COST BEHAVIOR:

ANALYSIS AND
USE
PATRICK LOUIE E. REYES,
CTT, MICB, RCA, CPA
Do Costs React? 😱
Yes, they do! And they react scientifically, which is good
news for you. It will be easy to predict how a cost will
react based on changes on different factors within the
relevant range. 😉

This reaction to changes is called Cost Behavior.

Why is it important to understand
Cost Behavior?
•For future use. 🗓 How a manager plans is based on past
or current trends. 😁
•For emergency. 🚨 In case things do not go well as
planned, you know what to tweak, based on your
understanding of cost behavior, just because it is under
your control. 😉
•For analysis. 🧠 Cost Analysis is an integral part of the
above-mentioned functions, planning and control. To
predict accurately, you must understand how costs behave.
How do Costs Behave?
The assumed range of
activity that reflects the
company’s normal
operating range is
referred to as the
relevant range.

Types of Cost Behavior Patterns:

Variable Costs
• Changes proportionately and directly in response to the
level of activity.
Level of activity (x) Total costs (y) Per-unit cost (y÷x)
1 5 5
2 10 5
3 15 5
4 20 5
5 25 5

• In total, it depends on the direction of the activity level.

• Per-unit costs are constant.
Fixed Costs
•Does not change regardless of level of activity.
Level of activity (x) Total costs (y) Per-unit cost (y÷x)
1 60 60
2 60 30
3 60 20
4 60 15
5 60 12

•In total, it does not change.

•Per-unit costs decrease as level of activity increases.
(Inverse relationship between fixed cost and activity
level)
Examples
Variable cost Fixed cost
•Direct material •Rent
•Direct labor •Insurance
•Some overhead costs •Taxes
• Materials handling •Salaries of
• Utilities supervisors
• Supplies
•Straight-line
•Some selling costs depreciation
• Sales commission
• Distribution
•Advertising
Mixed Costs
•Also called semi-variable costs (Part-fixed, part-variable)
Level of activity (x) Total costs (y) Per-unit cost (y÷x)
1 150 150
2 180 90
3 210 70
4 240 60
5 270 54

•In total, it is like variable cost, in the sense that total

costs increase as activity level increases.
•As to per-unit cost, it is like fixed cost, in the sense that
per-unit cost decreases as activity level increases.
 Analysis and Example of Mixed Costs
•Fixed component: represents the
minimum cost of having a service
ready and available for use
•Variable component: represents the
cost incurred for actual consumption
Example:
☎️Internet subscribers incur costs that are mixed: The fixed
component represents the cost of being connected. 🖇 The
variable component represents the amount of data consumed
or time lapsed. 🕒
Separation of Mixed Costs
Importance: to make separate analyses on the fixed and
variable components; separate decisions could be made
on those components.

Methods to be used in ACCT 1033: 🔧🔨

• High-low method ⬆️ ⬇️
• Least-squares regression method 📊
The Cost Formula
Before proceeding to the methods of separating mixed
costs, we need to be acquainted with the cost formula:
y = a + bx
where note: the cost formula is
y: total costs derived from the
a: fixed costs slope-intercept
b: variable cost per activity level formula in linear
x: activity level algebra
High-Low Method ⬆️ ⬇️
•Uses two points, representing two situations (activity
levels and corresponding costs) in predicting the
relationship between costs and activity level
Formulae:
b = (Cost at highest activity – Cost at lowest activity)
Highest activity – Lowest activity
a = y – bx (highest) or
a = y – bx (lowest)
High-Low Method ⬆️ ⬇️
Level of activity (x) Total costs (y) Per-unit cost (y÷x)
1 150 150
2 180 90
3 210 70
4 240 60
5 270 54

b = (270–150) ÷ (5-1) = 120/4 = 30

a = 270 – (30)(5) = 270-150 = 120
a = 150 – (30)(1) = 150-30 = 120
Fixed component: 120
Cost function: y = 120 + 30x Variable component: 30 per activity
Least-squares regression method 📊
Statistical technique which determines a line of
regression by solving a systems of linear equations which
are based on the condition that the sum of deviations
above the regression line equals the sum of deviations
below it.
Equations:
Σy = na + bΣx
Σxy = Σxa + bΣx2
 Least-squares regression method 📊
Equations: Level of activity (x)
1
Total costs (y)
150
Per-unit cost (y÷x)
150

Σy = na + bΣx 2 180 90
3 210 70
Σxy = Σxa + bΣx2 4 240 60
5 270 54

x
1
y
150
xy
150
x2
1
We will need to expand the table
2 180 360 4 above 👆🏻 in order to obtain the
3 210 630 9 necessary variables needed in
4
5
240
270
960
1,350
16
25
both equations.
Σx = 15 Σy = 1,050 Σxy = 3,450 Σx2 = 55 👈🏻 Here is the expanded table.
Least-squares regression method 📊
x y xy x2

Equations: 1
2
150
180
150
360
1
4
Σy = na + bΣx 3 210 630 9
4 240 960 16
Σxy = Σxa + bΣx2 5 270 1,350 25
Σx = 15 Σy = 1,050 Σxy = 3,450 Σx2 = 55

Substituting the variables into the equations, we get two

equations:
(1) 1,050 = 5a + 15b
(2) 3,450 = 15a + 55b
Least-squares regression method 📊
In order to solve this system of equations, we need to
multiply 3 to equation (1), to easily eliminate the variable a.
(1) 1,050 = 5a + 15b ➡️ 3,150 = 15a + 45b
(2) 3,450 = 15a + 55b ➡️ 3,450 = 15a + 55b
Eliminating a and subtracting (2) from (1) , we get:
300 = 10b

Dividing both sides by 10, we get: b = 30

Least-squares regression method 📊
We can solve for a by substituting b into any of (1) or (2).
(1) 1,050 = 5a + 15b (2) 3,450 = 15a + 55b
1,050 = 5a + 15(30) 3,450 = 15a + 55(30)
1,050 = 5a + 450 3,450 = 15a + 1,650
5a = 600 15a = 1,800
a = 120 a = 120
Therefore, we have the cost formula y = 120 + 30x, same
cost formula we obtained using the high-low method ⬆️ ⬇️.
Other methods to separate mixed cost
•Scattergraph method
• Like Least-squares, it also aims to draw a line (called the
“regression line” or “line of best fit”) such that the distances of
the points above and below the line are equal. The only
difference is that Least-square is mathematical, Scattergraph
is visual.
•Account Analysis method
• based on experience and judgment of managers and
accountants familiar with the company’s operations.
Other methods to separate mixed cost
•Industrial Engineering method
• Estimates the cost function by analyzing the relationship
between inputs and outputs.
• Steps:
• A study of the physical relation between inputs and units of output
is made by
• making a detailed step-by-step analysis of each phase of
manufacturing is done.
• estimates of materials required for each unit to be produced are
obtained from specification sheets.
• Costs are assigned to each physical input
Correlation analysis
Correlation: measure of the co-variation between the
dependent (cost) and independent (level of activity)
variables.

Coefficient of correlation (r): measure of the extent of the

linear relationship between the two variables.

Note: values of r can only be from -1 to 1.

Correlation analysis
Additional notes:
•If r = 0, there is no correlation
•If r is positive, there is a direct relationship between x and y
(If x increases, y increases). The regression line slopes
upward to the right.
•If r is negative, there is an inverse relationship between x
and y (If x increases, y decreases). The regression line
slopes downward to the right.
•If r is 1 or -1, there is perfect correlation.
Correlation analysis
Coefficient of Determination (r2): represents the percentage
of the total variation in the dependent variable (y) that is
explained or accounted for by the regression equation.

A very high r2 means that the values in the regression

equation explain virtually the entire amount of the total cost.
The variables are highly correlated, i.e. the cost driver (x)
selected is highly related to the dependent cost (y).
Correlation analysis
Standard Error of the Estimate: standard deviation about the
regression line; serves as a confidence interval or
acceptable range of tolerance, for use in exercising control
over the costs. A small standard error indicates a good fit.
Zero standard error is the best fit. Formula: std error = 1-r2

Prediction errors/Errors of estimates: difference between

the estimated values computed using the regression
equation and actual values.