Cost Behavior Analysis

CHAPTER 3:
COST BEHAVIOR ANALYSIS
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distributed with a certain product or service or otherwise on a password-protected website for classroom use. COST BEHAVIOR ANALYSIS
Learning Objectives
1. Explain the meaning of cost behavior, and
define and describe fixed and variable costs.
2. Define and describe mixed and step costs.
3. Separate mixed costs into their fixed and
variable components using the high-low
method, the scattergraph method, and the
method of least squares.
Basics of Cost Behavior
▪ Cost behavior is the relationship between cost and activity –
as to how costs react to changes in an activity like production.
As production increase, some costs remain the same (i.e.
fixed) while some costs increase or decrease (i.e. variable).
▪ Cost behavior is the foundation upon which managerial
accounting is built.
▪ Describes whether a cost changes when the level of output
changes.
▪ Costs can be variable, fixed, or mixed.
▪ A cost that does not change in total as output changes is a
fixed cost.
LO-1
Basics of Cost Behavior (cont.)
▪ A variable cost, on the other hand, increases in
total with an increase in output and decreases in
total with a decrease in output.
▪ Knowing how costs change as output changes is
essential to planning, controlling, and decision
making.
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Measures of Output and the
Relevant Range
▪ Fixed and variable costs have meaning only
when related to some output measure.
▪ A cost driver is a causal factor that measures
the output of the activity that leads (or causes)
costs to change.
▪ Identifying and managing drivers helps managers
better predict and control costs.
▪ For example: weather is a significant driver in
the airline industry.
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Relevant Range and
Cost Relationships
▪ Relevant range is the range of output over which
the assumed cost relationship is valid for the
normal operations of a firm.
▪ Limits the cost relationship to the range of
operations that the firm normally expects to
occur.
▪ The following graph shows the relevant range
which allows managers to assume a linear cost
relationship.
LO-1
Relevant Range and Cost
Relationships (cont.)
LO-1
COST BEHAVIOR ASSUMPTIONS AND
LIMITATIONS
▪ RELEVANT RANGE Assumption
Relevant range refers to the range of activity within which the
cost behaviour patterns are valid. Any level of activity outside
this range may show a different cost behavior pattern.
▪ TIME Assumption
The cost behavior patterns identified are true only over a
specified period of time. Beyond this, the cost may show a
different cost behavior pattern.
▪ LINEARITY Assumption
The cost is assumed to manifest a linear relationship over a
relevant range despite its tendency to show otherwise over the
long run.
Fixed Costs
▪ Fixed costs are costs that in total are constant
within the relevant range as the level of output
increases or decreases.
▪ In this example of Colley Computers, notice while
the total fixed cost of supervision remains the
same, the unit cost decreases as more
computers are produced.
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To illustrate fixed cost behavior, consider a factory
operated by Colley Computers, Inc., a company that
produces unlabeled personal computers for small computer
stores across the Midwest. The assembly department of
the factory assembles components into a completed
personal computer. Assume that Colley Computer wants to
look at the cost relationship between supervision cost and
the number of computers processed and has the following
information:
▪ The assembly department can process up to 50,000
computers per year.
▪ The assemblers (direct labor) are supervised by a
production-line manager who is paid $32,000 per
year.
▪ The company was established 5 years ago.
▪ Currently, the factory produces 40,000 to 50,000
computers per year.
▪ Production has never fallen below 20,000 computers
in a year.
Fixed Costs (cont.)
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Fixed Costs (cont.)
▪ The number of computers produced is called the
output measure, or driver.
▪ Even though fixed costs may change, this does
not make them variable.
▪ They are fixed at a new higher (or lower) rate.
▪ A graph of Colley’s fixed supervision costs is
shown below:
LO-1
Fixed Costs (cont.)
LO-1
Discretionary Fixed Costs and
Committed Fixed Costs
▪ Two types of fixed costs: discretionary fixed costs
and committed fixed costs.
▪ Discretionary fixed costs are fixed costs that
can be changed or avoided easily at
management discretion.
▪ Committed fixed costs, on the other hand, are
fixed costs that cannot be easily changed.
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Discretionary Fixed Costs and
Committed Fixed Costs
▪ Advertising is a discretionary fixed cost,
because it depends on a management decision.
▪ Lease cost is a committed fixed cost because it
involves a long-term contract.
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Variable Costs
▪ Variable costs are costs that vary in direct
proportion to changes in output within the
relevant range.
▪ Variable costs can also be represented by a
linear equation.
▪ Total variable costs depend on the level of output.
▪ This relationship can be described by the
following equation or graphs:
LO-1
Variable Costs (cont.)
Total variable costs = Variable rate x Amount of output
LO-1
Mixed Costs
▪ Mixed costs are costs that have both a fixed and
a variable component.
▪ The formula and graph depiction for a mixed cost
is as follows:
LO-2
Mixed Costs (cont.)
Total cost = Total fixed cost + Total variable cost
LO-2
Step Costs: Narrow Steps
▪ Some cost functions may be discontinuous.
▪ Known as step costs (or semi-fixed).
▪ Displays a constant level of cost for a range of output
and then jumps to a higher level (or step) of cost at
some point, where it remains for a similar range of
output.
LO-2
Step Costs: Narrow Steps (cont.)
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Step Costs: Wide Steps
▪ Step cost with wide steps are more characteristic
of fixed costs.
▪ Example: A company may have to lease
production machinery.
▪ If the machine can only produce 1,000 units and the
company grows, they will have to lease additional
machines for each 1,000 units of production needed
▪ Resulting in the wide steps shown in the following
graph.
LO-2
Step Costs: Wide Steps (cont.)
LO-2
Accounting Records and
Need for Cost Separation
▪ Only through a formal effort to separate costs can
all costs be classified into the appropriate cost
behavior categories.
▪ If mixed costs are a very small percentage of total
costs, formal cost separation may be more
trouble than it’s worth.
LO-2
Accounting Records and
Need for Cost Separation (cont.)
▪ Mixed costs could be assigned to either the fixed
or variable cost category without much concern
for the classification error or its effect on decision
making.
▪ Alternatively, the total mixed cost could be
divided between the two cost categories. (This is
rarely done and not a good option.)
▪ Typically, mixed costs for many firms are large
enough to call for separation.
LO-2
Separating Mixed Costs into Fixed
and Variable Components
▪ Three methods of separating a mixed cost into its
fixed and variable components:
▪ high-low method
▪ scattergraph method
▪ method of least squares
▪ Each method requires the simplifying assumption
of a linear cost relationship.
LO-3
Separating Mixed Costs into Fixed,
Variable Components (cont.)
▪ Expression of cost as an 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.
▪ In the previous equation, total cost is the
dependent variable; it is the cost we are trying to
predict.
LO-3
Methods for Separating Mixed Costs
into Fixed, Variable Components
(cont.)
▪ The independent variable measures output and
explains changes in the cost or other dependent
variable.
▪ A good independent variable is one that causes or is
closely associated with the dependent variable.
▪ Many managers refer to an independent variable as a
cost driver.
▪ The intercept corresponds to fixed cost.
▪ The slope of the cost line corresponds to the
variable rate.
LO-3
COSTS TOTAL AMOUNT PER UNIT AMOUNT
1. FIXED constant decreases as production

increases
2. VARIABLE Increases as production constant
increases
3. MIXED Increases less decreases less
proportionately as proportionately as
production increases production increases
FIXED COST (a)
VARIABLE COST (bX)
Y = a + bX
[Y] – the total costs (dependent variable)
[a] – the total fixed costs (vertical/ y-axis intercept)
[b] – the variable cost per unit (slope of the line)
[X] – the activity or cost driver (independent variable)
[bX] – the total variable cost
Cornerstone 3.1
Creating and Using A Cost
Formula
LO-3
Cornerstone
Creating and3.1Using A Cost
Formula
(cont.)
LO-3
The High-Low Method
▪ Given two points, the slope and the intercept can
be determined.
▪ The high-low method is method of separating
mixed costs into fixed and variable components
by using just the high and low data points.
▪ To demonstrate, we will use data from materials
handling costs at Anderson Company:
LO-3
The High-Low Method (cont.)
LO-3
The High-Low Method
▪ Four steps must be taken in the high-low method:
▪ Step 1: Find the high point and the low point for a given
data set.
▪ Step 2: Using the high and low point, calculate the
variable rate.
Variable rate =
(High point cost - Low point cost) ÷ (High point
output - Low point output)
LO-3
Variable cost per unit (b) = Change in Costs (YH-YL)
Change in Activity (XH-XL)
The High-Low Method (cont.)
▪ Step 3: Calculate the fixed cost using the variable rate
(from Step 2) and either the high point or low point.
Fixed cost = Total cost at high point -

(Variable rate x Output at high point)
▪ Step 4: Form the cost formula for materials handling

based on the high-low method.
LO-3
Cornerstone 3.2
High-Low Method to Calculate Fixed
Cost, Variable Rate and Cost Formula
LO-3
Cornerstone 3.2
High-Low Method to Calculate Fixed
Cost, Variable Rate and Cost Formula
LO-3
Cornerstone 3.3
Calculate PredictedTotal Variable
Cost and Total Cost for Budgeted
Output
LO-3
Cornerstone 3.4
Variable Cost. Total Cost for A Time
Period that Differs from the Data Period
LO-3
Advantages of high-low method
▪ Objectivity – any two people using the high-low method
on a particular data sell will arrive at the same answer.
▪ Quick overview – the high-low method allows a manager
to get a quick fix on a cost relationship by using only two
data points. For example, a manager may have only two
months of data. Sometimes this will be enough to get a
crude approximation of the cost relationship.
▪ Ease of use – the high-low method is simple, inexpensive
and easily communicated to other individuals, even those
who are not comfortable with numerical analyses.
Disadvantags
▪ Occurrence of outliers – the high and low points
can be what are known as outliers. They may
represent a typical cost-activity relationship.
▪ Potential for misrepresentative data – Even if
the high and low points are not outliers, other
pairs of points may be more representative.
Scattergraph Method
▪ The scattergraph method
is a way to see the cost
relationship by plotting
the data points on a
graph.
▪ The first step is to plot the
data points so that the
relationship between
materials handling costs
and activity output can be
seen.
LO-3
Scattergraph Method (cont.)
▪ Inspect the scattergraph
to see if it reveals one or
more points (outliers)
that do not seem to fit
the pattern of behavior.
▪ This might justify their
elimination and perhaps
lead to a better estimate
of the underlying cost
function.
LO-3
▪ Is the line determined
by the high and low
points is representative
of the overall
relationship.
▪ Notice that three points
lie above the high-low
line, but five points lie
below it.
LO-3
▪ This does not give us
confidence in the high-
low results for fixed
and variable costs.
We wonder if the
variable cost (slope) is
somewhat higher than
it should be and the
fixed cost is somewhat
lower than it should be.
LO-3
▪ Finally, we can use the
scattergraph to visually
fit a line to the data
points on the graph.
▪ The manager or cost
analyst will choose the
line that appears to fit
the points the best.
LO-3
▪ An infinite number of
lines might go through
the data, but this one
goes through the point
for January (100,
$2,000) and intersects
the y-axis at $800.
LO-3
▪ Our two points are (100, $2,000) and (0, $800).
Next, use these two points to compute the
variable rate (the slope):
▪ Variable rate = ($2,000 - $800)

= $100 - 0
= $1,200/100
= $12
LO-3
▪ The variable rate is $12 per material move.
▪ The fixed cost and variable rate for materials
handling cost have now been identified.
▪ The cost formula for the materials handling
activity can be expressed as:
Total cost = $800 + ($12 x Number of moves)
LO-3
Using the Formula from the
▪ Using this formula, the total cost of materials
handling for between 100 and 500 moves can be
predicted and then broken down into fixed and
variable components.
▪ For example, assume that 350 moves are
planned for November.
LO-3
Using the Formula from the
Scattergraph Method
▪ Using the cost formula, the predicted cost is:
$5,000 = $800 + ($12 x 350)
▪ Of this total cost, $800 is fixed, and $4,200 is
variable.
▪ Unfortunately, the scattergraph method suffers
from the lack of any objective criterion for
choosing the best-fitting line.
▪ The quality of the cost formula depends on the
quality of the subjective judgment of the analyst.
LO-3
SCATTERGRAPH (Scatter Diagram)
Method
▪ All observed costs at various activity levels are
plotted on a graph. Based on sound judgment, a
regression line is then fitted to the plotted points
to represent the line function.
The Method of Least Squares
▪ The method of least squares (regression) is a
statistical way to find the best-fitting line through a
set of data points.
▪ One advantage is that for a given set of data, it
will always produce the same cost formula.
▪ The best-fitting line is the one in which the data
points are closer to the line than to any other line.
LO-3
LEAST-SQUARE REGRESSION
Method
Least-square method is a statistical technique that
investigates the association between dependent and
independent variables. This method determines the line of
best fit for a set of observations by minimizing the sum of
the squared deviations between cost line and data points.
▪ If there is only one independent variable, the analysis is
known as SIMPLE REGRESSION.
▪ If the analysis involves multiple dependent variable, it is
known as MULTIPLE REGRESSION
LEAST-SQUARE REGRESSION
Method
▪ Equation 1 Y = a + bx
▪ Equation 2 ∑y = na + b∑x
▪ Equation 3 ∑xy = ∑xa + b∑x2
Comparison of Methods for Separating
Fixed Costs into Fixed and Variable
Components
LO-3
Other Cost Estimation Methods:
A) Industrial Engineering Method – based on the

relationship between inputs and outputs in physical forms;
engineering estimates indicate what and how much costs
should be.
B) Account Analysis Method – each account is classified as
either fixed or variable based on experience and judgment
of accounting and other qualified personnel in the
organization.
C) Conference Method – costs are classified based on
opinions from various company departments such as
purchasing, process engineering, manufacturing, employee
relations and so on.
CORRELATION ANALYSIS
CORRELATION ANALYSIS is used to measure the
strength of linear relationship between two or more
variables.
The correlation between two variables can be seen by
drawing a scatter diagram:
▪ If the points seem to form a straight line, there is high
correlation
▪ If the points form a random patter, there is low
correlation or no correlation at all.
COEFFICIENT OF CORRELATION (r) measure
the relative strength of linear relationship between
two (2) variables. Its value ranges from -1.0 to
+1.0
▪ If r = -1.0, there is perfect inverse linear
relationship between X and Y.
▪ If r = 0, no linear relationship
▪ If r = +1.0, there is perfect direct relationship
between X and Y.
COEFFICIENT OF DETERMINATION (r2 ) is the
proportion of the total variation in Y that is
accounted for by the regression equation,
regardless of whether the relationship between X
and Y is direct or inverse. It is a measure of
‘goodness of fit’ in the regression. The higher the r
, the more confidence can have in the estimated
cost formula.
Managerial Judgment
▪ Managerial judgment is critically important in
determining cost behavior and is by far the most
widely used method in practice.
▪ Many managers simply use their experience and
past observation of cost relationships to
determine fixed and variable costs.
LO-3
Managerial Judgment (cont.)
▪ This method may take a number of forms.
▪ Some managers simply assign some costs to the fixed
category and others to the variable category and ignore
the possibility of mixed costs.
▪ Other managers may identify mixed costs and divide
these into fixed and variable components.
LO-3
▪ Management may use experience and judgment
to refine statistical estimation results.
▪ The experienced manager might ‘‘eyeball’’ the
data and throw out several points as being highly
unusual or revise the results of estimation
account for projected changes in cost structure or
technology.
LO-3
▪ The advantage of using managerial judgment to
separate fixed and variable costs is its simplicity.
▪ In situations in which the manager has a deep
understanding of the firm and its cost patterns,
this method can give good results.
▪ However, if the manager does not have good
judgment, errors will occur.
LO-3
Ethical Decisions
▪ There are ethical implications to the use of
managerial judgment.
▪ Managers use their knowledge of fixed and
variable costs to make important decisions, such
as whether to switch suppliers, expand or
contract production, or lay off workers.
▪ These decisions affect the lives of workers,
suppliers, and customers.
▪ Ethical managers will make sure that they have
the best information possible when making these
decisions.
LO-3

Cost Behavior Analysis

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CHAPTER 3:

COST BEHAVIOR ANALYSIS

Total variable costs = Variable rate x Amount of output

Total cost = Total fixed cost + Total variable cost

1. FIXED constant decreases as production

Fixed cost = Total cost at high point -

▪ Step 4: Form the cost formula for materials handling

▪ Variable rate = ($2,000 - $800)

Total cost = $800 + ($12 x Number of moves)

A) Industrial Engineering Method – based on the

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