Chapter 4

How to Estimate Fixed and

Variable Costs from the
Available Data
 Lecture outline
• cost structure estimation methods
 account classification
 high-low method
 regression analysis
• contribution margin statement
 Cost Structure Estimation:
Why do we care?
To make decisions, we need to predict
profit = revenue − costs
in various scenarios
=> need to be able to predict costs in various scenarios

Predicted costs depend on the cost structure (mix of fixed

and variable costs)
=> need to estimate the cost structure from the available data

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 Cost Structure Estimation
• The relation between total costs (TC) and volume is
TC = FC + unit VC × Volume
where
FC = total fixed costs
unit VC = variable costs per unit
Volume = activity volume: # units sold (sales volume) or
# units produced (production volume)

• We do not know the cost structure parameters FC and unit VC

 we estimate FC and unit VC from the available data
 after that, we use
TC = FC + unit VC × Volume
to predict costs in various scenarios on volume

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 Method 1: Account Classification
Detailed cost data for one period.
Activity volume was 100 units.
Cost account Amount Step 1: Fixed or Variable?
rent $2,000 F V
fire insurance $500 F V
sales staff salaries $5,000 F V
sales commissions $600 F V
cost of merchandise $20,000 F V
TV advertising $1,000 F V

Step 2
total FC =
total VC =
unit VC = total VC / volume =
total cost equation TC = _______ + ______ ×Volume
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 Account Classification

Advantages
• Accurate if done well
Disadvantages
• Requires detailed internal data
• Time-consuming
• Subjective judgment in classifying variable and
fixed costs

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 Method 2: High-Low
Data on total costs and activity volume for several periods
Activity
Total
Month Volume Step 1: Identify the lowest and highest
Cost
in units observation based on activity
Jan 1,000 $70,000  LOW  HIGH
Feb 1,250 $78,000  LOW  HIGH
Mar 1,100 $65,000  LOW  HIGH

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 Method 2: High-Low

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 High-Low Method
• Advantages
• Simple
• Does not require detailed cost data
• Disadvantages
• Only uses two observations => rough estimates of fixed
and variable costs

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 Method 3: Regression
• Regression = “high-low method on steroids”
 same general idea – find a line that best fits the data
 regression uses all available observations (and not just
the high & low observations)
=> extracts maximum information from the data
 we do not care about the technical details

• Advantages
• More accurate than the high-low method
• Does not require detailed cost data
• Disadvantages
• None, relative to the high-low method
• Less accurate estimates than in (well-executed) account
10 classification
 Relevant Range
• In all 3 methods, estimates are valid only in the
relevant range (normal range of operation), where
the relation between activity volume and costs is
stable
 outside the relevant range,
best estimate = “not enough information”

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 Example: Beware of the relevant range

A firm produces between 1,500–3,000 units per month.

Fixed costs = $25,000. Unit variable cost = $12.

(1) What is the total cost of producing 2,000 units per month?

(2) What is the total cost of producing 200,000 units per month?

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Contribution Margin Statement
An internal income statement that incorporates
useful cost structure information
 GAAP Income Statement vs
Contribution Margin Statement
GAAP Income Statement Contribution Margin
for external use Statement for internal use
Sales volume (units) 100
Revenue $20,000 Revenue $20,000
COGS $12,000 Variable costs $15,000
Gross margin $8,000 Contribution margin $5,000
SG&A $5,000 Fixed costs $2,000
Profit $3,000 Profit $3,000
Separates product & period costs, Provides useful information on
does not provide any information fixed & variable costs
on fixed & variable costs
Contribution margin (CM)
= revenue – VC
Profit = CM – FC
 Which Statement is More Useful for
Internal Decision-Making?
You are planning to increase sales by 10%. The selling price, unit VC, and
total FC will not change.
1. Predict the change in profit using the income statement.

GAAP Income Statement

Revenue $20,000
COGS $12,000
Gross margin $8,000
SG&A $5,000
Profit $3,000
 no change
 increase by $300
 increase by $800
 increase by $1,500
 not enough information
 (continued) Which Statement is More
Useful for Internal Decision-Making?
You are planning to increase sales by 10%. The selling price, unit VC, and
total FC will not change.
2. Predict the change in profit using the contribution margin statement.
Contribution Margin
Statement
Sales volume 100
Revenue $20,000
Variable costs $15,000
CM $5,000
Fixed costs $2,000
Profit $3,000
 no change
 increase by $300
 increase by $500
 increase by $1,800
 not enough information
 Additional Exercises

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 Exercise: Cost Structure Estimation
You have the following data. Sales volume was 100 units.
Cost account Amount
rent $5,000
fire insurance $2,000
sales staff salaries $8,000
sales commissions $400
cost of merchandise $24,600

(1) Which estimation method should we use? Why?

 account classification  high-low  GAAP income analysis
(2) Estimate the cost structure.
total cost equation TC = _______ + ______ ×Volume

(3) Predict total costs at sales volume of 120 units.

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 Exercise 2: Cost Structure Estimation
You have the following data.
Activity Volume
Month Total Cost
(# units)
Jan 900 $140,000
Feb 1,150 $156,000
Mar 1,000 $130,000

(1) Which estimation method should we use? Why?

 account classification  high-low  GAAP income analysis
(2) Estimate the cost structure.
total cost equation TC = _______ + ______ ×Volume

(3) Predict total costs at sales volume of 1,100 units.

(4) Predict total costs at sales volume of 11,000 units.

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 To dos:

1. Homework 3&4: due next Wednesday

2. In-class quiz (Ch. 1-3): next Wednesday

 What is managerial accounting
 Understand cost behavior: usage of recourses; short-
term vs. long-term
 Categorize costs based on cost behavior: variable vs.
fixed costs
 Categorize costs based on US GAAP: product vs
period costs

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