COST MANAGEMENT

Accounting & Control

Hansen▪Mowen▪Guan

Chapter 3
Cost Behavior

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 1

Cengage Learning and South-Western are trademarks used herein under license.
 Study Objectives
1. Define and describe fixed, variable, and mixed costs.
2. Explain the use of resources and activities and their relationship to
cost behavior.
3. Separate mixed costs into their fixed and variable components
using the high-low method, the scatterplot method, and the method
of least squares.
4. Evaluate the reliability of the cost formula.
5. Explain how multiple regression can be used to assess cost
behavior.
6. Define the learning curve, and discuss its impact on cost behavior.
7. Discuss the use of managerial judgment in determining cost
behavior.

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 Cost Behavior: Fixed Costs
Fixed costs are costs that in total are
constant within the relevant range as
the level of the activity driver varies.

Two production lines can process 10,000

computers per year each. The workers on each
line are supervised by a production-line manager
who is paid $24,000 per year. For production up
to 10,000 units, only one supervisor is needed.
When production is between 10,001 and 20,000
units, two supervisors are required.
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Cost Behavior: Fixed Costs
Days Computers, Inc.
Computers
Supervision Processed
$54,000 4,000
54,000 8,000
54,000 10,000
108,000 12,000
108,000 16,000
108,000 20,000

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 Cost Behavior: Fixed Costs
Days Computers, Inc.
Computers
Supervision Processed
$54,000 4,000
54,000 8,000
54,000 10,000
108,000 12,000
108,000 16,000
108,000 20,000

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 Cost Behavior: Fixed Costs
Days Computers, Inc.
Computers
Supervision Processed Unit Cost
$54,000 4,000 $13.50
54,000 8,000 6.75
54,000 10,000 5.40
108,000 12,000 9.00
108,000 16,000 6.75
108,000 20,000 5.40

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Cost Behavior: Fixed Costs

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Cost Behavior: Variable Costs
Variable costs are costs that in total
vary in direct proportion to changes in
an activity driver.

A CD-ROM disk drive is added to each

computer at a cost of $30 per computer.
The total cost of disk drives for each level of
production varies.

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Cost Behavior: Variable Costs

Days Computers, Inc.

Number of
Total Cost of Computers
CD-ROMs Processed
$120,000 4,000
240,000 8,000
360,000 12,000
480,000 16,000
600,000 20,000

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Cost Behavior: Variable Costs

Days Computers, Inc.

Number of
Total Cost of Computers Unit Cost of
CD-ROMs Processed CD-ROMs
$120,000 4,000 $30.00
240,000 8,000 30.00
360,000 12,000 30.00
480,000 16,000 30.00
600,000 20,000 30.00

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Cost Behavior: Variable Costs

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 Cost Behavior: Mixed Costs
Mixed costs are costs that have both a
fixed and a variable component.

Ten sales representatives each earn an

annual salary of $30,000 plus a commission
of $50 per computer sold. 10,000 computers
are sold.

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 Cost Behavior: Mixed Costs
Y = Fixed cost + Total variable cost
Y = F + VX
where
Y = Total cost

For Days Computer, the selling cost is:

Y = $300,000 + $50X

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 Cost Behavior: Mixed Costs
Days Computers, Inc.
Variable
Fixed Cost of Cost of Computers Selling Cost
Selling Selling Total Cost Sold per Unit
$300,000 $200,000 $500,000 4,000 $125.00
300,000 400,000 700,000 8,000 87.50
300,000 600,000 900,000 12,000 75.00
300,000 800,000 1,100,000 16,000 68.75
300,000 1,000,000 1,300,000 20,000 65.00

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Cost Behavior: Mixed Costs

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 Resources, Activities,
and Cost Behavior
• Flexible resources
– Acquired as used and needed
– Usually considered variable costs
• Examples: materials, energy
• Committed resources
– Acquired in advance of usage
– Usually considered fixed costs
• Examples: buying or leasing buildings, contracts
with employees
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 Resources, Activities,
and Cost Behavior
• Step cost behavior displays a constant
level of cost for a range of output and then
jumps to a higher level of cost at some
point
• Step-Variable costs
• Narrow increments
• Approximate as a strictly variable assumption
• Step-Fixed costs
• Wide increments
• Assigned to the fixed cost category

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Resources, Activities,
and Cost Behavior

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Methods for Separating Mixed Costs
into Fixed and Variable Components

Variable
Component
Fixed
Component

• The High-Low Method

• The Scatterplot Method
• The Method of Least Squares

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Methods for Separating Mixed Costs
into Fixed and Variable Components

Straight-line equation:
Y = F + VX
where
Y = Total activity cost
F = Fixed cost component
V = Variable cost per unit
X = Measure of activity output
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 High-Low Method
Materials Number of
Month Handling Cost Moves
January $2,000 100
February 3,090 125
March 2,780 175
April 1,990 200
May 7,500 500
June 5,300 300
July 4,300 250
August 6,300 400
September 5,600 475
October 6,240 425

Step 1: Solve for variable cost (V)

V = Change in cost ÷ Change in activity 21
 High-Low Method
Materials Number of
Month Handling Cost Moves
January $2,000 100 Low Activity
February 3,090 125
March 2,780 175
April 1,990 200
May 7,500 500 High Activity
June 5,300 300
July 4,300 250
August 6,300 400
September 5,600 475
October 6,240 425

$7,500 - $2,000
Step1: V   $13.75 22
500 - 100
 High-Low Method
Step 1: Solve for variable cost (V)
V = Change in cost ÷ Change in activity

$7,500 - $2,000
V  $13.75
500 - 100
Step 2: Using either the high cost or low cost, solve for
the total fixed costs F

Y  F V ( X )
Low cost $2,000  F  $13.75(100)
$625  F
Y  F V( X )
High cost $7,500  F  $13.75(500)
$625  F
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 Scatterplot Method
Step 1: Plot the data points on a scattergraph

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 Scatterplot Method
Step 2: Choose the two data points most representative
of the data to describe the cost behavior line

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 Method of Least Squares
Actual Predicted Deviation
Cost Cost Deviation Squared
2,000 1,742 258 66,564
3,090 2,088 1,002 1,004,004
2,780 2,780 - -
1,990 3,126 (1,136) 1,290,496
7,500 7,278 222 49,284
5,300 4,510 790 624,100
4,300 3,818 482 232,324
6,300 5,894 406 164,836
5,600 6,932 (1,332) 1,774,224
6,240 6,240 - -
Total measure of closeness 5,205,832 26
 Regression Programs
• The best-fitting line is the line with the
smallest sum of squared deviations
• Regression analysis determines the linear
function with the minimum sum of squared
deviations
• Utilize spreadsheet packages such as
Microsoft Excel to perform the
computation

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 Regression Analysis
for the Method of Least Squares
Spreadsheet Data for
Anderson Company

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 Regression Analysis
for the Method of Least Squares
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.92894908 Regression Output for
R. Square 0.862946394
Adjusted R 0.845814693
Anderson Company

Square
Standard Error 770.4987038
Observations 10

ANOVA
df SS MS F
Regression 1 29903853.98 29903853.98 50.37132077
Residual 8 4749346.021 593668.2526
Total 9 34653200

Coefficient Standard Error t-Stat P-value

Intercept 854.4993582 569.7810263 1.49967811 0.172079925
X Variable 1 12.3915276 1.745955536 7.097275588 0.000102268 29
 Regression Analysis
for the Method of Least Squares
The regression analysis gives rise to the following
equation for Anderson’s material handling cost:

$854.50 + ($12.39  number of moves)

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 Reliability of Cost Formulas
Hypothesis test of parameters

– The lower the P-value, the more likely that the

true parameter is significantly different from 0
– Traditional benchmarks of significance are
0.10, 0.05 or 0.01

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 Reliability of Cost Formulas
Goodness of fit

– R2 is the coefficient of determination

– Measures the percentage of change in the
dependent variable explained by changes in
the independent variable
– The closer to 1.0, the better; no benchmark

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 Reliability of Cost Formulas
Confidence intervals

– The standard error is used to determine the ±

range of possible values around the
predicted value:

 Standard  t-statistic  Confidence

Error Interval 
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 Multiple Regression
• Least-squares method is used to fit an
equation involving two or more
explanatory variables
Y = F + V1X1 + V2X2 etc.
where
X1 = first explanatory variable
X2 = second explanatory variable

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 Multiple Regression
Spreadsheet Data for
Anderson Company
Materials X1
Handling Number Pounds
Month Cost of Moves Moved
January $2,000 100 6,000 X2
February 3,090 125 15,000
March 2,780 175 7,800
April 1,990 200 600
May 7,500 500 29,000
June 5,300 300 23,000
July 4,300 250 17,000
August 6,300 400 25,000
September 5,600 475 12,000
October 6,240 425 22,400

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 Multiple Regression Analysis
for the Method of Least Squares
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.999420
R Square 0.998841
Adjusted R Square 0.998509
Standard Error 75.762721
Observations 10

ANOVA
df SS MS F
Regression 2 34613020.07 17306510.04 3015.076722
Residual 7 40179.92954 5739.989934
Total 9 34653200

Coefficients Standard Error t Stat P-value

Intercept 507.309711 57.322496 8.850098 0.000048
X Variable 1 7.835162 0.234048 33.476720 0.000000
X Variable 2 0.107181 0.003742 28.642864 0.000000

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 Multiple Regression
Based on the multiple regression analysis, the
cost formula is written as:
Y = $507 + $7.84X1 + $0.11X2
In November the company expects to make 350
moves with a weight of 17,000 pounds. The
predicted cost of material handling is:
Y = $507 + $7.84(350) + $0.11(17,000)
= $507 + $2,744 + $1,870
= $5,121
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Cumulative Average Time Learning
Curve with 80% Learning Rate
Cumulative Cumulative Cumulative Individual Units
Number Average Time Total Time: Time for nth
of Units per Unit in Hours Labor Hours Unit-Labor Hours
(1) (2) (3) = (1) × (2) (4)
1 100 100 100
2 80 (80% × 100) 160 60
3 70.21 210.63 50.63
4 64 (80% × 80) 256 45.37
5 59.57 297.85 41.85
6 56.17 337.02 39.17
7 53.45 374.15 37.13
8 51.20 (80% × 64) 409.60 35.45
16 40.96 655.36 28.06
32 32.77 1,048.64
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Graph of Cumulative Total Hours Required
and the Cumulative Average Time per Unit

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 Managerial Judgment
• Managerial judgment is critically important
in determining cost behavior and is by far
the most widely used method in practice
• Advantage – simplicity
• Disadvantage – poor judgment leads to errors

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COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan

End Chapter 3

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