Managerial

Accounting

Dr. Zubair Ahmad

Cost Behaviour

(Seal et al., 2015 Ch. 3)

2
Agenda:

We will

1. Briefly recall Direct, Indirect (Overhead) costs and

Period and Product costs

2. Look at Cost behaviour: analysis and use

I. Variable and Fixed costs
II. Contribution Margin Format
Direct and Indirect (Overhead) costs: assigning
costs to cost object
Direct Material £
Steel Frame 10.00
Fabric 05.00
Foam 00.50
Indirect Material
Screws 00.10
Glue 00.10
Direct Labour 10.00
Frame
Cutting of fabric
Assembly
Manufacturing Overhead 20.00
Supervision and management
Depreciation
Electricity
img2.wfrcdn.com/lf/48/hash/27969/11185395/1/Chairmans-Rest-Kelsey-Tablet-Lecture-Chair.jpg accessed 2014-10-12
 Direct and Indirect (Overhead) costs:
assigning (allocation) of costs to cost objects
Direct Costs: costs that can be easily and conveniently traced to the
particular cost object under consideration. To be traced to a cost object,
such as a product, the cost must be caused by the cost object.

For example: If Reebook is assigning costs to its various regional and

national sales offices, then the salary of the sales manager in its Tokyo
office would be a direct cost of that office.

Indirect Costs: is a cost that cannot easily and conveniently traced to the
particular cost object under consideration.

For example: A soup factory produce many different types of soup. The
factory manger’s salary would be an indirect cost of a particular variety of
soup i.e. chicken noodle soup. This salary is more a consequences of
running the factory as such. So this cost is common to all products
produced.
 Please Note

A particular cost may be Direct or Indirect Costs depending on

the cost object.

For example, while the factory manager’s salary is indirect cost

of manufacturing chicken noodle soup, it is a direct cost of the
manufacturing division.

For example: If you have a team of staff doing quality checks of

all manufactured products , they are part of the staff function and
hence indirect to products manufactured. However, if you train
production staff to do quality checks as part of the work, it
becomes integral of their work and hence direct (labour) to
products manufactured.
Quiz (1) NB: Only ONE answer is correct

Fixed costs are usually characterized by:

a. Total costs that remain constant.

b. Total costs that increase as activity decreases.
c. Total costs that increase as activity increases.
d. Unit costs that remain constant.

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Quiz (2) NB: Only ONE answer is correct

Variable costs are usually characterized by:

a. Unit costs that decrease as activity increases.

b. Total costs that increase as activity increases.
c. Total costs that increase as activity decreases.
d. Total costs that remain constant.

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Trend towards more fixed costs
 Increased automation
 Increase in salaried experts who
are difficult to replace.
 Business with a high proportion of
indirect and fixed costs may
require more skilful top
management
e.g. Port of Helsingborg
 Planning becomes key
 Understanding your business
source: http://www.port.helsingborg.se/english-summary
Mixed Costs (both variable and fixed costs)

Electricity and Phone costs

Y
Total Utility Cost

Variable
Utility Charge

Fixed Monthly
Utility Charge
X
Activity (Kilowatt Hours)

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Analysis of mixed costs: Some methods (1)
1. Inspection of Accounts
i. Classify each ‘cost object’ as ‘variable’ or ‘fixed’ cost.
ii. Aggregate the costs in each cost type.
iii. Divide the sum of costs of the ‘variable cost’ type by the
total activity. This gives an estimate of variable cost per unit

2. High-Low Method
i. Identify the highest and lowest levels of activity in a series
of activity level measures, and the total costs associated
with each.
ii. Divide the difference between the costs at each level by the
difference between the activity levels. This gives a simple
estimate of variable cost per unit of activity.
The High-Low Method: Example

WiseCo recorded the following production activity and

maintenance costs for two months
Units Cost (£)
High activity level 9,000 9,700
Low activity level 5,000 6,100
Change 4,000 3,600

Using these two levels of activity, compute:

 the variable cost per unit;
 the fixed cost; and then
 express the costs in equation form Y = a + bX.
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The High-Low Method-Example

Units Cost (£)

High activity level 9,000 9,700
Low activity level 5,000 6,100
Change 4,000 3,600

 Variable cost per unit = Change £ in cost

Change in units

£3,600 ÷ 4,000 units = £0.90 per unit

Hint: Remember that fixed costs does not vary with volume
The High-Low Method-Example
Units Cost (£)
High activity level 9,000 9,700
Low activity level 5,000 6,100
Change 4,000 3,600

 Variable cost per unit = £3,600 ÷ 4,000 units = £0.90 per

unit
 Fixed cost = Total cost – Total variable cost
(Take either the high OR the low activity total cost)
Fixed cost = £9,700 – (£0.90 per unit × 9,000 units)
Fixed cost = £9,700 – £8,100 = £1,600
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The High-Low Method-Example
Units Cost (£)
High activity level 9,000 9,700
Low activity level 5,000 6,100
Change 4,000 3,600
 Variable cost per unit = £3,600 ÷ 4,000 units = £0.90 per
unit
 Fixed cost = Total cost – Total variable cost
(Take either the high OR the low activity total cost)
Fixed cost = £9,700 – (£0.90 per unit × 9,000 units)
Fixed cost = £9,700 – £8,100 = £1,600
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = £1,600 + £0.90X 15
Analysis of Mixed costs: Further methods (2)
3. Scattergraph Method
i. All costs at different activity levels are plotted in a graph
(cost on the vertical axis and activity level on the
horizontal).
ii. A ‘line of best fit’ is drawn through the scatter of data points
(typically with 50% of points above and 50% below the line)
iii. This is a ‘visual inspection’ based ‘regression line’
indicating the average mix of fixed and variable costs
across activity levels.

4. Least-Square Regression Method

Uses equations to minimize the sum of ‘squared errors’ and so
give a more precise regression line, potentially indicating the
mix of fixed and variable costs more accurately.
 The Scattergraph Method
Change in cost
Slope =
Change in units
Y
20
1,000’s of pounds

* ** * Vertical
Total Cost in

* * distance
* * is the
10 * * change in
cost.
Horizontal distance is
the change in activity.
0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced
A useful management tool: ‘Contribution Margin’

Each unit sold has a ‘unit revenue’ (UR) and a ‘unit variable
cost’ (UVC)
Unit Contribution is (UR – UVC)
Each ‘unit contribution’ then contributes to.....
1. Total fixed costs
and then IF (and ONLY IF) total fixed costs are met....
2. PROFIT!
The typical ‘Contribution Margin’ Format
Total (£) Unit
Sales Revenue £100,000 £50
(-) Variable Cost 60,000 30
Contribution £40,000 £20
Margin
(-) Fixed Cost 30,000
Net Profit £10,000

This format enables top and department

managers to have a good initial sense of how well
the department has managed its variable costs
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A comparison

Needed for external More useful for

reporting managing
Contribution Margin Focus

Unit Contribution is (UR – UVC)

Each unit contribution contributes FIRST to Fixed Costs and
THEN to Profit
Contribution Margin enables

1. A department manager to focus on separate variable and

fixed cost patterns in her/his department, and to manage
exceptions
2. Top management to evaluate & reward each department
manager’s performance in managing cost categories
Summary:

• Variable and fixed cost is about analysing and predicting

cost behaviour (e.g. using High-Low method)

• Useful for decision making

• Fits with the Contribution

Format
Approach
 What to prepare for seminar 2 in week 4

Seminar 2 Week 4:
The End

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