PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 5 Cost Behavior

5- 3 Cost Behavior Patterns Cost behavior describes the way total cost behaves, or changes, when some measure of activity changes. The range of activity within which assumptions about cost behavior hold true is the relevant range. Unit variable costs remain unchanged. Total fixed costs remain unchanged.

5- 4 Identify costs as variable, fixed, step, or mixed. Learning Objective 5-1

5- 5 Variable Costs Variable cost per unit is constant as activity increases. Total variable costs increase as activity increases.

5- 6 Cost per cup declines as activity increases. Total fixed costs remain constant as activity increases. Fixed Costs

5- 7 Cost Behavior Summary

5- 8 Step Costs Step-fixed costs are fixed over a fairly wide range of activities. Step-variable costs rise in multiple steps across the relevant range.

5- 9 Mixed Costs Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. Utilities typically behave in this manner. Activity (Kilowatt Hours) Total Utility Cost Fixed Monthly Utility Charge Variable Cost per KW Total mixed cost

5- 10 Mixed Costs Total mixed costs increase as activity increases. Per unit mixed costs decrease as activity increases.

5- 11 y = total cost, which is plotted on the vertical axis, and is called the dependent variable. a = total fixed cost, an amount that will be incurred regardless of the activity level, and is called the intercept or the constant. b = the slope of the line, the unit variable cost, which tells us how much the total cost (y) will increase for each unit increase in activity (x). x = the activity that causes total cost (y) to change. Activity (x) is also called the cost driver, or the independent variable. Linear Approaches to Analyzing Mixed Costs y = Total Costs x = Activity b = Slope a = Intercept

5- 12 Linear Approaches to Analyzing Mixed Costs There are three different methods to analyze mixed costs, all using the linear assumption as a base. 1.Scattergraph: A graph that provides a visual representation of the relationship between total cost (y) and activity level (x). A scattergraph is a useful first step in analyzing cost behavior because it helps determine the nature of the relationship and whether the linearity assumption is valid. 2.High-low method: A simple approach that uses the two most extreme data points to determine the slope of the line (variable cost per unit) and the intercept (total fixed cost). 3.Least-squares regression: A statistical technique for finding the best fitting line based on historical data. The slope of the line provides an estimate of the variable cost per unit, while the intercept provides an estimate of the total fixed cost.

5- 13 Prepare a scattergraph to illustrate the relationship between total cost and activity. Learning Objective 5-2

5- 14 Scattergraph A scattergraph is a graph with total cost plotted on the vertical (Y) axis and some measure of activity on the horizontal (X) axis.

5- 15 Preparing a Scattergraph A scattergraph can be created by manually plotting data points on graph-paper, or by using a the following steps in Excel: 1. Enter the data in Excel, and highlight the data that you want to plot. 2. Select the Chart Wizard from the toolbar. 3. Select XY (Scatter) as the chart type. Be sure total cost is on the Y axis, with the activity driver on the X axis. 4. Add a chart title and labels for the X and Y axes. To apply these steps, consider the following data showing the total overhead cost (Y) of running our hypothetical Starbucks location, along with the number of customers served (X).

5- 16 Preparing a Scattergraph

5- 17 Use the high-low method to analyze mixed costs. Learning Objective 5-3

5- 18 High-Low Method

5- 19 High-Low Method = Total Fixed Cost Variable Cost per Unit × Activity Total Cost _ $0.25 × 15,000 $15,750 _ $12,000 = February Estimate Total Fixed Cost = $0.25 × 5,000 $13,250 _ $12,000 = May Estimate Total Fixed Cost =

5- 20 High-Low Method

5- 21 Use least-squares regression to analyze mixed costs. Learning Objective 5-4

5- 22 Least-Squares Regression Method The goal of this method is to minimize the sum of the squared errors. A statistical method used to analyze mixed costs. } Error

5- 23 Least-Squares Regression Method  Software such as Excel can be used to fit a regression line through the data points.  The cost analysis objective is the same: y = a + bx The output from the regression analysis can be used to create an equation that enables you to estimate total costs at any activity level.

5- 24 Least-Squares Regression Method

5- 25 Least-Squares Regression Method R 2 tell us how closely we can explain the relationship between our two variables. In our example, the number of customers explains about 64% of the overhead costs. The intercept and x coefficient, respectively, are estimated total fixed cost and variable cost per unit.

5- 26 Least-Squares Regression Method Total Fixed Cost = Total Variable Cost (Variable Cost per Unit × X) Total Cost $0.32 × 8,000 = $2,560 $13,741 $11,181 + Using our regression output, if Starbucks expected to serve 8,000 customers in July, we would estimate total overhead costs as follows: +=

5- 27 Summary of Linear Methods

5- 28 Prepare and interpret a contribution margin income statement. Learning Objective 5-5

5- 29 Contribution Margin Approach Contribution margin is the difference between sales revenue and variable costs.

5- 30 Contribution Margin Ratio Contribution Margin Sales Revenue Variable Costs = ‒ Contribution Margin Formula Contribution Margin Ratio Contribution Margin Sales Revenue = Contribution Margin Ratio

5- 31 Contribution Margin Unit contribution margin Contribution margin ratio

5- 32 Contribution Margin

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Supplement 5A Variable Versus Full Absorption Costing

5- 34 Compare variable costing to full absorption costing. Learning Objective 5-S1

5- 35 Variable Versus Full Absorption Costing

5- 36 Reconciling Variable and Full Absorption Costing

5- 37 Full Absorption Costing Income Statement

5- 38 Variable Costing Income Statement Variable costs only. All fixed manufacturing overhead is expensed.

5- 39 Difference between Full Absorption and Variable Costing Income Change in Units in Ending Inventory (Production ‒ Sales) Fixed Manufacturing Overhead Cost per Unit =× $40,0002,000 units$20 per unit =× Reconciling Variable and Full Absorption Costing

5- 40 Effect of Changes in Inventory Under Full Absorption and Variable Costing

5- 41 End of Chapter 5