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Chapter 5

Chapter 5. Cost Behavior. Learning Objective 1. Describe the differences between fixed costs and variable costs. Example. Laura Jorgensen is planning a party. She identifies two major costs: 1. Entertainment (a live band) 2. Food and drinks. $3,650 was spent last year on this party:

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Chapter 5

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  1. Chapter 5 Cost Behavior

  2. Learning Objective 1 Describe the differences between fixed costs and variable costs.

  3. Example Laura Jorgensen is planning a party. She identifies two major costs: 1. Entertainment (a live band) 2. Food and drinks $3,650 was spent last year on this party: ♫ $525 for entertainment ☺ $3,125 for food and drinks

  4. Example The spending limit for this event, this year, is $5,500. Prices for entertainment and food and drinks are expected to remain the same. 175 guests are expected to attend this year’s party, compared to 125 last year.

  5. Common Cost Behavior Patterns Cost behavior is the reaction of costs to changes in levels of business activity. Fixed Costs Fixed costs remain constant in total regardless of the level of activity. What is the fixed cost per guest?

  6. Common Cost Behavior Patterns 125 Guests175 Guests Total fixed cost: $525 $525 125 Guests Cost per guest: $525 ÷ 125 = $4.20 175 Guests Cost per guest: $525 ÷ 175 = $3.00

  7. Common Cost Behavior Patterns Variable Costs Variable costs are costs that change in direct proportion with changes in the level of activity. What is the variable cost per guest? Cost per guest: $3,125 ÷ 125 = $25.00

  8. Common Cost Behavior Patterns What is the total variable cost for 175 guests? $25 × 175 = $4,375

  9. Learning Objective 2 Classify costs by cost behavior.

  10. Comparison of Cost Behaviors The measure of activity is shown on the horizontal axis (the x-axis). The x-axis is the independent variable. The type of cost is shown on the vertical axis (the y-axis). The y-axis is the dependent variable.

  11. y Cost of the Band $525 x Number of Guests Graph of a Fixed Cost

  12. $4,375 175 Graph of a Variable Cost y Cost of Catering x Number of Guests

  13. Determining Total Cost Total Costs = Fixed Costs + Variable Costs

  14. Determining Total Cost What is the total cost for 175 guests? Total fixed cost = $525 Total variable cost: $25 × 175 = $4,375 Total cost: $525 + $4,375 = $4,900

  15. y $4,900 $525 x 175 Graph of Total Costs

  16. Learning Objective 3 Explain the concept of relevant range and its effect on cost behavior information.

  17. Relevant Range The range of activity within which cost behavior assumptions are valid is called the relevant range.

  18. y Relevant Range Fixed Cost x Activity Relevant Range of Fixed Costs

  19. Relevant Range of Fixed Costs y Relevant Range Variable Cost x Activity

  20. Learning Objective 4 Describe the characteristics of a mixed cost and the four basic approaches to separating a mix cost into its fixed and variable components.

  21. Mixed Costs Mixed costs contain elements of both fixed- and variable-cost behavior.

  22. Variable Component y Cost Fixed Component x Activity Graph of Mixed Cost

  23. Identifying the Fixed and Variable Elements of a Mixed Cost The engineering approach Scatter graphing The high-low method Regression analysis

  24. The Engineering Approach This approach relies on engineers or other professionals who are familiar with the technical aspect of the activity and the associated cost. The engineering approach may employ time-and-motion studies or other aspects of scientific management.

  25. Scatter Graphing The scatter graph plots historical activity and cost data on a graph to see how a cost relates to various levels of activity. The analyst places a straight line through the visual center of the points plotted on the graph, so roughly half the dots are above the line and half are below the line.

  26. y Cost x Activity A Scatter Graph

  27. The High-Low Method In the high-low method, only two of the data points are used to determine the fixed and variable cost components. The highest and lowest observations are picked.

  28. Regression Analysis Regression analysis, also called the least-squares method or linear regression analysis, is a mathematical approach to determining fixed and variable cost with statistical accuracy.

  29. Regression Analysis The basic mathematical equation is: Y = a + bX Where: Y = The dependent variable a = The Y intercept, or the amount for Y when X is zero b = The slope coefficient X = The independent variable

  30. Regression Analysis When applying regression analysis to find the fixed and variable elements of a mixed cost, the variables in the regression equation are defined as follows: Y = total cost a = fixed cost b = unit variable cost X = activity level

  31. Regression Analysis Microsoft Excel’s Chart Wizard uses a four-step sequence to do the graphing and mathematical computations to approximate costs at various levels of activity.

  32. Learning Objective 5 Determine the fixed and variable components of a mixed cost using scatter graphs and the high-low method.

  33. Scatter Graph Example The sales manager for Hinds Wholesale Supply Company needs to estimate the expected delivery vehicle operating cost (maintenance) for 2005.

  34. Truck Number Miles Driven Packages Delivered Maintenance Cost 202 204 205 301 422 460 520 15,000 11,000 24,000 30,000 31,000 26,000 20,000 1,200 1,000 1,500 1,500 500 1,000 2,000 $2,000 $1,600 $2,200 $2,400 $2,600 $2,200 $2,000 Scatter Graph Example Vehicle Data for 2004:

  35. Estimated Line Scatter Graph Example Maintenance Cost and Miles Driven

  36. Scatter Graph Example Maintenance Cost and Miles Driven Total Cost = Fixed Cost + Variable Cost Total Mixed Cost = Fixed Cost Element + Variable Cost Element Total Mixed Cost = $1,100 + Variable Cost Element

  37. Scatter Graph Example Maintenance Cost and Miles Driven

  38. Scatter Graph Example Maintenance Cost and Miles Driven Miles Cost 34,000 $2,700 0 1,100 34,000 $1,600 $1,600 ÷ 34,000 = $0.047059 or 4.7 cents per mile

  39. Scatter Graph Example Maintenance Cost and Miles Driven Vehicle maintenance cost = $1,100 + $0.047 per mile driven What is the estimated maintenance cost for a truck that will be driven 28,000 miles? $1,100 + ($0.047 × 28,000) = $2,416

  40. Truck Number Miles Driven Packages Delivered Maintenance Cost 202 204 205 301 422 460 520 15,000 11,000 24,000 30,000 31,000 26,000 20,000 1,200 1,000 1,500 1,500 500 1,000 2,000 $2,000 $1,600 $2,200 $2,400 $2,600 $2,200 $2,000 Scatter Graph Example Maintenance Cost and Packages Delivered

  41. Scatter Graph Example Maintenance Cost and Packages Delivered

  42. Maintenance Cost and Miles Driven Truck Number Miles Driven Packages Delivered Maintenance Cost 202 204 205 301 422 460 520 15,000 11,000 24,000 30,000 31,000 26,000 20,000 1,200 1,000 1,500 1,500 500 1,000 2,000 $2,000 $1,600 $2,200 $2,400 $2,600 $2,200 $2,000 High-Low Method Example

  43. ($2,600 – $1,600) (31,000 – 11,000) = $1,000 20,000 = $0.05 High-Low Method Example Maintenance Cost and Miles Driven What is the fixed cost element?

  44. High-Low Method Example Maintenance Cost and Miles Driven: High Observation $2,600 = Fixed cost + (31,000 × $0.05) Fixed cost = $2,600 – $1,550 = $1,050 $1,050 is the fixed cost element.

  45. High-Low Method Example Maintenance Cost and Miles Driven: Low Observation $1,600 = Fixed cost + (11,000 × $0.05) Fixed cost = $1,600 – $550 = $1,050 What is the estimated maintenance cost for a truck to be driven 28,000 miles? $1,050 + (28,000 × $0.05) = $2,450

  46. End of Chapter 5

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