CORNERSTONES
of Managerial Accounting, 6e
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CHAPTER 3:
COST BEHAVIOR
Cornerstones of Managerial
Accounting, 6e
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Basics of Cost Behavior
 Cost behavior is the foundation upon which
managerial accounting is built.
 Describes whether a cost changes when the level
of output changes.
 Costs can be variable, fixed, or mixed.
 A cost that does not change in total as output
changes is a fixed cost.
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Basics of Cost Behavior (cont.)
 A variable cost increases in total with an
increase in output and decreases in total with a
decrease in output.
 Knowing how costs change as output changes is
essential to planning, controlling, and decision
making.
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Measures of Output and the
Relevant Range
 Fixed and variable costs have meaning only
when related to an output measure.
 A cost driver measures the output of the activity
that leads (or causes) costs to change.
 Identifying and managing drivers helps managers
predict and control costs.
 For example, weather is a significant driver in the
airline industry.
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Relevant Range and Cost
Relationships
 Relevant range is the range of output over which
the assumed cost relationship is valid for the
normal operations of a firm.
 Limits the cost relationship to the range of
operations that the firm normally expects to occur.
 The following graph shows the relevant range
which allows managers to assume a linear cost
relationship.
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Relevant Range and Cost
Relationships
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Fixed Costs
 The number of computers produced is called the
output measure, or driver.
 Even though fixed costs may change, this does
not make them variable.
 They are fixed at a new higher (or lower) rate.
 A graph of Colley’s fixed supervision costs is
shown below:
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Fixed Costs (cont.)
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Discretionary Fixed Costs and
Committed Fixed Costs
 Two types of fixed costs: discretionary fixed costs
and committed fixed costs.
 Discretionary fixed costs are fixed costs that
can be changed or avoided easily at
management discretion.
 Committed fixed costs, on the other hand, are
fixed costs that cannot be easily changed.
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Discretionary Fixed Costs and
Committed Fixed Costs (cont.)
 Advertising is a discretionary fixed cost,
because it depends on a management decision.
 Lease cost is a committed fixed cost because it
involves a long-term contract.
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Variable Costs
 Variable costs are costs that vary in direct
proportion to changes in output within the
relevant range.
 Variable costs can also be represented by a
linear equation.
 Total variable costs depend on the level of output.
 This relationship can be described by the
following equation or graphs:
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Variable Costs (cont.)
Total variable costs = Variable rate x Amount of
output
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The Reasonableness of Straight-Line
Cost Relationships
 Caution when applying cost behavior
assumptions to output levels that fall outside of
the company’s relevant range of operations.
 Straight-line cost relationships that are assumed
within the relevant range may actually be semivariable costs.
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The Reasonableness of Straight-Line
Cost Relationships (cont.)
 Example: At extremely low levels of output,
workers often use more materials per unit or
require more time per unit than they do at higher
levels of output.
 As the level of output increases, workers learn
how to use materials and time more efficiently so
that the variable cost per unit decreases as more
and more output is produced.
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The Reasonableness of Straight-Line
Cost Relationships (cont.)
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Mixed Costs
 Mixed costs are costs that have both a fixed and
a variable component.
 Example: Overhead for a company may consist
of a fixed supervisor salary plus the cost of
supplies that vary with the quantity of output
produced.
 The formula and graph depiction for a mixed cost
is as follows:
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Mixed Costs (cont.)
Total cost = Total fixed cost + Total variable cost
Volume
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Step Costs: Narrow Steps
 Some cost functions may be discontinuous.
 Known as step costs (or semi-fixed).
 Displays a constant level of cost for a range of output
and then jumps to a higher level (or step) of cost at
some point, where it remains for a similar range of
output.
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Step Costs: Narrow Steps (cont.)
 If a step cost has narrow steps, it means that the
cost changes in response to small changes in
output and we can approximate it as a variable
cost (i.e., the red line).
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Step Costs: Narrow Steps (cont.)
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Step Costs: Wide Steps
 Step cost with wide steps are more characteristic
of fixed costs.
 Example: A company may have to lease
production machinery.
 If the machine can only produce 1,000 units and the
company grows, they will have to lease additional
machines for each 1,000 units of production needed
 Resulting in the wide steps shown in the following
graph.
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Step Costs: Wide Steps (cont.)
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Methods for Separating Mixed Costs
into Fixed and Variable Components
 Three methods of separating a mixed cost into its
fixed and variable components:
 the high-low method
 the scattergraph method
 the method of least squares
 Each method requires the simplifying assumption
of a linear cost relationship.
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Methods for Separating Mixed Costs
into Fixed and Variable Components
 Expression of cost as an equation for a straight
line is:
Total cost = Fixed cost + (Variable rate x Output)
 The dependent variable is a variable whose
value depends on the value of another variable.
 In the previous equation, total cost is the
dependent variable; it is the cost we are trying to
predict.
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Methods for Separating Mixed Costs
into Fixed & Variable Components
 The independent variable measures output and
explains changes in the cost or other dependent
variable.
 A good independent variable is one that causes or is
closely associated with the dependent variable.
 Many managers refer to an independent variable as a
cost driver.
 The intercept corresponds to fixed cost.
 The slope of the cost line corresponds to the
variable rate.
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Methods for Separating Fixed Costs
into Fixed &Variable Components
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Additional slides
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Types of Cost Behavior Patterns
Recall the summary of our cost behavior discussion from an earlier chapter.
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.
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.
Fixed
Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
significantly reduced
in the short term.
May be altered in the
short-term by current
managerial decisions
Examples
Examples
Depreciation on
Equipment and
Real Estate Taxes
Advertising and
Research and
Development
The Trend Toward Fixed Costs
The trend in many industries is toward
greater fixed costs relative to variable costs.
As machines take over
many mundane tasks
previously performed
by humans,
“knowledge workers”
are demanded for
their minds rather
than their muscles.
Knowledge workers
tend to be salaried,
highly-trained and
difficult to replace. The
cost to compensate
these valued employees
is relatively fixed
rather than variable.
The Contribution Format
Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
The Contribution Format
Sales Revenue
Less: Variable costs
Contribution margin
Total
$ 100,000
60,000
$ 40,000
Less: Fixed costs
Net operating income
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 Contribution Format
Used primarily for
external reporting.
Used primarily by
management.