Cornerstones: of Managerial Accounting, 5e

CORNERSTONES
of Managerial Accounting, 5e
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CHAPTER 3:
COST BEHAVIOR
Cornerstones of Managerial
Accounting, 5e
Basics of Cost Behavior
 Cost behavior is the foundation upon which
managerial accounting is built.
 Describes whether a cost changes when the level
of output changes.
 Costs can be variable, fixed, or mixed.
 A cost that does not change in total as output
changes is a fixed cost.
LO-1
Basics of Cost Behavior (cont.)
 A variable cost increases in total with an
increase in output and decreases in total with a
decrease in output.
 Knowing how costs change as output changes is
essential to planning, controlling, and decision
making.
LO-1
Measures of Output and the
Relevant Range
 Fixed and variable costs have meaning only
when related to an output measure.
 A cost driver measures the output of the activity
that leads (or causes) costs to change.
 Identifying and managing drivers helps managers
predict and control costs.
 For example, weather is a significant driver in the
airline industry.
LO-1
Relevant Range and Cost
Relationships
 Relevant range is the range of output over which
the assumed cost relationship is valid for the
normal operations of a firm.
 Limits the cost relationship to the range of
operations that the firm normally expects to occur.
 The following graph shows the relevant range
which allows managers to assume a linear cost
relationship.
LO-1
Relevant Range and Cost
Relationships
LO-1
Fixed Costs
 The number of computers produced is called the
output measure, or driver.
 Even though fixed costs may change, this does
not make them variable.
 They are fixed at a new higher (or lower) rate.
 A graph of Colley’s fixed supervision costs is
shown below:
LO-1
Fixed Costs (cont.)
LO-1
Discretionary Fixed Costs and
Committed Fixed Costs
 Two types of fixed costs: discretionary fixed costs
and committed fixed costs.
 Discretionary fixed costs are fixed costs that
can be changed or avoided easily at
management discretion.
 Committed fixed costs, on the other hand, are
fixed costs that cannot be easily changed.
LO-1
Discretionary Fixed Costs and
Committed Fixed Costs (cont.)
 Advertising is a discretionary fixed cost,
because it depends on a management decision.
 Lease cost is a committed fixed cost because it
involves a long-term contract.
LO-1
Variable Costs
 Variable costs are costs that vary in direct
proportion to changes in output within the
relevant range.
 Variable costs can also be represented by a
linear equation.
 Total variable costs depend on the level of output.
 This relationship can be described by the
following equation or graphs:
LO-1
Variable Costs (cont.)
Total variable costs = Variable rate x Amount of

output
LO-1
The Reasonableness of Straight-Line
Cost Relationships
 Caution when applying cost behavior
assumptions to output levels that fall outside of
the company’s relevant range of operations.
 Straight-line cost relationships that are assumed
within the relevant range may actually be semi-
variable costs.
LO-1
Cost Relationships (cont.)
 Example: At extremely low levels of output,
workers often use more materials per unit or
require more time per unit than they do at higher
levels of output.
 As the level of output increases, workers learn
how to use materials and time more efficiently so
that the variable cost per unit decreases as more
and more output is produced.
LO-1
Cost Relationships (cont.)
LO-1
Mixed Costs
 Mixed costs are costs that have both a fixed and
a variable component.
 Example: Overhead for a company may consist
of a fixed supervisor salary plus the cost of
supplies that vary with the quantity of output
produced.
 The formula and graph depiction for a mixed cost
is as follows:
LO-2
Mixed Costs (cont.)
Total cost = Total fixed cost + Total variable cost
Volume
LO-2
Step Costs: Narrow Steps
 Some cost functions may be discontinuous.
 Known as step costs (or semi-fixed).
 Displays a constant level of cost for a range of output
and then jumps to a higher level (or step) of cost at
some point, where it remains for a similar range of
output.
LO-2
Step Costs: Narrow Steps (cont.)
 If a step cost has narrow steps, it means that the
cost changes in response to small changes in
output and we can approximate it as a variable
cost (i.e., the red line).
LO-2
Step Costs: Narrow Steps (cont.)
LO-2
Step Costs: Wide Steps
 Step cost with wide steps are more characteristic
of fixed costs.
 Example: A company may have to lease
production machinery.
 If the machine can only produce 1,000 units and the
company grows, they will have to lease additional
machines for each 1,000 units of production needed
 Resulting in the wide steps shown in the following
graph.
LO-2
Step Costs: Wide Steps (cont.)
LO-2
Methods for Separating Mixed Costs
into Fixed and Variable Components
 Three methods of separating a mixed cost into its
fixed and variable components:
 the high-low method
 the scattergraph method
 the method of least squares
 Each method requires the simplifying assumption
of a linear cost relationship.
LO-3
into Fixed and Variable Components
 Expression of cost as an equation for a straight
line is:
Total cost = Fixed cost + (Variable rate x Output)
 The dependent variable is a variable whose
value depends on the value of another variable.
 In the previous equation, total cost is the
dependent variable; it is the cost we are trying to
predict.
LO-3
into Fixed & Variable Components
 The independent variable measures output and
explains changes in the cost or other dependent
variable.
 A good independent variable is one that causes or is
closely associated with the dependent variable.
 Many managers refer to an independent variable as a
cost driver.
 The intercept corresponds to fixed cost.
 The slope of the cost line corresponds to the
variable rate.
LO-3
Methods for Separating Fixed Costs
into Fixed &Variable Components
LO-3
APPENDIX 3A:
Using the Regression Programs
 Computing the regression formula manually is
tedious, even with only a few data points.
 As the number of data points increases, manual
computation becomes impractical.
 Fortunately, spreadsheet packages like Microsoft
Excel have regression routines that perform these
computations.
LO-4
APPENDIX 3A:
Using the Regression Programs
 Input the data and the spreadsheet regression
program supplies more than the estimates of the
coefficients.
 Also provides information that can be used to see
how reliable the cost equation is—a feature that
is not available for the scattergraph and high-low
methods.
LO-4

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CORNERSTONES

Total variable costs = Variable rate x Amount of

Total cost = Total fixed cost + Total variable cost

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