Cost Behavior

1. Cost Behavior Chapter 6

2. Objective 1 Identify key features of various cost behaviors

3. Cost Behavior • How costs change in response to changes in volume • Variable costs • Fixed costs • Mixed costs

4. Variable Costs • Change in total in direct proportion to changes in volume • Total variable costs = variable cost per unit of activity x volume of activity

5. Total Variable Costs

6. Fixed Costs • Do not change over wide ranges of volume

7. Total Fixed Costs

8. Mixed Costs • Contain both variable and fixed components

9. Mixed Costs

10. Mixed Costs Variable Fixed

11. S6-1 F ____ a. Depreciation on equipment used to cut wood enclosures ____ b. Wood for speaker enclosures ____ c. Patents on crossover relays (internal components) ____ d. Crossover relays ____ e. Grill cloth ____ f. Glue ____ g. Quality inspector’s salary V F V V V F

12. E6-15 a.

13. E6-15 b.

14. E6-15 c.

15. Objective 2 Forecast costs using cost equations

16. Cost Equation Total costs = Total variable costs + Total fixed costs y = vx + f y = total cost v = variable cost per unit of activity (slope) x = volume of activity (x) f = fixed cost over a given period of time (vertical y intercept)

17. Relevant Range • Band of volume where total fixed costs remain constant and variable cost per unit remains constant. • Outside the relevant range, the cost either increases or decreases

18. Other Cost Behaviors Step costs – fixed over small range of activity, then jump to new fixed level

19. Other Cost Behaviors Curvilinear Costs

20. E6-17 1. Variable costs per unit: $2,625 / 3,500 garments = $0.75 Total fixed costs: $2 x 3,500 garments = $7,000

21. 7,000 $1,500 7,000 $2,625 7,000 $3,750 $8,500 $9,625 $10,750 E6-17 1.

22. E6-17 3. Actual costs at 2,000 garments $8,500 Total predicted costs: ($2.15 × 2,000 garments) (4,300 ) Underestimated costs $4,200

23. E6-18 a. 1,000 x $26.43 $26,430 b. Total costs $26,430 Less total fixed costs (18,000) Total variable costs $8,430 ÷ 1,000 Variable cost per mailbox $8.43

24. E6-18 c. y = $8.43x + $18,000 d. $26.43 x 1,200 mailboxes $31,716 e. y = ($8.43 • 1,200) + $18,000 = $28,116

25. E6-18 f. Using average at 1,000 $31,716 Using cost equation 28,116 $3,600

26. Objective 3 Determine cost behavior using account analysis, the high-low method, and regression analysis

27. High-Low Method • Method to separate mixed costs into variable and fixed components • Select the highest level and the lowest level of activity over a period of time

28. High-Low Method – E6-21 Step 1: Find slope of the mixed cost line (variable cost/unit) = Δ in cost (y) / Δ in volume (x) ($5,748-$5,020) ÷ (17,300-14,500) $728 ÷ 2,800 = $0.26

29. High-Low Method – E6-21 Step 2: Find the vertical intercept (fixed costs) = Total mixed cost – Total variable cost $5,748 – ($0.26 • 17,300) = $1,250 or $5,020 – ($0.26 • 14,500) = $1,250

30. High-Low Method – E6-21 Step 3: Create and use an equation to show the behavior of a mixed cost Y = $0.26 per mile + $1,250 Predicted operating costs at 15,000 miles: ($0.26 • 15,000) + $1,250 = $5,150

31. Regression Analysis • Statistical procedure to find the line that best fits data • Uses all data points • Results in equation of line and an R-square value

32. R-Square Value • “Goodness of fit” • How well does the line fit the data points? • Ranges from 0 to 1 • “0” – no relationship between costs and volume – activity is not a cost driver • “1” – perfect relationship – activity is a cost driver

33. Data Concerns • Seasonal variations • Inflation • Outliers – abnormal data points

34. E6-22

35. E6-22

36. E6-22 5. y = 0.29x + 802.39 y = ($0.29 • 15,000) + $802.39 y = $5,152.39

37. Objective 4 Prepare contribution margin income statements for service firms and merchandising firms

38. Traditional Income Statement Sales - Cost of Goods Sold Gross Margin - Selling,general & administrative costs Operating Income

39. Contribution Margin Income Statement Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income

40. Contribution Margin Income Statement • Predict how changes in volume will affect operating income

41. E6-25 Rachel’s Rock Shop Income Statement For the year ending 20XX Revenue: Sales Revenue (27,000 + 7,000) $34,000 Rental Revenue 22,000 Lesson Revenue 40,000 Total Revenue $96,000 Less: Cost of Goods Sold (7,500 + 2,000) (9,500) Gross Margin $86,500 Less Operating Costs: Depreciation $ 4,000 Employee Salary expenses 30,000 Musician wages 25,000 Lease 12,000 Total operating costs 71,000 Operating Income $15,500

42. E6-25 Rachel’s Rock Shop Contribution Margin Income Statement For the year ending 20XX Revenue: Sales Revenue (27,000 + 7,000) $34,000 Rental Revenue 22,000 Lesson Revenue 40,000 Total Revenue $96,000 Less: Variable Costs Cost of Goods Sold (7,500 + 2,000) $ 9,500 Musician wages 25,000 Total Variable costs (34,500) Contribution Margin $61,500 Less Fixed Costs: Depreciation $ 4,000 Employee Salary expenses 30,000 Lease 12,000 Total fixed costs (46,000) Operating Income $15,500

43. Objective 5 Use variable costing to prepare contribution margin income statements for manufacturers (Appendix)

44. Variable Costing • Assigns only variable manufacturing costs to products • Direct materials • Direct labor • Variable manufacturing overhead • Fixed manufacturing overhead = period cost • Contribution margin income statements • For internal management decisions

45. Absorption Costing • Required by GAAP for external reporting • Assign all manufacturing costs to product • Direct materials • Direct labor • Variable manufacturing overhead • Fixed manufacturing overhead • Traditional income statement

46. E6-26

47. E6-26 * computation of variable cost of goods sold

48. E6-26 Incremental analysis: Increase in contribution margin(($35-20) x 15,000 goggles) $225,000 Increase in fixed costs (150,000) Increase in operating income $75,000

49. End of Chapter 6