Cost Behavior: Analysis and Use

Topic 2 (Chapter 2)

© 2012 McGraw-Hill Education (Asia)

 Learning Objective 1

Identify and give examples

of each of the three basic
manufacturing cost
categories.

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 Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product

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 Direct Materials

Raw materials that become an integral

part of the product and that can be
conveniently traced directly to it.

Example: A radio installed in an automobile

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 Direct Labor

Those labor costs that can be easily

traced to individual units of product.

Example: Wages paid to automobile assembly workers

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 Manufacturing Overhead
Manufacturing costs that cannot be traced
directly to specific units produced.

Examples: Indirect materials and indirect labor

Materials used to support Wages paid to employees

the production process. who are not directly
involved in production
Examples: lubricants and work.
cleaning supplies used in the Examples: maintenance
automobile assembly plant. workers, janitors and
security guards.

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 Nonmanufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to All executive,

secure the order and organizational, and
deliver the product. clerical costs.

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 Learning Objective 1

Understand how fixed and

variable costs behave and
how to use them to predict
costs.

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 Cost Classifications for Predicting Cost
Behavior

How a cost will react to

changes in the level of
activity within the
relevant range.
} Total variable costs
change when activity
changes.
} Total fixed costs remain
unchanged when activity
changes.

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 The Activity Base (also called a cost driver)

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven hours

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 Variable Cost
The activity base is the number of text sent.
Your total texting bill is based on how
many texts you send.
Total Texting Bill

Number of Texts Sent

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 Variable Cost Per Unit

The cost per text sent is constant at

5 cents per text.

Cost Per Text Sent

Number of Texts Sent

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 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.

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 Fixed Cost
Your monthly contract fee for your cell phone is fixed
for the number of monthly minutes in your contract.
The monthly contract fee does not change based on
the number of calls you make.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
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 Fixed Cost Per Unit

Within the monthly contract allotment, the average

fixed cost per cell phone call made decreases as
more calls are made.

Monthly Cell Phone

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Contract Fee
Number of Minutes Used
Within Monthly Plan
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 Cost Classifications for Predicting Cost
Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes
as activity level changes.
Fixed Total fixed cost remains
the same even when the
activity level changes.
Variable cost per unit remains
the same over wide ranges
of activity.
Average fixed cost per unit goes
down as activity level goes up.

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 Quick Check ü

Which of the following costs would be variable

with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be more
than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

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 Quick Check ü

Which of the following costs would be variable

with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be more
than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

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 Fixed Costs and the Relevant Range
For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.

Fixed costs would increase

in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

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 Fixed Costs and the Relevant Range

90
Rent Cost in Thousands

The relevant range

Relevant of activity for a fixed
of Dollars

60 cost is the range of

Range activity over which
the graph of the
cost is flat.
30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)

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 Quick Check ü
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.

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 Quick Check ü
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.

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 Mixed Costs (also called semivariable costs)

A mixed cost contains both variable and fixed

elements. Consider the example of utility cost.
Y
Total Utility Cost

o s t
d c
x e
a l mi
To t
Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

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 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
Y vertical intercept of the line).
b = The variable cost per unit of
Total Utility Cost

o s t activity (the slope of the line).

c X = The level of activity.
m i xe d
ta l
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

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 Mixed Costs – An 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, what is
the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
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 Learning Objective 2

Analyze a mixed cost

using the high-low
method.

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 The High-Low Method – An Example
Assume the following hours of maintenance work
and the total maintenance costs for six months.

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 The High-Low Method – An Example
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $6.00/hour
400

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 The High-Low Method – An Example

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700
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 The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
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 Quick Check ü
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

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 Quick Check ü
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
d. $0.125 per unit Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit

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 Quick Check ü
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

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 Quick Check ü
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 Total cost = Total fixed cost +
b. $ 4,000 Total variable cost

c. $10,000 $14,000 = Total fixed cost +

($0.10 × 120,000 units)
d. $12,000
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000

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 Learning Objective 3

Prepare an income
statement using the
contribution format.

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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
Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000

The contribution margin format emphasizes cost

behavior. Contribution margin covers fixed costs
and provides for income.
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 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 4).
2.Budgeting (Chapter 10).
3.Segmented reporting of profit data (Chapter 13).
4.Special decisions such as pricing and make-or-
buy analysis (Chapter 14).

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 The Contribution Format

Used primarily for Used primarily by

external reporting. management.

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