22747

Accounting for Managerial Decisions

Topic 8
Cost Behaviour

22747 – Lecture 8 1-1

 Learning objectives
LO1: Describe the nature and behaviour of fixed and variable costs.
LO2: Define and analyse mixed costs using regression analysis and
the high/low method.
LO3: Illustrate the impact of income taxes on costs and decision
making.
LO4: Identify the difference between variable costing and
absorption costing.
LO5: Identify the impact on the income statement of variable
costing and absorption costing.
LO6: Recognise the benefits of using variable costing for decision
making.

22747 – Lecture 8 2
LO1 The Behaviour of
Fixed and Variable Costs
• As production volume changes, some costs
may increase or decrease and other costs
may remain stable.
• The predictability of whether specific costs
change with volume provides an important
tool for managerial accountants.

22747 – Lecture 8 3
 Fixed Costs
Fixed cost: Y = a
Slope is
Total Zero
Fixed Represented
Costs by a
(Y) flat line
a

0
Total activity (X)
a = Total fixed costs

No change as production volume increases or decreases

22747 – Lecture 8 4
 Fixed Costs
Fixed costs stay the They vary when expressed
same in total on a per unit basis

22747 – Lecture 8 5
 Variable Costs
Variable cost: Y = bX

Higher
variable
Total costs as
Variable production
costs b volume
(Y) increases
create a
steeper slope

0
Total activity (X)
b = variable cost per unit

• Total variable costs increase as production volume increases

• Equals zero dollars when production activity is zero
22747 – Lecture 8 6
 Variable Costs
Variable costs vary They are constant
in direct proportion when expressed as
to volume changes per unit amounts

22747 – Lecture 8 7
 LO2 Mixed Costs
Mixed costs: Y = a + bX

Contains
both fixed
Total and variable
Variable cost
costs components
(Y) Variable cost portion
a
Fixed cost portion

0
Total activity (X)
b = variable cost per unit

• Mixed costs have both a fixed and a variable cost component.

• They are costs that change in total and also change per unit.
22747 – Lecture 8 8
 Total Cost Behaviour

Total Cost Equation (Y) = a + bX

=Total Fixed Costs + (Variable Costs per unit x Number of Units)

a = total fixed costs

b = variable cost per unit
X = product volume (activity)

22747 – Lecture 8 9
 Relevant Range
• The relevant range is the normal range of
production capacity that can be expected for a
particular product and company.
• The relevant range can also be viewed as the
volume of production for which the fixed and
variable cost relationships hold true (linear
relationship).

(A business assumes that, given an activity level within the

relevant range, the fixed costs are known and correct. When
production falls outside this range, fixed costs might no longer
remain fixed).

22747 – Lecture 8 10
 Regression Analysis
• A variety of tools can be used to estimate the fixed and
variable components of a mixed cost.
• One of those tools is regression analysis, which is a
statistical methods to have a ‘best fit’ a line through all
the data points.
• Regression statistically finds the line that minimises the
sum of the squared distances from each data point to
the line (when we do it ‘by eye’ we tend to be
influenced by the outliers).

22747 – Lecture 8 11
 Regression Analysis
The following is Ultimo Pizza’s overhead costs for the last 12
months.

22747 – Lecture 8 12
 Regression Summary Output
Using an Excel spreadsheet program, we obtain the regression line for
Ultimo Pizza’s overhead costs:
Total overhead cost = $3998.25 + ($2.09 X Volume)

22747 – Lecture 8 13
 Regression Summary Output
Total overhead cost = Y = a + bX
= $3998.25 + ($2.09 x volume)

This equation can be used to help predict the total amount of

overhead costs that will be incurred for any number of pizzas
within the relevant range.

Assume Ultimo Pizza’s plans to produce 1750 pizzas next

month, then its overhead costs will be expected to be about:

$3998.25 + ($2.09 x 1750 pizzas) = $7655.75

22747 – Lecture 8 14
 High-Low Method

The high/low method uses only two data

points to derive an estimate of the cost equation.

Now let’s look at Ultimo Pizza’s monthly data and a

simpler estimate of its cost structure.

22747 – Lecture 8 15
 High-Low Method

Data points are:

High Activity = 2600 Pizzas

(with $10 100 in overhead)
AND

Low Activity = 1,200 Pizzas

(with $6750 in overhead)

The High-Low Method focus on activity not cost

22747 – Lecture 8 16
 High-Low Method
Step 1: Identify the high and low volume points from the
data set.
Step 2: Determine the variable cost per unit
Step 3: Subtract total variable costs from the total costs
using either the high or the low volume point.

Variable cost Change in Cost_

per unit =
Change in Volume
$10,100 - $6,750_
=
2,600 – 1,200

= $2.39
22747 – Lecture 8 17
 High-Low Method
Calculate fixed costs:
Variable cost per unit (b) = $2.39 per pizza
Fixed cost (a) = Total costs – total variable costs

High data point $10,100 = a + (2.39 x 2,600 pizzas)

= $3,886
Low data point $6,750 = a + (2.39 x 1,200 pizzas)
= $3,882*
*(due to rounding – but that is fine because it is an estimate
of future costs – costs will almost certainly not be $3,88X)
22747 – Lecture 8 18
 High-Low Method
Thus, the cost equation using the high-low method is:

Total overhead costs = $3886 + ($2.39 x # of pizzas)

This equation is different from the regression because

regression fits the ‘best’ line through all 12 data points.
High-low, instead, forces a line between two points. If
one of the two points is an outlier, the line will be
skewed.

22747 – Lecture 8 19
 Lecture Demonstration Question 8-1
HB Enterprises has normal annual production of 84,000 units
per annum. Performance for the first four months of 2017 for
production activity and manufacturing support costs (factory
overhead) were as follows:

Month Production Overhead costs

Jan 6,000 $75,000

Feb 8,000 $86,000
Mar 7,500 $71,500
Apr 8,500 $87,500
Required:
(i) Using the High-Low Analysis, determine the cost
estimation function in the form:
TC = FC + UVC x Q
22747 – Lecture 8 20
Lecture Demonstration Question 8-1 (continued)
(ii) In the coming month it is expected that production will
fluctuate between 7,000 and 8,000 units. You are
required to utilise the analysis of fixed and variable
costs as calculated in part (i) to complete the following
table at the activity levels specified:
Production Levels (Units)
7,000 7,500 8,000
Total Variable Costs
Total Fixed Costs
TOTAL OVERHEAD COSTS

UNIT Variable Costs

UNIT Fixed Costs
UNIT OVERHEAD COSTS
22747 – Lecture 8 21
 Solution to LDQ 8-1
(i) Units TC($) VC= 8,500* 5 = $42,500
8,500 87,500 FC=87,500-42,500 = $45,000
-6,000 -75,000 VC= 6,000* 5 = $30,000
2,500 12,500 FC=75,000-30,000 = $45,000

$12500 TC= 45,000 + 5 (Q)

UVC= = $5
2,500

(ii) Production Levels (Units)

7,000 7,500 8,000
Total Variable Costs $35,000 $37,500 $40,000
Total Fixed Costs $45,000 $45,000 $45,000
TOTAL OVERHEAD COSTS $80,000 $82,500 $85,000

UNIT Variable Costs $5.00 $5.00 $5.00

UNIT Fixed Costs $6.43 $6.00 $5.63
UNIT OVERHEAD COSTS $11.43 $11.00 $10.63
22747 – Lecture 8 22
 LO3 The Impact of Income Taxes
on Cost and Decision Making
• Managers need to consider the impact of income
taxes on a decision.
• Essentially, many costs of operating businesses are
deductible for income tax purposes and most
business revenues are taxable.
• So the benefit and detriment of business decisions
are reduced by tax.

22747 – Lecture 8 23
 After-Tax Cost
The after-tax cost of a tax-deductible cash
expenditure can be found by subtracting the income
tax savings from the before-tax cost or by simply
multiplying the before-tax amount by (1 - tax rate):

After-Tax Cost
=
Pretax cost x (1 – tax rate)

22747 – Lecture 8 24
 After-Tax Cost
Implication for Decision Makers
If a company spends an extra $20,000 on tax-
deductible expenditures and has a 30 per cent tax
rate, their cash flow will only decrease by $14 000.

After-Tax Cost Pretax cost x (1 – tax rate)

=

$14,000 $20,000 x (1 – 30%)

=

22747 – Lecture 8 25
LO4 A Comparison of
Absorption Costing and Variable Costing
Absorption Variable
Costing Costing

• Product costs • Only variable

attach to the costs are
product. product costs.
• They are • Fixed
expensed when manufacturing
the product is overhead is a
sold. period cost.

22747 – Lecture 8 26
 A Comparison of
Absorption Costing and Variable Costing

Absorption Variable
Costing Costing

Used for both

external financial Used
statements For
prepared under internal
GAAP and for decision making
income tax
reporting
22747 – Lecture 8 27
 Manufacturing Costs
• Direct Materials – cost of raw materials converted into
finished products
• Direct Labour – wages earned by production
employees for the time they spend converting raw
material into finished products
• Manufacturing Overhead – All manufacturing costs
other than direct material and direct labour. Overhead
costs are indirect costs which consist of fixed and
variable components, for example:
• Fixed overhead: factory rent, depreciation, insurance
premium and factory manager’s salary
• Variable overhead: electricity to operate machines and
lubricants for cutting and packaging machines
22747 – Lecture 8 28
 A Summary of
Absorption Costing and Variable Costing

22747 – Lecture 8 29
 LO5 An Example: Absorption Costing and
Variable Costing
Lim Locks produces 100,000 units each year.
Costs per Unit are:
• direct material of $0.30
• direct labour of $0.35
• variable overhead of $0.10
• variable selling/adm. of $0.05
• Fixed manufacturing overhead costs are $30 000
and . fixed selling and administrative costs are
$10 000.
22747 – Lecture 8 30
 A Summary of
Absorption Costing and Variable Costing

22747 – Lecture 8 31
 When Units Produced Equals Units Sold

*Variable costs in Variable Costing include $0.05 selling costs

22747 – Lecture 8 32
When units
produced
exceeded units
sold, absorption
costing reported
higher net
income than
variable costing.

When units sold

exceeded units
produced,
variable costing
will report
higher net
income than
absorption
costing.

22747 – Lecture 8 33
 A Summary of
Absorption Costing and Variable Costing
Now let’s take a look at a summary of the
three-year period:

Because units Absorption Variable

produced are
equal to units
Production Sales Net Net
sold over the Units Units Income Income
three years, total
Year 1 100,000 100,000 $80,000 $80,000
income is the
same under both Year 2 100,000 80,000 62,000 56,000
methods.
Year 3 100,000 120,000 98,000 104,000
TOTAL 300,000 300,000 $240,000 $240,000

22747 – Lecture 8 34
 Problems with Absorption Costing

The use of absorption costing for internal decision

making can result in less than optimal decisions.

For example: By increasing production, unethical

managers can increase income, reduce cost of goods
sold, meet their own performance goals, and saddle
the company with the costs of unsold inventory and
storing costs.

22747 – Lecture 8 35
 Choosing the Best Method for
Performance Evaluation

For external reporting and income tax filing, managers

have no choice but to use absorption costing, as it is
required by GAAP.

However, using variable costing for internal decision

making removes the impact of changing production
levels on income and is best for performance
evaluation of managers.

22747 – Lecture 8 36
 Other advantages of Variable Costing

1. Variable costing focuses attention on relevant product

costs rather than on fixed product costs, which are
often unavoidable in the short run.
2. Under variable costing, cost behaviour is emphasised
on the income statement.
3. Variable costing income is more closely aligned with a
company’s cash flows.

22747 – Lecture 8 37