Chapter
5
Cost Behavior:
Analysis and Use
Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from Chapter 2.
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.
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.
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Total Variable Cost Example
Total Long Distance
Telephone Bill
Your total long distance telephone bill is
based on how many minutes you talk.
Minutes Talked
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Variable Cost Per Unit Example
Per Minute
Telephone Charge
The cost per minute talked is constant. For
example, 10 cents per minute.
Minutes Talked
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Total Fixed Cost Example
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
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Fixed Cost Per Unit Example
Monthly Basic Telephone
Bill per Local Call
The fixed cost per local call decreases as
more local calls are made.
Number of Local Calls
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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
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The Activity Base
Units
produced
Machine
hours
A measure of the event
causing the incurrence of a
variable cost – a cost driver
Miles
driven
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Labor
hours
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The Linearity Assumption and the
Relevant Range
Total Cost
Economist’s
Curvilinear Cost
Function
Activity
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The Linearity Assumption and the
Relevant Range
Total Cost
Economist’s
Curvilinear Cost
Function
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
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Total Cost
The Linearity Assumption and the
A straight line
Relevant Range
Relevant
Range
closely
approximates
a curvilinear
Economist’s
Curvilinear Cost variable cost
line within the
Function
relevant
range.
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
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Types of Fixed Costs
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
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Trend Toward Fixed Costs
Increased automation.
Increase in salaried knowledge workers
who are difficult to train and replace.
Implications
Managers are more “locked-in” with fewer decision
alternatives.
Planning becomes more crucial because fixed costs are
difficult to change with current operating decisions.
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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.
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Rent Cost in
Thousands of Dollars
Fixed Costs and Relevant Range
90
60
30
00
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Relevant
Range
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)
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Total Costs
Total cost
has both fixed
and variable
components.
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Total Costs
Cost
Y
Variable
Costs
Fixed
X
Costs
Activity
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Total Costs
Cost
Y
Variable
bX
Costs
Fixed Costs
a
X
Activity
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The Analysis of Total Costs
Account Analysis
Engineering Approach
High-Low Method
Scattergraph Method
Least-Square Regression Method
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Account Analysis
Each account is classified as either
variable or fixed based on the analyst’s
knowledge of how the account behaves.
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Engineering Estimates
Cost estimates are based on an evaluation
of production methods, and material, labor
and overhead requirements.
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The High-Low Method
WiseCo recorded the following production activity
and maintenance costs for two months:
High activity level
Low activity level
Change
Units
9,000
5,000
4,000
Cost
$ 9,700
6,100
$ 3,600
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.
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The High-Low Method
High activity level
Low activity level
Change

Units
9,000
5,000
4,000
Cost
$ 9,700
6,100
$ 3,600
Change in cost
Unit variable cost = Change in units
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The High-Low Method
High activity level
Low activity level
Change
Units
9,000
5,000
4,000
Cost
$ 9,700
6,100
$ 3,600
 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit
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The High-Low Method
High activity level
Low activity level
Change
Units
9,000
5,000
4,000
Cost
$ 9,700
6,100
$ 3,600
 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit
 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600
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The High-Low Method
High activity level
Low activity level
Change
Units
9,000
5,000
4,000
Cost
$ 9,700
6,100
$ 3,600
 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit
 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = $1,600 + $0.90X
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The High-Low Method
If sales salaries and commissions are $10,000
when 80,000 units are sold and $14,000 when
120,000 units are sold, 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
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The High-Low Method
If sales salaries and commissions are $10,000
when 80,000 units are sold and $14,000 when
120,000 units are sold, what is the fixed portion
of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
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The Scattergraph Method
Plot the data points on a
graph (total cost vs. activity).
Total Cost in
1,000’s of Dollars
Y
20
10
0
* *
* *
* ** *
**
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
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The Scattergraph Method
Draw a line through the data points with about an
equal numbers of points above and below the line.
Total Cost in
1,000’s of Dollars
Y
20
10
0
* *
* *
* ** *
**
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
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The Scattergraph Method
Total Cost in
1,000’s of Dollars
The slope of this line is the variable unit
cost. (Slope is the change in total cost for
a one unit change in activity).
Y
20
10
* *
* *
* ** *
**
Estimated fixed cost = $10,000
0
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
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The Scattergraph Method
Slope =
Total Cost in
1,000’s of Dollars
Y
20
10
* *
* *
Change in cost
Change in units
* ** *
**
Vertical
distance
is the
change
in cost.
Horizontal distance is
the change in activity.
0
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
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Least-Squares Regression Method
 Accountants and managers
may use computer software
to fit a regression line
through the data points.
 The cost analysis objective
is the same: Y = a + bx
Least-squares regression also provides a statistic, called
the adjusted R2, that is a measure of the goodness
of fit of the regression line to the data points.
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Least-Squares Regression Method
R2 is the percentage of the variation
in total cost explained by the activity.
Y
Total Cost
20
* *
* *2
10
0
0
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* ** *
**
R for this relationship is near
100% since the data points are
very close to the regression line.
X
1
2
3
4
Activity
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The Contribution Format
Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
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The Contribution Format
Sales Revenue
Less: Variable costs
Contribution margin
Less: Fixed costs
Net 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.
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The Contribution Format
Used primarily for
external reporting.
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Used primarily by
management.
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End of Chapter 5
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