Example Exercise 1 Cost Behavior Variable Costs Vary in proportion to changes in the activity base Cost behavior is the manner in which a cost changes as a related activity changes. Variable costs [CLICK] are costs [CLICK] that vary in proportion to changes in the activity base. When the activity base is units produced, direct materials and direct labor costs are classified as variable costs. [CLICK] As the number of units increases, the total variable cost [CLICK] increases. Variable cost per unit [CLICK] remains constant.

Example Exercise 1 Cost Behavior Fixed Costs Remain the same in total dollar amount as the activity base changes. Fixed Costs Fixed costs [CLICK] are costs [CLICK] that remain the same in total dollar amount as the activity base changes. When the activity base is units produced, many factory overhead costs such as depreciation and supervisory salaries are classified as fixed costs. [CLICK] As the number of units produced increases, the total fixed cost [CLICK] remains the same; however, fixed costs per unit [CLICK] decreases.

Example Exercise 1 Cost Behavior Mixed Costs Have characteristics of both a variable and a fixed cost. Mixed Costs Mixed costs [CLICK] are costs [CLICK] that have characteristics of both a variable and a fixed cost. Notice in this graph [CLICK] that the total fixed portion of the cost [CLICK] remains constant while the total variable portion [CLICK] increases. For purposes of analysis, mixed costs are usually separated into their fixed and variable components. The high-low method is a cost estimation method that may be used for this purpose.

2 Example Exercise 1 Assume that the Equipment Maintenance Department incurred the following costs for the past five months: The number of units is the activity base and the relevant range is the low of 750 units produced to the high of 2,100 units produced between June and October. Using the high-low method, [CLICK] we determine that the highest level of production is in August at 2,100 units [CLICK] and the lowest level is for October at 750 units. [CLICK] Then, to determine the variable cost per unit, [CLICK] we’ll take the difference in total cost of $20,250 divided by the difference in units of 1,350 to get the variable cost per unit of $15.

2 Example Exercise 1 Assume that the Equipment Maintenance Department incurred the following costs for the past five months: The fixed cost can be determined by using either [CLICK] the highest level at 2,100 units, or the lowest level at 750 units. Let’s look at the highest level. Total costs at 2,100 units were $61,500. By subtracting variable cost per unit times units produced, we get total fixed cost of $30,000. [CLICK] Using the lowest level of 750 units, we get the same total fixed cost of $30,000. [CLICK]

2 Example Exercise 1 (a) $45,000 1,500 units 1 Total Cost Production Highest level $125,000 2,500 Lowest level 80,000 1,000 Difference $ 45,000 1,500 Let’s look at the example exercise for Alex Industries. Using the high-low method, we must first determine the variable cost per unit. The highest level of production is 2,500 units in February and the lowest level is 1,000 units in January. [CLICK] We’ll take the difference in total cost of $45,000 [CLICK] divided by the difference in units of 1,500 to get the variable cost per unit of $30. $45,000 1,500 units = $30 per unit

2 Example Exercise 1 1 (b) Fixed Cost = Total Costs – (variable cost per unit x units produced) Fixed Cost = $125,000 – ($30 x 2,500) Fixed Cost = $125,000 – $75,000 Fixed Cost = $50,000 Next, we need to determine the total fixed cost. By subtracting variable cost per unit times units produced, we get total fixed cost of $50,000. [CLICK]

Example Exercise 1 1 1  For Practice: PE 1A, PE 1B 1 Refer to Practice Exercises PE 1A and PE 1B to practice using the high-low method. 1A, 1B  For Practice: PE 1A, PE 1B