Chapter 6

Cost Behavior: Analysis and Use

 Fixed and variable costs
 The linearity assumption and the relevant
range.
 Step variable and mixed costs
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 Variable cost per unit remains

proportional to the activity
level within the relevant range.
Fixed Total fixed cost remains the
same even when the activity
level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
Total Variable Cost Example

Your total long distance telephone bill is

based on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
Variable Cost Per Unit Example

The cost per minute talked is constant.

For example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
Total Fixed Cost Example
Your monthly basic telephone bill is
probably fixed and does not change
when you make more local calls.
Monthly Basic
Telephone Bill

Number of Local Calls

Fixed Cost Per Unit Example
The fixed cost per local call decreases
as more local calls are made.

Monthly Basic Telephone

Bill per Local Call

Number of Local Calls

Cost Behavior
Examples of normally variable costs
Merchandisers Service Organizations
Cost of Goods Sold Laundry and guest supplies (gel, shampoo,
toilet paper)

Manufacturers Merchandisers and

Direct Material, Direct Manufacturers
Labor, and Variable Sales commissions and
Manufacturing Overhead shipping costs

Examples of normally fixed costs

Merchandisers, manufacturers, and service organizations
Real estate taxes, Insurance, Management salaries
Depreciation, Advertising
The Activity Base (variable cost)
Units Units
produced sold

A measure of the event

causing the incurrence of a
variable cost – a cost driver

Miles Labor
driven Machine hours
hours
The Activity Base
Units
Sometimes people think that if Machine
a cost
produced hours
does not vary with production or sales,
then is not a variable cost... Wrong!

Costs are caused by many different

A measure
activities inof
anthe event Although
organization.
we usually look at the relation between
causing the incurrence of a
a cost and the level of production.
variable cost – a cost driver

Miles Labor
driven hours
Cost Behavior (Linearity assumption and
relevant range)
Units
Linearity hypothesis: the expected value of the dependent
Machine
variable depends linearly on the independent variables. The
produced hours
expected impact of a unitary change in each of the independent
variables, keeping the others constant, is always the same.

A measure of the event

The relevant range are the limits within
causing the incurrence of a
which the cost behaviour assumptions are
variable
valid. cost – a cost driver

If the company decides to operate outside

these limits it will need to change its structure
Miles Labor
and therefore cost assumptions will change
driven as well. hours
Quick Check 
INPA Restaurant has a capacity to attend up to 70 clients. As a
manager, Carmen is working on expanding the business. However she
complains about space restrictions. Currently the rental cost is € 30 per
square metre and the restaurant has a size of 100 m2.
She has decided to move to a wider location, with the same cost per
square metre, but a 30% more spacious so they will be able to attend a
30% more clients. Therefore the rental cost will increase in a 30%. Which
of the following statements about INPA’s rental costs are true?

a. Rental cost have changed from fixed to variable costs.

b. The new fixed costs correspond to a new relevant range.
c. Total fixed costs are constant within a new relevant range.
d. Rental costs are variable as they depend on the size of the
location.
Quick Check 
INPA Restaurant has a capacity to attend up to 70 clients. As a
manager, Carmen is working on expanding the business. However she
complains about space restrictions. Currently the rental cost is € 30 per
square metre and the restaurant has a size of 100 m2.
She has decided to move to a wider location, with the same cost per
square metre, but a 30% more spacious so they will be able to attend a
30% more clients. Therefore the rental cost will increase in a 30%. Which
of the following statements about INPA’s rental costs are true?

a. Rental cost have changed from fixed to variable costs.

b. The new fixed costs correspond to a new relevant range.
c. Total fixed costs are constant within a new relevant range.
d. Rental costs are variable as they depend on the size of the
location.
 Whether
Quick Check the company attends 50, 70 or 91 clients,
new rental costs will be the same.
INPA Restaurant has a capacity to attend up to 70 clients. As a
manager, Carmen Fixed costs doonnot
is working change within
expanding the relevant
the business. However she
complains about space restrictions. Currently the rental cost is the
range. Thus, they do not change shortly. Once € 30 per
new fixed costs have been adjusted,
square metre and the restaurant has a size of 100 m2. they are
She has decidedunaffected
to move tobya the actual
wider level with
location, of activity.
the same cost per
square metre, but a 30% more spacious so they will be able to attend a
30% more clients.Therefore,
Therefore over
the arental
longcost
termwill
time period,
increase inall cost Which
a 30%.
will tend to change
of the following statements and adapt
about Elea’s rentaltocosts
largeare
changes
true? in
activity.
a. Rental cost have changed from fixed to variable costs.
b. The new fixed costs correspond to a new relevant range.
c. Total fixed costs are constant within a new relevant range.
d. Rental costs are variable as they depend on the size of the
location.
Types of Fixed Costs

Committed Discretionary
•Multi-year planning •One-year planning
horizon horizon
•Cannot be cut for •Can be cut for short
short periods of time periods of time

Examples Examples
Depreciation on Advertising and
Buildings and Research and
Equipment Development
Committed fixed costs

Fixed costs related to basic

organizational structure such as
investments in facilities,
equipment… Relate to the
capacity to provide goods and
services, but also to a quality
dimension.
Depreciation of buildings
and equipment, taxes,
insurance, salaries of top
management,...
Committed
fixed cost
They are the result of
multiyear planning horizon.
Even if operations are
interrupted, they continue
largely unchanged.
Discretionary fixed costs

Fixed costs which do not affect

a establishment’s current Discretionary
capacity. Relate to annual fixed cost
decisions such as advertising
budget, research, public
relations programs,...
They are the result of one-year
planning horizon.

Can be cut from one period to

the next one.
Discretionary fixed costs

Fixed costs which do not affect

a establishment’s
However, current
if they are Discretionary
capacity. Relate
cut , to annual
unfavourable
fixed cost
decisions suchconsequences
as advertising may
arise... When
budget, research, public
reducing training,
relations programs,...
advertising...
They are the result of one-year
planning horizon.

Can be cut from one period to

the next one.
Labor Costs: Fixed or Variable?

Fixed if work force is stable because management

is reluctant to increase/decrease the number of
employees in response to short-term fluctuations
in business activity.

Variable if size of work force is easily adjusted for

short-term fluctuations in business activity.

May be both fixed and variable if temporary

workers are employed to accommodate short-term
fluctuations in business activity.
Quick Check 
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.
Quick Check 
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.
Mixed Costs
A mixed cost has both fixed
and variable
components.
Faced with a situation, a
mixed cost could remain
unchanged over time or the
opposite. This is why they
are also called semi-fixed Consider the
costs or semi-variable costs. following electric
utility example.
Mixed Costs

Y
Total Electic Utility
Cost

Variable
Utility Charge

Fixed Monthly
Utility Charge
X
Activity (Kilowatt Hours)
Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Y
Where: Y = the total mixed cost
Total Utility Cost

a = the total fixed cost (the

vertical intercept of the line)
b = the variable Variable
cost per unit of
activity (the slopeCharge
Utility of the line)
X = the level of activity

Fixed Monthly
Utility Charge
X
Activity (Kilowatt Hours)
Mixed Costs

Y
Total Utility Cost

Variable
bX
Utility Charge

Fixed Monthly
a
Utility Charge
X
Activity (Kilowatt Hours)
How do we anticipate mixed costs in a
budget?

The only way to anticipate mixed costs is to prepare a

flexible budget, taking into consideration a low point
and a high point.

High-Low Method
This calculation technique consists of trying to segment the mixed
cost into a fixed and a variable part in order to see how it would
behave at different levels of activity: the highest or maximum
point and the lowest or minimum point.
 Mixed costs: The high-low method: steps
1. Select two extreme periods of activity in the period under
consideration. For example, the two months with highest and lowest
activity (rooms sold, meals served…).
2. Compute the difference between the total costs for the two periods
and the difference in the activity for the two periods.
3. Divide the cost difference by the activity difference to determine the
variable cost per activity unit. Change in cost
Variable cost per unit = ---------------------------
Change in activity
4. Choose one of the periods and multiply the activity by the per unit variable
cost, to arrive ate the total variable cost. Deducting from total mixed cost,
total variable cost you will reach the total fixed cost.
Fixed cost component = Total cost – Total variable cost
5. Now, express the cost in equation form
Y=a+bX
 Mixed costs: The high-low method
Considering the information about the total electrical costs of the
hotel Fermi and about the number of rooms sold, the two
periods with highest and lowest activity are shown:

Rooms sold Electrical costs (€)

1 Highest activity level

Lowest activity level
August
February
2500
350
4200
1000

2 Change 2150 3200

3 Unit variable cost =Change in cost

Change in units
= €1,49

4 Fixed costs =Total cost – total variable cost = 4200 – (2500 * 1,49)= €475

5 Total cost = Fixed costs + Variable cost = 480 + (1,49 * X)

 Mixed costs: The high-low method

5 Total mixed cost = Fixed costs + Variable cost = 480 + (1,49 * X)

estimate of the cost of electricity when selling

600 rooms

Total cost = 480 + (1,49*600) = 1.374€

Quick Check 

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
Quick Check 

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 Units Cost
b. $0.10 per unit High level 120,000 $ 14,000
Low level 80,000 10,000
c. $0.12 per unit
Change 40,000 $ 4,000
d. $0.125 per unit
$4,000 ÷ 40,000 units
= $0.10 per unit
Quick Check 

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
Quick Check 

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?
Total cost = Total fixed cost +
a. $ 2,000 Total variable cost
$14,000 = Total fixed cost +
b. $ 4,000 ($0.10 × 120,000 units)
c. $10,000 Total fixed cost = $14,000 - $12,000
d. $12,000 Total fixed cost = $2,000
Note

Problems with the high-low method:

• Disregards information contained in all of the data
other than the low and the high points.
• The low and high levels of activity tend to be
unusual.
Always plot the data if you have more than two
points to make sure it makes sense to use the
high-low method.
End of Chapter 6