The Behavior of Fixed

and Variable Costs

• As production volume changes, some costs may
increase or decrease and other costs may
remain stable.
• However, the predictability of specific costs to
change with volume provides an important tool
for managerial accountants.
 Fixed Costs
Fixed costs stay They vary when
the same in expressed on a per
total. unit basis.
 Variable Costs
Variable costs vary They are constant
in direct proportion when expressed as
to volume changes. per unit amounts.
 Relevant Range

• The relevant range is the normal range

of production that can be expected for a
particular product and company.
• The relevant range can also be viewed as
the volume of production for which the
fixed and variable cost relationships hold
true.
Types of Information Needed By
External Users

The concept of the relevant range

allows managerial accountants to
assume a linear cost relationship.
 The Cost Equation

Expressing the link between costs

and production volume as an
algebraic equation is useful.

The equation for a straight line is:

y = a + bx
 The Cost Equation
Using y = a + bx, the a in the equation is
the point where the line intersects the
vertical (y) axis and b is the slope of the
line.
 The Cost Equation
Using y = a + bx,
if y is total direct material costs and
x is units produced, then y = $0 + $20x.

Check it out.

Y=$20(2,500)

Y = $50,000
 The Cost Equation
For y = $0 + $20x,
the y intercept is zero and slope of the
line is 20.
 The Cost Equation
y = $0 + $20x,
For every one-unit increase (decrease) in
production (x), direct material
costs increase (decrease) by $20.
 The Cost Equation
If y = rent cost and x = units produced,
y = $10,000 + $0x.
In this case, the y intercept is $10,000 and the slope is
zero. In other words, fixed costs are $10,000 at any level
of production within the relevant range.

COSTS

Fixed Costs
(RENT)
$10,000
0 X

VOLUME
 Mixed Costs
• Mixed costs have both a fixed and a variable
component.
• They are costs that change in total and also
change per unit.
• If you can’t draw a straight line through all
the data points (below), then it is mixed.
 Regression Analysis
• A variety of tools can be used to estimate the
fixed and variable components of a mixed
cost.
• One of those tools is regression analysis,
which uses statistical methods to fit a cost
line (called a regression line) through a
number of data points.
• Regression analysis statistically finds the line
that minimizes the sum of the squared
distances from each data point to the line
(thus, sometimes called least squares
regression).
 Regression Summary Output
Using a spreadsheet program, we can obtain the
regression line for KenCor’s overhead costs:
Total overhead cost = $3,998.25 + ($2.09 X Volume)
 Regression Summary Output

Total
overhead = $3,998.25 + ($2.09 X Volume)
cost

This equation can be used to help predict the

total amount of overhead costs that will be
incurred for any number of pizzas within the
relevant range.
 Regression Summary Output

Total
overhead = $3,998.25 + ($2.09 X Volume)
cost

Assume KenCor plans to produce 1,750 pizzas next

month, then its overhead costs will be: $7,655.75
( or $3,998.25 + [$2.09 X 1,750 pizzas])
 Regression Graph
Graphically, the line for the total
overhead costs can be expressed as
shown in the following illustration.
R-Square (Coefficient of Determination)
R-square is a measure of goodness of fit of the
regression line (in fitting the data). An R2 of 1.0 indicates
a perfect correlation between the independent and
dependent variables in the regression equation. In this
case, R2 of 0.8933 indicates that over 89 percent of the
variation in overhead costs is explained by increasing or
decreasing pizza production.
 Low R-Squares

Low R2 may indicate:

(1) the chosen independent variable
is not a very reliable predictor of
the dependent variable;
(2) other independent variables
may have an impact on the
dependent variable; OR
(3) extreme outliers are present.
High-Low Method
Now let’s look at
KenCor’s monthly data
and a simpler estimate
of its costs.

The high/low
method uses
only two data
points to derive
an estimate of
the cost
equation.
High-Low Method
Data points are:

High Activity = 2,600 Pizzas

(with $10,100 in overhead)

AND

Low Activity = 1,200 Pizzas

(with $6,750 in overhead)
 High-Low Method
Once the high and low volume points are identified,
we begin the calculation for variable costs.

Variable Cost Change in Cost

=
Per Unit
Change in Volume

$10,100 - $6,750
=
2,600 – 1,200

=
$2.39
 High-Low Method
We then solve for the fixed-cost component by
calculating the total variable cost incurred at either
the high or the low level of activity and
subtracting the variable costs from the total overhead
cost incurred at that level.

Total overhead = Fixed costs + (Variable Number

costs cost/unit X of Pizzas)

$10,100 = Fixed costs + ($2.39 X 2,600 Pizzas)

Fixed costs = $3,886

 High-Low Method
Thus, the cost equation using the high-low method is:

Total
overhead = $3,886 + ($2.39 X # of Pizzas)
costs

This equation is different from the regression because

regression fits the “best” line through all 12 data
points. High-low, instead, forces a line between two
points. If one of the two points is an outlier, the line
will be skewed.
 The Impact of Income Taxes
on Cost and Decision Making
Managers should consider the
impact of income taxes on a
decision.

Essentially, many costs of operating

businesses are deductible for income tax
purposes and most business revenues are
taxable.
 After-Tax Cost
The after-tax cost of a tax-deductible cash
expenditure can be found by subtracting the income
tax savings from the before-tax cost or by simply
multiplying the before-tax amount by (1 - tax rate):

After-Tax =
Pretax cost x (1- tax rate)
Cost
What Does this Mean for Decision-
Makers?
If a company spends an
extra $20,000 on tax-
deductible expenditures
and has a 40% tax rate,
their cash flow will only
decrease by $12,000.
After-Tax
Cost
=
Pretax cost x (1- tax rate)
=
$12,000 $20,000 x (1- 40%)
 After-Tax Benefit
Similarly, the after-tax benefit of a taxable cash
receipt can be found by subtracting the additional
income tax to be paid from the before-tax receipt or
by simply multiplying the pretax receipt by (1-tax
rate):

After-Tax =
Pretax
Benefit receipts x (1- tax rate)
What Does this Mean for Decision-
Makers?
If taxable revenue
increases by $20,000 and
the tax rate is 40%, a
company will only see an
increase in cash flow of
$12,000.
After-Tax
Benefit
=
Pretax receipts x (1- tax rate)
=
$12,000 $20,000 x (1- 40%)