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MBA 502B Managerial Accounting University of Scranton, Dr. Robyn Lawrence Analyzing Cost Behavior Session Two

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 2 Classifying Costs In GAAP system, costs are classified according to function –Cost of goods sold –Selling –Administrative Another classification system generally improves internal (management) decisionsaccording to cost behavior.

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 3 Cost Behavior Activity Base: –Cost Driver: causes changes in the behavior of costs. –Cost Predictor: accompanied by consistent, observable changes in a cost item (correlated with)--predicts but may not cause the cost to change Activity Base Examples: –miles driven – in a trucking company, –room occupancy – in a hotel, –number of customers called on – by a salesperson, or –number of patientsin a hospital. Relevant (Normal or Practical) Range: –the range of interest; or –the range over which a company expects to operate during a year. The manner in which a cost changes as a related activity changes Variable Fixed Mixed

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 4 Variable Costs Vary in total directly and proportionately with changes in the activity level; Remain the same per unit at every level of activity. Number of Cost perTotal Weekday Minutes MinuteCost $

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 5 Fixed Costs Remain the same in total regardless of changes in the activity level (within the relevant range). Per unit cost varies inversely with the activity level. Number of Cost perMonthly Units Produced Unit Rent $

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 6 Variable versus Fixed Costs Varies in direct proportion to changes in activity Remains constant throughout the relevant range Remains constant throughout the relevant range Varies inversely with changes in activity throughout the relevant range Variable Cost Fixed Cost Total CostUnit Cost

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 7 Mixed Costs Contain both variable and fixed cost elements. Changes in total but not proportionately with changes in the activity level. Example: Assume that local rental terms for a 17-foot moving truck, including insurance, are $50 per day plus $.50 per mile. The per diem charge is a fixed cost with respect to miles driven in a day, while the mileage charge is a variable cost. High-low method, Scattergraph method or OLS Regression can be used to identify/estimate the fixed and variable components.

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 8 Practice Classifying Costs Below costs are given for two periods (and two levels of activity). Classify the costs as to variable, fixed, or mixed. January February 1,000 units1,200 units Classification Rent$ 700 $ 700 Maintenance Utilities Insurance Inspection Supplies Indirect Labor Direct Materials Fixed Variable Mixed Fixed Mixed Variable Mixed Variable

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 9 High-Low Estimation Method EXAMPLE:ProductionTotal cost June 700 units3,200 July 8003,800 August 9004,300 September 5002,700 October 4002,050 Essentially finding the slope (variable cost per activity unit) and then the intercept (total fixed costs) for a line going through two points: Difference in Total Cost Difference in Activity = Variable Cost per Unit of Activity 900 – 400 4,300 – 2,050 = 2, =$4.50/unit Find the slope (variable cost per activity): Find the intercept (total fixed costs): Using the higher point:4,300 – (900 x 4.50) = 4,300 – 4,050 = 250 Using the lower point:2,050 – (400 x 4.50) = 2,050 – 1,800 = 250 Variable costs are $4.50 per unit and fixed costs are $250. Cost formula: Total Costs = $250 + $4.50X

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 10 Graphing Costs $2,000 $1,000 $3,000 $4,000 $5,000 Total Costs Units Produced 250 Fixed Costs.. (400, 2,050). (900, 4,300) Total Variable Costs Fixed Costs Total Cost Line

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 11 Scattergraph Estimation $2,000 $1,000 $3,000 $4,000 $5,000 Total Costs Units Produced. (700, 3,200). (900, 4,300). (800, 3,800). (400, 2,050). (500, 2,700) 1.Plot all of the observations 2.Draw the most representative line. 3.Pick two points on the line & use high-low method to determine variable and fixed costs $4,250 - $3, = 1,250/300 = variable cost per unit $3,000 – x 600 = 3,000 – 2,500 = 500 Total Fixed Costs Total Cost = 4.17X + 500

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 12 OLS Regression Method MS Excel Ordinary Least Squares Output: For slope (variable cost per unit) use =INDEX(LINEST(known_y's,known_x's)1) For the intercept (total fixed costs) use =INDEX(LINEST(known_y's,known_x's)2) For the full regression output use =LINEST(known_y's,known_x's,const,stats) m = (Variable cost per unit) b = (Total fixed costs) Total Cost = 4.227X For Example:

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 13 Comparison of Methods to Calculate Mixed Cost Components High-low method –Uses the total costs incurred at the high and low levels of activity to calculate the variable cost per unit and the total fixed costs using the line formula. –Advantage: easy to calculate. –Disadvantages: relies on the representativeness of the high point and the low point. does examine whether a line (linear model) is appropriate. Scattergraph Method –Plots observations, draws in the best line and calculates the lines values. –Advantage: examines whether there is a linear relationship. –Disadvantage: the line drawn might be different from person to person. Ordinary Least Squares Regression –Estimates a line that minimizes sum of the squared differences between the actual y-values and the average of the y-values. –Advantages: uses all of the pointsefficient estimator; provides more information about how much of the variability is explained by the line. –Disadvantages: harder to use and explain overly affected by outliers.

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 14 Nonlinear Cost Behavior Total Mixed costs are fixed over some range then vary over the succeeding range. Total Cost Example: Monthly phone fee plus per call fee if number of calls exceed a preset number. Step-Fixed are fixed for a range, then jump and remain fixed for a range… Example: A salaried supervisor for every ten employees Total Cost Curvilinear (variable) do not have a linear pattern Example: Total cost of direct labor where overtime is sometimes involved. Total Cost

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 15 Linear Estimation of Nonlinear Cost Behavior Total Mixed Total Cost Step-Fixed Total Cost Curvilinear (variable) Total Cost Relevant Range is the range over which a company expects to operate during a year. Within this range, a relationship approximating a straight-line might exist.

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 16 Why Does Cost Behavior Matter? Determining Cost Behavior: Improves cost forecasts at different levels of activity. Managements volume response differs for variable versus fixed costs. For example: –If fixed costs are $1,000 for the relevant range of 1 to 100 units, then if 10 units are produced, the unit cost is $100; if 100 units are produced, the unit cost is $10. With fixed costs, unit costs change proportionately--there is incentive to produce more units with fixed costs to lower unit costs. –If variable costs are $1 per unit, then the unit cost will be $1 per unit whether 1 or 100 are produced. Unit costs will not decline if more units are produced.

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 17 Session 2: Analyzing Cost Behavior This Ends

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S-II: Analyzing Cost Behavior, MBA 502B, Univ. of Scranton, Dr. R. Lawrence 18 Concluding Activities Read Chapter 11: pp Suggested homework: –E11-1 [Classify costs] –E11-2 [Identify cost graphs] –E11-3 [Identify activity bases] –E11-6 [Relevant range; calculating variable & fixed costs] –E11-7 [High-low method; making an estimate] –E11-8 [High-low method] –P11-1 [Classify costs] Submit to the Session Two Dropbox your solutions to the following: Required: For each of the different costs given below, indicate whether it is a variable, fixed, or mixed cost. Use the high-low technique to estimate the variable cost per unit and the total fixed costs for each. Cost 400 hours550 hours A$ 875 $ 875 B C 1,440 1,980 D 3,900 5,250 E 1,000 1,000 F G H

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