Cornerstones of Managerial Accounting, 5e © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 3: Cost Behavior Cornerstones of Managerial Accounting, 5e © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basics of Cost Behavior Cost behavior is the foundation upon which managerial accounting is built. Describes whether a cost changes when the level of output changes. Costs can be variable, fixed, or mixed. A cost that does not change in total as output changes is a fixed cost. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basics of Cost Behavior (cont.) A variable cost increases in total with an increase in output and decreases in total with a decrease in output. Knowing how costs change as output changes is essential to planning, controlling, and decision making. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measures of Output and the Relevant Range Fixed and variable costs have meaning only when related to an output measure. A cost driver measures the output of the activity that leads (or causes) costs to change. Identifying and managing drivers helps managers predict and control costs. For example, weather is a significant driver in the airline industry. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Relevant Range and Cost Relationships Relevant range is the range of output over which the assumed cost relationship is valid for the normal operations of a firm. Limits the cost relationship to the range of operations that the firm normally expects to occur. The following graph shows the relevant range which allows managers to assume a linear cost relationship. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Relevant Range and Cost Relationships LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fixed Costs The number of computers produced is called the output measure, or driver. Even though fixed costs may change, this does not make them variable. They are fixed at a new higher (or lower) rate. A graph of Colley’s fixed supervision costs is shown below: LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fixed Costs (cont.) LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discretionary Fixed Costs and Committed Fixed Costs Two types of fixed costs: discretionary fixed costs and committed fixed costs. Discretionary fixed costs are fixed costs that can be changed or avoided easily at management discretion. Committed fixed costs, on the other hand, are fixed costs that cannot be easily changed. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discretionary Fixed Costs and Committed Fixed Costs (cont.) Advertising is a discretionary fixed cost, because it depends on a management decision. Lease cost is a committed fixed cost because it involves a long-term contract. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Variable Costs Variable costs are costs that vary in direct proportion to changes in output within the relevant range. Variable costs can also be represented by a linear equation. Total variable costs depend on the level of output. This relationship can be described by the following equation or graphs: LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Total variable costs = Variable rate x Amount of output Variable Costs (cont.) Total variable costs = Variable rate x Amount of output LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Reasonableness of Straight-Line Cost Relationships Caution when applying cost behavior assumptions to output levels that fall outside of the company’s relevant range of operations. Straight-line cost relationships that are assumed within the relevant range may actually be semi-variable costs. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Reasonableness of Straight-Line Cost Relationships (cont.) Example: At extremely low levels of output, workers often use more materials per unit or require more time per unit than they do at higher levels of output. As the level of output increases, workers learn how to use materials and time more efficiently so that the variable cost per unit decreases as more and more output is produced. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Reasonableness of Straight-Line Cost Relationships (cont.) LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mixed Costs Mixed costs are costs that have both a fixed and a variable component. Example: Overhead for a company may consist of a fixed supervisor salary plus the cost of supplies that vary with the quantity of output produced. The formula and graph depiction for a mixed cost is as follows: LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Total cost = Total fixed cost + Total variable cost Mixed Costs (cont.) Total cost = Total fixed cost + Total variable cost Volume LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Step Costs: Narrow Steps Some cost functions may be discontinuous. Known as step costs (or semi-fixed). Displays a constant level of cost for a range of output and then jumps to a higher level (or step) of cost at some point, where it remains for a similar range of output. LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Step Costs: Narrow Steps (cont.) If a step cost has narrow steps, it means that the cost changes in response to small changes in output and we can approximate it as a variable cost (i.e., the red line). LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Step Costs: Narrow Steps (cont.) LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Step Costs: Wide Steps Step cost with wide steps are more characteristic of fixed costs. Example: A company may have to lease production machinery. If the machine can only produce 1,000 units and the company grows, they will have to lease additional machines for each 1,000 units of production needed Resulting in the wide steps shown in the following graph. LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Step Costs: Wide Steps (cont.) LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Methods for Separating Mixed Costs into Fixed and Variable Components Three methods of separating a mixed cost into its fixed and variable components: the high-low method the scattergraph method the method of least squares Each method requires the simplifying assumption of a linear cost relationship. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Methods for Separating Mixed Costs into Fixed and Variable Components Expression of cost as an equation for a straight line is: Total cost = Fixed cost + (Variable rate x Output) The dependent variable is a variable whose value depends on the value of another variable. In the previous equation, total cost is the dependent variable; it is the cost we are trying to predict. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Methods for Separating Mixed Costs into Fixed & Variable Components The independent variable measures output and explains changes in the cost or other dependent variable. A good independent variable is one that causes or is closely associated with the dependent variable. Many managers refer to an independent variable as a cost driver. The intercept corresponds to fixed cost. The slope of the cost line corresponds to the variable rate. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Methods for Separating Fixed Costs into Fixed &Variable Components LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

APPENDIX 3A: Using the Regression Programs Computing the regression formula manually is tedious, even with only a few data points. As the number of data points increases, manual computation becomes impractical. Fortunately, spreadsheet packages like Microsoft Excel have regression routines that perform these computations. LO-4 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

APPENDIX 3A: Using the Regression Programs Input the data and the spreadsheet regression program supplies more than the estimates of the coefficients. Also provides information that can be used to see how reliable the cost equation is—a feature that is not available for the scattergraph and high-low methods. LO-4 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.