Managerial Accounting

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 5

Cost Behavior:Analysis and Use

5-2

Understand how fixed andvariable costs behave and how

to use them to predict costs.

5-3

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable

Fixed

Types of Cost Behavior Patterns

5-4

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: Office space is available at a rental rate of

$30,000 per year in increments of 1,000 square

feet. As the business grows, more space is rented,

increasing the total cost.

5-5

Ren

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0 1,000 2,000 3,000 Rented Area (Square Feet)

0

30

60

Fixed Costs and Relevant Range

90

Relevant

Range

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.

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.

5-6

The Activity Base= Cost Driver

A measure of what causes the

incurrence of a variable cost.

A measure of what causes the

incurrence of a variable cost.

UnitsUnitsproducedproduced

UnitsUnitsproducedproduced

Miles driven

Miles driven

Labor hours

Labor hours

Machine hours

Machine hours

5-7

Minutes Talked

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True Variable Cost Example

Your total long distance telephone bill is based on how many

minutes you talk.

5-8

Minutes Talked

To

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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.

5-9

Minutes Talked

Per

Min

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Variable Cost Per Unit Example

A variable cost remains constant if expressed on a per unit basis.

The per minute cost of long distance calls

is constant, for example, 10¢ per

minute.

5-10

Examples of Variable Costs

1.1. Merchandising companiesMerchandising companies – cost of goods sold. – cost of goods sold.

2.2. Manufacturing companiesManufacturing companies – direct materials, – direct materials, direct labor, and variable overhead.direct labor, and variable overhead.

3.3. Merchandising and manufacturing companiesMerchandising and manufacturing companies – – commissions, shipping costs, and clerical costs commissions, shipping costs, and clerical costs such as invoicing.such as invoicing.

4.4. Service companiesService companies – supplies, travel, etc… – supplies, travel, etc…

1.1. Merchandising companiesMerchandising companies – cost of goods sold. – cost of goods sold.

2.2. Manufacturing companiesManufacturing companies – direct materials, – direct materials, direct labor, and variable overhead.direct labor, and variable overhead.

3.3. Merchandising and manufacturing companiesMerchandising and manufacturing companies – – commissions, shipping costs, and clerical costs commissions, shipping costs, and clerical costs such as invoicing.such as invoicing.

4.4. Service companiesService companies – supplies, travel, etc… – supplies, travel, etc…

5-11

Volume

Co

st

True Variable Cost

Direct materials is a true or proportionately variable cost because the amount used duringa period will vary in direct proportion to the

level of production activity.

Direct materials is a true or proportionately variable cost because the amount used duringa period will vary in direct proportion to the

level of production activity.

5-12

Step-Variable Costs

A resource that is obtainable only in large A resource that is obtainable only in large chunks and whose costs increase or decrease chunks and whose costs increase or decrease

only in response to fairly wide changes in only in response to fairly wide changes in activity.activity.

A resource that is obtainable only in large A resource that is obtainable only in large chunks and whose costs increase or decrease chunks and whose costs increase or decrease

only in response to fairly wide changes in only in response to fairly wide changes in activity.activity.

Volume

Co

st

5-13

Step-Variable Costs

Small changes in the level of activity are not likely to have any effect on that certain cost

at that level.

Small changes in the level of activity are not likely to have any effect on that certain cost

at that level.

Volume

Co

st

5-14

Number of Local Calls

Mo

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Bill

Total Fixed Cost Example

Your monthly basic telephone bill is

probably fixed and does not change when you make more local calls.

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

5-15


Mo

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Total Fixed Cost Example

Your monthly basic telephone bill is

probably fixed and does not change when you make more local calls.

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

5-16

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges

level within the relevant range. of activity.

Total fixed cost remains thesame even when the activity Fixed cost per unit goes

Fixed level changes within the down as activity level goes up. relevant range. (inversely proportional to activity)

Types of Cost Behavior Patterns

5-17


Mo

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Fixed Cost Per Unit Example

Average fixed costs per unit decreaseas the activity level increases.

The fixed cost per local call decreases as more local calls

are made.

5-18

ExamplesAdvertising and Research and Development

ExamplesAdvertising and Research and Development

ExamplesDepreciation on Buildings and

Equipment and Real Estate Taxes

ExamplesDepreciation on Buildings and

Equipment and Real Estate Taxes

Types of Fixed Costs

DiscretionaryMay be altered in the short-term by current managerial decisions

DiscretionaryMay be altered in the short-term by current managerial decisions

CommittedLong-term, cannot be significantly reduced

in the short-term.

CommittedLong-term, cannot be significantly reduced

in the short-term.

5-19

The Trend Toward Fixed Costs

The trend in many industries is toward greater fixed costs relative to variable costs.

As machines take overAs machines take overmany routine tasksmany routine tasks

previously performedpreviously performedby humans, by humans,

““knowledge workersknowledge workers””are demanded forare demanded fortheir minds rathertheir minds rather

than their muscles.than their muscles.

As machines take overAs machines take overmany routine tasksmany routine tasks

previously performedpreviously performedby humans, by humans,

““knowledge workersknowledge workers””are demanded forare demanded fortheir minds rathertheir minds rather

than their muscles.than their muscles.

Knowledge workersKnowledge workerstend to be salaried,tend to be salaried,highly-trained andhighly-trained and

difficult to replace. Thedifficult to replace. Thecost to compensatecost to compensate

these valued employeesthese valued employeesis is relatively fixedrelatively fixed

rather than variable.rather than variable.

Knowledge workersKnowledge workerstend to be salaried,tend to be salaried,highly-trained andhighly-trained and

difficult to replace. Thedifficult to replace. Thecost to compensatecost to compensate

these valued employeesthese valued employeesis is relatively fixedrelatively fixed

rather than variable.rather than variable.

5-20

Quick Check

Which of the following statements about cost behavior is true (more than one could be true)?

1. Fixed costs per unit vary with the level of activity.

2. Variable costs per unit are constant within the relevant range.

3. Total fixed costs are constant within the relevant range.

4. Total variable costs are constant within the relevant range.






5-21











Quick Check

5-22

Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal

Uti

lity

Co

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X

Y

A mixed cost has both fixed and variablecomponents. Consider your utility costs. A mixed cost has both fixed and variablecomponents. Consider your utility costs.

Mixed Costs

Total mixed cost

5-23

Mixed Costs

Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal

Uti

lity

Co

st

X

Y

Total mixed cost

5-24

Mixed Costs Example

If your fixed monthly utility charge is $40, your If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, what is variable cost is $0.03 per kilowatt hour, what is

the equation to get the mixed cost:the equation to get the mixed cost:



5-25

Mixed Costs Example





Y = a + bX

5-26

Mixed Costs Example





Y = a + bX

Y = $40 + $0.03X

5-27

Mixed Costs Example

If your fixed monthly utility charge is $40, your If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, the monthly activity level is 2,000 kilowatt hours, the

amount of your utility bill is:amount of your utility bill is:



Y = a + bX

Y = $40 + $0.03 X

5-28

Mixed Costs Example





Y = a + bX

Y = $40 + ($0.03 × 2,000)

Y = $100$100

5-29

Using a Scattergraph plotto diagnose cost behavior.

5-30

Plot the data points on a graph Plot the data points on a graph (total cost vs. activity).(total cost vs. activity).

Plot the data points on a graph Plot the data points on a graph (total cost vs. activity).(total cost vs. activity).

0 1 2 3 4

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Machine-Hours (in 1,000’s)

X

Y

The Scattergraph Method

5-31


0 1 2 3 4

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X

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Draw a line Draw a line through the through the data points data points with about with about an equal an equal

number of number of points above points above

and below and below the line. the line.

Draw a line Draw a line through the through the data points data points with about with about an equal an equal

number of number of points above points above

and below and below the line. the line.

5-32


Use one Use one data point data point to estimate to estimate

the totalthe totallevel of level of activity activity and the and the

total cost. total cost.

Use one Use one data point data point to estimate to estimate

the totalthe totallevel of level of activity activity and the and the

total cost. total cost. 0 1 2 3 4

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X

Y

Machine-Hours= 800Machine-Hours= 800

Total maintenance cost = $11,000Total maintenance cost = $11,000

5-33


Make a quick estimate of variable cost perMake a quick estimate of variable cost perunit and determine the cost equation. unit and determine the cost equation.

Make a quick estimate of variable cost perMake a quick estimate of variable cost perunit and determine the cost equation. unit and determine the cost equation.

Variable cost per unit = $1,000 800

= $1.25/machine-hour$1.25/machine-hour

Y = $10,000 + $1.25XY = $10,000 + $1.25XY = $10,000 + $1.25XY = $10,000 + $1.25X

Total maintenance at 800 machine-hours 11,000$ Less: Fixed cost 10,000 Estimated total variable cost for 800 machine-hours 1,000$

Total maintenance at 800 machine-hours 11,000$ Less: Fixed cost 10,000 Estimated total variable cost for 800 machine-hours 1,000$

Total maintenance costTotal maintenance costTotal maintenance costTotal maintenance cost Number of machine-hoursNumber of machine-hoursNumber of machine-hoursNumber of machine-hours

5-34

Analyzing a mixed costusing the high-low method.

5-35The High-Low Method

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

related to the Activity level

5-36

The High-Low Method

The The variable cost variable cost per hourper hour of of

maintenance is maintenance is equal to the change equal to the change

in cost divided by in cost divided by the change in hours.the change in hours.

The The variable cost variable cost per hourper hour of of

maintenance is maintenance is equal to the change equal to the change

in cost divided by in cost divided by the change in hours.the change in hours.

= $8.00/hour$2,400

300

Hours Total CostHigh 800 9,800$ Low 500 7,400 Change 300 2,400$

5-37

The High-Low Method

Total Fixed Cost = Total Cost – Total Variable CostTotal Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour Total Fixed Cost = $9,800 – ($8/hour × 800 hours)× 800 hours)

Total Fixed Cost = $9,800 – $6,400Total Fixed Cost = $9,800 – $6,400

Total Fixed Cost = Total Fixed Cost = $3,400$3,400

5-38

The High-Low Method

Y = $3,400 + $8.00Y = $3,400 + $8.00XXThe Cost Equation for Maintenance

5-39

Quick Check

Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission?

a. $0.08 per unit

b. $0.10 per unit

c. $0.12 per unit

d. $0.125 per unit


a. $0.08 per unit

b. $0.10 per unit

c. $0.12 per unit

d. $0.125 per unit

5-40


a. $0.08 per unit

b. $0.10 per unit

c. $0.12 per unit

d. $0.125 per unit


a. $0.08 per unit

b. $0.10 per unit

c. $0.12 per unit

d. $0.125 per unit

Quick Check

$4,000 ÷ 40,000 units = $0.10 per unit

Units Cost

High level 120,000 14,000$

Low level 80,000 10,000

Change 40,000 4,000$

5-41

Quick Check

Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000


a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

5-42


a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000


a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

Quick Check

5-43

Preparing an income statementusing the contribution format.

5-44

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$

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 contribution margin format emphasizes The contribution margin format emphasizes cost behavior, by separating costs into fixed cost behavior, by separating costs into fixed and variable categories. Contribution margin and variable categories. Contribution margin covers fixed costs and provides for income.covers fixed costs and provides for income.

The contribution margin format emphasizes The contribution margin format emphasizes cost behavior, by separating costs into fixed cost behavior, by separating costs into fixed and variable categories. Contribution margin and variable categories. Contribution margin covers fixed costs and provides for income.covers fixed costs and provides for income.

5-45

Uses of the Contribution Format

The contribution income statement format is used The contribution income statement format is used as an internal planning and decision making tool. as an internal planning and decision making tool.

We will use this approach for:We will use this approach for:

1.1. Cost-volume-profit analysis (chapter 6).Cost-volume-profit analysis (chapter 6).

2.2. Budgeting (chapter 7).Budgeting (chapter 7).

3.3. Special decisions such as pricing and make-or-Special decisions such as pricing and make-or-buy analysis (chapter 11).buy analysis (chapter 11).

The contribution income statement format is used The contribution income statement format is used as an internal planning and decision making tool. as an internal planning and decision making tool.

We will use this approach for:We will use this approach for:

1.1. Cost-volume-profit analysis (chapter 6).Cost-volume-profit analysis (chapter 6).

2.2. Budgeting (chapter 7).Budgeting (chapter 7).

3.3. Special decisions such as pricing and make-or-Special decisions such as pricing and make-or-buy analysis (chapter 11).buy analysis (chapter 11).

5-46

The Contribution Format

Used primarily forUsed primarily forexternal reporting.external reporting.

Used primarily byUsed primarily bymanagement.management.

5-47

End of Chapter 5

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Managerial Accounting