Chapter 5
Cost Behavior:
Analysis and Use
McGraw-Hill /Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2
Learning Objective 1
Understand how fixed and
variable costs behave and how
to use them to predict costs.
5-3
Types of Cost Behavior Patterns
Recall the summary of our cost
behavior discussion from Chapter 1.
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
5-4
The Activity Base
Units
produce
d
Machine
hours
A measure of what
causes the
incurrence of a
variable cost.
Miles
driven
Labor
hours
5-5
True Variable Cost Example
Total Long Distance
Telephone Bill
A variable cost is a cost whose total dollar
amount varies in direct proportion to
changes in the activity level.
Your total long
distance telephone bill
is based on how many
minutes you talk.
Minutes Talked
5-6
Types of Cost Behavior Patterns
Recall the summary of our cost
behavior discussion from Chapter 1.
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
5-7
Variable Cost Per Unit Example
The per minute cost
of long distance calls
is constant, for
example, 10¢ per
minute.
Per Minute
Telephone Charge
A variable cost remains constant if
expressed on a per unit basis.
Minutes Talked
5-8
Extent of Variable Costs
The proportion of variable costs differs across
organizations. For example . . .
A public utility with
large investments in
equipment will tend
to have fewer
variable costs.
A manufacturing company
will often have many
variable costs.
A service company
will normally have a high
proportion of variable costs.
A merchandising company
usually will have a high
proportion of variable costs
like cost of sales.
5-9
Examples of Variable Costs
1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.
5-10
True Variable Cost
Cost
Direct materials is a true or proportionately
variable cost because the amount used during
a period will vary in direct proportion to the
level of production activity.
Volume
5-11
Step-Variable Costs
Cost
A resource that is obtainable only in large
chunks (such as maintenance workers) and
whose costs increase or decrease only in
response to fairly wide changes in activity.
Volume
5-12
Step-Variable Costs
Cost
Small changes in the level of production are
not likely to have any effect on the number
of maintenance workers employed.
Volume
5-13
Step-Variable Costs
Cost
Only fairly wide changes in the activity
level will cause a change in the number
of maintenance workers employed.
Volume
The Linearity Assumption and the
Relevant Range
A straight line
Economist’s
closely
Curvilinear Cost approximates a
Function
curvilinear
Total Cost
5-14
Relevant
Range
variable cost
line within the
relevant range.
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
5-15
Types of Cost Behavior Patterns
Let’s turn our attention to fixed cost behavior.
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
5-16
Total Fixed Cost Example
A fixed cost is a cost whose total dollar amount
remains constant as the activity level changes.
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
5-17
Types of Cost Behavior Patterns
Recall the summary of our cost
behavior discussion from Chapter 1.
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
5-18
Fixed Cost Per Unit Example
The fixed cost per
local call decreases
as more local calls
are made.
Monthly Basic Telephone
Bill per Local Call
Average fixed costs per unit decrease
as the activity level increases.
Number of Local Calls
5-19
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
Buildings and
Equipment and
Real Estate Taxes
Advertising and
Research and
Development
5-20
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.
5-21
Is Labor a Variable or a Fixed Cost?
The behavior of wage and salary costs can
differ across countries, depending on labor
regulations, labor contracts, and custom.
In France, Germany, China, and Japan,
management has little flexibility in adjusting
the size of the labor force.
Labor costs are more fixed in nature.
Most companies in the United States continue
to view direct labor as a variable cost.
5-22
Rent Cost in
Thousands of Dollars
Fixed Costs and Relevant Range
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)
5-23
Fixed Costs and Relevant Range
The relevant range of activity for a fixed
cost is the range of activity over which
the graph of the cost is flat.
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.
5-24
Fixed Costs and Relevant Range
How does this type
of fixed cost differ
from a step-variable
cost?
Step-variable costs
can be adjusted
more quickly and . . .
The width of the
activity steps is
much wider for the
fixed cost.
5-25
Quick Check 
Which of the following statements about cost
behavior are true?
1.
2.
3.
4.
Fixed costs per unit vary with the level of
activity.
Variable costs per unit are constant within the
relevant range.
Total fixed costs are constant within the
relevant range.
Total variable costs are constant within the
relevant range.
5-26
Quick Check 
Which of the following statements about cost
behavior are true?
1.
2.
3.
4.
Fixed costs per unit vary with the level of
activity.
Variable costs per unit are constant within the
relevant range.
Total fixed costs are constant within the
relevant range.
Total variable costs are constant within the
relevant range.
5-27
Mixed Costs
A mixed cost has both fixed and variable
components. Consider your utility costs.
Total Utility Cost
Y
Variable
Cost per KW
X
Activity (Kilowatt Hours)
Fixed Monthly
Utility Charge
5-28
Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:
Y = the total mixed cost
a = the total fixed cost (the
vertical intercept of the line)
b = the variable cost per unit of
activity (the slope of the line)
X = the level of activity
Total Utility Cost
Y
Variable
Cost per KW
X
Activity (Kilowatt Hours)
Fixed Monthly
Utility Charge
5-29
Mixed Costs Example
If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, the
amount of your utility bill is:
Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
5-30
Analysis of Mixed Costs
Account analysis
Each account is classified as either
variable or fixed based on the analyst’s
knowledge of how the account behaves.
Engineering Approach
Cost estimates are based on an
evaluation of production methods,
and material, labor and overhead
requirements.
5-31
Learning Objective 2
Use a scattergraph plot
to diagnose cost behavior.
5-32
The Scattergraph Method
Plot the data points on a graph
(total cost vs. activity).
Maintenance Cost
1,000’s of Dollars
Y
20
* *
* *
10
0
0
1
2
* ** *
**
3
4
Patient-days in 1,000’s
X
5-33
The Scattergraph Method
Maintenance Cost
1,000’s of Dollars
Y
20
* *
* *
10
0
0
1
2
* ** *
**
3
4
Patient-days in 1,000’s
X
Draw a line
through the
data points
with about
an equal
number of
points above
and below
the line.
5-34
Maintenance Cost
1,000’s of Dollars
The Scattergraph Method
Y Total maintenance cost = $11,000
20
* *
* *
10
* ** *
**
Intercept = Fixed cost: $10,000
0
0
1
2
3
4
Patient-days in 1,000’s
Patient days = 800
X
Use one
data point
to estimate
the total
level of
activity
and the
total cost.
5-35
The Scattergraph Method
Make a quick estimate of variable cost per
unit and determine the cost equation.
Total maintenance at 800 patients
Less: Fixed cost
Estimated total variable cost for 800 patients
Variable cost per unit =
$1,000
800
$ 11,000
10,000
$ 1,000
= $1.25/patient-day
Y = $10,000 + $1.25X
Total maintenance cost
Number of patient days
5-36
Learning Objective 3
Analyze a mixed cost
using the high-low method.
5-37
The High-Low Method
Assume the following hours of maintenance work
and the total maintenance costs for six months.
5-38
The High-Low Method
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
Hours Total Cost
High
800 $ 9,800
Low
500
7,400
Change
300 $ 2,400
$2,400
300
= $8.00/hour
5-39
The High-Low Method
Total Fixed Cost = Total Cost – Total Variable Cost
Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
5-40
The High-Low Method
The Cost Equation for Maintenance
Y = $3,400 + $8.00X
5-41
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
5-42
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
Units
Cost
b. $0.10 per unit
High level
120,000
$ 14,000
c. $0.12 per unit
Low level
80,000
10,000
40,000
$ 4,000
d. $0.125 per unit Change
$4,000 ÷ 40,000 units
= $0.10 per unit
5-43
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
5-44
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?
Total cost = Total fixed cost +
a. $ 2,000
Total variable cost
b. $ 4,000
$14,000 = Total fixed cost +
c. $10,000
($0.10 × 120,000 units)
d. $12,000
Total fixed cost = $14,000 - $12,000
Total fixed cost
= $2,000
5-45
Least-Squares Regression Method
A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
5-46
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
The output from the regression analysis can be
used to create an equation that enables you to
estimate total costs at any activity level.
5-47
Comparing Results From the Three Methods
The three methods just discussed provide
slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses different amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all of the
data points.
5-48
Learning Objective 4
Prepare an income statement
using the contribution format.
5-49
The Contribution Format Income Statement
Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
5-50
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, by separating costs into fixed and
variable categories. Contribution margin covers
fixed costs and provides for income.
5-51
Uses of the Contribution Format
The contribution income statement format is used
as an internal planning and decision making tool.
We will use this approach for:
1. Cost-volume-profit analysis (chapter 6).
2. Budgeting (chapter 7).
3. Special decisions such as pricing and make-orbuy analysis (chapter 11).
5-52
The Contribution Format
Used primarily for
external reporting.
Used primarily by
management.
Appendix 5A
Variable Costing
McGraw-Hill /Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
5-54
Learning Objective 5
Use variable costing to prepare a
contribution format income statement
and contrast absorption costing and
variable costing.
(Appendix 5A)
5-55
Overview of Absorption
and Variable Costing
Absorption
Costing
Variable
Costing
Direct Materials
Product
Costs
Direct Labor
Product
Costs
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period
Costs
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Period
Costs
5-56
Quick Check 
Which method will produce the highest values
for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
5-57
Quick Check 
Which method will produce the highest values
for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
5-58
Unit Cost Computations
Harvey Company produces a single product
with the following information available:
5-59
Unit Cost Computations
Unit product cost is determined as follows:
Selling and administrative expenses are
always treated as period expenses and deducted
from revenue as incurred.
5-60
Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional information
for Harvey Company.


20,000 units were sold during the year at a price of
$30 each.
There is no beginning inventory.
Now, let’s compute net operating
income using both absorption
and variable costing.
5-61
Absorption Costing
5-62
Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30)
Less variable expenses:
Beginning inventory
$
Add COGM (25,000 × $10)
250,000
Goods available for sale
250,000
Less ending inventory (5,000 × $10)
50,000
Variable cost of goods sold
200,000
Variable selling & administrative
expenses (20,000 × $3)
60,000
Contribution margin
Less fixed expenses:
Manufacturing overhead
$ 150,000
Selling & administrative expenses 100,000
Net operating income
$ 600,000
All fixed
manufacturing
overhead is
expensed.
260,000
340,000
250,000
$ 90,000
5-63
Comparing Absorption and
Variable Costing
Let’s compare the methods.
5-64
Comparing Absorption and
Variable Costing
We can reconcile the difference between absorption
and variable net operating income as follows:
Variable costing net operating income
$ 90,000
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit)
30,000
Absorption costing net operating income $ 120,000
Fixed mfg. overhead
$150,000
=
= $6.00 per unit
Units produced
25,000 units
5-65
Extended Comparison of Income Data
Here is information about the operation
of Harvey Company for the second year.
5-66
Unit Cost Computations
Since there was no change in the variable costs
per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
5-67
Absorption Costing
Absorption Costing
Sales (30,000 × $30)
Less cost of goods sold:
Beg. inventory (5,000 × $16)
Add COGM (25,000 × $16)
Goods available for sale
Less ending inventory
Gross margin
Less selling & admin. exp.
Variable (30,000 × $3)
Fixed
Net operating income
$ 900,000
$ 80,000
400,000
480,000
-
$ 90,000
100,000
These are the 25,000 units
produced in the current period.
480,000
420,000
190,000
$ 230,000
5-68
Variable Costing
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.
5-69
Comparing Absorption and
Variable Costing
We can reconcile the difference between absorption
and variable net operating income as follows:
Variable costing net operating income
$ 260,000
Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit)
30,000
Absorption costing net operating income $ 230,000
Fixed mfg. overhead
$150,000
=
= $6.00 per unit
Units produced
25,000 units
5-70
Comparing Absorption and
Variable Costing
5-71
Summary of Key Insights
NOI = net operating income
5-72
End of Chapter 5