Cost Behavior: Analysis and Use

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1 Types of Cost Behavior Patterns Cost Behavior: Analysis and Use Chapter Five Recall the summary of our cost behavior discussion from an earlier chapter. 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 the same over wide ranges level within the of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. The Activity Base True Variable Cost Example produced Miles driven A measure of what causes the incurrence of a variable cost hours hours A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. our total long distance telephone bill is based on how many minutes you talk. Total Long Distance Telephone Bill Minutes Talked Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from an earlier chapter. 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 the same over wide ranges level within the of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. 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, 1 cents per minute. Per Minute Telephone Charge Minutes Talked

2 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 variable costs. A service company will normally have a high proportion of variable costs. A manufacturing company will often have variable costs. A merchandising company usually will have a high proportion of variable costs like cost of sales. 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. True Variable Cost Step-Variable Costs 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. 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 Cost Volume Volume Step-Variable Costs Step-Variable Costs Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed. Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed Cost Cost Volume Volume

3 The Linearity Assumption and the Relevant Range Types of Cost Behavior Patterns Total Cost Relevant Range Activity Economist s Curvilinear Cost Function A straight line closely approximates a curvilinear variable cost line within the Accountant s Straight-Line Approximation (constant unit variable cost) Let s look at fixed cost behavior on the next screens. 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 the same over wide ranges level within the of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. Total Fixed Cost Example Types of Cost Behavior Patterns A fixed cost is a cost whose total dollar amount remains constant as the activity level changes. our 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 Recall the summary of our cost behavior discussion from an earlier chapter. 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 the same over wide ranges level within the of activity. Total fixed cost remains the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. Fixed Cost Per Unit Example Types of Fixed Costs 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 Committed Long-term, cannot be significantly reduced in the short term. Examples Discretionary May be altered in the short-term by current managerial decisions Examples

4 The Trend Toward Fixed Costs Is Labor a Variable or a Fixed Cost? The trend in many industries is toward 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. 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. In the United States and the United Kingdom management has greater latitude. Labor costs are more variable in nature. Fixed Costs and Relevant Range Fixed Costs and Relevant Range Rent Cost in Thousands of Dollars 9 Total cost doesn t Relevant change for a wide 6 Range range of activity, and then jumps to a new higher cost for 3 the next higher range of activity. 1, 2, 3, Rented Area (Square Feet) 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 \$3, per year in increments of 1, square feet. As the business grows more space is rented, increasing the total cost. Fixed Costs and Relevant Range Quick Check How does this type of fixed cost differ from a stepvariable cost? Step-variable costs can be adjusted more quickly and... The width of the activity steps is much wider for the fixed cost. Which of the following statements about cost behavior are true? 1. Fixed costs per unit vary with the level of activity. 2. Variable costs per unit are constant within the 3. Total fixed costs are constant within the 4. Total variable costs are constant within the

5 Mixed Costs Mixed Costs Total Utility Cost A mixed cost has both fixed and variable components. Consider the example of utility cost. Total mixed cost Activity (Kilowatt Hours) Variable Cost per KW Fixed Monthly Utility Charge Total Utility Cost Total mixed cost Activity (Kilowatt Hours) The The total total mixed mixed cost cost line line can can be be expressed as as an an equation: equation: = a + b b Where: Where: = 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) = the the level level of of activity activity Variable Cost per KW Fixed Monthly Utility Charge Mixed Costs Example Analysis of Mixed Costs If your fixed monthly utility charge is \$4, your variable cost is \$.3 per kilowatt hour, and your monthly activity level is 2, kilowatt hours, what is the amount of your utility bill? = a + b = \$4 + (\$.3 2,) = \$ Account Analysis and the Engineering Approach Each account is classified as either variable or fixed based on the analyst s knowledge of how the account behaves. Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. The Scattergraph Method The Scattergraph Method Maintenance Cost 1, s of Dollars 2 1 Plot the data points on a graph (total cost vs. activity) Patient-days in 1, s Maintenance Cost 1, s of Dollars Draw a line through the data points with about an equal numbers of points above and below the line Patient-days in 1, s

6 The Scattergraph Method The High-Low Method Maintenance Cost 1, s of Dollars Use one data point to estimate the total level of activity and the total cost. Total maintenance cost = \$11, 2 1 Intercept = Fixed cost: \$1, Patient-days in 1, s Patient days = 8 Assume the following hours of maintenance work and the total maintenance costs for six months. The High-Low Method The High-Low Method The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours. \$2,4 3 = \$8./hour Total Fixed Cost = Total Cost Total Variable Cost Total Fixed Cost = \$9,8 (\$8/hour 8 hours) Total Fixed Cost = \$9,8 \$6,4 Total Fixed Cost = \$3,4 The High-Low Method Quick Check The Cost Equation for Maintenance = \$3,4 + \$8. Sales salaries and commissions are \$1, when 8, units are sold, and \$14, when 12, units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. \$.8 per unit b. \$.1 per unit c. \$.12 per unit d. \$.125 per unit

7 Quick Check Least-Squares Regression Method Sales salaries and commissions are \$1, when 8, units are sold, and \$14, when 12, units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. \$ 2, b. \$ 4, c. \$1, d. \$12, A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the and 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. Least-Squares Regression Method Least-Squares Regression Method Software can be used to fit a regression line through the data points. The cost analysis objective is the same: = a + b Least-squares regression also provides a statistic, called the R 2, that is a measure of the goodness of fit of the regression line to the data points. R 2 is the percentage of the variation in total cost explained by the activity. Total Cost 2 1 R 2 varies from % to 1%, and the higher the percentage the better Activity 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 differing amounts of the data points to provide estimates. Least-squares regression provides the most accurate estimate because it uses all the data points. Let s put our knowledge of cost behavior to work by preparing a contribution format income statement.

8 The Contribution Format Uses of the Contribution Format Total Unit Sales Revenue \$ 1, \$ 5 Less: Variable costs 6, 3 Contribution margin \$ 4, \$ 2 Less: Fixed costs 3, Net operating income \$ 1, The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income. 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 9). 3. Segmented reporting of profit data (Chapter 12). 4. Special decisions such as pricing and make-orbuy analysis (Chapter 13). The Contribution Format Comparison of the Contribution Income Statement with the Traditional Income Statement Traditional Approach (costs organized by function) Contribution Approach (costs organized by behavior) Sales \$ 1, Sales \$ 1, Less cost of goods sold 7, Less variable expenses 6, Gross margin \$ 3, Contribution margin \$ 4, Less operating expenses 2, Less fixed expenses 3, Net operating income \$ 1, Net operating income \$ 1, Used primarily for external reporting. Used primarily by management.

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