COST BEHAVIOR: ANALYSIS AND USE

KNOWLEDGE OF COST BEHAVIOR

Setting Sales Make-or-Buy

Prices decisions

Entering new
markets

Introducing new
products

Buying/Replacing
Equipment
 METHODS OF ANALYSIS

• Account Analysis
• Engineering Approach
• High-Low Method
• Scattergraph Plot
• Regression Analysis

3
 THE SCATTERGRAPH METHOD

Plot
Plotthe
thedata
datapoints
pointsononaa
Y graph
graph(total
(total cost
cost vs.
vs. activity).
activity).
20
* ** *
1,000’s of Dollars
* *
Total Cost in

**
10 * *

0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced
 QUICK-AND-DIRTY METHOD

Draw
Draw aaline
linethrough
throughthe
thedata
datapoints
pointswith
withabout
about anan
equal
equal numbers
numbersof of points
pointsabove
aboveand
andbelow
below the
theline.
line.
Y
20
* ** *
1,000’s of Dollars

* *
Total Cost in

* **
10 * Intercept is the estimated
Intercept is the estimated
fixed
fixedcost
cost==$10,000
$10,000

0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced
 QUICK-AND-DIRTY METHOD

The
Theslope
slopeis
isthe
theestimated
estimatedvariable
variablecost
costper
perunit.
unit.
Slope
Slope== Change
Changeinincost
cost ÷÷ Change
Changeininunits
units
Y
20
1,000’s of Dollars

* * * ** *
Total Cost in

* **
10 *
Horizontal
Horizontal Vertical
Verticaldistance
distanceisis
distance
distanceisis the
thechange
changeinincost.
cost.
the
thechange
changein in
activity.
activity.
0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced
 ADVANTAGES

• One of the principal advantages of

this method is that it lets us “see”
the data.
• What are the advantages of
“seeing” the data?
 NONLINEAR RELATIONSHIP

Activity
Cost

* * *
*
*
0 Activity Output
 UPWARD SHIFT IN COST RELATIONSHIP

Activity
Cost *
*
*
*
* *
0 Activity Output
 PRESENCE OF OUTLIERS

Activity
Cost *
*
*

*
* *
0 Activity Output
 Brentline Hospital Patient Data

Activity Level: Maintenance

Month
Patient Days Cost Incurred
January 5,600 $7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
June 8,000 9,800
July 6,200 7,800

Textbook Example
 Brentline Hospital Patient Data

12000

10000

Maintenance Cost 8000

6000

4000

2000

0
0 2000 4000 6000 8000 10000
Patient-Days
 Brentline Hospital Patient Data

12000

10000

8000
Maintenance Cost

6000

4000

2000

y = 0.7589x + 3430.9
0
0 2000 4000 6000 8000 10000
Patient-Days
 Brentline Hospital Patient Data

12000

10000

8000
Maintenance Cost

6000

4000

2000

y = 0.7589x + 3430.9
0
0 2000 4000 6000 8000 10000
Patient-Days
 Brentline Hospital Patient Data

12000

10000

8000
Maintenance Cost

6000

4000

2
2000 R = 0.8964
y = 0.7589x + 3430.9
0
0 2000 4000 6000 8000 10000
Patient-Days
 FROM ALGEBRA . . .

• If we know any two points on a line,

we can determine the slope of that
line.
 HIGH-LOW METHOD

• A non-statistical method whereby we

examine two points out of a set of
data . . .
• The high point; and
• The low point
 HIGH-LOW METHOD

• Using these two points, we

determine the equation for that
line . . .
• The intercept; and
• The Slope parameters
 HIGH-LOW METHOD

• To get the variable costs . . .

• We compare the difference in costs
between the two periods to
• The difference in activity between
the two periods.
 Brentline Hospital Patient Data

Activity Level: Maintenance

Month
Patient Days Cost Incurred
January 5,600 $7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
June 8,000 9,800
July 6,200 7,800

Textbook Example
High/
High/ Low
Low Month
Month Patient
PatientDays
Days Maint.
Maint.Cost
Cost

High
High June
June 8,000
8,000 $9,800
$9,800

Low
Low March
March 5,000
5,000 7,400
7,400

Difference
Difference 3,000
3,000 $2,400
$2,400
 Change
Change in
in Cost
Cost
V
V == ------------------
------------------
Change
Change in
in Activity
Activity

(Y
(Y22 -- Y
Y11))
V
V == ------------
------------
(X
(X22 -- X
X11))
High/
High/ Low
Low Month
Month Patient
PatientDays
Days Maint.
Maint.Cost
Cost

High June
The
8,000
Change
$9,800
High June 8,000 $9,800
in Cost
Low
Low March
March 5,000
5,000 7,400
7,400
Divided by the
Difference
change in
Difference 3,000
3,000 $2,400
$2,400
activity
 Change
Change in
in Cost
Cost
V
V == ------------------
------------------
Change
Change in
in Activity
Activity

$2,400
$2,400
V
V == ------------
------------
3,000
3,000
== $0.80
$0.80 Per
Per Unit
Unit
Total
Total Cost
Cost (TC)
(TC) == FC
FC ++ VC
VC
-- FC
FC == -- TC
TC ++ VC
VC
FC
FC == TC
TC -- VC
VC
FC
FC == $9,800
$9,800 -- (8,000
(8,000 xx $0.80)
$0.80)
== $3,400
$3,400
FC
FC == $7,400
$7,400 -- (5,000
(5,000 xx $0.80)
$0.80)
== $3,400
$3,400
TC
TC == $3,400
$3,400 ++ $0.80X
$0.80X
 Activity Level: Maintenance
Month
Patient Days Cost Incurred
January 5,600 $7,900
February 7,100 8,500
March 5,000 7,400
We have taken “Total
April 6,500 8,200
Costs” which is a 7,300
May 9,100
mixed cost and we8,000
June 9,800
July
have separated it 6,200
into 7,800
its VC and FC
components.
So what? You say! Thank you for asking!
Now I can use this formula for planning
purposes. For example, what if I believe my
activity level will be 6,325 patient days in
February. What would I expect my total
maintenance cost to be?
What is the estimated total cost if
the activity level for February is
expected to be 6,325 patient days?

Y
Y == aa ++ bx
bx
TC
TC == $3,400
$3,400 ++ 6,325
6,325 xx $0.80
$0.80
TC
TC == $8,460
$8,460
 SOME IMPORTANT
CONSIDERATIONS

• We have used historical cost to

arrive at the cost equation.
• Therefore, we have to be careful in
how we use the formula.
• Never forget the relevant range.
$

Relevant Range

Volume (Activity Base)

 STRENGTHS OF HIGH-LOW
METHOD

• Simple to use
• Easy to understand
 WEAKNESSES OF HIGH-LOW

• Only two data points are used in the

analysis.
• Can be problematic if either (or
both) high or low are extreme (i.e.,
Outliers).
 Extreme values -
not necessarily
representative
. .
. . . . .
. . .
.. . .
. Representative
High/Low Values
 WEAKNESSES OF HIGH-LOW

• Other months may not yield the

same formula.
FC = $8,500 - (7,100 x $0.80)
= $2,820
FC = $7,800 - (6,200 x $0.80)
= $2,840
 REGRESSION ANALYSIS

• A statistical technique used to separate

mixed costs into fixed and variable
components.
• All observations are used to fit a
regression line which represents the
average of all data points.
 REGRESSION ANALYSIS

• Requires the simultaneous solution of

two linear equations
• So that the squared deviations from the
regression line of each of the plotted
points cancel out (are equal to zero).
 Cost

Actual Y
Error
Estimated y

The objective is to find

values of a and b in the
equation y = a + bX that
minimize (Y  y ) 2

Production
The equation for a linear function
(straight line) with one independent
variable is . . .
yy == aa ++ bX
bX
Where:
y = The Dependent Variable
a = The Constant term (Intercept)
b = The Slope of the line
X = The Independent variable
The equation
The for a linear function
(straight line) with one independent
Dependent
variable isVariable
...
yy == aa ++ bX
bX
Where:
The Variable
y = The Dependent
Independent
a = The Constant term (Intercept)
b = TheVariable
Slope of the line
X = The Independent variable
 REGRESSION ANALYSIS

• With this equation and given a set

of data.
• Two simultaneous linear equations
can be developed that will fit a
regression line to the data.
  xy  a  
x  b x 2

 y  na  b  x
Where: a = Fixed cost
b = Variable cost
n = Number of observations
X = Activity measure (Hours, etc.)
Y = Total cost
 (Y )(X )  (X )(XY )
2
a
n(X )  (X )(Y )
2

n(XY )  (X )(Y )

b
n(X )  (X )(X )
2
Fixed
Costs

Variable
Costs
 R2, the Coefficient of Determination is
the percentage of variability in the
dependent variable being explained by
the independent variable.

This is referred to as a “goodness of fit”

measure.
R, the Coefficient of Correlation is
square root of R2. Can range from -1 to
+1. Positive correlation means the
variables move together. Negative
correlation means they move in opposite
directions.
 Fixed
Fixed Variable
Variable
Method
Method Cost
Cost Cost
Cost

High-Low
High-Low $3,400
$3,400 $0.80
$0.80

Scattergraph
Scattergraph $3,300
$3,300 $0.79
$0.79

Regression
Regression $3,431
$3,431 $0.76
$0.76
 COEFFICIENT OF DETERMINATION

• R2 is the percentage of variability in the

dependent variable that is explained by
the independent variable.
 COEFFICIENT OF DETERMINATION

• This is a measure of goodness-of-

fit.
• The higher the R2, the better the fit.
 COEFFICIENT OF DETERMINATION

• The higher the R2, the more variation

(in the dependent variable) being
explained by the independent variable.
 COEFFICIENT OF DETERMINATION

• R2 ranges from 0 to 1.0

• Good Vs. Bad R2s is relative.
• There is no magic cutoff
 COEFFICIENT OF CORRELATION

• The relationship between two variables

can be described by a correlation
coefficient.
• The coefficient of correlation is the
square root of the coefficient of
determination.
 COEFFICIENT OF CORRELATION

• Provides a measure of strength of

association between two variables.
• The correlation provides an index of
how closely two variables “go
together.”
Machine Utility Machine Utility
Hours Costs Hours Costs
Hours of Industrial Hours of Industrial
Safety Accidents Safety Accidents
Training Training
Hair 202 Hair 202
Length Grade Length Grade
 EXAMPLE
Davidson Engine Repairs provides maintenance and repair services for small engines. The repair shop
costs include the salaries for mechanics, insurance and depreciation on the repair equipment, materials
and parts used for the jobs, and utilities. The repair shop manager would like to develop a model for
predicting repair costs and over past 10 months has carefully recorded the total repair costs incurred,
along with the number of maintenance and repair jobs completed each month. The data are shown
below:
Month Jobs Repair Costs
January 220 $22,000
February 180 18,000
March 160 17,600
April 200 20,000
May 260 24,000
June 240 22,400
July 140 16,000
August 120 12,800
September 100 13,600
October 80 9,600

Required:

1. Using the high-low method, estimate a cost formula for repair costs.
2. What total repair cost would you expect to be incurred at an activity level of 110?
3. Now assume your manager wants to predict costs for a month where 500 jobs will be completed.
Should you use the formula development above to predict costs? Why or why not?
REC Kayaks Inc. manufactures a single product. Selected data from the company’s cost the two recent
months are given below:

Level of Activity
November – Low April - High
Number of units produced 9,000 12,000
Cost of goods manufactured $285,000 $390,000
Work in process inventory, opening 14,000 22,000
Working process inventory, closing 25,000 15,000
Direct materials cost per unit 15 15
Direct labour cost per unit 6 6
Manufacturing overhead cost, total ? ?

The company’s manufacturing overhead cost consists of both variable and fixed cost elements. To have
data available for planning, management wants to determine how much of the overhead cost is variable
with units produced and how much ol it is fixed per year.
Required:

1. For both April and November, estimate the amount of manufacturing overhead cost added to
production. The company had no underapplied or overapplied overhead in the either month.
2. Using the high-low method, estimate a cost formula for manufacturing overhead.
3. If 10,000 units are produced during a month, what will the cost of goods manufactured be? Assume
the company’s opening WIP is $16,000 and the ending WIP is $19,000. Also assume there is no
under or over applied overhead cost for the month.