Chapter 3-Cost Behavior

Chapter 3
Cost Behavior
Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives (1 of 2)
1. Define and describe fixed, variable, and mixed costs
2. Explain the use of resources and activities and their relationship to cost
behavior
3. Explain how several methods of cost estimation can be used
4. Separate mixed costs into their fixed and variable components using the
high-low method, the scatterplot method, and the method of least squares
Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives (2 of 2)
5. Evaluate the reliability of the cost formula
6. Explain how multiple regression can be used to assess cost behavior
7. Define the learning curve, and discuss its impact on cost behavior
8. Discuss the use of managerial judgment in determining cost behavior
Cost Behavior
• Used to describe whether a cost changes when the level of output changes
• Fixed costs do not change as output changes
• Variable costs increase in total with an increase in output and decrease in
total with a decrease in output
Cost objects
• Item for which managers want cost information
• For manufacturing or merchandising firms, it is usually the tangible product
• For service firms, it is usually the service provided
Measures of output
• Activity drivers explain changes in activity costs by measuring changes in
activity output (usage)
o General categories
• Unit-level drivers
• Non-unit-level drivers
Fixed Costs (1 of 3)
• Costs that in total are constant within the relevant range as the level of the
associated driver varies
• JCM Audio Systems, Inc. produces speakers for home audio systems
o One department produces voice coils
o There are two production lines that can each make up to 100,000 voice coils per
year
o Production-line manager is paid $60,000 per year
o For production up to 100,000 units, only one manager is needed; above that (up
to 200,000 units), two managers are needed
JCM Audio Systems, Inc.
Supervision Voice Coils Unit Cost

Cost Produced
$ 60,000 40,000 $1.50
60,000 80,000 0.75
60,000 100,000 0.60
120,000 120,000 1.00
120,000 160,000 0.75
120,000 200,000 0.60
The total cost of supervision remains the same within the relevant range, but
the unit cost decreases as production increases
EXHIBIT 3.1 – Fixed Cost Behavior
Variable costs (1 of 2)
• Costs that, in total, vary in direct proportion to changes in an activity driver
• Total cost of direct materials for each level of production varies, but the unit
cost stays the same
Variable costs (2 of 2)
JCM Audio Systems, Inc.
Total Direct Materials Voice Coils Produced Unit Direct Materials

Cost of Voice Coils Cost of Voice Coils
$120,000 40,000 $3
240,000 80,000 3
360,000 120,000 3
480,000 160,000 3
600,000 200,000 3
Total cost of Direct Materials increases or decreases within the relevant range,
but the unit cost stays the same
JCM Audio System
Production Total Fixed Fixed Cost Total Variable Total Cost Total cost
cost per unit Variable cost per per unit
Cost unit
40,000 P 60,000 P 1.5 P120,000 P 3 P 180,000 P 4.5
80,000 60,000 0.75 240,000 3 300,000 3.75
100,000 60,000 0.60 300,000 3 360,000 3.60
120,000 120,000 1.0 360,000 3 480,000 4.0
160,000 120,000 0.75 480,000 3 600,000 3.75
200,000 120,000 0.60 600,000 3 720,000 3.60
EXHIBIT 3.2 - Variable Cost Behavior
EXHIBIT 3.3 - Nonlinearity of variable costs
EXHIBIT 3.4 - Relevant range for variable costs
Mixed Costs
• Costs that have both a fixed and a variable component
• Example - JCM’s sales costs are mixed
o There are 10 sales representatives, each earning $30,000 plus receive a
commission of $5 per speaker sold that can be represented by the following
equation:
EXHIBIT 3.5 - Mixed Cost Behavior
Resources, Activities, and Cost Behavior (1 of 2)
• Resources
o Economic elements that enable one to perform activities
o Activity capacity: Obtained when a firm acquires the resources needed to
perform an activity (defines relevant range)
o Practical capacity: Activity level where the activity is performed efficiently (level
of output)
o Unused capacity: Activity capacity that is not used completely
Resources, Activities, and Cost Behavior (2 of 2)
• Types of Resources
o Flexible resources (comprises the variable costs)
• Supplied as needed and used
• Quantity of resource supplied equals the quantity demanded
• No unused capacity
o Committed resources (comprises the fixed costs)
• Supplied in advance of usage
• A given quantity is obtained, whether or not that full amount is used
o Unused capacity is possible
Step-Cost Behavior (1 of 3)
• Step-cost function: Displays a constant level of cost for a range of output
and then jumps to a higher level of cost at some point (this is a fixed costs
behavior)
EXHIBIT 3.6 – Step-cost function (ex. Class size)
Step-Cost Behavior (2 of 3)
• Step-variable costs
o Follow a step-cost behavior with narrow steps
• Step-fixed costs
o Follow a step-cost behavior with wide steps
o Activity rate: Average unit cost
• Obtained by dividing the resource expenditure by the activity’s practical capacity
EXHIBIT 3.7 - Step-fixed costs
Activities and Mixed Cost Behavior
• Activities have characteristics of both flexible and committed resources
o Example
• A power department acquires long-term capacity for supplying power by investing in
a building and equipment - Resources acquired in advance
• It acquires fuel to produce power as needed - Resources acquired as needed
(Cost of Machine Hours)
Need for cost separation (for cost of machine
hours)
• Accounting records show only total cost and associated output of a mixed
cost item
o Total cost should be separated into fixed and variable components
Methods to separate fixed & variable costs from a
mixed costs:
• Industrial Engineering Method
• Account Analysis Method
• Quantitative Methods
o High-low method
o Scatterplot Method
o Method of Least Square (Regression Method)
Industrial Engineering Method
• Forward-looking method of determining what activities, in what amounts, are
needed to complete a process
o Through physical observation and analysis
• Engineering studies are very precise
• Used for manufacturing processes
• Advantage - Can be applied to new processes and designs
Industrial Engineering Method (example)
• Cara is the CFO of a large business that manufactures curtains. The inputs
for these curtains include wood, dye, thread, machine hours, and labor. The
output, of course, is the finished curtain. Her business uses the industrial
engineering method to help estimate costs. Why is this a good choice for
Cara’s organization? What information might it give her?
• Cara’s organization benefits from the use of this method because it is large
and there is a physical relationship between the inputs and the output. It
might allow her to discover how much of an input produces a certain amount
of output. She may discover, for example, that it takes two hours of
direct labor to produce twenty square feet of curtain.
Account Analysis Method
• Used to estimate costs by classifying accounts in the general ledger as:
o Fixed
o Variable
o Mixed
Quantitative methods for separating mixed costs into
fixed and variable components (1 of 2)
• Cost as an equation for a straight line Y = F + VX
o Where
• Y = Total cost (the dependent variable)
• F = Fixed cost component (the intercept parameter)
• V = Variable cost per unit (the slope parameter)
• X = Measure of output (the independent variable)
Quantitative methods for separating mixed costs into
fixed and variable components (2 of 2)
• Dependent variable: Variable whose value depends on the value of another
variable
• Independent variable: Variable that measures output and explains changes
in the cost
• Intercept parameter: Corresponds to fixed cost
• Slope parameter: Corresponds to the variable cost per unit of output
High-Low Method (1 of 2)
• Takes two points (the high and the low by volume of activity) and determines
the slope and the intercept
o Slope is variable rate
o Intercept is fixed cost
High-Low Method (2 of 2)
• Advantages
o Objective in nature
o Simple to calculate
• Disadvantages
o High and low points may be outliers that represent atypical cost-activity
relationships
o Other pairs of points may be more representative
High –Low Method
Month Materials Handling Cost Number of Moves

(Y) (X)
January $2,000 100
February 3,090 125
March 2,780 175
April 1,990 200
May 7,500 500
June 5,300 300
July 4,300 250
August 6,300 400
September 5,600 475
October 6,240 425
High-Low Method
Y = F + VX
F= Fixed Costs
V= Variable cost per unit
X= level of activity
High Low Method:
1) Solve for V (Choose high & low level of activity (X) as primary criteria)
Y X
High 7500 500
Low 2000 100
5500 400
V = 5,500 / 400 = 13.75
2) Solve for F, by using one pair (of activity & cost) of either the low or high level of activity and
substituting the values of X, Y & V in the equation Y = F + VX
Using Low level:
2,000 = F + 13.75(100)
2,000 = F + 1,375
F = 2,000-1,375 = 625
3) Predictive Formula: Y = 625 + 13.75X
4) Cost estimation / Cost perdiction

If number of moves is 600
Y = 625 + 13.75(600)
Y = 625 + 8,250
Y = 8,875
Scatterplot Method (1 of 3)
• Uses a scattergraph to visually assess the relationship between cost and
output
o Intercept is fixed cost
o Slope is variable rate
• Assesses the validity of the assumed linear relationship
• Advantages
o Allows for visual inspection of the data
o Identifies nonlinearity, outliers, and shifts in the cost relationship
• Disadvantages
o Lacks objective criterion for choosing the best-fitting line
o Subjective in nature
• Anderson Company had the following 10 months of data on materials
handling cost and number of moves:
Month Materials Handling Cost Number of Moves
January $2,000 100
February 3,090 125
March 2,780 175
April 1,990 200
May 7,500 500
June 5,300 300
July 4,300 250
August 6,300 400
September 5,600 475
October 6,240 425
EXHIBIT 3.8 A - Scattergraph for Anderson Company’s
Materials Handling Costs
EXHIBIT 3.8 B - Scattergraph for Anderson Company’s
EXHIBIT 3.8 C - Scattergraph for Anderson Company’s
EXHIBIT 3.9 A - Scattergraph for various cost behavior
patterns
EXHIBIT 3.9 B - Scattergraph for various cost
behavior patterns
EXHIBIT 3.9 C - Scattergraph for various cost
behavior patterns
Method of Least Squares
• Deviation: Difference between the predicted and actual costs
o Shown by the distance from the points marked in the scattergraph to the best-
fitting line
• Measure of closeness is the sum of the squared deviations of the points from
the line
o Smaller the measure, the better the line fits the points
EXHIBIT 3.10 - Deviations of Data from a Line
Using Regression Programs (1 of 2)
• Enter the data
• Choose “Data Analysis” option from the “Tools” menu
o If not available, choose "Add-ins" and select "Analysis ToolPak" to add the data
analysis tools
• Click on “Regression”
• Click on “Input Y Range” and highlight the dependent variables column
Using Regression Programs (2 of 2)
• Click on “Input X Range” and highlight the independent variables column
• Choose preferred location for output
• Click “OK”
Exhibit 3.11 - Spreadsheet Data for Anderson
Company’s Materials Handling Cost
EXHIBIT 3.12 - Regression Results for Anderson
Company’s Materials Handling Cost
Using Regression Programs
• Interpreting the results
o Under “Coefficients” in the bottom left of the output, find the intercept and the
slope
o Write the equation
• Y = $12.39X + $854.50
o Use the equation to make a point estimate
• At a point of 350 moves, total cost is predicted
o Y = $12.39(350) + $854.50
o Y = $5,191
Reliability of Cost Formulas
• Statistical assessments concerning the cost formula’s reliability
o Hypothesis test of cost parameters: Indicates whether the parameters are
different from zero
o Goodness of fit: Measures the degree of association between cost and activity
output
o Confidence intervals - Provide a range of values for the actual cost with a
prespecified degree of confidence
Hypothesis test of cost parameters
• t Stat tests the hypothesis that the parameters are different from zero
• P-value is the level of significance achieved
o P-value of 0.05 or less is needed for significance
Goodness of fit measures
• Coefficient of determination
o Percentage of variability in the dependent variable explained by an independent
variable
o always has a value between 0 and 1.00
o Adjusted R Square is used because value has been adjusted for the number
of variables included in the equation
Coefficient of correlation(R)
• Square root of the coefficient of determination when there is one independent
variable
• Ranges between −1 and +1
• Higher the magnitude, the greater the correlation
• Value close to zero indicates no correlation
EXHIBIT 3.13 - Correlation Illustrated
Standard Errors
• Tell how tightly the data points cluster around the regression line
• Small standard error indicates that the regression line more closely
approximates the data
o Larger standard error indicates the opposite
Multiple Regression (1 of 4)
• Used whenever least squares is used to fit an equation involving two or more
independent variables
• Linear equation is expanded to include the additional variable when there are
two explanatory variables Y = F + V1X1 + V2X2
o Where
• X1 = Number of moves
• X2 = Number of pounds moved
• Adding another independent variable might increase the explanatory power
of our model
• Performing the regression is very similar to simple regression
o Input the data - Make sure the two independent variables are placed next to each
other
o Follow the same directions, but select both independent variable columns for the
“Input X Range”
Month Materials Number of Pounds Moved

Handling Cost Moves
January $2,000 100 6,000
February 3,090 125 15,000
March 2,780 175 7,800
April 1,990 200 600
May 7,500 500 29,000
June 5,300 300 23,000
July 4,300 250 17,000
August 6,300 400 25,000
September 5,600 475 12,000
October 6,240 425 22,400
EXHIBIT 3.14 - Multiple Regression Results for
Anderson Company’s Materials Handling Cost
• Interpreting the results
o Under “Coefficients” in the bottom left of the output find the intercept and the
slope
o Write the equation
• Y = $507.31 + $7.84X1 + $0.11X2
• Examine reliability of the new model
o Adjusted R Square is 99% - Significant improvement
Learning Curve and Nonlinear Cost Behavior (1 of 2)
• Learning curve: Shows how labor hours per unit decrease as units
produced increases
• Experience curve: Relates cost to increased efficiency, such that the more
often a task is performed, the lower the cost is of doing it
• Incremental unit-time learning curve model
o Decreases by a constant percentage each time the cumulative quantity of units
produced doubles
Learning Curve and Nonlinear Cost Behavior (2 of 2)
• Cumulative average-time learning curve model
o States that the cumulative average time per unit decreases by a constant
percentage, or learning rate, each time the cumulative quantity of units produced
doubles
• Learning rate: Gives the percentage of time needed to make the next unit, based on
the time it took to make the previous unit
o Expressed as a percent
EXHIBIT 3.15 - Spreadsheet for Cumulative Average-
Time Learning Model
EXHIBIT 3.16 - Graph of Cumulative Total Hours
Required and the Cumulative Average Time per Unit
Managerial Judgment
• Most widely used method in practice in determining cost behavior
• Managers may:
o Use their experiences and observations to determine fixed and variable costs
o Identify mixed costs and use experience to determine what part is fixed, thus
denoting the rest as variable
• Yields good results when the manager has a good understanding of the
processes

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Chapter 3

Supervision Voice Coils Unit Cost

Total Direct Materials Voice Coils Produced Unit Direct Materials

40,000 P 60,000 P 1.5 P120,000 P 3 P 180,000 P 4.5

80,000 60,000 0.75 240,000 3 300,000 3.75

100,000 60,000 0.60 300,000 3 360,000 3.60

120,000 120,000 1.0 360,000 3 480,000 4.0

160,000 120,000 0.75 480,000 3 600,000 3.75

200,000 120,000 0.60 600,000 3 720,000 3.60

(Cost of Machine Hours)

Month Materials Handling Cost Number of Moves

High Low Method:

V = 5,500 / 400 = 13.75

3) Predictive Formula: Y = 625 + 13.75X

4) Cost estimation / Cost perdiction

Month Materials Number of Pounds Moved

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