Cost Accounting

Chapter 3
Cost Behavior Analysis
Learning Objectives
1. Classify an expenditure as fixed, variable, or semivariable.
2. List reasons for separating fixed and variable costs.
3. Compute the fixed and variable components of costs by
three methods.
4. Define, compute, and explain the use of the coefficient
of determination.
5. Define, compute, and explain the use of the standard
error of the estimate.
6. Compute an estimate of cost using the equation
developed by the method of least squares and then compute a
confidence interval for that estimate.

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3-1 Classifying Cost
• Fixed Cost
– A fixed cost is defined as one that does not change in total as
business activity increases or decreases.
– For this reason, a particular kind of expenditure should be
classified as a fixed cost only within a limited range of
activity. This limited range of activity is referred to as the
relevant range.

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FIGURE 3-1 Fixed Cost

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3-1 Classifying Cost
• Some expenditures are fixed as a result of management
policy. For example, the level of advertising
expenditure and the amount of charitable contribution
are determined by management and are not directly
related to sales or production activity. Such
expenditures are sometimes referred to as
discretionary fixed costs or programmed fixed costs.
Expenditures that require a series of payments over a
long-term period of time are often called committed
fixed costs. Examples include interest on long-term
debt and long-term lease rentals.

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3-1 Classifying Cost
• Variable Cost
– A variable cost is defined as one that increases in total
proportionately with an increase in activity and decreases
proportionately with a decrease in activity.
– In practice, the relationship between a business activity and
the related variable cost usually is treated as if it were linear;
that is, total variable cost is assumed to increase by a constant
amount for each unit increase in activity.

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FIGURE 3-2 Variable Cost

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3-1 Classifying Cost
• Semivariable Cost
– A semivariable cost is defined as one that displays both
fixed and variable characteristics.
– Two reasons for the semivariable characteristic types of
expenditures are:
1. A minimum of organization may be needed, or a minimum quantity
of supplies or services may need to be consumed, to maintain
readiness to operate. Beyond this minimum level of cost, which is
essentially fixed, additional cost varies with volume.
2. Accounting classifications, based on the object of expenditure or
function, commonly group fixed and variable items together.

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FIGURE 3-3 Semivariable Cost

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3-2 Separating Fixed and Variable Costs
• As discussed in later chapters, the separation of fixed
and variable costs is necessary for the following
purposes:
1. Predetermined factory overhead rate computation and
variance analysis.
2. Flexible budget preparation and variance analysis.
3. Direct costing and contribution margin analysis.
4. Break-even and cost-volume-profit analysis.
5. Differential and comparative cost analysis.

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3-2 Separating Fixed and Variable Costs
• As discussed in later chapters, the separation of fixed
and variable costs is necessary for the following
purposes:
6. Short-run profit maximization and cost minimization
analysis.
7. Capital budgeting analysis.
8. Marketing profitability analysis by territories, products, and
customers.

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3-2 Separating Fixed and Variable Costs
• Generally, more reliable classifications and cost
estimates are obtained by using one of the following
computational methods, all of which are illustrated in
this section: (1) the high and low points method, (2) the
scattergraph method, or (3) the method of least squares.

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3-2 Separating Fixed and Variable Costs
• Fixed and variable cost estimates based on historical
data should be adjusted to reflect changes that are
expected to occur during the forecast period.
Technological improvements in production techniques
or facilities can affect the behavior of costs.
• For example, if management acquires (or plans to
acquire) new machinery that is expected to operate
more efficiently than machinery used during the sample
period, cost-behavior estimates based on historical data
should be adjusted to reflect the expected improvement
in efficiency.
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3-2 Separating Fixed and Variable Costs
• Product design changes, as well as changes in production
technology, may affect cost behavior.
• If the historical data base includes observations from
several different years, the analyst should consider the
potential distorting effects of inflation.
• If the rate of inflation was substantial during one or more
of the periods in the sample, fixed and variable cost
estimates are likely to be unreliable.
• To compensate for this problem, first restate the cost for
each period in the sample to current dollars, and then
perform the analysis on the inflation-adjusted costs.
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EXHIBIT 3-1

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3-2 Separating Fixed and Variable Costs
• High and Low Points Method
– In the high and low points method, the fixed and variable
elements of a cost are computed from two data points.

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3-2 Separating Fixed and Variable Costs
• Scattergraph Method
– The scattergraph method can be used to analyze cost
behavior. In this method, the cost being analyzed is called the
dependent variable and is plotted on a vertical line called the
y-axis. The associated activity is called the independent
variable—for example, direct labor dollars, direct labor
hours, machine hours, units of output, or percentage of
capacity—and is plotted along a horizontal line called the x-
axis.

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3-2 Separating Fixed and Variable Costs

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FIGURE 3-4 Scattergraph Representing the
Fixed and Variable Elements for Electricity Costs

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3-2 Separating Fixed and Variable Costs
• Method of Least Squares
– The method of least squares, sometimes called regression
analysis, determines mathematically a line of best fit, or
linear regression line, through a set of points.

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EXHIBIT 3-2

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 3-2 Separating Fixed and Variable Costs
• The variable rate for electricity cost, b, is computed as
follows:
( xi  x )( yi  y ) Column 6 total $2, 270, 000
b    $.0044 per direct labor hour
( xi  x ) 2
Column 5 total 512, 000, 000

• The fixed cost, a, can be computed using the formula

for a straight line as follows:

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3-2 Separating Fixed and Variable Costs
• Method of Least Squares for Multiple Independent
Variables
– Multiple Regression Analysis is a further application and
expansion of the method of least squares, permitting
consideration of more than one independent variable.

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