University of Luzon Dagupan City ACC308

COST BEHAVIOR: ANALYSIS AND USE

Key Terms and Concepts to Know
Cost Classifications for Predicting Cost Behavior
Costs may be classified by how they behave in total when the activity level changes: In Total Varies The same Varies Per Unit The same Varies inversely Varies(often inversely)

Variable Cost Fixed Cost Mixed Cost

The relevant range is the range of activity levels throughout which the assumptions for cost behavior are valid. Outside the relevant range, total fixed costs may change and/or variable costs per unit may change. The activity level or allocation base is a measure of the activity that causes total variable cost to change. Common activity bases are: direct labor hours, machine hours, units produced, and units sold.

True variable cost is a cost that varies in direct proportion to the level of activity.
Direct material is an example of true variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts of direct materials purchased but not used can be stored and carried forward to the next period as inventory.

Step-variable cost is a cost of a resource that is obtainable only in large chunks

and that increases and decreases only in response to fairly wide changes in activity. Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.

Committed fixed costs relate to costs that the company will incur over the
longterm. These costs, such as depreciation expense, property tax expense and insurance expense, cannot be changed during short periods of time and are only somewhat under the control of management.

Discretionary fixed costs usually arise from annual decisions by management and
can be changed during short periods of time such as advertising, research and public relations.

Mixed costs contain both variable and fixed cost elements. For example, a
companys selling expenses may include fixed expenses, such as the advertising costs and the base salary of the sales manager; and variable costs, such as sales commissions paid to the regional salesmen.

University of Luzon Dagupan City ACC308

Contribution Margin Income Statement

The traditional income statement separates expenses by function emphasizing the distinction between production, administration and selling expenses. Gross margin is the first key measure of profitability. The contribution margin income statement separates expenses by behavior, emphasizing the distinction those revenues and expenses that change when the level of activity changes and those that are unaffected by changes in the level of activity. Contribution margin is the first key measure of profitability.

Key Topics to Know

Separating Mixed Costs into Fixed and Variable Elements
In order to predict the profits of a company, it is necessary to separate all costs into either fixed costs or variable costs. Many costs are clearly variable, such as direct labor, or, clearly fixed, such as rent. Mixed costs must be separated into their fixed and variable elements using one of three methods and a regression line developed to predict total mixed costs at various levels of activity. The equation of the regression line takes the form: Total Cost = Fixed Cost + Variable Cost Y = a + bx Least Squares Regression Method A rigorous, mathematical approach in which a series of data points are used to develop a regression line to predict total costs. Scattergraph Method Plots a series of data points for the mixed costs and the activity which produced these costs. The Y axis is dollars of mixed cost and the X axis is the activity level. A regression line is drawn by best guess through one of the data points and a point on the Y axis with an approximately the same number of data points above and below the line. The point where the line crosses Y axis represents the fixed cost, the only cost incurred at zero activity. For any data point, the difference between the total mixed cost and the fixed cost is total variable cost and total variable cost divided by the activity level for the data point is variable cost per unit.

University of Luzon Dagupan City ACC308 High-Low Method From a series of data points, uses only the high and low data points, based on activity, to develop a regression line to predict total costs. Variable cost per unit (b) is calculated first:

Using either the high point or low point, total fixed cost is calculated next: Fixed Cost = Total Cost - Variable Cost a = Y bx Example # 1: Travis Inc. employed several maintenance engineers to keep the equipment running in peak condition. Over the past eight months, Travis incurred the following maintenance cost for these engineers. Plant activity is best measured by direct labor hours. Month January February March April May June July August Direct Labor Hours 1,700 1,900 1,800 1,600 1,500 1,300 1,100 1,400 Maintenance Cost P14,300 P15,200 P16,700 P14,000 P14,300 P13,000 P12,800 P14,200

Required: Determine the fixed and variable components of the maintenance costs using the following methods: a. High Low Method b. Least Squares Regression Method Example #2: Strummer Inc. manufactures and sells guitars for beginning students. Their income statement for April, 2010 was as follows: Sales Cost of Goods Sold Gross Margin Selling and Administrative Expenses: Selling expense Administrative expense Operating Income P600,000 400,000 200,000 60,000 90,000 150,000 P50,000

The product sells for P300 each. Variable selling expenses are P20 per unit sold with the remaining selling expenses being fixed. The administrative expenses are 40% fixed. The companys manufacturing costs are 75% variable. Required: Prepare an income statement using the contribution margin approach.
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University of Luzon Dagupan City ACC308 Exercises True or False 1. The relevant range is the range in which costs remain variable. 2. A variable cost increases in total as the volume increases. 3. A fixed cost will stay constant on a per unit basis as the volume increases. 4. The equation for a mixed cost is total fixed costs + variable cost per unit x units of activity. 5. Contribution margin is defined as sales revenue less variable costs. 6. Contribution margin plus variable cost per unit equals total sales revenue. 7. The unit contribution margin tells how much each additional unit sold will contribute to covering variable costs. 8. If volume increases, all costs will increase

Practice Problem #1:

Active Company accumulated the following data for a delivery truck. Miles Driven Total Cost January 10,000 P15,000 March 9,000 P12,500 February 8,000 P14,500 April 7,500 P13,000 Required: a) Determine the equation to predict total costs for the delivery truck. b) What should total costs be if 12,187 miles were driven? Practice Problem #2: The Lawn Mower Shop is a retailer that sells lawn mowers. The income statement for the month of June showed a gross margin of P60,000 and operating income of P20,000. Selling and administrative expenses were 50% fixed. Two hundred mowers were sold at an average price of P750 per unit. All mowers are purchased from Toro and John Deere. Required: a) Prepare an income statement for the month using the contribution approach. b) What is the contribution margin per unit? Practice Problem #3: When the Tom-Tom Companys controller was asked to budget the cost of manufacturing supplies for the next year, she plotted supplies cost and units produced by month for the year. She then drew a regression line through the point she plotted for November when the supplies cost was P21,000 and 5,000 drum sets were produced. Required: If the regression line intersected the Y axis at P6,000, determine the equation of the regression line.