Chapter 5

Cost Behavior:
Analysis and Use

PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
5-2

Learning Objective 1

Understand how fixed and

variable costs behave and how
to use them to predict costs.
5-3

Types of Cost Behavior Patterns

Recall the summary of our cost
behavior discussion from Chapter 1.
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.
Total fixed cost remains the
same even when the activity
Fixed level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
5-4

The Activity Base

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost.

Miles Labor
driven hours
5-5

True Variable Cost Example

A variable cost is a cost whose total dollar
amount varies in direct proportion to
changes in the activity level.
Total Long Distance

Your total long

Telephone Bill

distance telephone bill

is based on how many
minutes you talk.

Minutes Talked
5-6

Types of Cost Behavior Patterns

Recall the summary of our cost
behavior discussion from Chapter 1.
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.
Total fixed cost remains the
same even when the activity
Fixed level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
5-7

Variable Cost Per Unit Example

A variable cost remains constant if
expressed on a per unit basis.

Telephone Charge
The per minute cost

Per Minute
of long distance calls
is constant, for
example, 10¢ per
minute.
Minutes Talked
5-8

Extent of Variable Costs

The proportion of variable costs differs across
organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
proportion of variable costs.
like cost of sales.
5-9

Examples of Variable Costs

1. Merchandising companies – cost of goods sold.
2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.
5-10

True Variable Cost

Direct materials is a true or proportionately
variable cost because the amount used during
a period will vary in direct proportion to the
level of production activity.
Cost

Volume
5-11

Step-Variable Costs
A resource that is obtainable only in large chunks
(such as maintenance workers) and whose costs
increase or decrease only in response to fairly
wide changes in activity.
Cost

Volume
5-12

Step-Variable Costs
Small changes in the level of production are not
likely to have any effect on the number of
maintenance workers employed.
Cost

Volume
5-13

Step-Variable Costs
Only fairly wide changes in the activity
level will cause a change in the number
of maintenance workers employed.
Cost

Volume
5-14

The Linearity Assumption and the

Relevant Range
Economist’s A straight line
closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
Relevant line within the
Total Cost

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

Activity
5-15

Types of Cost Behavior Patterns

Let’s turn our attention to fixed cost behavior.

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.
Total fixed cost remains the
same even when the activity
Fixed level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
5-16

Total Fixed Cost Example

A fixed cost is a cost whose total dollar amount
remains constant as the activity level changes.

Your monthly basic

telephone bill is
Telephone Bill
Monthly Basic

probably fixed and does

not change when you
make more local calls.

Number of Local Calls

5-17

Types of Cost Behavior Patterns

Recall the summary of our cost
behavior discussion from Chapter 1.
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.
Total fixed cost remains the
same even when the activity
Fixed level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
5-18

Fixed Cost Per Unit Example

Average fixed costs per unit decrease
as the activity level increases.

Monthly Basic Telephone

The fixed cost per

Bill per Local Call

local call decreases
as more local calls
are made.

Number of Local Calls

5-19

Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced short-term by current
in the short-term. managerial decisions

Examples Examples
Depreciation on Advertising and
Buildings and Research and
Equipment and Development
Real Estate Taxes
5-20

The Trend Toward Fixed Costs

The trend in many industries is toward
greater fixed costs relative to variable costs.
As machines take over Knowledge workers
many mundane tasks tend to be salaried,
previously performed highly-trained, and
by humans, difficult to replace. The
“knowledge workers” cost to compensate
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.
5-21

Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can
differ across countries, depending on labor
regulations, labor contracts, and custom.
In France, Germany, China, and Japan,
management has little flexibility in adjusting
the size of the labor force.
Labor costs are more fixed in nature.

Most companies in the United States continue

to view direct labor as a variable cost.
5-22

Fixed Costs and Relevant Range

90
Thousands of Dollars

Total cost doesn’t

Rent Cost in

Relevant change for a wide

60 range of activity,
Range
and then jumps to a
new higher cost for
30 the next higher
range of activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
5-23

Fixed Costs and Relevant Range

The relevant range of activity for a fixed cost is
the range of activity over which the graph of
the cost is flat.
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.
5-24

Fixed Costs and Relevant Range

Step-variable costs
can be adjusted
How does this type more quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is
cost? much wider for the
fixed cost.
5-25

Quick Check 
Which of the following statements about cost
behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
5-26

Quick Check 
Which of the following statements about cost
behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
5-27

Mixed Costs
A mixed cost has both fixed and variable
components. Consider your utility costs.
Y
Total Utility Cost

ost
d c
i xe
l m
ta
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
5-28

Mixed Costs

Y
Total Utility Cost

ost
d c
i xe
l m
ta
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
5-29

Mixed Costs Example

If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, the
amount of your utility bill is:

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
5-30

Analysis of Mixed Costs

Account analysis
Each account is classified as either
variable or fixed based on the analyst’s
knowledge of how the account behaves.

Engineering Approach
Cost estimates are based on an
evaluation of production methods,
and material, labor and overhead
requirements.
5-31

Learning Objective 2

Use a scattergraph plot

to diagnose cost behavior.
5-32

The Scattergraph Method

Plot the data points on a graph
Y (total cost vs. activity).
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
5-33

The Scattergraph Method

Draw a line
through the
Y
data points
20
* ** *
Maintenance Cost
1,000’s of Dollars

with about
* * an equal
** number of
10 * * points above
and below
the line.
0 X
0 1 2 3 4
Patient-days in 1,000’s
5-34

The Scattergraph Method

Use one
Y Total maintenance cost = $11,000 data point
20 to estimate
* ** *
Maintenance Cost
1,000’s of Dollars

the total
* *
** level of
10 * * activity
Intercept = Fixed cost: $10,000 and the
0 X
total cost.
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800
5-35

The Scattergraph Method

Make a quick estimate of variable cost per
unit and determine the cost equation.
Total maintenance at 800 patients $ 11,000
Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25 per patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

5-36

Learning Objective 3

Analyze a mixed cost

using the high-low method.
5-37

The High-Low Method

Assume the following hours of maintenance work
and the total maintenance costs for six months.
5-38

The High-Low Method

The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
Hours Total Cost
High 800 $ 9,800
Low 500 7,400
Change 300 $ 2,400

$2,400
= $8.00/hour
300 hours
5-39

The High-Low Method

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
5-40

The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
5-41

Quick Check 
Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, what is the variable portion of sales
salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
5-42

Quick Check 
Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, what is the variable portion of sales
salaries and commission?
a. $0.08 per unit
Units Cost
b. $0.10 per unit High level 120,000 $ 14,000
c. $0.12 per unit Low level 80,000 10,000

d. $0.125 per unit Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit
5-43

Quick Check 
Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, what is the fixed portion of sales
salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
5-44

Quick Check 
Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, what is the fixed portion of sales
salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
5-45

Least-Squares Regression Method

A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.

This method uses all of the

data points to estimate
the fixed and variable
cost components of a The goal of this method is
mixed cost. to fit a straight line to the
data that minimizes the
sum of the squared errors.
5-46

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
The output from the regression analysis can be
used to create an equation that enables you to
estimate total costs at any activity level.
5-47

Comparing Results From the Three

Methods
The three methods just discussed provide
slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses different amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all of the
data points.
5-48

Learning Objective 4

Prepare an income statement

using the contribution format.
5-49

The Contribution Format Income

Statement
Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
5-50

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, by separating costs into fixed
and variable categories. Contribution margin
covers fixed costs and provides for income.
5-51

Uses of the Contribution Format

The contribution income statement format is used
as an internal planning and decision making tool.
We will use this approach for:
1. Cost-volume-profit analysis (chapter 6).
2. Budgeting (chapter 7).
3. Special decisions such as pricing and make-or-
buy analysis (chapter 11).
5-52

The Contribution Format

Used primarily for Used primarily by

external reporting. management.