1. Chapter 5 Cost Behavior: Analysis and Use

2. Variable Costs Total Variable Cost Graph Total Costs $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 102030 0 Unit Variable Cost Graph $20 $15 $10 $5 0 Cost per Unit 102030 5,000 $ 50,000 $10 10,000 100,000 10 15,000 150,000 10 20,000 200,000 10 25,000 250,000 10 30,000 300,000 10 Units Total Cost Produced Cost per Unit Units Produced (000)

3. The Activity Base/Cost driver A measure of what causes the incurrence of a variable cost Units produced Miles driven Labor hours Machine hours

4. True Variable vs. Step Variable Step Variable Costs - A cost that is obtainable only in chunks – changes abruptly at intervals of activity. Cost Volume Cost Volume True variable cost Step variable cost

5. Step-Variable Costs Activity Cost Total cost remains constant within a narrow range of activity Total cost increases to a new higher cost for the next higher range of activity

6. Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity Total Cost Economist’s Curvilinear Cost Function The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost)

7. Fixed Costs Total Fixed Cost Graph Total Costs 0 Unit Fixed Cost Graph Cost per Unit 50,000 $75,000 $1.500 100,000 75,000.750 150,000 75,000.500 200,000 75,000.375 250,000 75,000.300 300,000 75,000.250 Units Total Cost Produced Cost per Unit $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 100200300 $1.50 $1.25 $1.00 $.75 $.50 $.25 100200300 0 Units Produced (000)

8. Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Equipment and Real Estate Taxes Examples Depreciation on Equipment and Real Estate Taxes Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short term. Committed Long-term, cannot be significantly reduced in the short term.

9. 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. Step-Fixed Costs

10. Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 0 30 60 Step-Fixed Costs and Relevant Range 90 Relevant Range Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

11. 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. Fixed Costs and Relevant Range

12. Quick Check Which of the following statements about cost behavior are true? 1.Fixed costs per unit vary with the level of activity. 2.Variable costs per unit are constant within the relevant range. 3.Total fixed costs are constant within the relevant range. 4.Total variable costs are constant within the relevant range. Which of the following statements about cost behavior are true? 1.Fixed costs per unit vary with the level of activity. 2.Variable costs per unit are constant within the relevant range. 3.Total fixed costs are constant within the relevant range. 4.Total variable costs are constant within the relevant range.

13. Cost Behavior Patterns Example Bicycles by the Sea incurs variable costs of $52 for each of its bicycles. Bicycles by the Sea also incurs $94,500 in fixed costs per year

14. Total Costs and Unit Costs Example What is the unit cost when Bicycles assembles 1,000 bicycles in a year?

15. Use Unit Costs Cautiously Assume that Bicycles management uses a unit cost of $146.50 Management is budgeting costs for different levels of production. What is their budgeted cost for an estimated production of 600 bicycles? 600 × $146.50 = $87,900?

16. Use Unit Costs Cautiously What is their budgeted cost for an estimated production of 3,500 bicycles? 3,500 × $146.50 = $512,750?

17. Pop Quiz Which of the following costs would be variable with respect to the number of cones sold at a Baskins & Robbins shop? (There may be more than one correct answer.) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers.

18. Pop Quiz Which of the following costs would be variable with respect to the number of people who buy a ticket for a show at a movie theater? (There may be more than one correct answer.) A. The cost of renting the film. B. Royalties on ticket sales. C. Wage and salary costs of theater employees. D. The cost of cleaning up after the show.

19. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y A mixed cost has both fixed and variable components. Consider the example of utility cost. Mixed Costs Total mixed cost

20. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y Mixed Costs Total mixed cost

21. Mixed Costs Example If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill? Y = a + bX Y = $40 + ($0.03 × 2,000) Y = $100

22. Practice…Hospital Costs Variable, step, mixed, discretionary or committed fixed? Training costs of an administrative employee Straight line depreciation Cost of services of L&J Consulting Nursing supervisor salaries – supervisor needed for each 45 nursing personnel

23. Practice…Hospital Costs Variable, step, mixed, discretionary or committed fixed? Operating costs of x-ray equipment ($95,000 per year plus $3 per film) Insurance for all full time employees Costs incurred by Dr. Rath in cancer research

24. Account-Classification Method Engineering Method Scattergraph Method High-Low Method The Analysis of Mixed Costs Least-Squares Regression Method

25. Analysis of Mixed Costs Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. Account Analysis and the Engineering Approach

26. Account Classification Method Example

27. Plot the data points on a graph (total cost vs. activity). 0 1 2 3 4 * Maintenance Cost 1,000’s of Dollars 10 20 0 * * * * * * * * * Patient-days in 1,000’s X Y The Scattergraph Method

28. High-Low Method - Cost and Activity Data Assume the following hours of maintenance work and the total maintenance costs for six months.

29. The Contribution Format Used primarily for external reporting. Used primarily by management.

30. Uses of the Contribution Format The contribution income statement format is used as an internal planning and decision making tool. We will use this approach for: 1.Cost-volume-profit analysis (Chapter 6). 2.Budgeting (Chapter 9). 3.Segmented reporting of profit data (Chapter 12). 4.Special decisions such as pricing and make-or-buy analysis (Chapter 13). The contribution income statement format is used as an internal planning and decision making tool. We will use this approach for: 1.Cost-volume-profit analysis (Chapter 6). 2.Budgeting (Chapter 9). 3.Segmented reporting of profit data (Chapter 12). 4.Special decisions such as pricing and make-or-buy analysis (Chapter 13).