Cost Behavior:

Analysis and Use

Chapter Five

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Types of Cost Behavior Patterns

Recall the summary of our cost behavior

discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 The Activity Base

Units
Units Machine
Machine
produced
produced hours
hours

A
A measure
measure ofof what
what
causes
causes the
the
incurrence
incurrence ofof aa
variable
variable cost
cost

Miles
Miles Labor
Labor
driven
driven hours
hours
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 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 Distance
Telephone Bill

Minutes Talked
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Types of Cost Behavior Patterns

Recall the summary of our cost behavior

discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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.

Telephone Charge
Per Minute

Minutes Talked
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Extent of Variable Costs

The proportion of variable costs differs across

organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
proportion of variable costs.
like cost of sales.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 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 Copyright © 2006, The McGraw-Hill Companies, Inc.

 The Linearity Assumption and the Relevant Range

Economist’s A
A straight
straight line
line
closely
closely
Curvilinear Cost approximates
approximates aa
Function curvilinear
curvilinear
variable
variable cost
cost
Relevant line
line within
within the
the
Total Cost

relevant
relevant range.
range.
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Types of Cost Behavior Patterns

Let’s look at fixed cost behavior on the next

screens.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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.
Telephone Bill
Monthly Basic

Number of Local Calls

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Types of Cost Behavior Patterns

Recall the summary of our cost behavior

discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Types of Fixed Costs

Committed
Committed Discretionary
Discretionary
Long-term,
Long-term, cannot
cannot bebe May
May be
be altered
altered in
in the
the
significantly
significantly reduced
reduced short-term
short-term byby current
current
in
in the
the short
short term.
term. managerial
managerial decisions
decisions

Examples Examples
Examples
Depreciation on Advertising
Advertising and
and
Equipment and Research
Research and
and
Real Estate Taxes Development
Development
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 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 Knowledge
Knowledge workers
workers
many
many mundane/routine
mundane/routine taskstasks tend
tend toto be
be salaried,
salaried,
previously
previously performed
performed highly-trained
highly-trained andand
by
by humans,
humans, difficult
difficult to
to replace.
replace. The
The
““knowledge
knowledge workers
workers”” cost
cost toto compensate
compensate
are
are demanded
demanded for for these
these valued
valued employees
employees
their
their minds
minds rather
rather is
is relatively
relatively fixed
fixed
than
than their
their muscles
muscles rather
rather than
than variable.
variable.
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 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/freedom. Labor costs are more variable in nature.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Fixed Costs and Relevant Range

90
Thousands of Dollars

Total
Total cost
cost doesn’t
doesn’t
Rent Cost in

Relevant change
change for
for aa wide
wide
60 range
range of
of activity,
activity,
Range
and
and then
then jumps
jumps to to aa
new
new higher
higher cost
cost for
for
30 the
the next
next higher
higher
range
range of
of activity.
activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Fixed Costs and Relevant Range

The relevant range of activity for a fixed cost

is the range of activity over which the graph of
the cost is flat.
Example:
Example: Office
Office space
space isis
available
available at
at aa rental
rental rate
rate of
of
$30,000
$30,000 perper year
year in
in
increments
increments of of 1,000
1,000 square
square
feet.
feet. As As the
the business
business grows
grows
more
more space
space isis rented,
rented,
increasing
increasing the
the total
total cost.
cost.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Mixed Costs

A
A mixed
mixed cost
cost has
has both
both fixed
fixed and
and variable
variable
components.
components. Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Y
Total Utility Cost

s t
co
d
i xe
l m
ta
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Mixed Costs

Y
Total Utility Cost

s t
co
d
i xe
l m
ta
To Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 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?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Analysis of Mixed Costs

Account Analysis and the Engineering Approach

Each
Each account
account isis classified
classified as
as either
either
variable
variable or
or fixed
fixed based
based on
on the
the analyst’s
analyst’s
knowledge
knowledge of of how
how the
the account
account behaves.
behaves.

Cost
Cost estimates
estimates are
are based
based on
on an
an
evaluation
evaluation of
of production
production methods,
methods, and
and
material,
material, labor
labor and
and overhead
overhead
requirements.
requirements.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 The Scattergraph Method

Plot
Plot the
the data
data points
points on
on aa graph
graph
(total
(total cost
cost vs.
vs. activity).
activity).
Y
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 The Scattergraph Method

Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about anan
equal
equal numbers
numbers of of points
points above
above and
and below
below the
the line.
line.
Y
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 The Scattergraph Method

Use
Use one
one data
data point
point to
to estimate
estimate thethe total
total level
level of
of activity
activity
and
and thethe total
total cost.
cost.
Y Total maintenance cost = $11,000
20
Maintenance Cost

* ** *
1,000’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
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 The Scattergraph Method

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.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

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 The High-Low Method

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

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 The High-Low Method

The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $8.00/hour
300

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 The High-Low Method

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

Sales
Sales salaries
salaries and
and commissions
commissions areare $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 Copyright © 2006, The McGraw-Hill Companies, Inc.

 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? Units Cost
a.
a. $0.08
$0.08 per
per unit
unit High level 120,000 $ 14,000
b.
b. $0.10
$0.10 per
per unit
unit Low level 80,000 10,000
c.
c. $0.12
$0.12 per unit Change
per unit 40,000 $ 4,000

d.
d. $0.125
$0.125 per
per unit
unit $4,000 ÷ 40,000 units
= $0.10 per unit

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

Sales
Sales salaries
salaries and
and commissions
commissions areare $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 Copyright © 2006, The McGraw-Hill Companies, Inc.

 Quick Check 

Sales
Sales salaries
salaries and
and commissions
commissions areare $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 Copyright © 2006, The McGraw-Hill Companies, Inc.

 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.
(p. 227 or pdf. 259)

This method uses all of the

data points to estimate
the fixed and variable The goal of this method is
cost components of a to fit a straight line to the
mixed cost. data that minimizes the
sum of the squared errors.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Least-Squares Regression Method

• 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
Least-squares regression
regression also
also provides
provides aa statistic,
statistic,
2
called
called the
the RR2,, that
that is
is aa measure
measure ofof the
the goodness
goodness
of
of fit
fit of
of the
the regression
regression line
line to
to the
the data
data points.
points.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 Least-Squares Regression Method

2
R2 is
R is the
the percentage
percentage of
of the
the variation
variation inin total
total cost
cost
explained
explained by
by the
the activity.
activity.
Y
20
* ** *
Total Cost

* * **
10 * *
R2 varies from 0% to 100%, and
the higher the percentage the better.
0 X
0 1 2 3 4
Activity
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.
 Comparing Results From the Three Methods

The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates ofof 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 Copyright © 2006, The McGraw-Hill Companies, Inc.

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

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 The Contribution Format

Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000

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 Copyright © 2006, The McGraw-Hill Companies, Inc.
 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
decision making
making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.
1. Cost-volume-profit
Cost-volume-profit analysis
analysis (Chapter
(Chapter 6).
6).
2.
2. Budgeting
Budgeting (Chapter
(Chapter 9).
9).
3.
3. Segmented
Segmented reporting
reporting of
of profit
profit data
data (Chapter
(Chapter 12).
12).
4.
4. Special
Special decisions
decisions such
such as
as pricing
pricing and
and make-or-
make-or-
buy
buy analysis
analysis (Chapter
(Chapter 13).
13).

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 The Contribution Format

Used primarily for Used primarily by

external reporting. management.

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