5-1
Chapter 5
Cost Behavior:
Analysis and Use
Types of Cost Behavior
Patterns
Recall the summary of our cost behavior
discussion from Chapter 2.
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.
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
The Activity Base
Units
produced
Machine
hours
A measure of the
event that causes
the incurrence of a
variable cost – a
cost driver
Miles
driven
McGraw-Hill/Irwin
Labor
hours
© The McGraw-Hill Companies, Inc., 2003
5-2
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
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Variable Cost Per Unit Example
Per Minute
Telephone Charge
The cost per minute talked is constant. For
example, 10 cents per minute.
Minutes Talked
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Step-Variable Costs
Cost
Total cost remains
constant within a
narrow range of
activity.
Activity
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
5-3
Step-Variable Costs
Cost
Total cost increases to a
new higher cost for the
next higher range of
activity.
Activity
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
The Linearity Assumption and
the Relevant Range
Exh.
5-4
A straight line
Economist’s
closely
Curvilinear Cost approximates a
Function
curvilinear
Total Cost
Relevant
Range
variable cost
line within the
relevant range.
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
5-4
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
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Cost Behavior
Examples of normally variable costs
Merchandisers
Service Organizations
Cost of Goods Sold
Supplies and travel
Manufacturers
Merchandisers and
Manufacturers
Direct Material, Direct
Labor, and Variable
Manufacturing Overhead
Sales commissions and
shipping costs
Examples of normally fixed costs
Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
reduced in the short
term.
May be altered in the
short-term by current
managerial decisions
Examples
Examples
Depreciation on
Buildings and
Equipment
Advertising and
Research and
Development
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
5-5
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.
Continue
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Rent Cost in
Thousands of Dollars
Fixed Costs and Relevant
Range
Exh.
5-6
90
Relevant
60
Range
30
0
0
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.
1,000
2,000
3,000
Rented Area (Square Feet)
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Fixed Costs and Relevant
Range
How does this type
of fixed cost differ
from a step-variable
cost?
McGraw-Hill/Irwin
Step-variable costs
can be adjusted more
quickly and . . .
The width of the
activity steps is much
wider for the fixed
cost.
© The McGraw-Hill Companies, Inc., 2003
5-6
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.
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Mixed Costs
A mixed cost has both fixed and variable
components. Consider the example of utility cost.
Total Utility Cost
Y
ta
To
i xe
lm
os
dc
t
Variable
Cost per KW
X
Activity (Kilowatt
Hours)
Fixed Monthly
Utility Charge
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Mixed Costs
The
The total
totalmixed
mixedcost
costline
line can
canbe
be expressed
expressed
as
asan
anequation:
equation: YY==aa ++bX
bX
Where:
Where:
Total Utility Cost
Y
ta
To
i xe
lm
os
dc
t
Y=
a+
bX
YY == the
the total
totalmixed
mixedcost
cost
aa == the
the total
totalfixed
fixedcost
cost(the
(the
vertical
verticalintercept
interceptof
ofthe
the line)
line)
bb == the
variable
cost
per
the variable cost perunit
unitof
of
activity
activity(the
(the slope
slope of
ofthe
the line)
line)
XX == the
the level
levelof
ofactivity
activity
Variable
Cost per KW
Activity (Kilowatt
Hours)
McGraw-Hill/Irwin
X
Fixed Monthly
Utility Charge
© The McGraw-Hill Companies, Inc., 2003
5-7
The Analysis of Mixed Costs
Account Analysis
Engineering Approach
Scattergraph Plot
High-Low Method
Least-Square Regression Method
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Account Analysis &
Engineering Estimates
Each account is classified as either
variable or fixed based on the analyst’s
knowledge of how the account behaves.
Cost estimates are based on an
evaluation of production methods,
and material, labor and overhead
requirements.
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
The High-Low Method
WiseCo recorded the following production activity and
maintenance costs for two months:
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
5-8
The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
in cost in units
Variable cost per unit = ChangeChange
in cost ÷ change
Change in units
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
Variable cost per unit = $2,400 ÷ 3,000 units
= $0.80 per unit
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
5-9
The High-Low Method
High activity level
Low activity level
Change
Units
8,000
5,000
3,000
Cost
$ 9,800
7,400
$ 2,400
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
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Quick Check
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000 units
are sold. Using the high-low method, 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
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
Quick Check
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
5-10
Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
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.
© The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin
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.
McGraw-Hill/Irwin
Used primarily by
management.
© The McGraw-Hill Companies, Inc., 2003