LESSON 1-3

COST BEHAVIOR: ANALYSIS AND USE

INTRODUCTION

Cost behavior pertains to how a cost will react to the changes in the level of business activity. Managers
must understand and apply the concept of cost behavior to real world data which do not always behave in
an expected manner. An understanding of cost behavior under varying conditions is essential to adequate
decision making in the planning and control of firm activity.

Importance of Understanding Cost Behavior

Planning requires the management to make decisions based on future expectations. Data relevant to the
decision objectives, gathered and analyzed in a competent and unbiased manner shall be the basis of
these expectations.

Control is the process of comparing feedback information with expectations and implementing actions
based on the comparison.

Cost Analysis is an essential component of the planning and control function. Effective cost prediction will
highly depend on the understanding of cost behavior patterns.

Types of Behavior Patterns

1. Variable Costs

Variable costs are those costs that proportionally change in total to the activity level within the relevant
range. Relevant range is the range of activity within which assumptions relative to variable and fixed
cost are valid. Variable cost per unit is assumed to remain constant within this range. For a cost to be
variable, it must be variable with respect to its activity base, sometimes referred to as a cost driver.
Activity based is a measure of whatever causes the incurrence of variable costs. Common activity cost
drivers are units sold, units produced, direct-labor hours and machine hours.
 The telephone bill and charge (Y-axis) is the variable cost while the minutes talked (X-axis) is the cost
driver. As you can see in the illustrations above, as the minutes talked increases the total variable cost
also increases while the per minute telephone charge (per unit variable costs) is constant within the
relevant range.

Examples of Variable Costs

In a Manufacturing Company: Direct Materials

Direct Labor
Some manufacturing overhead such as
indirect materials, materials handling costs,
energy costs, supplies
Distribution costs
Sales commissions

In a Merchandising Company: Cost of Sales

Sales commissions

In a Service Organization: Direct labor and materials used to

perform the services such as auto repair and
consulting; supplies, travel

2. Fixed Costs

Fixed costs are costs that remain constant in total regardless of changes in the level of activity within
the relevant range. Fixed costs however may change due to external factors, such as price changes.
Fixed cost per unit will react inversely with the change in activity. Fixed cost per unit decrease as the
level of activity rises and increase per unit as the activity level fall.

The telephone bill and charge (Y-axis) is the fixed cost while the number of local calls (X-axis) is the
level of activity. As you can see in the illustrations above, as the number of local calls increases the
fixed cost per unit decreases while the monthly basic telephone bill (total fixed cost) is constant within
the relevant range.
 Types of Fixed Costs

• Committed fixed costs are cost that represents long-term commitment as a result of
management’s past decisions. Examples of such costs include depreciation of buildings and
equipment, taxes on real estate, insurance and salaries of top management and operating
personnel. The two key characteristics of committed fixed costs are that (1) they are long term in
nature and (2) they cannot be significantly reduced even for short periods of time without seriously
impairing the profitability or long-run goals of the organization.

• Discretionary fixed costs (managed fixed costs) are incurred in a short-term basis and can be
easily modified in response to changes in management objectives. Examples include advertising,
research, public relations, management development programs, and internship for students. The
most important characteristic of discretionary fixed costs is that management is not locked into a
decision regarding such costs.

Fixed Costs and Relevant Range

The concept of relevant range is also important in understanding fixed cost. The levels of discretionary
fixed costs are usually decided at the beginning of the year and depend on the support needs of planned
programs such as advertising and training. The scope of these programs will depend, in turn, on the
overall anticipated level of activity for the year. At very high levels of activity, programs are usually
broadened or expanded.

To further understand see the illustrations below:

Examples of Costs that are Generally Fixed:

Rent, insurance, property taxes, supervisory salaries, straight-line depreciation, administrative salaries
and advertising.

3. Mixed Costs (Semi variable Costs)

A mixed cost is one that contains both variable and fixed cost elements. The total cost line, starting at
the total fixed costs in the Y-axis, slopes upward as the variable cost element is added to the fixed
costs element.
 The relationship between mixed cost and the level of activity also be expressed in the following
equation:

Y = a + bX

Where:
Y = the total mixed cost b = the variable cost per unit of activity
a = the total fixed cost X = the level of activity
Cost Estimation

The basic idea in cost estimation is to estimate the relation between costs and the variables (factors)
affecting the costs. Mixed costs are harder to evaluate, because they change in response to fluctuation in
volume, but the fixed cost element means the overall change is not directly proportional to the activity.

To illustrate, assume that Bukal Car Wash has a contract for its water supply that provides for a flat monthly
meter charge of ₱1,000 and additional ₱3 per thousand liters of usage. Below is a graphic portraying Bukal’s
potential water bill, keyed to liters.

18000
16000
14000
12000
10000
8000
6000
4000
2000
0
0 1,000 2,000 3,000 4,000 5,000

Variable Fixed Total

 # of Liters Variable Fixed Total
0 0 1,000 1,000
1,000 3,000 1,000 4,000
2,000 6,000 1,000 7,000
3,000 9,000 1,000 10,000
4,000 12,000 1,000 13,000
5,000 15,000 1,000 16,000

In the illustration above, fixed cost is constant and the variable cost changes proportionally with the
consumption of water in liters. The illustration is clear enough and we have easily identified the fixed and
variable costs of the mixed costs, however in real life situation what will be handed to us are past water bills
which means that only the total costs will be known. Therefore, you will learn the methods of estimating the
relation between cost behavior and activity levels that are commonly used in practice as well as a brief
overview of the theory and some important considerations for their application. These are:
1. Account Analysis method
2. Industrial Engineering method or Work Measurement method
3. Conference method
4. Quantitative Analysis of Current and Past Costs Relationships
a. High-Low Method
b. Regression Analysis Method
i. Scattergraph or Visual fit method
ii. The Least-squares Regression method

It is possible that results will differ from method to method. Usually more than one approach is applied and
comparison of the results are made by the managers which shall use their professional judgement in
analyzing each estimated and assumption used for the final use of the management in decision making.

Account Analysis Method

Account Analysis Method Account analysis is considered a very useful and easier way to estimate costs it
makes use of the experience and judgment of managers and accountants who are familiar with company
operations and the way costs react to changes in activity level.

The account analysis involves the following steps:

1. Review each cost account used to record the costs that are of interest Each cost is identified as
either fixed or variable depending on the relationship between the cost and some activity.

2. Each major class of manufacturing overhead or other mixed cost is itemized. Each cost is then
divided into its estimated violable and fixed components. This is done on the basis of the experience
and judgement of accounting and other personnel.

An advantage of account analysis is that it involves a detailed examination of the database by accountants
and managers who are familiar with it. Other methods may overlook this expert judgment in uncovering
cost behavior patterns. A disadvantage of this method is that it uses subjective, judgmental approach so
that different analysts may provide different estimated of cost behavior.
Industrial Engineering Method

This method estimates cost functions by analyzing the relationship between inputs and outputs in physical
forms. Engineering estimates indicate what costs should be.

Steps in Applying the Engineering Method of Estimating Costs

1. A study of the physical relation between the quantities of inputs. (material, labor, etc.) and each
unit of output (finished product) is done. This involves the following activities.

a. A detailed step-by-step analysis of each phase of each manufacturing process together

with the kinds of work performed, and time to perform each step is done. (This is sometimes
part of lime-and-motion study). This serves as a basis for estimating direct labor time.

b. Engineering estimates of the materials required for each unit of production are obtained
from drawings and specifications sheets.

2. Costs are then assigned to each of the physical inputs. (wages, material price, insurance
charges, etc.) to estimate the cost of the outputs.

One advantage to the engineering approach. is that it can detail each step required to perform an operation.
It therefore enables the company to review its manufacturing productivity and identify specific strengths and
weaknesses. Another advantage is that it can be used to estimate costs for totally new activities because
it does not require data from prior activities in the organization.

A disadvantage can be attributed to this method is that it can be quite expensive to use because each
activity is using engineering norms and expert engineers which are costly. Another consideration is that
engineering estimates are often based on optimal condition. It is also difficult to estimate the indirect costs
of production.

Conference Method

Under the conference method, cost functions are estimated based on the analysis and opinions about costs
and their drivers obtained from various departments of an organization such as purchasing, process
engineering, manufacturing, employee relations and so on. This information is used to determine the selling
price of the product, optimum product mix and evaluate cost improvements over time.

The conference method allows quick development of cost functions and cost estimates. Its credibility is
gained through the pooling of expert knowledge from each value-chain area. The accuracy of the cost
estimates, however, is dependent largely on the objectivity, care, and the detail taken by the people
providing the inputs or information.

The High-Low Method

The High-Low method of analyzing mixed costs is based on costs observed at both the high and low
levels of activity within the relevant range. This method is perhaps the simplest technique for separating a
mixed cost into fixed and variable portions.

Steps in Applying the High-Low Cost Estimation

1. Obtain relevant data on past costs and related actual activity levels.
2. Estimate the variable cost per unit or rate using the following equation.

Cost at highest activity −Cost at lowest activity

Variable cost rate per unit =
Highest activity – Lowest activty
 3. Compute the fixed cost as follows:

Lowest
Total Cost Variable
Fixed activity
at lowest − cost per x
Cost = stated in
activity unit
units

The fixed cost represent the intercept on the graph because it represents the cost that would be incurred
at a zero activity level give existing capacity if the relationship plotted is valid from the data points back to
the origin.

Illustrative Problem 1: High-Low Method

Data for the past 10 months were collected for Malamlam, Inc. to estimate the variable and fixed
manufacturing overhead.

The following data on supplies costs and direct labor hours from January to October are available.

X Y X Y
Direct Labor Direct Labor
Hours Supplies Cost Hours Supplies Cost
Jan 20 50 Jun 40 100
Feb 40 110 Jul 50 150
Mar 60 150 Aug 10 60
Apr 20 70 Sep 30 110
May 30 80 Oct 50 120
Determine the variable cost rate per hour and the fixed cost portion using the high-low method.

Solution:

1 Variable cost 150 − 60 2 at 60-hour level

=
rate per hour 60 − 10 Fixed Cost = 150 − (1.80 x 60)
= 150 − 108
= 90 = 42
50
at 10-hour level
= 1.80 Fixed Cost = 60 − (1.80 x 10)
= 60 − 18
= 42

Regression Analysis Method

Regression analysis uses all available data to estimate the cost function. It is a statistical method that
measures the average amount of change in the dependent variable (costs) that is associated with a unit
change of one or more independent variables (cost drivers such as number of units produced, machine
hours, etc.). Simple regression analysis estimates the relationship between the dependent variable and
one independent variable, while multiple regression analysis estimates the relationship between the
dependent variable and multiple independent variables. Multiple regression is used when the dependent
variable (i.e., cost) is caused by more than one factor. Although adding more factors or variables make
the computation more complex, the principles involved are the same as in the simple regression analysis.

Simple regression analysis uses the following equation:

Y = a + bX

While multiple regression analysis uses the following equation:

Y = a + b1X1 + b2X2 ………. + u

Where:

Y = costs to be predicted (dependent variable)

X, X1, X2, … = independent variables on which the prediction is to be based

a = fixed cost

b, b1, b2, … = estimated coefficients of the regression model

u = residual term that includes the net effect of other factors not in the model and measurement
errors in the dependent and independent variables

Least-squares Regression Method

A statistical technique which is often used in separating mixed costs into their fixed and variable
components is least-squares regression. Basically, a line of regression is determined by solving two
simultaneous linear equations which are based on the condition that the sum of deviations above the line
equals the sum of deviations below the line.

The equation for the determination of straight line is:

Y = a + bX

The two linear equations that are used to solve for a and b are:

Equation (1) ΣY = Na + bΣX

Equation (2) ΣXY = ΣXa + bΣX2

Where:

Y = Total cost
a = Fixed cost
b = Variable cost rate
X = measure of activity (e.g., hours, units)
N = number of observations
Σ = Greek letter signifying summation
Illustrative Problem 2: Least-squares Regression Method

Using the data in Illustrative Problem 1, determine the variable cost rate and the fixed cost under the
Least-squares Regression Method.

Solution:

X Y XY X2
20 50 1,000 400
40 110 4,400 1,600
60 150 9,000 3,600
20 70 1,400 400
30 80 2,400 900
40 100 4,000 1,600
50 150 7,500 2,500
10 60 600 100
30 110 3,300 900
50 120 6,000 2,500
∑X = 350 ∑Y = 1,000 ∑XY = 39,600 ∑X2 = 14,500

Equation (1) 1,000 = 10a +350b

Equation (2) 39,600 = 350a +14,500b

To eliminate one unknown (a), and solve for b, multiply Equation 1 by 35 (least common denominator)
and subtract the new Equation 3 from Equation 2

Equation (2) 39,600 = 350a +14,500b

Equation (3)
[Equation 1 x 35] 35,000 = 350a +12,250b
4,600 = 2,250b

Variable cost rate or b = 2.04

To solve for a (Fixed cost) substitute the value of b to Equation 1. Thus,

1,000 = 10a + 350 (2.04)

1,000 – 714 = 10a
a = -286
-10
a = 28.60

Scattergraph or Visual Fit

This is a rough guide for cost estimation which plot the cost against past activity levels. These activities
are referred to the right-hand-side of a regression equation. The cost to be estimated may be called the
dependent variables, (Y)or the left-hand-side of the regression equation. The line is drawn, insofar as it is
possible by visual judgment, so that the distances of the observation above the line are equal to the
distances of the observations below the line. This line called the line of regression represents the data as
a line of conditional expected values.
The steps involved in the use of Seattergraph are as follows:

1. On a graph, plot actual costs (on vertical axis) during the period under study against the volume
levels (on horizontal axis).
2. The line of best fit is then drawn by visual inspection of the plotted points, the line representing
the trend shown by the majority of the points.
3. The fixed cost is estimated by extending the left end of the line m the vertical axis.
4. The variable cost rate or slope of the cost line is determined by dividing the difference between
any net level of activities by the difference in costs corresponding to the same level of activities.

Illustrative Problem 3: Scattergraph

Using the data in Illustrative Problem 1, determine the variable cost rate and the fixed cost using the
Scattergraph.

Solution:

Based on the illustration in the succeeding page, fixed cost (a) is P30 where the line of regression begins.

While variable cost rate is computed as follows:

110 − 70
Variable cost rate (b) = 40 − 20
= 40
20
= P2 per hour

Scattergraph
160
150 Line of Regression

140
130
120
110
100
90
80
70
60
50
40
30
20
10
-
- 10 20 30 40 50 60 70
Strengths and Weaknesses of Cost Estimation Methods

Each of the methods discussed have strengths and weaknesses which are summarized as follows:

Method Strengths Weaknesses

Account Analysis Provides a detailed expert
analysis of the cost behavior in
each account.
Engineering Method Based on studies of what future
costs should be rather than what
past costs have been.
High-low Method Simple to apply.
Scattergraph Method Uses all the observations of cost
data.
Relatively easy to understand
and apply.
Least-squares Regression Uses all of the observations of
Method cost data.
The line is statistically fit to the
observations.
Relatively easy to use with
computers and sophisticated
calculators.
Subjective.
Not particularly useful when the
physical relation between inputs
and outputs is indirect.
Uses only two data points which
may not produce accurate
results.
The fitting of the line to the
observations is subjective.
Difficult to do where several
independent variables are to be
used.
The regression model requires
that several relatively strict
assumptions be satisfied for the
results to be valid.

Correlation Analysis

In the process of eliminating and controlling costs, management must evaluate whether the factor
selected for estimating cost behavior is suitable for that purpose. Cost may or may not react with changes
in the factor selected for cost analysis.

The degree of correlation between the level of activity and costs may be measured the “coefficient of
determination”, most frequently designated as r2. To commit for this, the equation is:

(Estimated conditional standard deviation measured from line of regression) 2

r2 = 1 −
(Standard deviation measured from the average of all data)2

a. Estimated conditional standard deviation measured from the line of regression:

∑(Y − ̅
Y)2
√
n−2
Y = actual cost
̅ = line of regression cost
Y
n = number of items of data
 b. Standard deviation measured from average of all data:

∑(Y − ̅
Y)2
√
n
Y = actual cost
̅ = line of regression cost
Y
n = number of items of data

If r2 expressed as a percentage will be relatively high, the correlation is good. It means that the costs
follow the factor selected.

Using the data in Illustration 1, evaluate the degree of correlation between the direct labor hours and
suppliers cost by solving for r2 or coefficient of determination.

(2.83)2
r2 = 1−
(33.17)2

8
r2 = 1−
1,100

r2 = 1− 0.007

= 99.3%

Conclusion: There is apparently a high degree of correlation between hours of operation and
supplies costs.

Computation of Estimated Conditional Standard Deviation Measured from the line of regression.

Conditional
Expected Deviations
Hours Actual Cost Average Cost* Deviations Squared
Y ̅
Y Y−̅
Y (Y − ̅
Y)2
20 50 69.40 (19.40) 376.36
40 110 110.20 (0.20) 0.04
60 150 151.00 (1.00) 1.00
20 70 69.40 0.60 0.36
30 80 89.80 (9.80) 96.04
40 100 110.20 (10.20) 104.04
50 150 130.60 19.40 376.36
10 60 49.00 11.00 121.00
30 110 89.80 20.20 408.04
50 120 130.60 (10.60) 112.36
1,595.60
* [28.60 + (2.04 x No. of Hours)]

1595.60
Estimated Conditional Standard Deviation = √ = 2.83
10−2
Schedule II. Computation of standard deviation measured from average of all data.

Deviations
ActualCost AverageCost* Deviations Squared
Y ̅
Y ̅
Y−Y ̅)2
(Y − Y
50 100 (50.00) 2,500.00
110 100 10.00 100.00
150 100 50.00 2,500.00
70 100 (30.00) 900.00
80 100 (20.00) 400.00
100 100 − −
150 100 50.00 2,500.00
60 100 (40.00) 1,600.00
110 100 10.00 100.00
120 100 20.00 400.00
11,000.00
*(1,000÷10)

11000
Standard Deviation = √ = 33.17
10

Cost behavior models are correlational rather than casual; In a casual model, X results in Y, while in a
correlational model, occurrences or movements in Y are associated with occurrences or movements in X.

The most important issue in estimating a cost function (behavior) is to determine whether a cause-and-
effect relationship exists between the cost driver (X) and the resulting costs (Y). The cause-and-effect
relationship might arise in several ways:

1. A physical relationship exists between costs and the cost driver

Example: To produce more units of product requires more materials which result in higher materials
costs.

2. Cause-and-effect then arise from a contractual arrangement.

Example: Under the metered system, the number of phone-minutes used is the cost driver of the
telephone line costs.

3. Logic and knowledge of operations can establish cause-and-effect.

Example: Under the metered system, the number of phone-minutes used is the cost driver of the
telephone line costs.

A high correlation or connection between two variables may not mean that either variable causes the other.
A high correlation between two variables, X and Y, may not necessarily imply cause-and-effect but may
merely indicate that the two variables move together. It is possible that X may cause Y; X and Y may
interact; both may be affected by a third variable Z or a correlation may be due to chance. No conclusion
about cause-and0effect may be warranted by high correlations. For example, higher materials costs and
higher labor costs are caused by higher production. Materials costs and labor costs are highly correlated
but neither causes the other.
A vital aspect of cost estimation is establishing economic plausibility. Only a true cause-and-effect
relationship not merely correlation establishes an economically plausible relationship not merely correlation
establishes an economically plausible relationship between costs and their costs drivers. Economic
plausibility gives the analyst confidence that the estimated relationship will repeatedly appear in other
similar sets of data.

The Learning Curve Theory

One assumption in estimating cost behavior is that the cost of each input is a linear function of the quantity
assigned. However, the relationship between costs and independent variables is not always linear.

As a worker performs a certain task, a systematic, nonlinear relationship has been found. The learning
curve theory, also called the improvement curve theory is based on the proposition that as workers gain
experience in a task, they need less time to complete the job and productivity increases.

Case studies have shown that learning often follows a pattern as the cumulative number of units
manufactures is doubled the cumulative average time that it takes to make a unit is advised by a constant
percentage. If the rate of reduction is 20%, the learning curve is referred to as an 80% curve. The learning
curve is a power function, and if plotted on double logarithmic paper will appear as a straight line.

Some of the Uses of Learning Curves are as follows:

1. Preparing cost estimated for bidding purposes.

2. Setting standards and budget allowances.
3. Scheduling labor requirements.
4. Evaluating performance by comparing progress reports with the accomplishments anticipated
under the learning curve.
5. Setting incentive wage rates with due consideration for the fact that labor times will normally be
reduces as the workman becomes more experienced.

For example, a worker can finish one unit of product in two hours and a 20% learning curve is applicable.
The cumulative time schedule will be shown as follows:

Cumulative Cumulative Average Predicted Total Hours

Quantity Worker-Hours per unit to Perform Task
1 2.0 2.0
2 1.6 (2.0 hrs x 80%) 3.2 (2 x 1.6 hrs)
4 1.3 (1.6 hrs x 80%) 5.2 (4 x 1.3 hrs)
8 1.0 (1.3 hrs x 80%) 8.0 (8 x 1.0 hr)
16 0.8 (1.0 hr x 80%) 12.8 (16 x 0.8 hr)
32 0.6 (0.8 hr x 80%) 19.2 (32 x 0.6 hrs)
64 0.5 (0.6 hr x 80%) 32 (64 x 0.5 hrs)

Learning Rate. The reduction in time varies 10 and 40 percent depending in the repretitiveness of labor
operations, with 20% being a common reduction. In calculating the learning rate that applies to the specific
situation, data on manufacturing the forst two lots of a product can be used. The formula to compute for
the Learning Rate is

Average input quantity (cost) for the first 2 x units

Average input quantity (cost) for the first x units
Example: Assume that for a project, the first lot of four units required for a total of 4000 direct labor hours.
The second lot of four more units requires an additional 2,800 direct labor hours. Learning rate for this
operation is calculated as follows:

(4000 + 2800) / 8 = Average input quantity (cost) for the first 2 x units = 85%
4000 / 4 Average input quantity (cost) for the first x units

Illustrative Problem

Speed, Inc. manufactures complex units of motorboats. Fabricating these units require a high degree of
technical skill. However, employees have an opportunity to learn how to produce the units more
effectively. In estimating direct labor-hours, 70% learning curve can be used. Completing one prototype
required 1,200 labor hours at a cost of P18,000.

1. The cumulative average worker-hours per unit for a total of units is ____________.
2. The cumulative average worker-hours per unit for a total of 8 units is ____________.
3. The estimated direct labor cost for an order of seven additional units, after completing one unit is
____________.

Solution:

Cumulative Cumulative Ave. Total Hours

Units Hours per unit
1 1,200 1,200 @ 15 Direct labor cost for 8 units P49,620
840.0 (1,200 x 0.70) 1,680 Less: Direct labor cost for
2
the 1st unit 18,000
558.0 ( 840 x 0.70) 2,532 Direct labor cost for 7
4
additional units P31,620
8 411.6 ( 588 x 0.70) 3,293