Reading 1
Cost behavior
Variable cost – variable cost per unit x no. of units of activity
Mixed cost – Fixed cost + Variable cost
Discretionary
fixed costs
Advertising, for example
is something that the
management can
decide to stop paying
the monthly amount
for
Committed fixed costs
A lease, for example, is
something that must be
paid long-term due to
the contract. It cannot
be shortened.
Step-costs are fixed costs that are constant for a level of output
➢ If it is a step-fixed-cost for a narrow range of activity, treat it like a
variable cost
// The high-low method is used to separate the fixed and variable
components in mixed costs.
There are 4 steps. (1) Identify the highest and lowest point in the data set.
(2) Use the high and low points to calculate the variable rate (variable cost
per unit)(gradient). Using this rate, multiply it by the output . This derives
the total VC. (3) To get the FC, take the Total cost(Mixed cost) minus the
(Variable rate x output level). (4) Now, the cost formula can be created
using the variable rate found earlier and the fixed cost that was just
derived.
Total cost (Mixed cost) = FC + VC
Weakness : The 2 points used can be outliers, thus not representative of the
typical cost activity relationship.
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Scatter graph ∙ line of best fit ∙ is there a linear relationship?
(1) Plot the cost observations. (2) Select 2 points that appears to be the best
at representing the relationship between cost and activity. (3) Calculate
the variable rate. (4) Calculate FC. (5) Create the cost formula.
The HL method and Scatter graph differs in how the 2 points used are
selected.
Method of least squares. It uses Excel to perform the regression calculations.
This method will result in a line fitting the observations the best.
Managerial judgement. This can be used on its own or with any or all of
the other 3 methods to estimate the FC and VC.
When production volume drastically increases, the variable rate may
decrease. Why? Sometimes, there will be bulk discounts from the vendor.
Example of FC and VC
FC
VC
Depreciation
Fuel
Insurance
Wages
Tire repairs
Example of cost drivers
Rent
Advertising
Equipment hire/lease
Salary
Photo sales
Cost to prepare product
Print costs
Engine hours
More photos do not change the FC at the relevant range.
Understanding cost behavior is crucial to provide the cost information
required for management decisions; (1) product mix, (2) outsourcing, (3)
pricing decisions.
2
Cost formula = FC + (Variable rate x cost driver)
Single independent variable
It can be one source that is being used i.e. electricity.
The cost driver can be no. of batches produced and no. of customers.
More customers
entering means more
electricity being used
More batches baked
means more electricity
used
y = a + 𝑏1 𝑥1 + 𝑏2 𝑥2
Fixed cost
Variable and absorption costing
The main difference between the 2 costing methods is the way Fixed
manufacturing overhead is treated.
Why are there 2 different costing methods?
Absorption costing is for financial reporting purposes.
➢ The COGS would be more accurate as it will show the variable costs and the fixed costs
expensed for the period.
o The fixed productions costs are incurred only for the purpose of manufacturing the
product. This results in fixed production costs incurred for the unsold
manufactured products (inventory) to be inventoried instead of expensed. Thereby,
this reduces the actual expenses that is reported. Resulting in higher profits.
➢ There is a proper allocation of fixed overhead costs between COGS and ending inventory.
➢ Ending inventory is more accurate.
o The expense of fixed production costs are delayed under absorption costing. This
provides more accuracy for accounting with regards to the ending inventory.
➢ There is better matching of cost against revenue. There will be lesser volatility in the
company’s earnings. (This is one of the fundamental principles of accounting – only what
is sold is expensed off or only what is incurred is recorded. Asset = Liabilities + Equity)
Variable costing is for managerial decision-making purposes.
Variable costing
Absorption costing
FOH expensed as incurred
FOH inventoried until goods sold
Examples of manufacturing overheads
Variable MOH
Fixed MOH
➢ Indirect material
➢ Salary
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➢ Indirect labour
➢ Utilities costs
➢ Telephone costs
➢ Rent
➢ Depreciation on machines
➢ Insurance
UNIT PRODUCT COST
Direct material
Direct labour
V MOH
Variable product cost
F MOH
Absorption product cost
Variable product cost Absorption product cost
X
X
X
X
X
X
3X
3X
Y
3X + Y
Businesses using variable costing will prepare an income statement called
contribution margin.
Contribution margin ∙ Contribution margin statement ∙ Contribution statement ∙
Variable costing statement (these all means the same thing)
Total Contribution Margin = Sales revenue – Variable product cost (V COGS)
– Variable Selling and Administrative expense
Reconciliation short cut:
Difference in F MOH
expensed under AC
Change in inventory
=
x
and VC
(in units)
Predetermined F MOH
rate per unit
When inventory increase > difference is positive
When inventory decreases > difference is negative
Profit under variable costing
Product name
Sales revenue
Less: Variable expenses
COGS
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V S&A
Total variable expenses
Contribution margin
Less: Fixed expenses
F MOH
F S&A
Operating profit
Profit under absorption costing
Product name
Sales revenue
Less: COGS
Absorption product cost x units
sold
Gross margin
Less: S&A
F S&A
V S&A
Operating profit
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