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Cost Behavior: Analysis and Use

Chapter 5. Cost Behavior: Analysis and Use. Types of Cost Behavior Patterns. Recall the summary of our cost behavior discussion from Chapter 1. Total Long Distance Telephone Bill. Minutes Talked. Total Variable Cost Example.

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Cost Behavior: Analysis and Use

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  1. Chapter5 Cost Behavior:Analysis and Use

  2. Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 1.

  3. Total Long DistanceTelephone Bill Minutes Talked Total Variable Cost Example Your total long distance telephone bill is based on how many minutes you talk.

  4. Per MinuteTelephone Charge Minutes Talked Variable Cost Per Unit Example The cost per minute talked is constant. For example, 10 cents per minute.

  5. Monthly Basic Telephone Bill Number of Local Calls Total Fixed Cost Example Your monthly basic telephone bill is probablyfixedand does not change when you make more local calls.

  6. Monthly Basic Telephone Bill per Local Call Number of Local Calls Fixed Cost Per Unit Example The fixedcost per local call decreases as more local calls are made.

  7. Cost Behavior Examples of normally variable costs Service Organizations Supplies and travel Merchandisers Cost of Goods Sold Merchandisers and Manufacturers Sales commissions and shipping costs Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Examples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salariesDepreciation, Advertising

  8. Unitsproduced Machinehours Milesdriven Laborhours The Activity Base A measure of the event causing the incurrence of a variable cost – a cost driver

  9. Total cost remainsconstant within anarrow range ofactivity. Step-Variable Costs Cost Activity

  10. Total cost increases to a new higher cost for the next higher range of activity. Step-Variable Costs Cost Activity

  11. Accountant’s Straight-Line Approximation (constant unit variable cost) The Linearity Assumption and the Relevant Range Economist’sCurvilinear Cost Function Total Cost Activity

  12. RelevantRange The Linearity Assumption and the Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Economist’sCurvilinear Cost Function Total Cost Accountant’s Straight-Line Approximation (constant unit variable cost) Activity

  13. Committed Long-term, cannot be reduced in the short term. Discretionary May be altered in the short-term by current managerial decisions Examples Depreciation on Buildings and Equipment Examples Advertising and Research and Development Types of Fixed Costs Fixed Costs

  14. Trend Toward Fixed Costs Increased automation. Increase in salaried knowledge workers who are difficult to train and replace. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions.

  15. Continue 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.

  16. Fixed Costs and Relevant Range 90 Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Relevant Range 60 Rent Cost in Thousands of Dollars 30 0 0 1,000 2,000 3,000 Rented Area (Square Feet)

  17. 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.

  18. Step-variable costs can be adjusted more quickly and . . . • The width of the activity steps is much wider for the fixed cost. How does this type of fixed cost differ from a step-variable cost? Fixed Costs and Relevant Range

  19. Consider thefollowing electric utility example. Mixed Costs A mixed costhas both fixed and variablecomponents.

  20. Y Variable Utility Charge Fixed MonthlyUtility Charge X Mixed Costs Total mixed cost Total Utility Cost Activity (Kilowatt Hours)

  21. Y X Mixed Costs Total mixed cost Y = a + bX Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

  22. Y X Mixed Costs Total mixed cost Y = a + bX Variable Utility Charge Total Utility Cost bX Fixed MonthlyUtility Charge a Activity (Kilowatt Hours)

  23. Account Analysis Engineering Approach High-Low Method Scattergraph Method Least-Square Regression Method The Analysis of Mixed Costs

  24. Account Analysis Each account is classified as eithervariable or fixed based on the analyst’s knowledge of how the account behaves.

  25. Engineering Estimates Cost estimates are based on an evaluation of production methods, and material, laborand overhead requirements.

  26. 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.

  27. The High-Low Method Changein costChange in units • Unit variable cost =

  28. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

  29. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit • Fixed cost = Total cost – Total variable cost • Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) • Fixed cost = $9,700 – $8,100 = $1,600

  30. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit • Fixed cost = Total cost – Total variable cost • Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) • Fixed cost = $9,700 – $8,100 = $1,600 • Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $1,600 + $0.90X

  31. Quick Check  If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit

  32. Quick Check  If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000

  33. Note • How does the high-low method work when you have data for more than two periods? • Select the two periods with the lowest and highest level of activity. Low High

  34. Quick Check  Using the high-low method, estimate the cost formula Y = a +bX for the patient admitting costs on the previous page. a. Y = $9,720 + $2.00X b. Y = $7,050 + $3.00X c. Y = $8,385 + $2.50X d. Y = $8,480 + $2.50X

  35. Y 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Method Plot the data points on a graph (total cost vs. activity).

  36. Y 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Method Draw a line through the data points with about anequal numbers of points above and below the line.

  37. Y 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 Estimated fixed cost = $10,000 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Method The slope of this line is the variable unit cost. (Slope is the change in total cost for a one unit change in activity).

  38. Y 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 Change in costChange in units Horizontal distance is the change in activity. Slope = 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Method Vertical distance is the change in cost.

  39. 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, calledthe adjusted R2, that is a measure of the goodnessof fit of the regression line to the data points.

  40. R2 is the percentage of the variationin total cost explained by the activity. R2 for this relationship is near100% since the data points arevery close to the regression line. Least-Squares Regression Method Y 20 * * * * * * * * * * Total Cost 10 0 X 0 1 2 3 4 Activity

  41. Note • Let’s plot the data for patient admitting costs.

  42. Note • Problems with the high-low method: • Throws away information contained in all of the data other than the low and the high points. • The low and high levels of activity tend to be unusual. • You should always plot the data if you have more than two points to make sure it even makes sense to be using the high-low method.

  43. The Contribution Format Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement.

  44. The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costsand provides for income. The Contribution Format

  45. Used primarily forexternal reporting. Used primarily bymanagement. The Contribution Format

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