Cost Behavior

1. Chapter Three Cost Behavior

2. Cost Behavior • General term for describing whether a cost changes when the level of output changes. • Classifications of Cost Behavior • Variable Costs • Fixed Costs • Mixed Costs

3. Cost Behavior • Terms variable and fixed only have meaning when related to some output measure • Behavior is relative to the context it is presented in meaning that if the output measure changes the cost behavior may change • The term fixed or variable is based on the total cost.

4. What causes a cost to go up or down? • Cost driver – factor that measures the output of the activity that leads or causes costs to change • Examples: • # of units • # of labor hours • # of square feet • # of departments

5. Spring Break • Let’s say you and 2 friends are going to Cabo San Lucas for 4 nights. • You are going to fly down there and stay in a hotel. • The hotel charges $100 per night regardless of how many people stay in the room. • TOTAL Expected Lodging Cost = $400

6. Two days before you leave one more friend decides to come along. • How does this affect your hotel bill? • No change – total lodging is still $400 • This is a fixed cost – The total cost does not change.

7. Two days before you leave one friend backs out. • What happens to your hotel bill now? • No Change • This is a fixed cost – The total cost does not change

8. How does all this affect you? • Total Hotel Bill = $400 • How much do you have to pay? Fixed Cost Behavior

10. Fixed Costs • Fixed costs – costs that in total are constant within the relevant range as the level of output changes • Two types of fixed costs • Discretionary fixed costs – costs that can be changed or avoided relatively easily • Example: Advertising • Committed fixed costs – costs that cannot easily be changed • Examples: Long-term contracts (leases on machinery or buildings; Purchase of property, plant & equipment

11. What about the airfare? You were able to get plane tickets for $200 roundtrip per person. Variable Cost Behavior

12. Under a variable cost structure the cost per unit stays the same and the total cost changes • Using the Variable Cost Structure avoids Fixed Cost Risk

13. Whether a cost is fixed or variable depends on the underlying circumstances. • Let’s look back at our lodging for spring break. • What if we decide to stay 5 nights instead of 4? • What if we come home a day early?

14. Here the lodging is a variable cost. • The cost per night stays the same and the total cost changes.

15. Variable Costs • Variable costs – costs that in total vary in direct proportion to changes in output within the relevant range

16. Relevant Range • What happens if three more friends decide to come along and you have a total of 6 people? • You will more than likely have to rent 2 rooms each night. • Now your total lodging is $200 per night. • The structures work within a relevant range. • Our range here is 1 to 4 people.

17. When the activity level increases, total fixed costs • Increases • Decreases • Remains constant

18. When the activity level increases, fixed cost per unit • Increases • Decreases • Remains constant

19. When the activity level increases, variable cost per unit • Increases • Decreases • Remains constant

20. When the activity level increases, total variable costs • Increases • Decreases • Remains constant

21. Mixed Cost • Has characteristics of both a variable and a fixed cost. • Most company’s costs are typically mixed. Total cost = Total fixed cost + Total variable cost • Example: Sales representative Total pay = Salary + commission on sales

22. Mixed Cost • Colley Computers has 10 sales people. Each earns a salary of $30,000 per year, plus $25 per computer sold. 50,000 computers were sold during the year. • What is the company’s total sales people expense for the year? Total Cost = Fixed Cost + Variable Cost =(10*$30,000) + ($25*50,000) =$300,000 + $1,250,000 =$1,550,000

23. Step Cost • Displays a constant level of cost for a range of output and then jumps to a higher level of cost at some point. • Think back to our spring break example • Lodging cost for 4 nights • 1 – 4 people = $400 • 5 – 8 people = $800 • 9 – 12 people = $1,200

24. Methods to SeparateFixed and Variable Costs • High-low method • Scattergraph method • Method of least squares • Each method requires the simplifying assumption of a linear cost relationship Total cost = Fixed cost + (Variable rate * Output)

25. High-Low Method • Used to estimate future costs Step 1: Find High and Low Points Step 2: Use high and low points to calculate variable rate (VC per unit) Step 3: Calculate fixed cost using variable rate Step 4: Form cost formula

26. HIGH HIGH LOW LOW

27. Step 2 • Use high and low points to calculate variable rate. (High Cost – Low Cost) = VC per unit (High Output – Low Output) (450,000 – 145,000) = $12,200 / unit (35 – 10)

28. Step 3 - Calculate the FC using the variable rate and either the high or low point. FC + VC = Total Cost FC = TC – VC FC = $450,000 – (35 * $12,200) FC = $450,000 – 427,000 FC = $23,000

29. Step 4 • Form cost formula TC = FC + VC TC = $23,000 + ($12,200 * # of units) *Useful because once you have cost formula, you can use it in budgeting and in performance control.

30. Scattergraph Method - Way to see cost relationship by plotting data on a graph. • Plot points on graph. • Draw line through points. • Fixed cost is where line intercepts Y-axis • Variable rate is the slope of the line.

31. Method of Least Squares • Statistical way to find the best-fitting line through a set of data points. • Best-fitting line is the one in which the data points are closer to the line than to any other line. • Calculated using software; rarely done by hand