# Part Three. Cost Behavior Analysis

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1 Part Three Cost Behavior Analysis

2 Cost Behavior Cost behavior is the manner in which a cost changes as some related activity changes An understanding of cost behavior is necessary to plan and control costs A relevant range is the range over which we are interested in the cost s behavior

3 COST BEHAVIOR ANALYSIS Definition: The study of how specific costs respond to changes in the level of business activity Some costs change; others remain the same Helps management plan operations and make decisions Applies to all types of businesses and entities

4 COST BEHAVIOR ANALYSIS Continued Starting point is measuring key business activities Activity levels may be expressed in terms of Sales dollars (in a retail company) Miles driven (in a trucking company) Room occupancy (in a hotel) Dance classes taught (by a dance studio)

5 COST BEHAVIOR ANALYSIS Continued Many companies use more than one measurement base For an activity level to be useful: Changes in the level or volume of activity should be correlated with changes in cost

6 COST BEHAVIOR ANALYSIS Continued The activity level selected is called the activity (or volume) index Identifies the activity that causes changes in the behavior of costs Allows costs to be classified according to their response to changes in activity as: Variable Costs Fixed Costs Mixed Costs

7 COST BEHAVIOR ANALYSIS VARIABLE COSTS Costs that vary in total directly and proportionately with changes in the activity level If the activity level increases 10 percent, total variable costs increase 10 percent If the activity level decreases by 25 percent, total variable costs will decrease by 25 percent

8 COST BEHAVIOR ANALYSIS VARIABLE COSTS Continued Variable costs also remain constant per unit at every level of activity Examples of variable costs include Direct material and direct labor for a manufacturer Sales commissions for a merchandiser Gasoline in airlines and trucking companies

9 COST BEHAVIOR ANALYSIS VARIABLE COSTS Continued Example: Continued

10 Step Variable Costs Total cost remains constant within a narrow range of of activity. Cost Activity

11 Step Variable Costs Total cost increases to to a new higher cost for the next higher range of of activity. Cost Activity

12 COST BEHAVIOR ANALYSIS FIXED COSTS Costs that remain the same in total regardless of changes in the activity level. Per unit cost varies inversely with activity: Examples include As volume increases, unit cost decline, and vice versa Property taxes Insurance Rent Depreciation on buildings and equipment

13 COST BEHAVIOR ANALYSIS FIXED COSTS Continued Example: Continued

14 Types of Fixed Costs Committed Long term, cannot be be reduced in in the short term. Discretionary May be be altered in in the short term by by current managerial decisions Examples Depreciation on on Buildings and Equipment Examples Advertising and Research and Development

15 COST BEHAVIOR ANALYSIS RELEVANT RANGE Throughout the range of possible levels of activity, a straight line relationship usually does not exist for either variable costs or fixed costs The relationship between variable costs and changes in activity level is often curvilinear For fixed costs, the relationship is nonlinear some fixed costs will not change over the entire range of activities, others may

16 COST BEHAVIOR ANALYSIS RELEVANT RANGE Continued

17 COST BEHAVIOR ANALYSIS RELEVANT RANGE Continued Defined as the range of activity over which a company expects to operate during a year Within this range, a straight line relationship usually exists for both variable and fixed costs

18 COST BEHAVIOR ANALYSIS MIXED COSTS Costs that have both a variable cost element and a fixed cost element Sometimes called semivariable cost Change in total but not proportionately with changes in activity level

19 Mixed Costs Total Utility Cost Y A mixed cost has both fixed and variable components. Consider the example of of utility cost. Total mixed cost Activity (Kilowatt Hours) X Variable Cost per KW Fixed Monthly Utility Charge

20 Mixed Costs The The total total mixed mixed cost cost line line can can be be expressed expressed as as an an equation: equation: Y = a + bx bx Total Utility Cost Y Activity (Kilowatt Hours) Where: Where: Total mixed cost Y = a + bx X Y = the the total total mixed mixed cost cost a = the the total total fixed fixed cost cost (the (the vertical vertical intercept intercept of of the the line) line) b = the the variable variable cost cost per per unit unit of of activity activity (the (the slope slope of of the the line) line) X = the the level level of of activity activity Variable Cost per KW Fixed Monthly Utility Charge

21 The Analysis of Mixed Costs Mixed costs must be classified into their fixed and variable elements The methods to analysis of mixed costs includes:

22 The Analysis of Mixed Costs Account Analysis Engineering Approach Scattergraph Plot High Low Method Least Square Regression Method

23 Account Analysis & Engineering Estimates Each account is is classified as as either variable or or fixed based on on the analyst s knowledge of of how the account behaves. Cost estimates are based on on an an evaluation of of production methods, and material, labor and overhead requirements.

24 The Scattergraph Method Total Cost in 1,000 s of Dollars Y Plot the data points on on a graph (total cost vs. activity). 0 X Activity, 1,000 s of Units Produced

25 Total Cost in 1,000 s of Dollars Quick and Dirty Method Draw a line through the data points with about an an equal numbers of of points above and below the line Y 0 X Activity, 1,000 s of Units Produced Intercept is is the the estimated fixed cost cost = \$10,000

26 Quick and Dirty Method The slope is is the estimated variable cost per unit. Slope = Change in in cost Change in in units Total Cost in 1,000 s of Dollars Y Horizontal distance is is the the change in in activity. 0 X Activity, 1,000 s of Units Produced Vertical distance is is the the change in in cost.

27 High Low Method Compares the points of highest and lowest activities, and their related costs, and calculates the formula for a straight line connecting the two points Dividing the incremental cost by the incremental units of activity gives the variable cost per unit of activity The variable cost per unit is substituted into the cost formula to determine the fixed cost Total cost = fixed cost + variable cost per unit number of units of activity

28 High Low Method Units of Cost activity High point \$ 18,000 10,000 Low point 12,000 6,000 Difference \$ 6,000 4,000 \$6,000 / 4,000 = \$1.50 per unit At the low point: \$12,000 = Fixed cost + \$1.50 per unit 6,000 units \$3,000 = Fixed cost Total cost = \$3,000 + \$1.50 per unit number of units

29 Applications of Cost Behavior Contribution margin Concepts Excess of sales over variable costs Contribution is the incremental amount of each sale that is available to cover fixed costs and provide a profit Knowing the contribution margin allows us to predict changes in net income that will result from a change in sales volume

30 Applications of Cost Behavior Concepts Total Percentage Per unit Sales \$ 1,000, % \$ 1,000 Variable costs 600,000 60% 600 Contribution margin \$ 400,000 40% \$ 400 Fixed costs 300,000 Net income \$ 100,000 assume 1,000 units are sold

31 Applications of Cost Behavior Concepts Contribution margin percentage Proportion of each sales dollar that is available to cover fixed costs and provide a profit If sales increase by \$100,000, profit will increase by \$40,000 (\$100,000 40%) Contribution margin per unit Dollar amount that each unit contributes toward covering fixed costs and providing a profit If 50 more units are sold, profit will increase by \$20,000 (50 units \$400)

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