R
fit, or R ,, by
by
using
using the
the RSQ
RSQ
function.
function.

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Simple Regression Using Excel 2000

2
The
Theestimated
estimatedRR2 for
foryour
yourestimated
estimated
cost
cost function
functionis
is identified
identified here.
here.

McGraw-Hill/Irwin

As
Aspreviously,
previously,
enter
enter the
the
appropriate
appropriatecell
cell
ranges
ranges in
intheir
their
appropriate
appropriate
places.
places.

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Lets put our


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

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The Contribution Format


Sales Revenue
Less: Variable costs
Contribution margin
Less: Fixed costs
Net operating income

Total
$ 100,000
60,000
$ 40,000
30,000
$ 10,000

Unit
$ 50
30
$ 20

The contribution margin format emphasizes cost


behavior. Contribution margin covers fixed costs
and provides for income.
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The Contribution Format


Comparison of the Contribution Income Statement
with the Traditional Income Statement
Traditional Approach
(costs organized by function)

Contribution Approach
(costs organized by behavior)

Sales
$ 100,000
Less cost of goods sold
70,000
Gross margin
$ 30,000
Less operating expenses
20,000
Net operating income
$ 10,000

Sales
$ 100,000
Less variable expenses
60,000
Contribution margin
$ 40,000
Less fixed expenses
30,000
Net operating income
$ 10,000

Used primarily for


external reporting.
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Used primarily by
management.

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End of Chapter 5

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