The Activity Base A measure of what causes the incurrence of a variable cost. Units produced Miles driven Machine hours Labor hours 5-1

Minutes Talked Total Long Distance Telephone Bill True Variable Cost Example A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. Your total long distance telephone bill is based on how many minutes you talk. 5-2

Minutes Talked Per Minute Telephone Charge Variable Cost Per Unit Example A variable cost remains constant if expressed on a per unit basis. The per minute cost of long distance calls is constant, for example, 10¢ per minute. 5-3

Extent of Variable Costs The proportion of variable costs differs across organizations. For example... A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. A merchandising company usually will have a high proportion of variable costs like cost of sales. A merchandising company usually will have a high proportion of variable costs like cost of sales. A service company will normally have a high proportion of variable costs. A service company will normally have a high proportion of variable costs. 5-4

Step-Variable Costs A resource that is obtainable only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity. Volume Cost 5-5

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) 5-6

Number of Local Calls Monthly Basic Telephone Bill Total Fixed Cost Example Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. A fixed cost is a cost whose total dollar amount remains constant as the activity level changes. 5-7

Number of Local Calls Monthly Basic Telephone Bill per Local Call Fixed Cost Per Unit Example Average fixed costs per unit decrease as the activity level increases. The fixed cost per local call decreases as more local calls are made. 5-8

Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Buildings and Equipment and Real Estate Taxes Examples Depreciation on Buildings and 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. 5-9

The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles. Knowledge workers tend to be salaried, highly-trained, and difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable. 5-10

Is Labor a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In France, Germany, China, and Japan, management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. Most companies in the United States continue to view direct labor as a variable cost. 5-11

Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 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. 5-12

Mixed Costs Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y Total mixed cost 5-13

Analysis of Mixed Costs Account analysis Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. Account analysis Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. Engineering Approach Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. Engineering Approach Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. 5-14

The Scattergraph Method Use one data point to estimate the total level of activity and the total cost. Intercept = Fixed cost: $10, * Maintenance Cost 1,000’s of Dollars * * * * * * * * * Patient-days in 1,000’s X Y Patient days = 800 Total maintenance cost = $11,

The High-Low Method The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours. = $8.00/hour $2, hours 5-16

The High-Low Method Total Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $9,800 – ($8/hour × 800 hours) Total Fixed Cost = $9,800 – $6,400 Total Fixed Cost = $3,

The High-Low Method Y = $3,400 + $8.00X The Cost Equation for Maintenance 5-18

Least-Squares Regression Method A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. This method uses all of the data points to estimate the fixed and variable cost components of a mixed cost. The goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors. 5-19

The Contribution Format The contribution margin format emphasizes cost behavior, by separating costs into fixed and variable categories. Contribution margin covers fixed costs and provides for income. 5-20

The Contribution Format Used primarily for external reporting. Used primarily by management. 5-21

Overview of Absorption and Variable Costing Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs Product Costs Period Costs 5-22

Unit Cost Computations Harvey Company produces a single product with the following information available: 5-23

Unit Cost Computations Unit product cost is determined as follows: Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred. 5-24

Absorption Costing 5-25

Variable manufacturing costs only. All fixed manufacturing overhead is expensed. Variable Costing 5-26

Comparing Absorption and Variable Costing: Year 1 Let’s compare the methods. 5-27

Summary of Key Insights NOI = net operating income 5-28