Managerial Acc Chap 03

Cost Behavior: Analysis and Use
Chapter 3
2012 McGraw-Hill Education (Asia)
Learning Objective 1
Understand how fixed and

variable costs behave and
how to use them to predict
costs.
McGraw-Hill Education (Asia)

McGraw-Hill/Irwin
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 2
Types of Cost Behavior Patterns Variable

A variable cost is a cost whose total dollar
amount varies in direct proportion to changes
in the activity level.

McGraw-Hill/Irwin
Slide 3
The Activity Base (also called a cost driver)

Machine
hours
Units
produced
A measure of what
causes the
incurrence of a
variable cost
Miles
driven
McGraw-Hill/Irwin
Labor
hours
Slide 4
True Variable Cost An Example
Total Overage
Charges on Cell
Phone Bill
As an example of an activity base, consider

overage charges on a cell phone bill. The activity
base is the number of minutes used above the
allowed minutes in the calling plan.
Minutes Talked
McGraw-Hill/Irwin
Slide 5
Types of Cost Behavior Patterns Variable

Variable costs remain constant if expressed on
a per unit basis.

McGraw-Hill/Irwin
Slide 6
Variable Cost Per Unit An Example
Per Minute
Overage Charge
Referring to the cell phone example, the cost per

overage minute is constant, for example 45 cents per
overage minute.
Minutes Talked
McGraw-Hill/Irwin
Slide 7
Extent of Variable Costs

The proportion of variable costs differs across organizations.
For example . . .
A public utility like Florida
Power and Light,
with large investments in
equipment, will tend to have
fewer variable costs.
Some service companies
have high variable costs,
while other service
companies have high
fixed costs.
McGraw-Hill/Irwin
A manufacturing company
like Black and Decker
will often have many
variable costs.
A merchandising company
like Wal-Mart
usually has a high
proportion of variable costs,
like cost of sales.
Slide 8
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.

McGraw-Hill/Irwin
Slide 9
True Variable Costs
Cost
The amount of a true variable cost used during the

period varies in direct proportion to the activity level.
The overage charge on a cell phone bill was one
example of a true variable cost.
Volume
McGraw-Hill/Irwin
Direct material is
another example
of a cost that
behaves in a true
variable pattern.
Slide 10
Step-Variable Costs
Cost
A step-variable cost is a resource that is obtainable only

in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.
Volume
McGraw-Hill/Irwin
Slide 11
Step-Variable Costs
Cost
Small changes in the level of production are not

likely to have any effect on the number of
maintenance workers employed.
Volume
McGraw-Hill/Irwin
Slide 12
Step-Variable Costs
Cost
Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
workers employed.
Volume
McGraw-Hill/Irwin
Slide 13
The Linearity Assumption and the Relevant Range
Total Cost
Economists
Curvilinear Cost
Function
Relevant
Range
A
A straight
straight line
line
closely
closely
approximates
approximates aa
curvilinear
curvilinear
variable
variable cost
cost
line
line within
within the
the
relevant
relevant range.
range.
Accountants Straight-Line
Approximation (constant
unit variable cost)
Activity

McGraw-Hill/Irwin
Slide 14
Types of Cost Behavior Patterns Fixed

A fixed cost is a cost whose total dollar
amount remains constant as the activity level
changes.

McGraw-Hill/Irwin
Slide 15
Total Fixed Cost An Example
Monthly Basic
Cell Phone Bill
For example, your cell phone bill probably includes a

fixed amount related to the total minutes allowed in
your calling plan. The amount does not change when
you use more or less allowed minutes.
Number of Minutes Used

within Monthly Plan
McGraw-Hill/Irwin
Slide 16
Types of Cost Behavior Patterns Fixed

Average fixed costs per unit decrease as the
activity level increases.

McGraw-Hill/Irwin
Slide 17
Fixed Cost Per Unit Example
Cost Per Cell Phone Call
For example, the fixed cost per minute used

decreases as more allowed minutes are used.
Number of Minutes Used

within Monthly Plan
McGraw-Hill/Irwin
Slide 18
Types of Fixed Costs
Committed
Discretionary
Long-term, cannot be
significantly reduced in
the short term.
May be altered in the

short-term by current
managerial decisions
Examples
Examples
Depreciation on Buildings
and Equipment and Real
Estate Taxes
Advertising and
Research and
Development

McGraw-Hill/Irwin
Slide 19
The Trend Toward Fixed Costs

The trend in many industries is toward greater
fixed costs relative to variable costs.
As
As machines
machines take
take over
over
many
many mundane
mundane tasks
tasks
previously
previously performed
performed
by
by humans,
humans,
knowledge
knowledge workers
workers
are
are demanded
demanded for
for
their
their minds
minds rather
rather
than
than their
their muscles.
muscles.
McGraw-Hill/Irwin
Knowledge
Knowledge workers
workers
tend
tend to
to be
be salaried,
salaried,
highly-trained
highly-trained and
and
difficult
difficult to
to replace.
replace. The
The
cost
cost of
of compensating
compensating
these
these valued
valued employees
employees
is
is relatively
relatively fixed
fixed
rather
rather than
than variable.1
variable.1
Slide 20
Is Labor a Variable or a Fixed Cost?

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.
Within countries managers can view labor costs differently
depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.
McGraw-Hill/Irwin
Slide 21
Rent Cost in Thousands

of Dollars
Fixed Costs and the Relevant Range

90
Relevant
60
Range
30
0

McGraw-Hill/Irwin
The
The relevant
relevant range
range
of
of activity
activity for
for aa fixed
fixed
cost
cost is
is the
the range
range of
of
activity
activity over
over which
which
the
the graph
graph of
of the
the
cost
cost is
is flat.
flat.
1,000
2,000
3,000
Rented Area (Square Feet)
Slide 22

For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase
in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

McGraw-Hill/Irwin
Slide 23
How does this

step-function
pattern differ from a
step-variable cost?
McGraw-Hill/Irwin
Step-variable costs
can be adjusted more
quickly as conditions
change and . . .
The width of the activity
steps is much wider for
the fixed cost.
Slide 24
Quick Check
Which of the following statements about
cost behavior are true?
a.
b.
c.
d.
Fixed costs per unit vary with the level of

activity.
Variable costs per unit are constant within the
relevant range.
Total fixed costs are constant within the relevant
range.
Total variable costs are constant within the
relevant range.

McGraw-Hill/Irwin
Slide 25
Quick Check
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
McGraw-Hill/Irwin
Slide 26
Mixed Costs (also called semivariable costs)

A
A mixed
mixed cost
cost contains
contains both
both variable
variable and
and fixed
fixed
elements.
elements. Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Total Utility Cost
al
t
o
T
d
e
x
mi
t
s
o
c
Variable
Cost per KW
Activity (Kilowatt Hours)

McGraw-Hill/Irwin
Fixed Monthly
Utility Charge
Slide 27
Mixed Costs
Total Utility Cost
al
t
o
T
d
e
x
mi
t
s
o
c
Variable
Cost per KW
Activity (Kilowatt Hours)

McGraw-Hill/Irwin
Fixed Monthly
Utility Charge
Slide 28
Mixed Costs An 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?

McGraw-Hill/Irwin
Slide 29
Analysis of Mixed Costs

Account Analysis and the Engineering Approach
In
In account
account analysis
analysis,, each
each account
account is
is
classified
classified as
as either
either variable
variable or
or fixed
fixed based
based
on
on the
the analysts
analysts knowledge
knowledge of
of how
how
the
the account
account behaves.
behaves.
The
The engineering
engineering approach
approach classifies
classifies
costs
costs based
based upon
upon an
an industrial
industrial
engineers
engineers evaluation
evaluation of
of production
production
methods,
methods, and
and material,
material, labor
labor and
and
overhead
overhead requirements.
requirements.
McGraw-Hill/Irwin
Slide 30
Why and how to reduce fixed costs or switch

them to variable costs?
Typical fixed costs: production facilities, rentals, employees

salaries and related benefits and utilities
Converting them into variable may reduce risk of financial commitment

and provide flexibility of capacity utilisation
Outsourcing
Business with fast and regular change and/or large varieties of
products most likely will benefit from this approach e.g. Nike and
Apple
Non-core business functions with lower value-add to majority
customers e.g. call centers for enquiries, 3rd party logistics, brokerdealers securities back office operations
Offshoring
Honda and Toyota Thailand plants
HSBC back office functions in China

McGraw-Hill/Irwin
Slide 31
Use a scattergraph plot to

diagnose cost behavior.

McGraw-Hill/Irwin
Slide 32
The Scattergraph Method

Plot
Plot the
the data
data points
points on
on aa graph
graph
(Total
(Total Cost
Cost Y
Y vs.
vs. Activity
Activity X).
X).
Maintenance Cost
1,000s of Dollars
Y
20
* *
* *
10
* ** *
**
Patient-days in 1,000s
McGraw-Hill/Irwin
Slide 33
Maintenance Cost
1,000s of Dollars
Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about an
an
equal
equal numbers
numbers of
of points
points above
above and
and below
below the
the line.
line.
Y
20
* *
* *
10
* ** *
**
McGraw-Hill/Irwin
Slide 34
Maintenance Cost
1,000s of Dollars
Use
Use one
one data
data point
point to
to estimate
estimate the
the total
total level
level of
of activity
activity
and
and the
the total
total cost.
cost.
Y Total maintenance cost = $11,000
20
* ** *
**
* *
* *
10
Intercept = Fixed cost: $10,000
Patient days = 800

McGraw-Hill/Irwin
Slide 35

Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per unit
unit and
and
determine
determine the
the cost
cost equation.
equation.
Variable cost per unit = $1,000

800
= $1.25/patient-day
Y = $10,000 + $1.25X
Total maintenance cost
McGraw-Hill/Irwin
Number of patient days

Slide 36
Analyze a mixed cost

using the high-low method.

McGraw-Hill/Irwin
Slide 37
The High-Low Method An Example

Assume the following hours of maintenance work and the total maintenance costs for six months.

McGraw-Hill/Irwin
Slide 38

The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $6.00/hour
400

McGraw-Hill/Irwin
Slide 39
Total Fixed Cost = Total Cost Total Variable Cost

Total Fixed Cost = $9,800 ($6/hour 850 hours)
Total Fixed Cost = $9,800 $5,100
Total Fixed Cost = $4,700
McGraw-Hill/Irwin
Slide 40
The Cost Equation for Maintenance
Y = $4,700 + $6.00X
McGraw-Hill/Irwin
Slide 41
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is the
the
variable
variable portion
portion of
of sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit

McGraw-Hill/Irwin
Slide 42
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is the
the
variable
variable portion
portion of
of sales
sales salaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
Units
Cost
b.
b. $0.10
$0.10 per
per unit
unit
High level
120,000
$ 14,000
c.
Low level
80,000
10,000
c. $0.12
$0.12 per
per unit
unit
40,000
$ 4,000
d.
d. $0.125
$0.125 per
per unit
unit Change
$4,000 40,000 units
= $0.10 per unit
McGraw-Hill/Irwin
Slide 43
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

McGraw-Hill/Irwin
Slide 44
Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

McGraw-Hill/Irwin
Slide 45
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 the
data points to estimate
the fixed and variable
cost components of a
mixed cost.

McGraw-Hill/Irwin
The goal of this method is

to fit a straight line to the
data that minimizes the
sum of the squared errors.
Slide 46
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 also provides a statistic, called

the R22, which is a measure of the goodness
of fit of the regression line to the data points.
McGraw-Hill/Irwin
Slide 47
Total Cost
R22 is the percentage of the variation in the dependent

variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20
* *
* *
10
* ** *
**
R2 varies from 0% to 100%, and

the higher the percentage the better.

McGraw-Hill/Irwin
2
3
Activity
X
Slide 48
Comparing Results From the Three

Methods
The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates of
of the
the fixed
fixed and
and
variable
variable cost
cost components
components of
of the
the mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses differing
differing amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because itit uses
uses all
all the
the data
data
points.
points.
McGraw-Hill/Irwin
Slide 49
Prepare an income
statement using the
contribution format.

McGraw-Hill/Irwin
Slide 50
The Contribution Format

Lets put our
knowledge of cost
behavior to work
by preparing a
contribution
format income
statement.

McGraw-Hill/Irwin
Slide 51
The
The contribution
contribution margin
margin format
format emphasizes
emphasizes cost
cost
behavior.
behavior. Contribution
Contribution margin
margin covers
covers fixed
fixed costs
costs
and
and provides
provides for
for income.
income.
McGraw-Hill/Irwin
Slide 52
Uses of the Contribution Format

The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning and
and decision-making
decision-making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.Cost-volume-profit
1.Cost-volume-profit analysis
analysis (Chapter
(Chapter 4).
4).
2.Budgeting
2.Budgeting (Chapter
(Chapter 10).
10).
3.Segmented
3.Segmented reporting
reporting of
of profit
profit data
data (Chapter
(Chapter 13).
13).
4.Special
4.Special decisions
decisions such
such as
as pricing
pricing and
and make-ormake-orbuy
buy analysis
analysis (Chapter
(Chapter 14).
14).
McGraw-Hill/Irwin
Slide 53
Used primarily for

external reporting.
McGraw-Hill/Irwin
Used primarily by
management.
Slide 54
Least-Squares Regression
Computations
Appendix 3A
2012 McGraw-Hill Education (Asia)
Analyze a mixed cost

using the least-squares
regression method.

McGraw-Hill/Irwin
Slide 56
Simple Regression Analysis An Example

Matrix,
Matrix, Inc.
Inc. wants
wants to
to
know
know its
its average
average
fixed
fixed cost
cost and
and
variable
variable cost
cost per
per unit.
unit.
Using
Using the
the data
data to
to the
the
right,
right, lets
lets see
see how
how to
to
do
do aa regression
regression using
using
Microsoft
Microsoft Excel.
Excel.
McGraw-Hill/Irwin
Slide 57
Simple Regression Using Excel An Example

You
You will
will need
need three
three pieces
pieces of
of
information
information from
from your
your
regression
regression analysis:
analysis:
1.
1. Estimated
Estimated Variable
Variable Cost
Cost Per
Per
Unit
Unit (line
(line slope)
slope)
2.
2. Estimated
Estimated Fixed
Fixed Costs
Costs (line
(line
intercept)
intercept)
3.
3. Goodness
Goodness of
of fit,
fit, or
or R
R22
To
Toget
get these
these three
three pieces
pieces
information
information we
we will
will need
need to
to
use
use three
three Excel
Excel functions.
functions.
SLOPE,
SLOPE, INTERCEPT,
INTERCEPT,and
and RSQ
RSQ

McGraw-Hill/Irwin
Slide 58
Place
Place your
your cursor
cursor in
in
cell
cell F4
F4 and
and press
press the
the
== key.
key. Click
Click on
on the
the
pull
pull down
down menu
menu and
and
scroll
scroll down
down to
to More
More
Functions
Functions .. .. ..

McGraw-Hill/Irwin
Slide 59

Scroll
Scroll down
down to
to the
the
Statistical
Statistical,,
functions.
functions. Now
Now
scroll
scroll down
down the
the
statistical
statistical
functions
functions until
until you
you
highlight
highlight
SLOPE
SLOPE

McGraw-Hill/Irwin
Slide 60
1. In the Known_ys box, enter C4:C19 for the range.

2. In the Known_xs box, enter D4:D19 for the range.

McGraw-Hill/Irwin
Slide 61

Here is the
estimate of the
slope of the line.


McGraw-Hill/Irwin
Slide 62

With
With your
your cursor
cursor in
in
cell
cell F5,
F5, press
press the
the ==
key
key and
and go
go to
to the
the pull
pull
down
down menu
menu for
for
Special
Special Functions.
Functions.
Select
Select Statistical
Statistical and
and
scroll
scroll down
down to
to
highlight
highlight the
the
INTERCEPT
INTERCEPT function.
function.

McGraw-Hill/Irwin
Slide 63
Here is the
estimate of the
fixed costs.

McGraw-Hill/Irwin
Slide 64

Finally,
Finally, we
we will
will
determine
determine the
the
goodness
goodness of
of
fit
fit,, or
or R
R22,, by
by
using
using the
the RSQ
RSQ
function.
function.

McGraw-Hill/Irwin
Slide 65
Here is the
estimate of R2.

McGraw-Hill/Irwin
Slide 66
End of Chapter 3

McGraw-Hill/Irwin
Slide 67

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Cost Behavior: Analysis and Use

2012 McGraw-Hill Education (Asia)

Understand how fixed and

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Types of Cost Behavior Patterns Variable

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

The Activity Base (also called a cost driver)

True Variable Cost An Example

As an example of an activity base, consider

Garrison, Noreen, Brewer, Cheng & Yuen

Types of Cost Behavior Patterns Variable

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Variable Cost Per Unit An Example

Referring to the cell phone example, the cost per

Garrison, Noreen, Brewer, Cheng & Yuen

Extent of Variable Costs

Garrison, Noreen, Brewer, Cheng & Yuen

Examples of Variable Costs

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

True Variable Costs

The amount of a true variable cost used during the

Garrison, Noreen, Brewer, Cheng & Yuen

A step-variable cost is a resource that is obtainable only

Garrison, Noreen, Brewer, Cheng & Yuen

Small changes in the level of production are not

Garrison, Noreen, Brewer, Cheng & Yuen

Only fairly wide changes

Garrison, Noreen, Brewer, Cheng & Yuen

The Linearity Assumption and the Relevant Range

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Types of Cost Behavior Patterns Fixed

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Total Fixed Cost An Example

For example, your cell phone bill probably includes a

Number of Minutes Used

Garrison, Noreen, Brewer, Cheng & Yuen

Types of Cost Behavior Patterns Fixed

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Fixed Cost Per Unit Example

Cost Per Cell Phone Call

For example, the fixed cost per minute used

Number of Minutes Used

Garrison, Noreen, Brewer, Cheng & Yuen

Types of Fixed Costs

May be altered in the

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

The Trend Toward Fixed Costs

Garrison, Noreen, Brewer, Cheng & Yuen

Is Labor a Variable or a Fixed Cost?

Garrison, Noreen, Brewer, Cheng & Yuen

Rent Cost in Thousands

Fixed Costs and the Relevant Range

McGraw-Hill Education (Asia)

Fixed Costs and the Relevant Range

McGraw-Hill Education (Asia)