Chapter Five

1. Chapter Five Cost Behavior:Analysis and Use

2. Learning Objective 1 Understand how fixed and variable costs behave and how to use them to predict costs.

3. Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from an earlier chapter.

4. Unitsproduced Machine hours Miles driven Labor hours The Activity Base A measure of what causes the incurrence of a variable cost

5. True 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 DistanceTelephone Bill Minutes Talked

6. Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from an earlier chapter.

7. 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. Per MinuteTelephone Charge Minutes Talked

8. Extent of Variable Costs The proportion of variable costs differs across organizations. For example . . . A public utility withlarge investments inequipment will tendto have fewervariable costs. A manufacturing companywill often have manyvariable costs. A merchandising companyusually will have a high proportion of variable costs, like cost of sales. A service companywill normally have a high proportion of variable costs.

9. Examples of Variable Costs • Merchandising companies – cost of goods sold. • Manufacturing companies – direct materials, direct labor, and variable overhead. • Merchandising and manufacturing companies – commissions, shipping costs, and clerical costs, such as invoicing. • Service companies – supplies, travel, and clerical.

10. 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

11. Cost Volume Step-Variable Costs 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.

12. Cost Volume Step-Variable Costs Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.

13. Types of Cost Behavior Patterns Let’s look at fixed cost behavior on the next screens.

14. 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

15. Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from an earlier chapter.

16. 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

17. Fixed Costs and Relevant Range 90 Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Relevant Range 60 Rent Cost in Thousands of Dollars 30 0 0 1,000 2,000 3,000 Rented Area (Square Feet)

18. Fixed Costs and Relevant Range • Step-variable costs can be adjusted more quickly and . . . • The width of the activity steps is much wider for the fixed cost. How does this type of fixed cost differ from a step-variable cost?

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

20. Y X Mixed Costs Total mixed cost Total Utility Cost Variable Cost per KW Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

21. Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100 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?

22. Y 20 * * * * * * * * Maintenance Cost1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Patient-days in 1,000’s The Scattergraph Method Plot the data points on a graph (total cost vs. activity).

23. Y 20 * * * * * * * * Maintenance Cost1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Patient-days in 1,000’s The Scattergraph Method Draw a line through the data points with about anequal numbers of points above and below the line.

24. Y Total maintenance cost = $11,000 20 * * * * * * * * Maintenance Cost1,000’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 The Scattergraph Method Use one data point to estimate the total level of activity and the total cost.

25. $1,000 800 Variable cost per unit = = $1.25/patient-day Total maintenance cost Number of patient days The Scattergraph Method Make a quick estimate of variable cost per unit and determine the cost equation. Y = $10,000 + $1.25X

26. Learning Objective 3 Analyze a mixed cost using the high-low method.

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

28. $2,400300 =$8.00/hour The High-Low Method The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours.

29. Total Fixed Cost = $9,800 – $6,400 Total Fixed Cost = $3,400 The High-Low Method Total Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $9,800 – ($8/hour × 800 hours)

30. The Cost Equation for Maintenance Y = $3,400 + $8.00X The High-Low Method

31. Least-Squares Regression Method 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 thedata points to estimatethe fixed and variablecost components of amixed cost. The goal of this method isto fit a straight line to thedata that minimizes thesum of the squared errors.

32. Software can be used to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bX Least-Squares Regression Method Least-squares regression also provides a statistic, called the R2, which is a measure of the goodnessof fit of the regression line to the data points.

33. Least-Squares Regression Method R2 is the percentage of the variation in total cost explained by the activity. Y 20 * * * * * * * * * * Total Cost 10 R2 varies from 0% to 100%, andthe higher the percentage the better. 0 X 0 1 2 3 4 Activity

34. 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. Comparing Results From the Three Methods

35. The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income. The Contribution Format

36. Used primarily forexternal reporting. Used primarily bymanagement. The Contribution Format