Cost Behavior

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

Cost Behavior

Chapter 6

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Objective 1Describe key characteristics and graphs

of various cost behaviors

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Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. 3

Cost Behavior

Cost behavior—how costs change as volume changes.

There are three common cost behaviors: 1. Variable costs2. Fixed costs3. Mixed costs


Key Characteristics of Variable Costs

• Total variable costs change in direct proportion to changes in volume

• Variable cost per unit remains constant

• Slope

Total variable cost (y) = Variable cost per unit of activity (v) x Volume of activity (x)

or y=vx


Cost Graphs

• Vertical (y-axis) always shows total costs• Horizontal axis (x-axis) shows volume of

activity

TotalCosts

Total volume of activity

Note that the variable cost per customer remains constant in each of the graphs.


Total Variable Costs


Objective 2Use cost equations to express and

predict costs

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Cost Equation• Is a mathematical equation for a straight line, to predict

total cost

Total cost = total variable cost + total fixed cost or Y = vx + f

WhereY = total mixed costv = variable cost per unit of activityx = volume of activityf = fixed cost over a given period of time


Key Characteristics of Fixed Costs• Total fixed costs stay constant over relevant range*

• Fixed costs per unit of activity vary inversely with changes in volume

• Total fixed cost (y) = Fixed amount over a period of time (f)– y = f

*Relevant range is the normal operating range of activity


Total Fixed Costs


Costs and Decisions

• Committed fixed costs

• Discretionary fixed costs


Key Characteristics of Mixed Costs• Total mixed costs increase as volume increases

• Total mixed costs can be expressed as a combination of the variable and fixed cost equations:

Total mixed cost = total variable cost + total fixed cost or Y = vx + f

WhereY = total mixed costv = variable cost per unit of activityx = volume of activityf = fixed cost over a given period of time


Mixed Costs

Variable

Fixed


Now turn to S6-1


S6-1 Identify Cost Behavior

Cost ACost BCost C

Variable CostFixed CostMixed Cost


Relevant Range

• Band of volume where total fixed costs remain constant at a certain level

• Variable costs per unit remain constant at a certain level


Other Cost Behaviors

Step Costs


Other Cost Behaviors

Curvilinear Costs


Now turn to E6-22A


E6-22AGarments

4,500 6,000 7,500Total Variable Costs $5,100Total Fixed CostsTotal Operating Costs

Variable Cost/garment

Fixed Cost/garment $2.40 Average cost/garment


E6-22A (cont.)Garments

4,500 6,000 7,500Total Variable Costs $5,100Total Fixed CostsTotal Operating Costs

Variable Cost/garment $0.85 $0.85 $0.85

Fixed Cost/garment $2.40Average cost/garment



4,500 6,000 7,500Total Variable Costs $3,825 $5,100 $6,375Total Fixed CostsTotal Operating Costs





4,500 6,000 7,500Total Variable Costs $3,825 $5,100 $6,375Total Fixed Costs $14,400 $14,400 $14,400Total Operating Costs





4,500 6,000 7,500Total Variable Costs $3,825 $5,100 $6,375Total Fixed Costs $14,400 $14,400 $14,400Total Operating Costs $18,225 $19,500 $20,775







Fixed Cost/garment $3.20 $2.40 $1.92

Average cost/garment





Fixed Cost/garment $3.20 $2.40 $1.92

Average cost/garment $4.05 $3.25 $2.77


E6-22A (cont.)

The average cost per garment changes as volume changes, due to the fixed component of the dry cleaner’s costs. The fixed cost per unit decrease as volume increases, while the variable cost per unit remains constant.

Actual costs at 4,500 garments$12,465 Total predicted costs ($2.77 × 4,500 garments)(18,225) Actual costs at 4,500 garments$5,760 Difference (underestimated)


Now turn to E6-25A


E6-25A

Data: Freedom Mailbox produces decorative mailboxes. The company’s average cost per unit is $24.43 when it produces 1,300 mailboxes.

1. 1,300 x $24.43 $31,759

2. Total costs $31,759Less total fixed costs (21,359)Total variable costs $10,400

÷ 1,300 Variable cost per mailbox $8.00


E6-25A

3. y = $8.00x + $21,359

4. $24.43 x 1,700 mailboxes = $41,531

5. y = ($8.00 x 1,700) + $21,359 = $34,959


E6-25A

6. Using average at 1,700 $41,531 Using cost equation $34,959

$6,572


Sustainability and Cost Behavior

• Sustainable companies and changes in cost behavior• E-banking and e-billing drive down variable

costs• Greener lifestlyes• Environmental Impact


Objective 3Use account analysis and scatter plots to

analyze cost behavior

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Cost Behavior Analysis

• Four methods to analyze cost behavior– Account Analysis– Scatter Plots– High-Low Method– Regression Analysis


Account Analysis

• Use of judgment to classify each general ledger account as variable, fixed, or mixed

• Subjective


Scatter Plots

• Use historical data to determine a cost’s behavior

• Scatter plot is the graph of historical cost data on the y-axis and volume data on the x-axis

• Helps managers visually determine how strong the relationship is between the cost and the volume of the chosen activity base


Scatter Plot Example

Miles Driven

Tota

l Cos

t


Objective 4Use the high-low method to analyze

cost behavior

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High-Low Method

Step 1: Find variable cost per unit (slope) of cost line Step 2: Find the fixed costs (vertical intercept)Step 3: Create the cost equation

Advantage: Easy to useDisadvantage: Only uses 2 data points


Turn to E6-28A


High-Low Method: E6-28A

• Step 1: Find slope of the mixed cost line

(variable cost/unit) = Δ in cost (y) / Δ in volume (x)

• The slope represents the variable cost per unit of activity

($5,730 -$5,040) ÷ (18,500-15,500)$690 ÷ 3,000 = $0.23


High-Low Method: E6-28A (cont.)

• Step 2: Find the vertical intercept

Fixed costs = Total mixed cost – Total variable cost

$5,730 – ($0.23 • 18,500) = $1,475OR$5,040 – ($0.23 • 15,500) = $1,475


High-Low Method: E6-28A (cont.)

• Step 3: Create and use an equation to show the behavior of a mixed cost

Y = $0.23 per mile + $1,475

Predicted operating costs at 16,000 miles:($0.23 x 16,000) + $1,475 = $5,155


Objective 5Use regression analysis to analyze

cost behavior

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Regression Analysis – Exhibit 6-15

• Statistical procedure to find the line that best fits data (cost equation)

• Uses all data points• R-square, Intercept, X Variable 1



• Intercept = Fixed cost• X Variable 1 = Variable cost per activity unit• R Square = goodness of fit



• Utilities monthly cost equation =y = $7.85x + $14,538

where y = total monthly utilities costx = number of guests


R-Square Value

• “Goodness of fit”

• How well does the line fit the data points?

• Ranges from 0 to 1


Predicting Costs & Data Concerns

• Data Concerns– Only valid within relevant range– Seasonal variations– Inflation– Outliers – abnormal data points


Objective 6Describe variable costing and prepare a contribution margin income statement

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Absorption Costing

• Required by GAAP for external reporting

• Assign all manufacturing costs to products (DM, DL, Variable MOH, and Fixed MOH)

• Traditional (conventional) income statement


Traditional (Conventional) Income Statement

Sales- Cost of Goods Sold Gross Margin- Selling, general, and administrative costs Operating Income


Variable Costing• Assigns only variable manufacturing costs to

products (DM, DL, and Variable MOH)

• Fixed manufacturing overhead = period cost

• For internal management decisions

• Contribution Margin income statement


Contribution Margin Income Statement

Sales- Variable Costs Contribution Margin- Fixed Costs Operating Income


Reconciling Operating Income Between the Two Costing Systems

• Difference in Operating Income = (Change in inventory level, in units) x (Fixed MOH per unit)


Now turn to E6-44A


E6-44AConventional (Absorption Costing) Income Statement



Sales revenue (205,000 $44) $9,020,000



Sales revenue (205,000 $44) $9,020,000

Less: Cost of Goods Sold (205,000 x $26) ( 5,330,000)

• Fixed mfg per unit = $2,475,000 fixed MOH / 225,000 units produced = $11 per unit• Variable MOH per unit $15 (given)• Total manufacturing cost per unit = $11 + $15 = $26



Sales revenue (205,000 $44) $9,020,000


Gross Profit 3,690,000




Sales revenue (205,000 $44) $9,020,000



Operating Expenses [(205,000 x $6) + $250,000] (1,480,000)




Sales revenue (205,000 $44) $9,020,000



Operating Expenses [(205,000 x $6) + $250,000] (1,480,000)

Operating Income $2,210,000



E6-44A (cont.)

Now we turn to the Contribution Margin Income Statement (VARIABLE COSTING STMT)

First need to calculate:Variable cost of goods sold


E6-44A (cont.)• Variable cost of goods sold:

Beginning finished goods inventory $ 0Variable cost of goods manufactured ($15 x

225,000) 3,375,000Variable cost of goods available

for sale 3,375,000Ending fin. goods inv. ($15 x 20,000) (300,000)Variable cost of goods sold* $3,075,000

*Also can calculate as 205,000 units x $15 = $3,075,000


E6-44A (cont.)Contribution Margin (Variable Costing) Income Statement

Sales revenue (205,000 $44) $9,020,000



Sales revenue (205,000 $44) $9,020,000

Variable expenses:

Variable COGS (from prior calculation)

$3,075,000*



Sales revenue (205,000 $44) $9,020,000

Variable expenses:


$3,075,000*

Sales comm expense ($6x205,000) 1,230,000 (4,305,000)



Sales revenue (205,000 $44) $9,020,000

Variable expenses:


$3,075,000*


Contribution margin $4,715,000



Sales revenue (205,000 $44) $9,020,000

Variable expenses:


$3,075,000*



Fixed expenses:

MOH (given in exercise) $2,475,000

Operating expenses (given) 250,000 (2,725,000)



Sales revenue (205,000 $44) $9,020,000

Variable expenses:


$3,075,000*



Fixed expenses:

MOH $2,475,000

Operating expenses 250,000 (2,725,000)

Operating income $1,990,000


E6-44A (cont.)Req. 2 Difference between the two methods:Change in inventory x Fixed MOH per unit = (20,000 x $11*) = $220,000

*$11 is the fixed MOH per unit ($2,475,000 / 225,000)

Traditional method produces the higher operating income because of the fixed MOH still remaining in inventory.

Proof:Traditional operating income $2,210,000Contribution margin operating income 1,990,000Difference $ 220,000


E6-44A (cont.)

Req. 3Incremental analysis:

Increase in contribution margin $460,000 [($44-$21)*20,000 goggles]Increase in fixed costs (145,000)Increase in operating income $315,000


Now turn to S6-16


Patricia’s Quilt ShoppeTraditional Income Statement

Month Ended February 28 Sales revenue (75 × $380) $28,500Less: Cost of goods sold (75 × $230) (17,250)Gross profit 11,250Less: Operating expenses:

Sales commissions (10% × $28,500) (2,850)Payroll costs (1,200)Lease (800)

Operating income $ 6,400

S6-16


S6-16 (cont.)Patricia’s Quilt Shoppe

Contribution Margin Income StatementMonth Ended February 28

Sales revenue (75 × $380) $28,500Less: Variable costs:Cost of goods sold (75 × $320) (17,250)

Sales commissions (10% × $28,500) (2,850)

Contribution margin 8,400Less: Fixed costs:Payroll costs (1,200)Lease (800)Operating income $ 6,400


Absorption Costing and Manager Incentives

• When inventories increase, absorption costing income is higher than variable costing income.

• When inventories decrease, absorption costing income is lower than variable costing income.

• Therefore…managers may increase production to build up inventory to maximize income and, therefore, their own bonus.


End of Chapter 6

Cost Behavior

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