Chapter 5

Cost Behavior:
Analysis and Use
Mar 3, 2004
 Cost Behavior

How a cost will react or change as the

level of business activity changes
Cost can be either variable, fixed or mixed
Understanding cost behavior allows
managers to predict what costs will be at
various business activity levels
This information is essential for managing
your business efficiently

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 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
cost increases
increasesto toaa
new
newhigher
higher cost
cost for
forthe
the
next
nexthigher
higher range
rangeofof
activity.
activity. i.e.,
i.e.,hiring
hiringanan
additional
additional supervisor
supervisoror or
maintenance
maintenance worker.
worker.

Cost
Activity

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 Relevant Range

A range of business activity within which

the assumptions made about cost
behavior are valid.
Variable costs on a per unit basis remain
the same within the relevant range, and in
total vary directly with the level of activity
Fixed costs in total remain fixed within the
relevant range, but will change on a per
unit basis as the level of activity changes

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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
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 Cost Behavior - Examples
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
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 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
Property
PropertyTaxes
Taxes
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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

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 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
Fixedcosts
costsper
perunit
unit vary
varywith
withthe
thelevel
levelof
ofactivity.
activity.
bb Variable costs per unit are constant within the
Variable costs per unit are constant within the
relevant
relevantrange.
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
relevantrange.
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)
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 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
 Separating Variable and Fixed Costs

There are a number of methods for

separating variable and fixed costs for a
mixed cost total
Scattergraph
High-Low Method
Least Squares Regression

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 The Scattergraph Method

Plot
Plot the
thedata
datapoints
pointsononaa
Y graph
graph(total
(totalcost
cost vs.
vs.activity).
activity).
20
1,000’s of Dollars

* ** *
Total Cost in

* *
**
10 * *

0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced

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

 Quick-and-Dirty Method
Draw
Drawaaline
linethrough
through the
thedata
datapoints
pointswith
with about
about an
an
equal
equal numbers
numbersof of points
pointsabove
aboveand
andbelow
belowthe
theline.
line.
Y
20
1,000’s of Dollars

* ** *
Total Cost in

* *
* **
10 * Intercept is the estimated
Intercept is the estimated
fixed
fixedcost
cost==$10,000
$10,000

0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced

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

 Quick-and-Dirty Method
The
Theslope
slopeis
isthe
theestimated
estimated variable
variablecost
costper
perunit.
unit.
Slope
Slope==Change
Changeinincost
cost÷÷ Change
Changeininunits
units
Y
20
1,000’s of Dollars

* ** *
Total Cost in

* *
* **
10 *Horizontal
Horizontal
distance Vertical
Verticaldistance
distanceisis
distanceis is the
the thechange
changeinincost.
cost.
thechange
changein in
activity.
activity.
0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced

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 Calculating the Total Cost

Y = a + bX
“a” is the intersection of the slope line and
the y axis (fixed cost)
To find “b”, find a data point on the slope
line, and determine the level of activity (x
axis) and total cost (y axis)
Solve for b using the above equation
See example on page 204-05
Disadvantages: Outliers, accuracy of line
drawn through the dots

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 The High-Low Method
(Use example on page 204)
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.

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 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

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 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
(or do the same calculation with the low activity level)

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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 Mixed Cost Equation

If variable cost per unit is $.10 and fixed

cost is $2,000 then what is the Total cost
equation?
Y = $2,000 + $.10(X)

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 Hi-Lo Disadvantages

Utilizes only two data points out of the

entire data base; not enough for accurate
results in cost analysis
Outliers could cause a major discrepancy
if they are selected as a high or low

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 Least-Squares Regression
Method
Software can be used to fit
a regression line through
the data points.
The cost analysis objective
is the same: Y = a + bx

Least-squares
Least-squaresregression
regressionalso
alsoprovides
providesaa statistic,
statistic,
2
called
called the
the RR2,,that
that is
isaameasure
measureof of the
thegoodness
goodness
of
of fit
fitof
ofthe
theregression
regression line
lineto
tothe
thedata
data points.
points.

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 Least-Squares Regression
Method
RR22 is
isthe
thepercentage
percentage of
ofthe
thevariation
variation in
in total
totalcost
cost
explained
explainedby
bythe
theactivity.
activity.
Y
20
* ** *
Total Cost

* * **
10 * * R2 for this relationship is near
100% since the data points are
very close to the regression line.
0 X
0 1 2 3 4
Activity
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 Total Cost Formula using Least
Squares Method
Use the data provided by the least squares
for points a and b
See example on page 210
Result of least squares method:
Y = $3,431 + $0.759(X)

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

 Least Squares Disadvantages

Outliers can also cause least squares to

come up with a wrong answer.
Always use least squares on conjunction
with scatter grade to identify, and
eliminate if necessary, outliers that may
erroneously impact the results.

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

 Comparison of Methods

Scatter Graph
Y = $3,300 + $0.79(X)
High Low
Y = $3,400 + $0.80(X)
Least Squares
Y = $3,431 + $0.759(X)

Which one would you choose? Why?

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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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 Contribution Margin Approach

Provides the internal manager with an

income statement geared directly to cost
behavior; can predict future results
Contribution margin is what is left after
you subtract variable costs from sales
This allows you to determine if you are
selling enough product to cover your fixed
costs and, therefore, earn a profit
Provides ability to analyze profitability by
product line, operation, etc.

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 The Contribution Format
(Requires Segregation of variable and fixed cost)
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. Not GAAP
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 End of Chapter 5

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