Chapter 5

Cost Behavior:
Analysis and Use

McGraw-Hill /Irwin

Copyright2008byTheMcGrawHillCompanies,Inc.Allrightsreserved.

5-2

Learning Objective 1

Understand how fixed and

variable costs behave and how
to use them to predict costs.

5-3

Types of Cost Behavior Patterns

Recall the summary of our cost
behavior discussion from Chapter 1.

5-4

The Activity Base

Units
Units
produced
produced

Machine
Machine
hours
hours
A
Ameasure
measure of
of what
what
causes
causes the
the
incurrence
incurrence of
of aa
variable
variable cost.
cost.

Miles
Miles
driven
driven

Labor
Labor
hours
hours

5-5

True Variable Cost Example

Total Long Distance

Telephone Bill

A variable cost is a cost whose total dollar

amount varies in direct proportion to
changes in the activity level.
Your total long
distance telephone bill
is based on how many
minutes you talk.
Minutes Talked

5-6

Types of Cost Behavior Patterns

Recall the summary of our cost
behavior discussion from Chapter 1.

5-7

Variable Cost Per Unit Example

The per minute cost

of long distance calls
is constant, for
example, 10 per
minute.

Per Minute
Telephone Charge

A variable cost remains constant if

expressed on a per unit basis.

Minutes Talked

5-8

Examples of Variable Costs

1.
1. Merchandising
Merchandising companies
companies cost
cost of
of goods
goods sold.
sold.
2.
2. Manufacturing
Manufacturing companies
companies direct
direct materials,
materials,
direct
direct labor,
labor, and
and variable
variable overhead.
overhead.
3.
3. Merchandising
Merchandising and
and manufacturing
manufacturing companies
companies
commissions,
commissions, shipping
shipping costs,
costs, and
and clerical
clerical costs
costs
such
such as
as invoicing.
invoicing.
4.
4. Service
Service companies
companies supplies,
supplies, travel,
travel, and
and
clerical.
clerical.

5-9

True Variable Cost

Cost

Direct materials is a true or proportionately

variable cost because the amount used during
a period will vary in direct proportion to the
level of production activity.

Volume

5-10

Step-Variable Costs

Cost

A
A resource
resource that
that is
is obtainable
obtainable only
only in
in large
large
chunks
chunks (such
(such as
as maintenance
maintenance workers)
workers) and
and
whose
whose costs
costs increase
increase or
or decrease
decrease only
only in
in
response
response to
to fairly
fairly wide
wide changes
changes in
in activity.
activity.

Volume

5-11

Step-Variable Costs

Cost

Small changes in the level of production are

not likely to have any effect on the number
of maintenance workers employed.

Volume

5-12

Step-Variable Costs

Cost

Only fairly wide changes in the activity

level will cause a change in the number
of maintenance workers employed.

Volume

The Linearity Assumption and the

Relevant Range
A
A straight
straight line
line
Economists
closely
closely
Curvilinear Cost approximates
approximates aa
Function
curvilinear
curvilinear

Total Cost

5-13

Relevant
Range

variable
variable cost
cost
line
line within
within the
the
relevant
relevant range.
range.

Accountants Straight-Line
Approximation (constant
unit variable cost)
Activity

5-14

Types of Cost Behavior Patterns

Lets turn our attention to fixed cost behavior.

5-15

Total Fixed Cost Example

A fixed cost is a cost whose total dollar amount
remains constant as the activity level changes.

Monthly Basic
Telephone Bill

Your monthly basic

telephone bill is
probably fixed and does
not change when you
make more local calls.

Number of Local Calls

5-16

Types of Cost Behavior Patterns

Recall the summary of our cost
behavior discussion from Chapter 1.

5-17

Fixed Cost Per Unit Example

The fixed cost per

local call decreases
as more local calls
are made.

Monthly Basic Telephone

Bill per Local Call

Average fixed costs per unit decrease

as the activity level increases.

Number of Local Calls

5-18

Types of Fixed Costs

Committed
Committed

Discretionary
Discretionary

Long-term,
Long-term, cannot
cannot be
be
significantly
significantly reduced
reduced
in
in the
the short-term.
short-term.

May
May be
be altered
altered in
in the
the
short-term
short-term by
by current
current
managerial
managerial decisions
decisions

Examples
Examples

Examples
Examples

Depreciation
Depreciation on
on
Buildings
Buildings and
and
Equipment
Equipment and
and
Real
Real Estate
Estate Taxes
Taxes

Advertising
Advertising and
and
Research
Research and
and
Development
Development

5-19

Rent Cost in
Thousands of Dollars

Fixed Costs and Relevant Range

90
Relevant

60

Range

30
0

Total
Total cost
cost doesnt
doesnt
change
change for
for aa wide
wide
range
range of
of activity,
activity, and
and
then
then jumps
jumps to
to aa new
new
higher
higher cost
cost for
for the
the
next
next higher
higher range
range of
of
activity.
activity.

1,000
2,000
3,000
Rented Area (Square Feet)

5-20

Fixed Costs and Relevant Range

The relevant range of activity for a fixed
cost is the range of activity over which
the graph of the cost is flat.
Example: Office space is
available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows,
more space is rented,
increasing the total cost.

5-21

Fixed Costs and Relevant Range

How does this type

of fixed cost differ
from a step-variable
cost?

Step-variable costs
can be adjusted
more quickly and . . .
The width of the
activity steps is
much wider for the
fixed cost.

5-22

Mixed Costs
A mixed cost has both fixed and variable
components. Consider your utility costs.
Total Utility Cost

ta
o
T

xe
i
lm

s
o
dc

t
Variable
Cost per KW

Activity (Kilowatt Hours)

Fixed Monthly
Utility Charge

5-23

Mixed Costs

Total Utility Cost

ta
o
T

xe
i
lm

s
o
dc

t
Variable
Cost per KW

Activity (Kilowatt Hours)

Fixed Monthly
Utility Charge

5-24

Mixed Costs Example

IfIf your
your fixed
fixed monthly
monthly utility
utility charge
charge is
is $40,
$40, your
your
variable
variable cost
cost is
is $0.03
$0.03 per
per kilowatt
kilowatt hour,
hour, and
and your
your
monthly
monthly activity
activity level
level is
is 2,000
2,000 kilowatt
kilowatt hours,
hours, the
the
amount
amount of
of your
your utility
utility bill
bill is:
is:

Y = a + bX
Y = $40 + ($0.03 2,000)
Y = $100

5-25

Learning Objective 3

Analyze a mixed cost

using the high-low method.

5-26

Least-Squares Regression Method

A
A method
method used
used to
to analyze
analyze mixed
mixed costs
costs ifif aa
scattergraph
scattergraph plot
plot reveals
reveals an
an approximately
approximately linear
linear
relationship
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.

The goal of this method is

to fit a straight line to the
data that minimizes the
sum of the squared errors.

5-27

Least-Squares Regression Method

Software can be used to

fit a regression line

through the data points.

The cost analysis

objective is the same:

Y = a + bX

The
The output
output from
from the
the regression
regression analysis
analysis can
can be
be
used
used to
to create
create an
an equation
equation that
that enables
enables you
you to
to
estimate
estimate total
total costs
costs at
at any
any activity
activity level.
level.

5-28

End of Chapter 5