SAIYYIDAH NAFISAH BINTI SHAHAR (20190410493)

Chapter 3: Activity Cost Behavior

The Basics of Cost Behavior

Cost behavior is the general term for describing whether costs change as output changes.

Fixed Costs

A cost that stays the same as output changes is a fixed cost. More formally, a fixed cost is a cost that, in total,
remains constant within a relevant range as the level of activity output changes.

Two parts of the fixed-cost definition need further discussion: relevant range and the phrase “in total.”
Relevant range is the range of output over which the assumed cost/output relationship is valid.

Variable Costs

A variable cost is a cost that, in total, varies in direct proportion to changes in output. While fixed costs
remain unchanged as output varies, variable costs do change as output changes.

Total variable cost = Variable cost per unit x Number of units

Mixed Cost

A mixed cost is a cost that has both a fixed and a variable component. For example, sales representatives are
often paid a salary plus a commission on sales.

Total cost = Fixed cost + Total variable cost

Classifying Costs According to Behavior

Time Horizon: According to economics, in the long run, all costs are variable; in the short run, at least one
cost is fixed.

Resources and Output Measures: Resources might include materials, energy or fuel, labor, and capital. These
inputs are combined to produce an output. For example, if the activity is moving materials, the inputs could include
crates (materials), fuel (energy), a forklift operator (labor), and a forklift (capital). The output would be moved
materials. Activity drivers are divided into two general categories: production (or unit level) drivers and non-unit-
level drivers.

Non-Unit-Level Drivers: Non-unit-level drivers explain changes in cost as factors other than units change. For
example, setups are a non-unit-level activity.

Activities,Resource Usage,and Cost Behavior

Flexible resources are supplied as used and needed; they are acquired from outside sources, where the
terms of acquisition do not require any long-term commitment for any given amount of the resource. Since the cost
of the resources supplied as needed equals the cost of resources used, the total cost of the resource increases as
demand for the resource increases. Thus, the cost of flexible resources is a variable cost.

Committed resources are resources that are supplied in advance of usage; they are acquired by the use of
either an explicit or implicit contract to obtain a given quantity of resource, regardless of whether the amount of the
resource available is fully used or not. Committed fixed costs is the annual expense associated with the multi period
category is independent of actual usage of the resource which provide long-term activity capacity.

Step-Cost Behavior: A step cost displays a constant level of cost for a range of output and then at some
point jumps to a higher level of cost, where it remains for a similar range of output. Items that display step-cost
behavior must be purchased in chunks. The width of the step defines the range of output for which that amount of
resource must be acquired.
Implications for Control and Decision Making

The activity-based model just described can improve both managerial control and decision making.
Operational control systems encourage managers to pay more attention to controlling resource usage and spending.
The activity-based resource usage model also allows managers to calculate the changes in resource supply and
demand resulting from implementing such decisions as whether to make or buy a part, to accept or reject special
orders, and to keep or drop product lines.

Methods for Separating Mixed Costs into Fixed and Variable Components

Linearity Assumption: The definition of variable cost assumes a linear relationship between the cost of an activity
and its associated driver.

 Economists usually argue that variable costs increase at a decreasing rate up to a certain volume, at which
point they increase at an increasing rate. This type of nonlinear behavior is displayed in Exhibit 3-8. Here,
variable costs increase as the number of units increases, but not in direct proportion.

 If the linear relationship is assumed, then the main concern is how well this assumption approximates the
underlying cost function. Exhibit 3-9 gives us some idea of the consequences of assuming a linear cost
function.

 The equation for a straight line is Total cost = Fixed cost + (Variable rate x Output)
 The dependent variable is a variable whose value depends on the value of another variable.
 The independent variable is a variable that measures output and explains changes in the cost.
 the intercept parameter is the point at which the mixed-cost line intercepts the cost (vertical) axis. The slope
parameter corresponds to the variable cost per unit of activity.
High-Low Method

A method of determining the equation of a straight line by preselecting two points (the high and low points)
that will be used to compute the intercept and slope parameters. The high point is defined as the point with the
highest output or activity level. The low point is defined as the point with the lowest output or activity level. The high
and the low point are determined by the high amount and the low amount for the independent variable. The fixed-
cost component is computed using the total cost at either the high point or the low point.

The high-low method is usually not as accurate as the other methods because the high and low points may
be outliers.

Scatterplot Method

The scatterplot method is a method of determining the equation of a line by plotting the data on a graph.
Scattergraph is the plot the data points so that the relationship between setup costs and activity level can be seen.
The vertical axis is total setup cost, and the horizontal axis is number of setup hours. One purpose of a scattergraph
is to see whether or not an assumed linear relationship is reasonable.

The Method of Least Squares

The method of least squares defines best fitting and is objective in the sense that using the method for a
given set of data will produce the same cost formula.

The vertical distance measures the closeness of a single point to the line, but we need a measure of how
close all the points are to the line. One possibility is to measure the deviations of all points to the line and add all the
single measures to obtain an overall measure. However, this overall measure may be misleading. For example, the
sum of small positive deviations could result in an overall measure greater than the sum of large positive deviations
and large negative deviations because of the canceling effect of positive and negative numbers.

To correct for this problem, the method of least squares first squares each single deviation and then sums
these squared deviations as the overall measure of closeness. Squaring the deviations avoids the cancellation
problem caused by a mix of positive and negative numbers. Since the measure of closeness is the sum of the squared
deviations of the points from the line, the smaller the measure, the better the line fits the points.

The line that fits the points better than any other line is called the best-fitting line. It is the line with the smallest
(least) sum of squared deviations. The method of least squares identifies the best-fitting line.

Reliability of Cost Formulas

This measure is important because the method of least squares identifies the best-fitting line, but it does not
reveal how good the fit is. The best-fitting line may not be a good-fitting line.

R2—The Coefficient of Determination

 The percentage of variability in the dependent variable that is explained by an independent variable. This
percentage is a goodness-of-fit measure.
 The higher the percentage of cost variability explained, the better the fit. Since the coefficient of
determination is the proportion of variability explained, it always has a value between 0 and 1.0.

Coefficient of Correlation

 The square root of the coefficient of determination. Since square roots can be negative, the value of the
coefficient of correlation can range between -1 and +1.
 If the coefficient of correlation is positive, then the two variables move together in the same direction, and
positive correlation exists. Perfect positive correlation would yield a value of 1.00 for the coefficient of
correlation.
 If the coefficient of correlation is negative, then the two variables move in a predictable fashion but in
opposite directions. Perfect negative correlation would yield a coefficient of correlation of –1.00. A
coefficient of correlation value close to zero indicates no correlation.

Multiple Regression

In the case of two or more explanatory variables, the linear equation is expanded to include the additional variables:
 Multiple regression method is used whenever least squares is used to fit an equation involving two or more
explanatory variables. When there are two or more independent variables, the high-low and scatterplot methods
cannot be used. Fortunately, the extension of the method of least squares is straightforward.

Managerial Judgment

 Management would do well to make sure that each cost is predominantly fixed or variable and that the
decisions being made are not highly sensitive to errors in classifying costs.
 Management may instead identify mixed costs and divide these costs into fixed and variable components by
deciding just what the fixed and variable parts are.
 Management may use experience and judgment to refine statistical estimation results.
 Can be used alone or in conjunction with the high-low, scatterplot, or least-squares methods.
 Managers use their experience and knowledge of cost and activity-level relationships to identify outliers,
understand structural shifts, and adjust parameters due to anticipated changing conditions
 The advantage of using managerial judgment to separate fixed and variable costs is its simplicity.
 It is important to consider the experience of the manager, the potential for error, and the effect that the
error could have on related decisions.