Chapter 6 – Cost Behavior

6.1

Cost Behavior— How costs change as volume changes

There are three common cost behaviors:

1. Variable costs
2. Fixed Costs
3. Mixed costs

Variable Costs:

• Total variable costs change in direct proportion to changes in volume

• Variable cost per unit remains constant
• Total variable cost (Y) =

Variable cost per x Volume of

unit of activityor(v) activity (x)

or Y = vx
Assume you have a cellphone plan that charges you 5 cents for every text you make. We can graph the
relationship between the number of texts in a month and the total monthly cost:

$40
Total cost

$20
$0
0 100 200 300 400
Number of texts

 The total variable cost line begins at the Origin - zero volume and zero cost
 The slope of the total variable cost line is the variable cost per unit.

However, if we graphed the cost per unit at varying levels of volume, the graph would be as follows:
$0.20
Cost per text

$0.15
$0.10
$0.05
$0.00
0 100 200 300 400
Number of texts
Fixed Costs:

• Total fixed costs remain constant with changes in volume

• Fixed costs per unit of activity vary inversely with changes in volume

Y=f where f = total fixed costs

Assume your cellphone plan includes unlimited minutes of talk time. The TOTAL COST for voice service
would be graphed as follows:
$40
Total cost

$30
$20
$10
$0
0 100 200 300 400
Minutes talked

However, the COST PER MINUTE talked would decrease as the number of minutes talked increases as
follows:
$0.600
Cost per minute

$0.400
$0.200
$0.000
50 100 200 300 400
Minutes talked

Mixed Costs
• Total mixed costs increase as volume increases (but not proportionately)
• Total mixed costs can be expressed as a combination of the variable and fixed cost equations:

Total mixed cost = Total Total Fixed

Variable + Cost
Cost

Or Y = vx + f
The fixed cost component of $30 for unlimited minutes of talk is represented by the horizontal line. The
variable costs component varies in direct proportion to the volume of texts.
$60
Total cellphone bill

$50
$40
$30
$20
$10
$0
0 100 200 300 400
Total texts
  Total mixed costs increase as volume increases because of the variable cost component.
 Total mixed cost graphs slope upwards, and they intersect at the y-axis at the level of the fixed costs.

Identify each cost as variable, fixed, or mixed

Activity level Cost Behavior
5,000 Units 6,000 units 7,000 units F, V, M
1 Total Cost A $15,000 $16,000 $17,000 Mixed
2 Total Cost B $5,000 $6,000 $7,000 Variable
3 Total Cost C $15,000 $15,000 $15,000 Fixed
4 Per Unit Cost D $2.00 $2.00 $2.00 Variable
5 Per Unit Cost E $3.00 $2.50 $2.14 Fixed

$60,000 Step Costs

$45,000
Total Costs

$30,000

$15,000

$0
8 16 32 40
Number of Units

 Step costs are fixed for a SMALL range of volume and then jump to a new fixed level with moderate
changes in volume.
 An example is the caregiver-to-child ratio in a day care center. States usually require a limit of
students per care giver.

Identify the graph that most closely represents the cost behavior pattern described below:

1 2( 3 4

5 6 7 8

9 10 11 12
a. Straight line depreciation of equipment 1
b. Monthly electric bill which consists of a flat monthly service charge plus $.002 per kilowatt hour 5
c. Factory rent of $3000 per month, which will be forgiven by the City if the company employs 12 8
disadvantage youth. The x-axis is the number of disadvantaged youth employed by the company.
d. Office rent of $1500 (x-axis is units sold) 1
e. Tuition is $385 per semester credit hour up to 10 credit hours; tuition for 11 credit hours or more is 3
$4,215 per semester.
f. Salaries of delivery workers, where delivery person is needed for every 200 deliveries scheduled in a 11
given month.
g. Cost of direct materials for picnic tables when the wood costs $45 for each table 2
h. Cost of water used in plant with that has a flat fee of $10 per month plus the following price schedule 7
per gallon of water:
Up to 10,000- gallons $.005 per gallon
10,001 – 20,000 gallons $.006 per gallon
More than 20,000 gallons $.008 per gallon
i. Cell phone bill of $29.99 per month for 450 minutes plus $.25 per minute above 450 9
j. Salespersons earn $10 on each unit sold 2

6.2
Cost Equation
Mathematical equation for a straight line to predict total cost
Total cost = total variable cost + total fixed cost.
Or Y = vx + f
Where
Y = total mixed cost
v = variable cost per unit of activity
x = volume of activity
f = total fixed cost over a given period of time

Using Cost Behavior for Decision-Making

Relevant Range
 The normal range of operating activity.
 Band of volume where
o Total fixed costs remain constant
o Variable costs per unit remain constant
o The cost equation remains valid
 Managers must be sure that planned activity is within the relative range

Committed Fixed Costs

 Fixed costs that cannot be changed in the short-term
 Examples: depreciation, lease payments with years remaining on the lease

Discretionary Fixed Costs

 Fixed costs that can be changed in the short-term
 Examples: Advertising, training
1. Complete the following schedule related to a dry-cleaning business for the three volumes shown:
2,000 3,500 5,000
garments garments garments
Total variable costs $1,500 $2,625 $3,750
Total fixed costs $7,000 $7,000 $7,000
Total operating costs $8,500 $9,625 $10,750

Variable cost per garment $0.75 $0.75 $0.75

Fixed cost per garment $3.50 2.00 $1.40
Average cost per garment $4.25 $2.75 $2.15

2. Why does the average cost per garment change?

Fixed cost per unit changes= average cost will change
3. Suppose the owner erroneously uses the average cost per unit at FULL CAPACITY to predict total
costs at a volume of 2,000 garments. Would he overestimate or underestimate total costs? By how
much?
2,000 x $2.15= $4300 (estimated total cost he thinks for cleaning 2,000 garments)
 Estimated $4,200 too low ( underestimated)

Mailbox Magic produces decorative mailboxes. The company’s average cost per unit is
$26.43 when it produces 1,000 mailboxes.
1. What is the total cost of producing 1,000 mailboxes? $26.43 x 1000 mailboxes = $26,430

2. If $18,000 of the total cost is fixed, what is the variable cost of producing each mailbox?
$26,430 = v (1,000) + 18,000
V = $8.43
3. Write Mailbox Magic’s cost equation.
Y = $8.43x+$1800

4. If the plant manager uses average cost to predict total costs, determine is forecast for 1,200 boxes.
$1,200 mailboxes x $8.43 = $31,716 incorrectly predicted

5. If the plant manager uses the cost equation to predict total costs, determine is forecast for 1,200 boxes.
Y = $8.43 x 1200 mailboxes + $18,000 = $28,116 ( correctly predicted)

6. Determine the dollar difference between your answers above. Which is more accurate?
Incorrectly estimated $3,600 too high

The Akron Slugger Company produces various types of wooden baseball bats. It has calculated the average
cost per unit of a production level of 7,500 bats to be $10.00. Total cost= $75,000

1. If $22,500 of the costs are fixed, and the plant manager uses the average cost per unit to predict
total costs, her forecast for 8,500 bats will be: 8,500 bats x $10 = $85,000 (incorrect)

2. If the manager uses the cost equation to predict total costs, her forecast for 8500 bats would be:
Y = vx + f -> $75,000= v (7,500 bats) + $22,500 fixed costs -> V= $7.00 -> Y=$7.00 (8500 bats)
+$22,500 = $82,000 correct estimate

6.3
Determining Cost Behavior

Account Analysis
 Managers use judgment and experience
 Classify various accounts as mixed, variable, and fixed
 Subjective
Use your judgment (account analysis) to determine the cost behavior (FIXED, VARIABLE, OR
MIXED) of each of the following:
a. Apartment rental—$500 per month
b. Total factory overhead that includes indirect labor, indirect
materials and other MOH totals $250,000 per year
c. Cell phone plan where the first 700 minutes are included for
$39.99 / month and every minute thereafter costs 30 cents.
d. Car insurance - $1,400 per year
e. Gas—$2.59 per gallon and your car averages 25 miles per
gallon
f. Cable TV - $50 per month for 120 channels plus $4.99 per pay-
per-view movie
g. Commuter rail tickets - $2 per ride

Scatter Plots (graphs)

 Uses historical data to break mixed costs into fixed and variable components
 Scatter plot is the graph of historical cost data on the y-axis and
of volume data on the x-axis
 Helps managers visualize the relationship between cost and volume.
 Scatter plots helps to identify outliers.
 Data points will fall in a linear pattern with a fairly strong relationship between the cost
and volume
o Line drawn through data points will intercept y-axis at approximate level of fixed
costs
o Using a data point located on that line and the cost equation, an estimate of
variable costs can be made

The following details the miles driven and total costs to operate delivery vans for the past 7 months
for Flower Power, which operates a local chain of flower shops. The owner wants to set delivery
fees based on the distance driven, and, therefore, wants to separate the fixed and variable portions
of the van operating costs so that a fee structure may be implemented
Month Miles Driven Van Operating Costs
January 15,800 $5,450
February 17,300 $5,680
March 14,600 $4,940
 April 16,000 $5,310
May 17,100 $5,830
June 15,400 $5,420
July 14,100 $4,880

The following scatter plot graphs the data:

R elatio n s h ip o f V an O p eratin g
C o s ts to Miles D riven
V a n O p e r a ti n g

7000
6000
C o s ts

5000
4000
3000
2000
1000
0
0 5000 10000 15000 20000
Mile s Driv e n

1. Does the data appear to contain any outliers? No

2. How strong of a relationship between miles driven and van operating costs is there?

6.4

High-Low Method
 Also uses historical data, but only the highest and lowest activity points
 Use scatterplot to determine if a linear relationship exists; then, use high-low method to
estimate the cost equation

Steps:
1) Find variable cost per unit (v) (slope of the total cost line):
Using the highest and lowest ACTIVITY levels along with the associated cost at these
levels
Rise or Change in Cost = v
Run Change in Volume

2) Find the fixed cost (f):

Use the results for (v) from step 1), either the low or high point data (volume and
associated cost), and the total cost equation:
Y = f + vx (y, v, x are known)

Solve for f

3) Create the cost equation

Using the (v) per unit and (f) from steps 1) and 2)
 Use this equation to find expected cost for any volume (x)

Using the data from the previous problem, use the high-low method to determine Flower
Power’s cost equation for van operating costs.

Highest volume is 17,300 miles. $5,680

Lowest volume is 14,100 miles. $4,880

Step 1)

Rise y (high) − y (low) $5,680-$4,880

= = = V = $0.25
Run x (high) − x (low) 17,300-14,100

Step 2)

Using highest data:

y = vx + f $5,680 = $0.25(17,300) + f
f = $1,355

Step 3) Write the cost equation: y= $0.25(x)+$1,355

Using your results, predict van operating costs at a volume of 15,000 miles.
Y=$0.25(15,000)+$1,355
Y= $5,105

Pablo was reviewing the water bill for his carwash business and determined that the highest
bill, $5,000, occurred in July when 2,200 cars were washed and the lowest bill, $3,200,
occurred in February when 1,400 cars were washed.

What was the fixed portion of the water bill? $50

Advantage:
Quick and easy to use

Disadvantage:
 Only uses two data points
o Those points may be abnormal
o Make sure they are not outliers

Regression Analysis
• Statistical procedure to find the line that best fits data (COST EQUATION).
• R-Square statistic indicates how well the line generated fits the data points
• Uses all data points
• Most accurate method
• Tedious to complete by hand but simple to do using Microsoft Excel or certain graphing
calculators

SUMMARY OUTPUT FROM

Excel Data Analysis tools

Regression Statistics
Multiple R 0.94726 89.7 %
R Square 0.897301 goodness of
Adjusted R
Square 0.876762
Standard Error 123.6422
Observations 7

ANOVA
Significanc
  df SS MS F eF
667848. 667848.
Regression 1 7 7 43.6862 0.001192
76437.0 15287.4
Residual 5 3 1
744285.
Total 6 7      

Coefficient Standar FC Upper Lower Upper

  s d Error t Stat P-value Lower 95% 95% 95.0% 95.0%
671.562 1.38572 0.22445 2656.90 - 2656.90
Intercept 930.6014 8 5 7 -795.706 8 795.706 8

0.281014 0.04251 6.60955 0.00119 0.39030 0.17172 0.39030

X Variable 1 6 4 2 0.171722 5 2 5

VC per
unit
6.6
Contribution Margin Income Statement

 Contribution margin income statements organize costs by BEHAVIOR rather than by

FUNCTION

 Distinguishes between costs that will change IN TOTAL (VARIABLE) and those that will
not change IN TOTAL (FIXED)with changes in volume
  The Contribution Margin Income Statement begins with SALES and subtracts
VARIABLE COSTS to arrive at CONTRIBUTION MARGIN.

 Can be used to predict how changes in volume will affect OPERATING INCOME.

Comparison of the Contribution Margin Income Statement

with the Traditional Income Statement

Traditional Approach Contribution Approach

(costs organized by function) (costs organized by behavior)

Sales $ 100,000 Sales $ 100,000

Less cost of goods sold 70,000 Less variable costs 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating costs 20,000 Less fixed costs 30,000
Operating income $ 10,000 Operating income $ 10,000

Used primarily for Used primarily for

external reporting internal purposes

Traditional approach – Absorption Costing Contribution Approach – Variable Costing

Required by GAAP and tax reporting Used for management decision making

Contribution Margin (CM)

 CM = Sales – Variable Costs
 Not the same as gross margin
 What’s left after covering VC to cover FC and provide a profit (operating income)

The income statement for Precious Pets, a small e-tail business, for the past year
follows:

Sales Revenue $987,000

Cost of Goods Sold (665,000)
Gross Profit 322,000
Operating Expenses:
Selling and marketing expenses $61,000
Web site maintenance 56,000
Other operating expenses 17,000
Total Operating Expenses (134,000)
Operating Income $ 188,000

61,000 – 19,000 = 42,000 variable

> 20% of 42,000 is variable= $8,400
> Total Variable= 19,000+8400= 27,400
42,000-8400= 33,600 fixed

All of the costs of goods sold is variable. $19,000 of the selling and marketing expenses were
variable FREIGHT OUT. Only 20% of the remaining selling and marketing expenses and 25%
of the web site maintenance expenses were variable. Of the other operating expenses, 90%
were fixed. Based on this information, prepare Precious Pet’s income statement in
contribution margin format:

Precious Pets
Contribution Margin Income Statement
For the Year Ended December 31
Sales revenue 987,000
Variable expenses:
Cost of goods sold 665,000
Variable selling and marketing expenses 27,400
Variable web site maintenance expenses 25% of
56,000=
14,000
Other variable operating expenses (10%
variable) 1,700
Total variable expenses 708,100
Contribution margin 278,900
Fixed expenses:
Fixed selling and marketing expenses 33,600
Fixed web site maintenance expenses (75% of
56,000) 42,000
Other fixed operating expenses (90% fixed) 15,300
Total fixed expenses 90,900
Operating income 188,000

For service and merchandising firms, there is no difference in net income between absorption
and variable costing as service firms have no inventories and all COGS for merchandising
firms are variable.

For manufacturers, absorption costing includes DM, DL, and ALL MOH (both variable and
fixed) in inventory and COGS. Therefore, many manufacturing firms use variable costing with
the contribution margin income statement.

Variable Costing
  Only variable manufacturing costs are considered product costs (DM, DL
and Variable MOH)
 Variable costing treats all FIXED manufacturing costs as period costs
(expensed as incurred; not inventoried)
o Not allowed for financial reporting and income taxes
o Useful for management decision making
 For manufacturers, if inventory levels remain constant, no difference in net
income results.
o If inventory levels are different from the beginning of the year to the
end, absorption costing net income will be different than variable
costing net income due to the fixed MOH costs that are in inventory
under absorption costing, but not under variable costing

Comparing absorption and variable costing:

Fischer Manufacturing has the following information for the month of May:

Units produced 20,000

Units sold 20,000
Selling price per unit $10
Direct materials $2 per unit
Direct labor $1.50 per unit
Variable MOH $.30 per unit
Fixed MOH $28,000
Variable operating expenses $2 per unit
Fixed operating expense $20,000

Determine Product Costs under each method:

DM DL V MOH F MOH Total
Absorption Costing 2 1.50 .30 $28,000 / 20,000 units= $5.20
1.40 fixed overhead per
unit
Variable Costing 2 1.50 .30 none $3.80

Prepare the income statement using absorption costing:

Sales 20,000 units x $10 per $200,000

unit
Less COGS 20,000 units x $5.20 -$104,000
Gross Profit $96,000
Less operating expenses (20,000*$2) + $20,000 -$60,000
Operating Income $36,000
Prepare the income statement using variable costing:
Sales $200,000
Less Variable Costs
COGS 20,000*3.80 -$76,000
Operating expenses 20,000*2.00 -$40,000
Contribution Margin $84,000
Less Fixed Costs
MOH -$28,000
Operating expenses -$20,000
Operating Income $36,000