PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

CHAPTER 16. THE BEHAVIOR OF COSTS

DAY 13/09
ORIGIN OR NATURE CLASIFICATION (not online)
 Raw materials
 Labor/work
 Depreciation
 Energy
Its not appropriate if we want to know what’s the cost of an activity, so we have to classify costs according to
destination.
DESTINATION
 Product: We must split for example the topic of raw materials by the product (ex: raw material of
iPhone, raw material of Android)
 Activity: For example, which is the cost of painting (activity done in the organization)
 Responsibility: which is the cost that a production manager, administrative manager has done.
The total must be the same in any case, for example if we have split the cost of labor or raw material in this
new classification, it must be the same that in origin or nature classification.
Difficulty: Example: Nesquik (product)
Raw materials: 0.5 kilos of cocoa (50 euros per kilo), 0.1 kilograms of sugar (2 euros) 20 minutes time of the
worker (1 hour of work 30 euros), 1 package made of plastic (0.3 euro per unit)
Cost of one Nesquik?
25+10+0,2+0,3= 35,5 euros/per Nesquik
Do not get confused with raw materials and raw materials which are inside the product. We have to see the
difference between cost per kilo and cost per product. And also, the cost per hour of work.
Example: 250 kg of sugar and 2 euro per kilo (product)
Example: 300 thousand of Nesquik (300 thousand times 0,1 sugar) (amount per product) in the product of
Nesquik.
VARIABILITY OF THE COST (slide)
We are referring to the total cost (not per unit) by nature or origin. Is the total level of the cost changing due to
a change in the level of activities? That is the question we must answer to know if the cost is variable or fixed.
If the answer is yes, is this relatable or predictable if we increase the volume?
We cannot ask if the cost of painting is variable, this is an activity.
Raw materials: we must refer to the total cost of raw materials. So yes. If we produce more, we need more
raw materials. And if we produce 10% more, can we calculate the amount of sugar we need additional? Yes,
so it is a variable cost. Always the raw material, not the product (yes sugar, no product because it is nonsense).
Fixed: the total cost is not affected by the change of volume. The change is not due to the level or volume of
product.
We call it semifixed if the fixed amount is predominant, and semivariable if the variable part is
predominant.

1
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

COST-VOLUME RELATIONSHIPS
o Higher volume causes higher costs.
o However, percentage increase in costs is usually less than increase in volume.
o Depends on behavior of costs.
 Variable costs.
 Fixed costs.
 Semivariable costs.
– Part variable, part fixed.
– Also called semifixed costs or mixed costs.
VARIABLE COSTS
o In TOTAL, varies directly and proportionately with volume of activity.
o Cost PER UNIT of activity remains constant.
o Examples:
 Material costs varies with units sold.
 Vehicle fuel costs varies with miles driven.
 Salespersons’ commissions varies with sales dollars generated.
If you are a transportation person, fuel is obviously a variable cost. But in a company that sells iPhone the
answer it is not simple. If the company distributes the product, is probably a yes. But usually, fuel is not a
variable cost in a company where isn’t transportation.
If we refer to the cost per unit is constant. Example sugar: sugar is a variable cost because the total cost of
sugar change if we produce more. But if we decide to produce more boxes of Nesquik, the cost of sugar in the
first boxes is the same as in the second boxes. It remains 0,2 euros per kilo. That is why we must calculate the
total.
Exception: we make a graphic
Y= M * VOL
Y: 0,2 * volume of production
In real life we have another situation, but it is still variable cost. We sign a contract but out of the contract we
need more raw material, sometimes we have an incremental line because of the new price of sugar.
FIXED COSTS
o In TOTAL, does not change with volume of activity.
o However, are fixed for a range of activity and a limited period of time.
o Cost PER UNIT of activity decreases as the level of activity increases.
o Examples:
 Building rent.
 Property taxes.
 Management salaries.
Depreciation is a fixed cost but for example one room has limited space (line 2 of this slide), we are changing
the range of activity.
In the long term, all costs are variable, but we will analyze in the short time.
SEMIVARIABLE COSTS

2
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

o Part variable cost, part fixed cost.

o In TOTAL, varies less than proportionately with volume of activity.
o Example: Electricity cost in a factory.

 Variable component: Cost of powering production equipment.

 Fixed component: Cost of lighting.
To effectively analyze, will need to break down into variable and fixed components.
COST – VOLUME (C-V) DIAGRAM
o Illustrations 16-1 and 16-2.
o Y or vertical axis reflects total cost.
o X or horizontal axis reflects volume.
o y = mx + b.

 Total cost = total variable cost + total fixed cost.

 y is the total cost at a volume of x.
 m is the rate of cost change per unit of volume change, or the slope (i.e., variable costs).
 b is the vertical intercept, which represents the fixed cost component.

Break-even point is the point where total cost = total revenues. In this point the profit is 0. The higher
volume, the higher profit.
Example: Organization A and B have the same data but the only difference is that A has more variable costs
and B has more fixed costs
The volume of BEP is higher in B
Companies want to stay flexible even if you have less profit because you suffer less of decreasing of sales.
TC = TFC +(UVC*X)
o TC = total cost;
o TFC = total fixed cost (per time period),
o UVC = Unit variable cost (per unit of volume),

3
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

o X = volume.
o Equations for:
 Variable cost line: TC = (UVC*X).
 Fixed cost line: TC = TFC.
 Semivariable cost: TC = TFC + (UVC*X).
UNIT COSTS
o Average cost per unit.
 Total cost ÷ volume of activity.
o As volume goes up ↑

Type of Cost Total Cost Cost Per Unit

Variable Increases Stays the same

Fixed Stays the same Decreases

Semivariable Increases Decreases

INHERENT CONDITIONS OF C-V ANALYSIS

Relevant range
o A straight line approximates cost behavior only within a certain range of volume.

o When volume approaches zero, management takes steps to reduce fixed costs.

o When volume exceeds relevant range, fixed costs increase.

Relevant time period

o Amount of variable costs depends on the time period over which behavior is estimated.

o If the time period is one day, few costs are variable.

o Over an extremely long time period, no costs are fixed.

“Sticky Costs.”
o Many costs considered variable actually fall less with decreases of activity than they rise with increases.

o Why? Managers tend to increase resources more quickly than they decrease.

o Examples:

 Sales commissions with minimum guarantees.

 Managers slower to fire employees than to hire.
Environment.
o C-V analysis only shows how costs vary with volume.

o Many other environmental influences affecting cost.

o E.g., changes in wage rates, fringe benefits, material prices, technology.

4
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

Linear assumption
o C-V relationship is often not linear.

o Some cost functions are curved or occur in steps (i.e., curvilinear, step-function).

o Solution? Segments of the C-V relationship can be approximated by a straight line, each with its own
relevant range.
STEP-FUNCTION COSTS

For example: the capacity of this room is limited. The 20 additional people don’t enter because the increase of
the cost is very high.
o Incurred when costs are added in discrete chunks.
 E.g., a supervisor is needed for every 10 workers.
o Adding the new step or “chunk” of costs increases capacity.
o Height of step (riser) indicates the cost of adding incremental capacity.
o Width of step (tread) shows how much additional volume of activity can be serviced by the new step up in
cost.
EXAMPLE
A goes to a group trip with 5 people and they use a car. But there is one additional one and they have to use
another car. Do they pay more to bring B or not? We try to maximize the utilization of the fixed cost. If it was
variable, it wouldn’t be a problem because the can pay another ticket of train.
o If steps are small, then relationship can be approximated by a variable cost line.

o If steps are wider, then relationship can be approximated by a fixed cost line (but only if activity is within
relevant range and relevant time period).
EXAMPLE TOYOTA (Variable or fixed)
o Plastic: variable
o Wheels: variable
o Iron: variable
o Worker that puts and fixes wheels: variable (we need additional time related to the additional product,
and you have to pay the worker more = variable cost even of the obligation to pay to the person).
o Worker painting the car: variable
o Electricity to produce the car: variable

5
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

o Electricity or power needed to light the plant: fixed (the total bill of light is changing but it is not a
variable cost because the change doesn’t depend on the production).
o Insurance: fixed
o Rent of the plant: fixed
o Depreciation of the oven where they paint: fixed
o Telephone costs: fixed
o Wages of the accountant: fixed
o Overtime of the worker of the wheels: variable
o Social contribution of the worker: fixed
o Administrative worker: ---
o Transportation costs (refer to finish wood): fixed
o Wages of the supervisor of the production: fixed
o Compensation of the sile; ---
o Administrative costs: fixed

AND THEN IF THE COMPANY IS A TOYOTA CALL CENTER

Some costs are not applicable:
o Electricity or power needed to light the plant: fixed
o Insurance: fixed
o Rent of the plant: fixed
o Telephone costs: variable
o Wages of the accountant: fixed
o Social contribution of the worker: fixed
o Administrative worker: ---
o Transportation costs (refer to finish wood): fixed
o Compensation of the sile; ---
o Administrative costs: fixed

ESTIMATING THE C-V RELATIONSHIP

Judgment
 Also called account-by-account method.
 Each account in cost structure is estimated and divided between fixed and variable costs.
High-Low method
o Estimate total costs for two volume levels, preferably one high level and one low level.
o To determine slope or variable cost per unit:

 (Change in total cost between the two points) ÷ (change in units of activity).
o To determine fixed costs:

 Take total cost at either point and subtract out variable cost (i.e., variable cost per unit multiplied by
units of activity).
Scatter diagram
o Plot actual costs and volume on C-V diagram.

o Visually draw a line of best fit.

6
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

o Read across on diagram to determine total cost for any level of activity.

Linear regression
o A statistical method to determine line of best fit.

o Best to eliminate outliers or unusual observations (e.g., a period during which there was a strike).

POTENTIAL PROBLEMS WITH ESTIMATING THE C-V RELATIONSHIP

o Use of past data to predict the future.

o Other factors (other than volume) may be affecting cost.

 E.g., may be due to trend (or drift) of cost over time, not relationship of cost to volume.
o Linear approximations can hide step function characteristics.

o Costs may appear to be fixed in short run, but are actually variable in long run (i.e., long-term variable
costs).
MEASURES OF VOLUME
o Best measure is one that is the cause of the change in cost.

o Units produced?

 Can be reliable when considering a single-product.

 Not as reliable when producing multiple products with different cost structures.
o Common measures used:

 Labor hours, labor dollars, machine hours, weight/volume measures (e.g., tons, barrels), sales value.
QUESTIONS TO CONSIDER IN SELECTING A VOLUME MEASURE
o Input measure (resources used) or output measure (goods or services produced)?

o Monetary measure (e.g., labor dollars) or Nonmonetary measure (e.g., labor hours)?

INPUT VS. OUTPUT MEASURES

o Input measures (resources used).

 E.g., labor hours worked, labor cost, machine hours, kilowatt hours of electricity, pounds of material.
 Commonly used in manufacturing settings.
o Output measures (goods/services produced).

 E.g., units of product/service sold, revenue dollars.

 Commonly used in retail/service settings.
MONETARY VS. NONMONETARY MEASURES
o Nonmonetary measure is unaffected by price changes.
o However, if price changes affect all costs equally, use of dollars as an activity measure implicitly allows
for price changes (e.g., labor costs).
SELECTING A VOLUME MEASURE: GENERAL CONSIDERATIONS

7
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

o Practicality (i.e., the availability of data on volume measure).

o Causality (i.e., the volume measure causes the cost to be incurred).

o Scope (i.e., the more items of cost that are combined in the cost function the more difficult it is to relate
causality to a single measure).
o Appropriateness (i.e., changes in conditions may change current usefulness of a measure).

PROFITGRAPH
o Add revenue line to C-V diagram.

o Assumes constant selling price.

o UP = unit selling price.

o TR = total revenue.

BREAK-EVEN ANALYSIS
o TR = (UP*X).

o TC = TFC + (UVC*X).

o At break-even: TR = TC.

Break-even volume:
o (UP*X) = TFC + (UVC*X), or

o X = TFC ÷ (UP - UVC).

Unit contribution:
o Amount each unit contributes to covering fixed costs (first) and toward generating profit (second).

o (Unit selling price) – (variable cost per unit): UP - UVC.

o Constant (unchanging) for all volumes within relevant range.

o Also known as unit contribution margin or marginal income.

Contribution margin percentage.

o Contribution as a percentage of revenues.

o (UP - UVC) ÷ UP.

Break-even in units:
o Fixed costs ÷ unit contribution.

Break-even in revenue dollars:

o Fixed costs ÷ contribution percentage.

RELATED ANALYSIS
We assume that unitary variable costs are the same (book)
o Target Profit.

8
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

 Calculate volume needed to achieve a target (T) level of profit.

 (UP*X) = TFC + (UVC*X) + T, or
 X = (TFC+T) ÷ (UP - UVC).
o Operating Leverage.

 % change in profit caused by a % change in volume.

 Caused by degree (%) of fixed cost in company.
 Higher operating leverage means higher changes in profit.
USING THE PROFITGRAPH
o Contribution profitgraph.

 Replace total cost/revenue on vertical axis with income.

 Focuses on activity above break-even.
o Cash amounts vs. accrual amounts.

 Depends on desired focus (i.e., adequate cash flow vs. adequate profitability).
 Consistency is crucial (i.e., sales volume should equal production volume).

o Determine how each of the following improves profitability:

 Increase selling price per unit (UR).

 Decrease variable cost per unit (UVC).
 Decrease fixed costs (TFC).
 Increase volume (X).
o Margin of safety.

 The amount or ratio by which current volume exceeds breakeven volume.

C-V-P WITH MULTIPLE PRODUCTS
o Analysis is similar if:

 Each product has a similar contribution margin percentage.

 Product mix (proportion of each product in sales total) remains relatively constant.
– Use weighted-average unit contribution.
o If conditions above do not exist:

 Calculate C-V-P for each product individually.

– Requires allocation of fixed costs to individual products.
OTHER INFLUENCES ON COSTS
o Changes in input prices.
o Rate at which volume changes.

 E.g., rapid changes in volume may make it more difficult to change personnel costs.

9
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

o Direction of change in volume.

 Tends to be a lag in cost changes.

o Duration of change.

 Temporary changes affect costs less than long-term changes.

o Prior knowledge of change.

 Allows planning to occur.

o Productivity.

 As productivity changes costs change.

o Management discretion.
o Learning curves.

 Unit production costs decrease as a company gains experience producing a new product.
DAY 14/09. CONTRIBUTION MARGIN
We define contribution margin as sales (or revenues or price)-variable cost of the product. In the book
we find revenues – direct cost, but we will follow the first one.
Direct are cost that directly the resources go to the objective. The resources are touching the product directly.
Most of the variable costs are direct, but not all of them. For example: raw materials are direct and variable, as
well as labor. Electricity: indirect and variable.
The use of a specific machine for testing something on the product: the depreciation of this machine is a fixed
cost but also a direct cost.
Sales-Variable cost = CM (1 level)
CM-fixed specific costs (referred specific to the product we are studying) = CM (2 level)
We can classify it in different levels:
o Unitary level: referred to the unit
o Total level: referred to the total amount of product (sold = because we want to calculate the real profit).
Ex: Iphone (Total revenues-total variable costs)
o Percentage

If we have different products (iPhone and iPod) and the salesman can sell only one additional product to a
customer that doesn´t care. In this case we have to look to the unitary level (see Excel).
Is it more convenient for the company to increase the sales of product A or B? I have to look at the CM. We
need to look to see the maximum profit.

10
PAULA ROJO MANAGEMENT ACCOUNTING 13/09/2022

11