1. Chapter 5 Cost Behavior: Analysis and Use

2. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 1.

3. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Total Variable Cost Example Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill

4. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Variable Cost Per Unit Example Minutes Talked Per Minute Telephone Charge The cost per minute talked is constant. For example, 10 cents per minute.

5. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Total Fixed Cost Example Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. Number of Local Calls Monthly Basic Telephone Bill

6. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Fixed Cost Per Unit Example Number of Local Calls Monthly Basic Telephone Bill per Local Call The fixed cost per local call decreases as more local calls are made.

7. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Cost Behavior Merchandisers Cost of Goods Sold Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Merchandisers and Manufacturers Sales commissions and shipping costs Service Organizations Supplies and travel Examples of normally variable costs Examples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising

8. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin The Activity Base Machine hours Labor hours Miles driven A measure of the event causing the incurrence of a variable cost – a cost driver Units produced

9. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Step-Variable Costs Activity Cost Total cost remains constant within a narrow range of activity.

10. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Step-Variable Costs Total cost increases to a new higher cost for the next higher range of activity. Activity Cost

11. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Relevant Range The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost) Activity Total Cost Economist’s Curvilinear Cost Function A straight line closely approximates a curvilinear variable cost line within the relevant range.

12. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Types of Fixed Costs Discretionary One-year planning horizon Can be cut for short periods of time Discretionary One-year planning horizon Can be cut for short periods of time Committed Multi-year planning horizon Cannot be cut for short periods of time Committed Multi-year planning horizon Cannot be cut for short periods of time Examples Depreciation on Buildings and Equipment Examples Depreciation on Buildings and Equipment Examples Advertising and Research and Development Examples Advertising and Research and Development

13. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Trend Toward Fixed Costs Increased automation. Increase in salaried knowledge workers who are difficult to train and replace. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions.

14. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Fixed if work force is stable because management is reluctant to increase/decrease the number of employees in response to short-term fluctuations in business activity. Variable if size of work force is easily adjusted for short-term fluctuations in business activity. Labor Costs: Fixed or Variable? May be both fixed and variable if temporary workers are employed to accommodate short-term fluctuations in business activity.

15. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Fixed Costs and Relevant Range Continue Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows, more space is rented, increasing the total cost.

16. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 0 30 60 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.

17. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Quick Check Which of the following statements about cost behavior are true? a. Fixed costs per unit vary with the level of activity. b. Variable costs per unit are constant within the relevant range. c. Total fixed costs are constant within the relevant range. d. Total variable costs are constant within the relevant range. Which of the following statements about cost behavior are true? a. Fixed costs per unit vary with the level of activity. b. Variable costs per unit are constant within the relevant range. c. Total fixed costs are constant within the relevant range. d. Total variable costs are constant within the relevant range.

18. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Which of the following statements about cost behavior are true? a. Fixed costs per unit vary with the level of activity. b. Variable costs per unit are constant within the relevant range. c. Total fixed costs are constant within the relevant range. d. Total variable costs are constant within the relevant range. Which of the following statements about cost behavior are true? a. Fixed costs per unit vary with the level of activity. b. Variable costs per unit are constant within the relevant range. c. Total fixed costs are constant within the relevant range. d. Total variable costs are constant within the relevant range. Quick Check

19. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin How does this type of fixed cost differ from a step-variable cost? Step-variable costs can be adjusted more quickly and... The width of the activity steps is much wider for the fixed cost. Fixed Costs and Relevant Range

20. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin A mixed cost has both fixed and variable components. Mixed Costs Consider the following electric utility example.

21. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Fixed Monthly Utility Charge Variable Utility Charge Mixed Costs Activity (Kilowatt Hours) Total Utility Cost X Y Total mixed cost

22. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Fixed Monthly Utility Charge Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost X Y Total mixed cost Mixed Costs

23. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Mixed Costs bX a Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost X Y Total mixed cost = Y = a + bX Fixed Monthly Utility Charge

24. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin The Analysis of Mixed Costs Engineering Approach Account Analysis Scattergraph Plot Least-Squares Regression Method High-Low Method

25. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Account Analysis Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves.

26. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Engineering Estimates Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements.

27. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Plot the data points on a graph (total cost vs. activity). 0 1 2 3 4 Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced X Y The Scattergraph Plot

28. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Draw a line through the data points with about an equal numbers of points above and below the line. 0 1 2 3 4 Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced X Y The Scattergraph Plot

29. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Estimated fixed cost = $10,000 The slope of this line is the variable unit cost. (Slope is the change in total cost for a one unit change in activity). 0 1 2 3 4 Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced X Y The Scattergraph Plot

30. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Slope = Change in cost Change in units Horizontal distance is the change in activity. 0 1 2 3 4 * Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced X Y Vertical distance is the change in cost. The Scattergraph Plot

31. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin WiseCo recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute:  the variable cost per unit;  the fixed cost; and then  express the costs in equation form Y = a + bX. The High-Low Method

32. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin  Unit variable cost = Change  in cost Change in units The High-Low Method

33. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin The High-Low Method  Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

34. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin The High-Low Method  Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600

35. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin  Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600  Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $1,600 + $0.90X The High-Low Method

36. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit Quick Check

37. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit $4,000 ÷ 40,000 units = $0.10 per unit Quick Check

38. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 Quick Check

39. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 Quick Check

40. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin How does the high-low method work when you have data for more than two periods? Select the two periods with the lowest and highest level of activity. How does the high-low method work when you have data for more than two periods? Select the two periods with the lowest and highest level of activity. Low month High month Note

41. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Quick Check Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. a. Y = $9,720 + $2.00X b. Y = $7,050 + $3.00X c. Y = $8,385 + $2.50X d. Y = $8,480 + $2.50X Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. a. Y = $9,720 + $2.00X b. Y = $7,050 + $3.00X c. Y = $8,385 + $2.50X d. Y = $8,480 + $2.50X Low month High month

42. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. a. Y = $9,720 + $2.00X b. Y = $7,050 + $3.00X c. Y = $8,385 + $2.50X d. Y = $8,480 + $2.50X Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. a. Y = $9,720 + $2.00X b. Y = $7,050 + $3.00X c. Y = $8,385 + $2.50X d. Y = $8,480 + $2.50X Low month High month Quick Check b = = = $2 a = $15,060 – $2 × 2,670 = $15,060 – $5,340 = $9,720 b = = = $2 a = $15,060 – $2 × 2,670 = $15,060 – $5,340 = $9,720 $15,060 – $14,680 2,670 – 2,480 $380 190

43. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Let’s plot the data for patient admitting costs. Note

44. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Problems with the high-low method: Disregards information contained in all of the data other than the low and the high points. The low and high levels of activity tend to be unusual. Always plot the data if you have more than two points to make sure it even makes sense to use the high-low method. Problems with the high-low method: Disregards information contained in all of the data other than the low and the high points. The low and high levels of activity tend to be unusual. Always plot the data if you have more than two points to make sure it even makes sense to use the high-low method. Note

45. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Software can be used to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bx Software can be used to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bx Least-squares regression also provides a statistic, called the adjusted R 2, that is a measure of the goodness of fit of the regression line to the data points. Least Squares Regression

46. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin 0 1 2 3 4 Total Cost 10 20 0 Activity * * * * * * * * * * R 2 is the percentage of the variation in total cost explained by the activity. R 2 for this relationship is near 100% since the data points are very close to the regression line. X Y Least Squares Regression

47. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement. The Contribution Format

48. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income. The Contribution Format

49. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin Used primarily for external reporting. Used primarily by management. The Contribution Format

50. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill /Irwin End of Chapter 5