Chapter 5

Cost Behavior:
Analysis and Use
 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.

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 The Activity Base

Units
Units Machine
Machine
produced
produced hours
hours
A
A measure
measure ofof the
the
event
event that
that causes
causes
the
the incurrence
incurrence ofof aa
variable
variable cost
cost –– aa
cost
cost driver
driver
Miles
Miles Labor
Labor
driven
driven hours
hours
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 True Variable Cost Example

Your total long distance telephone bill is

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

Minutes Talked
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 Variable Cost Per Unit Example

The cost per minute talked is constant. For

example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
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 Step-Variable Costs

Total
Totalcost
cost remains
remains
constant
constantwithin
withinaa
narrow
narrow range
rangeofof
activity.
activity.

Cost
Activity

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 Step-Variable Costs

Total
Total cost
costincreases
increasestoto aa
new
new higher
highercost
costfor
forthe
the
next
next higher
higherrange
rangeofof
activity.
activity.

Cost
Activity

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 Exh.

The Linearity Assumption and 5-4

the Relevant Range

Economist’s AAstraight
straight line
line
closely
closely
Curvilinear Cost approximates
approximatesaa
Function curvilinear
curvilinear
variable
variablecost
cost
Relevant line
linewithin
withinthe
the
Total Cost

relevant
relevant range.
range.
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
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 Exh.
5-5

Total Fixed Cost Example

Your monthly basic telephone bill is

probably fixed and does not change when
you make more local calls.
Telephone Bill
Monthly Basic

Number of Local Calls

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 Exh.
5-5

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
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 Cost Behavior
Examples
Examples of
of normally
normally variable
variable costs
costs
Merchandisers
Merchandisers Service
ServiceOrganizations
Organizations
Cost
Costof
ofGoods
GoodsSold
Sold Supplies
Suppliesand
andtravel
travel

Manufacturers
Manufacturers Merchandisers
Merchandisersand
and
Direct Manufacturers
Manufacturers
DirectMaterial,
Material,Direct
Direct
Labor,
Labor,and
andVariable
Variable Sales
Salescommissions
commissionsand
and
Manufacturing
ManufacturingOverhead
Overhead shipping
shippingcosts
costs

Examples
Examples of
of normally
normally fixed
fixed costs
costs
Merchandisers,
Merchandisers, manufacturers,
manufacturers, and
and
service
serviceorganizations
organizations
Real
Realestate
estatetaxes,
taxes,Insurance,
Insurance,Sales
Salessalaries
salaries
Depreciation,
Depreciation,Advertising
Advertising
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 Types of Fixed Costs

Committed
Committed Discretionary
Discretionary
Long-term,
Long-term, cannot
cannot be
be May
May be
bealtered
altered in
in the
the
reduced
reducedinin the
theshort
short short-term
short-term byby current
current
term.
term. managerial
managerialdecisions
decisions

Examples
Examples Examples
Examples
Depreciation
Depreciation on
on Advertising
Advertising and
and
Buildings
Buildingsand
and Research
Research and
and
Equipment
Equipment Development
Development
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 Fixed Costs and Relevant
Range

Example: Office space

is available at a rental
rate of $30,000 per year
in increments of 1,000
square feet. As the
business grows more
space is rented,
increasing the total
cost. Continue

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 Exh.

Fixed Costs and Relevant 5-6

Range

90
Thousands of Dollars

Total
Totalcost
costdoesn’t
doesn’t
Rent Cost in

Relevant change
changeforforaawide
wide
60 range
rangeofofactivity,
activity,
Range and
andthen
thenjumps
jumpsto toaa
new
newhigher
highercost
costfor
for
the
thenext
nexthigher
higher
30 range
rangeofofactivity.
activity.

0
0 1,000 2,000 3,000
Rented Area (Square Feet)
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 Fixed Costs and Relevant
Range

Step-variable costs
can be adjusted more
How does this type quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is much
cost? wider for the fixed
cost.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 Quick Check 

Which
Which of
of the
the following
following statements
statements about
about
cost
cost behavior
behavior are
are true?
true?
aa Fixed
Fixed costs
costsper
perunit
unit vary
varywith
withthe
the level
levelof
of activity.
activity.
bb Variable costs per unit are constant within the
Variable costs per unit are constant within the
relevant
relevant range.
range.
cc Total fixed costs are constant within the relevant
Total fixed costs are constant within the relevant
range.
range.
dd Total variable costs are constant within the
Total variable costs are constant within the
relevant
relevant range.
range.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 Mixed Costs

AAmixed
mixedcost
costhas
hasboth
bothfixed
fixedand
andvariable
variable
components.
components. Consider
Considerthe
theexample
exampleof
ofutility
utilitycost.
cost.

Y
Total Utility Cost

s t
co
d
i xe
l m
ta
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt
Utility Charge
Hours)
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 Mixed Costs

Y bX
Total Utility Cost

a +
Y =
ost
d c
i xe
l m
ta
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt
Utility Charge
Hours)
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 The Analysis of Mixed Costs

Account Analysis

Engineering Approach

Scattergraph Plot

High-Low Method

Least-Square Regression Method

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 Account Analysis &
Engineering Estimates

Each
Eachaccount
accountisisclassified
classifiedas
aseither
either
variable
variableor
orfixed
fixedbased
basedononthe
theanalyst’s
analyst’s
knowledge
knowledgeof ofhow
how the
theaccount
accountbehaves.
behaves.

Cost
Costestimates
estimatesarearebased
basedon
onan
an
evaluation
evaluationofofproduction
productionmethods,
methods,
and
and material,
material, labor
labor and
andoverhead
overhead
requirements.
requirements.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 The High-Low Method
WiseCo recorded the following production activity and
maintenance costs for two months:

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.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 The High-Low Method

 Variable cost per unit = Change Changein cost in units

in cost ÷ change
Change in units

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 The High-Low Method

 Variable cost per unit = $2,400 ÷ 3,000 units

= $0.80 per unit

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 The High-Low Method

 Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)
Fixed cost = $9,800 – $6,400 = $3,400

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 The High-Low Method

 Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)
Fixed cost = $9,800 – $6,400 = $3,400
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = $3,400 + $0.80X

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 Quick Check 

Sales
Salessalaries
salariesand
andcommissions
commissions areare$10,000
$10,000when
when
80,000
80,000units
unitsare
aresold,
sold, and
and$14,000
$14,000when
when120,000
120,000units
units
are
aresold.
sold. Using
Using the
thehigh-low
high-lowmethod,
method, what
whatisisthe
the
variable
variableportion
portionof
of sales
salessalaries
salariesand
and commission?
commission?
a.
a. $0.08
$0.08per
perunit
unit
Units Cost
b. $0.10 per unit
b. $0.10 per unit High level 120,000 $ 14,000
c.
c. $0.12
$0.12per
perunit
unit Low level 80,000 10,000
d.
d. $0.125
$0.125per
per unit
unit Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 Quick Check 

Sales
Salessalaries
salariesand
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000units
unitsare
aresold,
sold,and
and$14,000
$14,000when
when120,000
120,000units
units
are
aresold.
sold. Using
Usingthethehigh-low
high-lowmethod,
method,what
whatis
isthe
the
fixed
fixed portion
portionofof sales
salessalaries
salariesand
andcommissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

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 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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 The Contribution Format

Used primarily for Used primarily by

external reporting. management.

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 End of Chapter 5

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