0 CHAPTER 4 Cost Behavior and Relevant Costs © 2009 Cengage Learning

1 1 Introduction What is the nature of costs and how are they used in decision making? Do they increase or decrease as production volume changes? Do they remain stable?

2 2 Introduction The concept of predictable cost behavior based on volume is very important to the effective use of accounting information for managerial decision making. As production volume changes, costs may Increase Decrease Remain the same

3 3 Introduction Costs behave in predictable ways. Key Concept

4 4 The Behavior of Fixed Costs  Fixed costs remain the same in total, but change per unit when production volume changes.  Examples: Rent, Depreciation, Salary of a Plant Manager, Insurance, Property Taxes Volume $ Total Fixed Costs Volume $ Fixed Cost Per Unit

5 5 The Behavior of Variable Costs  Variable costs stay the same per unit but change in total as volume changes.  Examples: Direct material, direct labor, and other unit-level costs like factory supplies Volume $ Total Variable Costs Volume $ Variable Cost Per Unit

6 6 Curvilinear Costs and the Relevant Range Cost Volume Relevant Range Straight-Line Approximation Curvilinear Function

7 7 Within the relevant range, fixed costs are constant in total and vary per unit, and variable costs vary in total and are constant per unit. Relevant Range Key Concept

8 8 The Cost Equation y = a + bx y = total direct material costs a = total fixed costs b = slope of line (variable costs per unit) x = volume of units produced

9 9 Cost Behavior and Decision Making Last month, 2,100 pizzas cost $15,750 Direct materials Direct labor Overhead Total Amount $4,200 3,150 8,400 $15,750 Per Unit $ $7.50 If all costs are variable, how much would 2,600 pizzas cost?

10 Cost Behavior and Decision Making Cost of Goods Sold for 2,600 pizzas: 2,600 x $7.50 = $19,500 Assume that direct materials were $2, direct labor was $1.50, and variable overhead was $1.00 per pizza, and that $6,300 is a fixed cost. What would be the cost of goods sold for 2,600 pizzas?

11 Cost Behavior and Decision Making Direct materials Direct labor Variable overhead Fixed costs Total cost of goods sold $2.00 x 2,600 = $1.50 x 2,600 = $1.00 x 2,600 = = $5,200 3,900 2,600 6,300 $18,000 Which do you think is more representative of the real cost??

12 Step Costs  Step Costs remain constant within a relevant range of production. Example: Janitorial services within a company that manufactures desks 0-7,500 desks 7,501-15,000 desks 1 Janitor 2 Janitors $25,000 $50,000

13 Mixed Costs  Fixed and Variable Components of Delivery Van Expense Fixed: Lease payment each month Variable: Gas, oil, maintenance and other costs that vary with the number of deliveries made (and miles driven)

14 Separating Mixed Costs into their Fixed and Variable Components Regression Analysis: A statistical technique used to estimate the fixed and variable components of a mixed cost. Is referred to as least squares regression. Regression analysis uses statistical methods to fit a cost line (regression line) through a set of data points which minimizes the sum of the squared distance from each data point to the line (hence the name least squares regression).

15 Least Squares Regression Analysis Costs Slope of Regression Line = Variable Cost per unit Fixed Cost Regression Line =Total Overhead Cost Volume 1 unit ? $ Slope represents the change in cost for a 1 unit change in volume

16 Using a Spreadsheet Program to Perform Regression Analysis Using the actual values of the mixed costs (dependent variable) and the volume of production (independent variable) and a spreadsheet program such as Excel, you can compute a regression line using least squares regression. See Exhibits in the text.

17 Regression Statistics  Exhibit 4-13 shows R2 of less than 1.0 (.883), which implies that other independent variables may help explain the change in overhead costs. Examples: Outside temperature and other environmental factors might impact overhead costs incurred.

18 Regression Statistics Other uses in managerial decision-making situations. Marketing Managers predicting changes in sales based on changes in advertising expenditures. Production Managers interested in quality control might collect data on overtime worked in a factory vs. the number of defective items produced.

19 Estimating Regression Results Using the High/Low Method 1. Use only two data points, the high and low levels of activity and their related total overhead costs. 2. Subtract the smallest from the largest for each and use the changes in the following formula. Change in volume = Variable cost per unit 3.3. Change in Cost

20 Estimating Regression Results Using the High/Low Method 4. Substitute the total cost of one of the points for “y” in the equation y = a + bx 5. Substitute the variable cost found using high-low for “b” 6. Substitute the number of activity units for the data point chosen for “x” 7. Solve for fixed costs “a” 8. Determine the formula to use in estimating the mixed costs at various levels

21 Estimating Regression Results Using the High/Low Method If the high point of activity was 2,500 units with $12,450 of overhead costs and the low point of activity was 1,950 units with $10,525 of overhead costs, what would be the estimated total costs at 2,435 units of activity?

22 Estimating Regression Results Using the High/Low Method 1. High Point = 2,500 units at $12,450 Low Point = 1,950 units at $10, , ,950 = 550 units (change in units) $12,450 - $10,525 = $1,925 (change in cost) 3. $1,925 / 550 units = $3.50 variable cost/unit

23 Estimating Regression Results Using the High/Low Method Steps 4,5,6,7. Y = $12,450 = $3,700 = Y = a + bx a + $3.50 (2,500) a + $8,750 a $3,700 + $3.50x 8. Y = $3,700 + $3.50 (2,435) Y = $12, which is total projected overhead costs at 2,435 units. Cost at high pt Volume at high pt Fixed Costs Variable Costs Projected volume

24 Relevant Costs and Cost Behavior It can be misleading to always view variable costs as relevant and fixed costs as not relevant. Step Costs

25 Taxes and Decision Making Three Tax Considerations: 1. Costs of operating businesses are deductible for income tax and revenues are taxable. 2. Form of a transaction may impact the amount of tax paid or whether cost is tax deductible 3. Payment of tax requires cash outflow, thus reducing the amount of cash available for other purposes.

26 Taxes and Decision Making Managers must consider the impact of taxes when making decisions. Key Concept

27 After-Tax Costs and Revenues After-Tax Cost of a tax deductible cash expenditure: After-tax cost = Pretax cost X (1-tax rate) After-Tax Benefit of a taxable cash receipt: After-tax benefit = Pretax receipts X (1-tax rate)

28 Before- and After-Tax Income After-tax income = Pretax income X (1- tax rate) $700 = $1,000 x (1 -.30)