Cost Behavior: Analysis and Use

Chapter 5

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

The Activity Base (also called a cost driver)

A measure of what causes the

incurrence of a variable cost

A measure of what causes the

incurrence of a variable cost

Unitsproduced

Unitsproduced

Miles drivenMiles driven

Machine hours

Machine hours

Labor hoursLabor hours

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Minutes Talked

Tot

al O

vera

ge

Cha

rges

on

Cel

l P

hone

Bill

True Variable Cost – An ExampleAs 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.

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Minutes Talked

Per

Min

ute

Ove

rage

Cha

rge

Variable Cost Per Unit – An Example

Referring to the cell phone example, the cost per overage minute is constant, for example 45 cents per

overage minute.

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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.

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.

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Volume

Cos

t

True Variable Costs

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.

Direct material is another example of a cost that behaves in a true variable pattern.

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Step-Variable CostsA step-variable coststep-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

Cos

t

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RelevantRange

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

Activity

Tot

al C

ost

Economist’sCurvilinear Cost

Function

The Linearity Assumption and the Relevant Range

Accountant’s Straight-Line Approximation (constant

unit variable cost)

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Number of Minutes Used within Monthly Plan

Mon

thly

Bas

ic

Cel

l Pho

ne B

illTotal Fixed Cost – An Example

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.

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Number of Minutes Used within Monthly Plan

Cos

t Per

Cel

l Pho

ne C

all

Fixed Cost Per Unit Example

For example, the fixed cost per minute used decreases as more allowed minutes are used.

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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 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.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 differentlydepending upon their strategy. Most companies in the

United States continue to view direct labor as a variable cost.

Within countries managers can view labor costs differentlydepending upon their strategy. Most companies in the

United States continue to view direct labor as a variable cost.

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Ren

t C

ost

in T

hous

ands

of

Dol

lars

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

0

30

60

Fixed Costs and the Relevant Range

90

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.

The relevant range of activity for a fixed cost is the range of activity over which the graph of the

cost is flat.

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Mixed Costs

Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

Tot

al U

tility

Cos

t

X

Y

Total mixed cost

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The Scattergraph Method

Use one data point to estimate the total level of activity and the total cost.

Use one data point to estimate the total level of activity and the total cost.

Intercept = Fixed cost: $10,000

0 1 2 3 4

*

Mai

nten

ance

Cos

t1,

000’

s of

Dol

lars

10

20

0

***

**

**

*

*

Patient-days in 1,000’s

X

Y

Patient days = 800

Total maintenance cost = $11,000

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The High-Low Method – An Example

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.

= $6.00/hour$6.00/hour$2,400

400

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The High-Low Method – An Example

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

Total Fixed Cost = $9,800 – ($6/hour Total Fixed Cost = $9,800 – ($6/hour × 850 hours)× 850 hours)

Total Fixed Cost = $9,800 – $5,100Total Fixed Cost = $9,800 – $5,100

Total Fixed Cost = Total Fixed Cost = $4,700$4,7005-16

The High-Low Method – An Example

YY = $4,700 + $6.00 = $4,700 + $6.00XXThe Cost Equation for Maintenance

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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 This method uses allall of the of thedata points to estimatedata points to estimatethe fixed and variablethe fixed and variablecost components of acost components of a

mixed cost.mixed cost.

This method uses This method uses allall of the of thedata points to estimatedata points to estimatethe fixed and variablethe fixed and variablecost components of acost components of a

mixed cost.mixed cost.The goal of this method isThe goal of this method isto fit a straight line to theto fit a straight line to thedata that data that minimizes theminimizes the

sum of the squared errorssum of the squared errors..

The goal of this method isThe goal of this method isto fit a straight line to theto fit a straight line to thedata that data that minimizes theminimizes the

sum of the squared errorssum of the squared errors..

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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 regression also provides a statistic, called

the R2, which is a measure of the goodness

of fit of the regression line to the data points.

Least-squares regression also provides a statistic, called

the R2, which is a measure of the goodness

of fit of the regression line to the data points.

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End of Chapter 5

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