ALFONSO T.

YUCHENGCO COLLEGE OF BUSINESS

MODULE 1

Topic 3: BEHAVIOR OF COSTS

3.1 Types of Costs as to Behavior

1. Variable Cost – the total amount varies directly to the change in activity level or cost
driver and the per unit amount is constant within the relevant range and time period
under consideration.
2. Fixed Cost – the total amount remains unchanged and the per unit amount varies
inversely or indirectly with the change in the cost driver within the relevant rate and
time period under consideration.

3. Mixed Cost – this cost has both a variable and a fixed component.

Total Amount Per Cost Driver

Variable Cost Varies directly with cost Constant

driver

Fixed Cost Constant Varies inversely with cost

driver

3.2 Cost Formulas

Mixed Costs or Total Costs – have variable and fixed cost components.

TC = FC + VC

Where: TC = total cost

VC = variable cost
FC = fixed cost

Total variable cost varies directly with the activity level or cost driver.

VC = bx

Where: VC = variable cost

b = variable cost per cost driver
x = cost driver

Thus, the total or mixed cost function may be expressed as:

TC = FX + bx

Within the relevant range, there is a strict linear relationship between the cost and cost
driver. Costs may therefore be shown graphically as straight line.
 ALFONSO T. YUCHENGCO COLLEGE OF BUSINESS

Since the total cost is linear related to the activity level or cost driver, the cost function
(cost formula) may be expressed as:

Y= a + bx

Where: Y = total cost

a = total fixed cost
b = variable cost per cost driver
x = cost driver

3.3 Methods of Splitting Mixed Costs into Variable and Fixed Costs

1. High-low point method

2. Scattergraph method
3. Least squares regression method

High and Low Point Method – is the easiest of the three methods. The highest and
lowest activity levels together with their related costs are isolated and the difference in
costs is divided by the difference in activity levels to determine the rate of variability of
the specific cost item. The fixed cost is determined by subtracting the variable portion
from the mixed cost.

Illustration: A mixed cost item of a manufacturing firm and the hours of activity for the
last six months are as follows:
Hours Mixed cost
January 60 P270
February 100 410
March 120 460
April 50 260
May 80 330
June 45 235

Solution:

Step 1: Determine the variable cost rate.

The highest and the lowest points are compared as follows:
Hours Mixed cost
Highest 120 P460
Lowest 45 235
Difference 75 P225

Variable cost rate = P225 = P3 per hour

75 hrs
Step 2: Compute for the fixed portion.
Fixed cost = Total cost – variable cost
At 120 hours –
Fixed cost = P460 – (120 hours x P3) = P100
 ALFONSO T. YUCHENGCO COLLEGE OF BUSINESS

At 45 hours –
Fixed cost = P235 – (45 hours x P3) = P100

Based on 90 hours of activity, the estimated variable cost may be computed as follows:

Y = a + bx
Y = P100 + P3 (90)
Y = P370

Scattergraph Method – makes use of various volume levels and the corresponding costs
plotted on a graph.

The horizontal axis represents the volume level (x) and the vertical axis represent cost.
A line is fitted in such a way that about half of the dots lie above the line and the other
half lie below. The point at which the fitted line intersects the cost axis is the estimated
fixed cost. The rate of variability (b) based on the volume measure (x) is determined by
dividing the total variable cost by the measure of activity at the selected levels. The
variable cost line (vc) intersects the cost axis at the point estimated to be P100, which
must be the fixed cost. A horizontal line is drawn to separate the fixed cost.

In determining the rate of variability, choose a volume range, say 80-100 hours. From
80 hours of activity to 100 hours, the variable cost increases from P340 to P400 or an
increase by P60. The rate of variability is therefore P60 / 20 hours or P3 per hour. It
may be noted that this method is based on visual inspection rather than on
mathematical computations. Visual examination may reveal unusual behavior, linear as
well as non-linear patterns.

Least Squares Method – is based on regression analysis. Regression analysis refers to

the systematic manner of determining the behavior pattern of one variable in relation to
a given factor. In other words, it is concerned with determining how costs (y values) are
related to volume measures (x values).

Since mixed cost is assumed to be a straight line, the least squares method makes use of
the linear equation as follows:

Y= a + bx

Where: Y = total cost

a = fixed cost
b = rate of variability
x = level of activity
 ALFONSO T. YUCHENGCO COLLEGE OF BUSINESS

The linear equation is modified to give consideration to the number of items used and
the possible changes in the rate of variability of the cost items in relation to the volume
measure. Two equations are used, namely:

Equation 1: Σy = Na + bΣx
Equation 2: Σxy = aΣx + bΣx2

Equation 1 may be interpreted as:

Total cost = (no. of periods x fixed cost) + (variable rate x total base)

Using the previous illustration, the fixed and variable costs are segregated as follows:
(x) (y)
Hours Mixed cost x2 xy
January 60 P270 3,600 16,200
February 100 410 10,000 41,000
March 120 460 14,400 55,200
April 50 260 2,500 13,000
May 80 330 6,400 26,400
June 45 235 2,025 10,575
2
Σx = 455 Σy = 1,965 Σx = 38,925 Σxy = 162,375

Equation 1: Σy = Na + bΣx 1,965 = 6a + 455b

Equation 2: Σxy = aΣx + bΣx2 162,375 = 455a + 38,925b

In both equations, the unknowns are a and b. The equivalents of these are computed
one at a time by eliminating either a or b from both equations. To eliminate a from both
equations, multiply the first equation by 455/6 or 75.8333 and to eliminate b, multiply
the first equation by 38,925/ 455 of 85.54945 before determining the difference
between the two equations.

Equation 1 multiplied by 75.83 1/3:

[1,965 = 6a + 455b] x 75.83 1/3 = [149,012 = 455a + 34,504b]
Subtract the above equation from equation 2 as follows:
149,012 = 455a + 34,504b
162,375 = 455a + 38,925b
- 13,363 = 0 – 4,421b
b = -13,363
- 4,421
b = 3.02

The equivalent of b is substituted in either equation 1 or 2 to determine the equivalent

of a as follows:

Equation 1:
1,965 = 6a + 455 (3.02)
1,965 = 6a + 1,374
6a = 1,965 – 1,374
a = 591/6
a = 98.50 or 99