CHAPTER 3:

Cost Behaviour:
Analysis and Use

Prepared by
Shannon Butler,
CPA, CA
Carleton University
 Learning Objectives

1 Describe how fixed and variable costs behave

and how to use them to predict costs.
2 Analyze mixed costs using various approaches.
3 Prepare an income statement using the
contribution format.
4 (Online Appendix 3A) Analyze a mixed cost
using the least-squares regression method.

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Types of Cost Behaviour Patterns

Recall the summary of our cost behaviour

discussion from a chapter 2.

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 The Activity Base

Units
Units Machine
Machine
produced
produced hours
hours

AAmeasure
measure of of what
what
causes
causes the
the incurrence
incurrence
of
of aa variable
variable cost
cost

Miles
Miles Labour
Labour
driven
driven hours
hours
© 2021 McGraw-Hill Limited 3-4
 Variable Cost Example
• A variable cost is a cost whose total dollar amount
varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is based
on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
© 2021 McGraw-Hill Limited 3-5
 Variable Cost Per Unit Example
• A variable cost remains constant if expressed on a
per unit basis. The cost per minute talked is
constant. For example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
© 2021 McGraw-Hill Limited 3-6
 Extent of Variable Costs
• The proportion of variable costs differs across
organizations. For example:
• A public utility with large investments in equipment
will tend to have fewer variable costs.
• A service company will normally have a high
proportion of variable costs.
• A merchandising company usually will have a high
proportion of variable costs, like cost of sales.
• A manufacturing company will often have many
variable costs.

© 2021 McGraw-Hill Limited 3-7

 Examples of Variable Costs
Exhibit 3-2 Costs That Are
Normally Variable with
Type of Organization Respect to Volume of Output
Merchandising company Cost of goods (merchandise) sold
Manufacturing company Manufacturing costs:
Direct materials
Variable portion of manufacturing overhead:
Indirect materials, such as lubricants or supplies

Both merchandising and
manufacturing companies
Service organizations
Power
Selling, general, and administrative costs:
Sales commissions
Clerical costs, such as billing
Shipping costs
Supplies, travel, clerical, sales commissions

© 2021 McGraw-Hill Limited 3-8

 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
© 2021 McGraw-Hill Limited 3-9
 Step-Variable Costs 1
• 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 is known as a step-variable cost.
Cost

Volume
© 2021 McGraw-Hill Limited 3-10
 Step-Variable Costs 2
•• Small
Small changes
changes in
in the
the level
level of
of production
production are
are not
not
likely
likely to
to have
have any
any effect
effect on
on the
the number
number of
of
maintenance
maintenance workers
workers employed.
employed.
Cost

Volume
© 2021 McGraw-Hill Limited 3-11
 Step-Variable Costs 3

Only fairly wide

changes in the activity
level will cause a
Cost

change in the number of

maintenance workers
employed

Volume

© 2021 McGraw-Hill Limited 3-12

 The Linearity Assumption and the
Relevant Range
A
A straight
straight line
line
Economist’s
closely
closely
Curvilinear Cost
approximates
approximates aa
Function
curvilinear
curvilinear variable
variable
cost
cost line
line within
within the
the
Total Cost

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

Activity
© 2021 McGraw-Hill Limited 3-13
 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 probably fixed and does
not change when you make more local calls.
Monthly Basic
Telephone Bill

Number of Local Calls

© 2021 McGraw-Hill Limited 3-14
 Fixed Cost Per Unit Example
• Average fixed costs per unit decrease as the activity
level increases. The fixed cost per local call decreases as
more local calls are made.
Monthly Basic Telephone Bill
per Local Call

Number of Local Calls

© 2021 McGraw-Hill Limited 3-15
 Types of Fixed Costs
• Committed Fixed Costs  Long-term, cannot
be significantly reduced in the short term.
Examples are depreciation on equipment and

• Committed Fixed Costs  Long-term, cannot

real estate taxes.

• Discretionary Fixed Costs  May be altered

in the short-term by current managerial
decisions. Examples are advertising and
research and development.

be significantly reduced in the short term.

Examples are depreciation on equipment and
real estate taxes.

• Discretionary Fixed Costs  May be altered

in the short-term by current managerial
decisions. Examples are advertising and
research and development.

© 2021 McGraw-Hill Limited 3-16

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

© 2021 McGraw-Hill Limited 3-17

 Fixed Costs & Relevant Range 1

90
Rent Cost in Thousands of

Total
Total cost
cost doesn’t
doesn’t
Relevant change
change forfor aa wide
wide
60 range
range of of activity,
activity, and
and
Dollars

Range then
then jumps
jumps toto aa new
new
higher
higher cost
cost for
for the
the
next
next higher
higher range
range ofof
30 activity.
activity.

0
0 1,000 2,000 3,000
Rented Area (Square Feet)

© 2021 McGraw-Hill Limited 3-18

 Fixed Costs & Relevant Range 2
• 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.
• How does this type of fixed cost differ from a step-
variable cost  Step-variable costs can be adjusted
more quickly and the width of the activity steps is
much wider for the fixed cost.
© 2021 McGraw-Hill Limited 3-19
 Quick Check 
Which of the following statements about cost
behaviour are true?

1. Fixed costs per unit vary with the level of activity.

2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the relevant
range.
4. Total variable costs are constant within the relevant
range.

© 2021 McGraw-Hill Limited 3-20

 Quick Check 
Which of the following statements about cost
behaviour are true?

1. Fixed costs per unit vary with the level of activity.

2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the relevant
range.

© 2021 McGraw-Hill Limited 3-21

 Mixed Costs Part 1

A mixed cost has both fixed and variable

components. Consider the example of utility cost.

Y
Total Utility Cost

os t
d c
ixe
al m
Tot
Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
© 2021 McGraw-Hill Limited 3-22
 Mixed Costs Part 2
The total mixed cost line can be expressed
as an equation: Y = a + bX

Where: Y = the total mixed cost

a = the total fixed cost (the
vertical intercept of the line)
b = the variable cost per unit of
Y activity (the slope of the line)
X = the level of activity
Total Utility Cost

os t
d c
ixe
al m
Tot
Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
© 2021 McGraw-Hill Limited 3-23
 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, what is
the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
© 2021 McGraw-Hill Limited 3-24
 Analyzing Mixed Costs Part 1
• The fixed portion of a mixed cost represents the basic
minimum cost of having an activity ready and available
for use.
• The variable portion represents the cost incurred for
actual consumption of the activity.
• Common methods used for estimating the fixed and
variable components of a mixed cost are:
• Account analysis
• Engineering approach
• High-low method
• Regression analysis

© 2021 McGraw-Hill Limited 3-25

 Analyzing Mixed Costs Part 2
• 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, labour and overhead requirements.

© 2021 McGraw-Hill Limited 3-26

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

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

© 2021 McGraw-Hill Limited 3-27

 Scattergraph Plots Part 2
Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about anan
equal
equal numbers
numbers of of points
points above
above and
and below
below the
the line.
line.
Y
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

© 2021 McGraw-Hill Limited 3-28

 Scattergraph Plots Part 3
Use
Use one
one data
data point
point to
to estimate
estimate thethe total
total level
level of
of activity
activity
and
and thethe total
total cost.
cost.
Y Total maintenance cost = $11,000
20
* ** *
Maintenance Cost
1,000’s of Dollars

* *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800
© 2021 McGraw-Hill Limited 3-29
 Scattergraph Plots Part 4
Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per unit
unit and
and
determine
determine the
the cost
cost equation.
equation.

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

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

© 2021 McGraw-Hill Limited 3-30

 The High-Low Method Part 1
• The high-low method is based on the rise-over-run
formula for the slope of a straight line.
• If the relationship between cost and activity can be
represented by a straight line, then the slope of the
straight line is equal to the variable cost per unit of
activity.
• To analyze the mixed cost, you need to identify the
period with the lower level of activity and the period
with the highest level of activity.
• Variable Cost = Change in cost / Change in activity

© 2021 McGraw-Hill Limited 3-31

 The High-Low Method Part 2
• Assume the following hours of maintenance work and
the total maintenance costs for six months.

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The High-Low Method Part 3

The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in
hours.

$2,400
= $8.00/hour
300

© 2021 McGraw-Hill Limited 3-33

 The High-Low Method Part 4

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
© 2021 McGraw-Hill Limited 3-34
The High-Low Method Part 5

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
© 2021 McGraw-Hill Limited 3-35
 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

© 2021 McGraw-Hill Limited 3-36

 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?

Answer: Units Cost

b. $0.10 per unit High level 120,000 $ 14,000
Low level 80,000 10,000
Change 40,000 $ 4,000

$4,000 ÷ 40,000 units

= $0.10 per unit
© 2021 McGraw-Hill Limited 3-37
 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

© 2021 McGraw-Hill Limited 3-38

 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?

Answer:
a. $ 2,000

© 2021 McGraw-Hill Limited 3-39

 Least-Squares Regression Method

•• The
The two
two methods
methods just
just discussed
discussed provide
provide slightly
slightly
different
different estimates
estimates of
of the
the fixed
fixed and
and variable
variable cost
cost
components
components of of the
the mixed
mixed cost.
cost.
•• This
This is
is to
to be
be expected
expected because
because each
each method
method uses
uses
differing
differing amounts
amounts of
of the
the data
data points
points to
to provide
provide
estimates.
estimates.
•• Least-squares
Least-squares regression
regression provides
provides the
the most
most accurate
accurate
estimate
estimate because
because itit uses
uses all
all the
the data
data points.
points. This
This
method
method isis discussed
discussed inin the
the appendix
appendix toto this
this chapter.
chapter.

© 2021 McGraw-Hill Limited 3-40

 The Contribution Format Part 1
• Why a New Income Statement Format?
• Traditional format income statement is
organized by function and fixed and variable
costs are not distinguished
• Separating costs into fixed and variable
elements is often crucial in making decisions
• Contribution format facilitates planning,
control, and decision making

© 2021 McGraw-Hill Limited 3-41

The Contribution Format Part 2

© 2021 McGraw-Hill Limited 3-42

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 the following in later chapters:
1.Cost-volume-profit analysis
2.Budgeting
3.Pricing
4.Use of scarce resources
5.Make or buy analysis

© 2021 McGraw-Hill Limited 3-43

 The Contribution Format

Used primarily for Used primarily by

external reporting. management.

© 2021 McGraw-Hill Limited 3-44

 End of Chapter Summary Part 1
• There are three major classifications of cost:
variable, fixed, and mixed.

• Mixed costs are a combination of variable and

fixed elements and can be expressed in equation
form as Y = a + bX, where Y is the cost, a is the
fixed cost element, b is the variable cost per unit
of activity, and X is the activity.

© 2021 McGraw-Hill Limited 3-45

 End of Chapter Summary Part 2
• The first step in analyzing a mixed cost is to prepare a
scattergraph. Costs are plotted on the vertical axis and
activity levels on the horizontal axis of the scattergraph.
• The high–low method estimates the variable and fixed
cost components by analyzing the change in cost between
the high and low levels of activity.
• The contribution format income statement classifies costs
by cost behaviour (i.e., variable versus fixed) rather than
by functional areas such as production, administration,
and sales.

© 2021 McGraw-Hill Limited 3-46

 Appendix 3A
Least Squares Regression
Calculations

© 2021 McGraw-Hill Limited 3-47

 Least-Squares Regression Method
Part 1
• 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 mixed cost.
• The goal of this method is to fit a straight line to the
data that minimizes the sum of the squared errors.

© 2021 McGraw-Hill Limited 3-48

 Least-Squares Regression
Method Part 2
• Software can be used to fit a regression line
through the data points.
• The cost analysis objective is the same:
• Y = a + bX
• Provides a statistic called the R2, which is a
measure of the goodness of fit of the regression
line to the data points.

© 2021 McGraw-Hill Limited 3-49

 Least-Squares Regression
Method Part 3
2
R
R2 is
is the
the percentage
percentage of
of the
the variation
variation in
in total
total cost
cost explained
explained
by
by the
the activity.
activity.
Y
20
* ** *
Total Cost

* * **
10 * * 2
R varies from 0% to 100%, and
the higher the percentage the better.
0 X
0 1 2 3 4
Activity
© 2021 McGraw-Hill Limited 3-50
 Least-Squares Regression
Method Part 4
• Economic plausibility:
•Does it make sense that a change in the activity level
of the independent variable would cause a change in
the dependent variable ?
• Multiple regression:
•An analytical method used when the dependent
variable (e.g. cost) is caused by more than one activity.

© 2021 McGraw-Hill Limited 3-51