2. 1 Managerial Accounting & Costing ACC 122 Week 2 Lecture 2

3. 2 Learning Goals  To be able to describe the different types of cost behavior patterns.  To be able to analysis mixed costs.  Cost Estimation

4. 3 Cost Behavior  Cost Behavior: is how a cost will react – change – as changes take place in the activity base. As the activity level rises and falls, a particular cost may rise and fall as well – or it may remain constant.  A cost behavior is a key tool in the hands of managers who are request to predict the costs that will be occurred under various activity levels.  In order to predict costs we use 3 cost behavior patterns: Variable costs Fixed Costs Fixed Costs Mixed (semi variable) Costs Mixed (semi variable) Costs Cost Structure is the percentage of each type of cost in an organization’s total cost of production.

5. 4 Minutes Talked Total Long Distance Telephone Bill Your total long distance telephone bill is increasing as the minutes you talk are increasing. Variable Costs Are those costs that vary-fluctuate directly as the company’s level of activity changes. They rise as production increases and fall as production decreases. If activity level by 50% total variable cost by 50% If activity level by 10% total variable cost by 10%

6. 5 Minutes Talked Per Minute Telephone Charge Variable Costs The per minute cost of long distance calls is constant, for example, 10¢ per minute. A variable cost remains constant if expressed on a per unit basis. So a variable cost is constant per unit but varies in total with the activity level.

7. 6 Variable Costs  For a cost to be variable it must be variable in respect to something, that is the activity base. Activity base or cost driver is whatever causes the rise and fall of a variable cost.  For example the direct materials for the production of a ford car is a variable costs. As the output of ford increases, car increases, the direct materials needed increases.

8. 7 The Activity Base A measure of what causes the fluctuation of a variable cost. Units produced Miles driven Labor hours Machine hours

9. 8 VARIABLE COSTS  Extent of Variable Costs:  Extent of Variable Costs: The proportion of variable costs in a firm differs across organizations. For example.. A service company : audit, consulting, medical, architectural companies have very large fixed costs (salaries etc) A service company : audit, consulting, medical, architectural companies have very large fixed costs (salaries etc) A manufacturing company or a restaurant will often have many variable costs. A manufacturing company or a restaurant will often have many variable costs.

10. 9  True Variable Costs. Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity, moreover any amounts purchased but not used can be stored and carried forward to the next period as inventory.  Step – Variable Costs. A resource that is acquire in large amount and that increases or decreases only in response to wide changes in activity is known as a step – variable cost. For example, the wages of skilled repair technicians are often considered to be a step – variable costs.  Step – Variable Costs. A resource that is acquire in large amount and that increases or decreases only in response to wide changes in activity is known as a step – variable cost. For example, the wages of skilled repair technicians are often considered to be a step – variable costs. Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.

11. 10 Volume Cost Step-Variable Costs Cost Volume True Variable Cost

12. 11 Volume Cost Volume Cost Small Changes Wide Changes Step variable cost

13. 12  The Linearity Assumption and the Relevant Range. – Except in the case of step – variable costs, we ordinarily assume a strictly linear relationship between cost and volume. –Economists correctly point out that many costs that the accountant classifies as variable actually behave in a curvilinear fashion, that is, the relation between cost and activity is a curve. –The relevant range is that range of activity within which the assumptions made about cost behaviour by the manager are valid.

14. 13 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)

15. 14 FIXED COSTS Are costs that tends to remain the same regardless of production volume. Such examples are rents, advertising, insurance, office supplies e.t.c Average fixed costs per unit decrease as the activity level increases.

16. 15 Number of customers Total Cost of Rent Total Fixed Cost Example Total Fixed Cost of Rent Number of customers Per Unit Cost of Rent Fixed Cost of Rent per customer Fixed costs decreases on a per unit basis as the activity level – customers increases

17. 16 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.

18. 17  1. Committed Fixed Costs. Investments in facilities, equipment, and the basic organisation structure.  Examples: depreciation on buildings and equipment, real estate taxes, insurance expenses, salaries of managers and operational staff e.t.c  They have long-term nature and they can not be significantly reduced even for short periods of time without affecting seriously the goals and profitability of the company. E.g. if we discharge a manager because operation lowers the cost of re-employment a new is greater than the short- run saving realized.  As it is difficult to change committed costs management should make such engagements only after careful thoughts.

19. 18  2.Discretionary Fixed Costs. Discretionary Fixed Costs usually arise from annual decisions by management to spend on certain fixed cost items.  Examples: advertising, research, public relations, internship for students, training of employees etc.  Differences with committed fixed costs: 1. Are planning for the short run not for many 1. Are planning for the short run not for many years years 2. They can be alter or cut-down without serious impact on profitability and goals. 2. They can be alter or cut-down without serious impact on profitability and goals. 3. They are optional costs and not practically necessary for the operation of the firm. 3. They are optional costs and not practically necessary for the operation of the firm.

20. 19 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. The demand for knowledge workers has grown extremely and most companies consider their employees as a valuable asset. As a result knowledge workers are relatively a fixed cost. On the other hand direct workers are a variable cost because managers prefer to recruit temporary or part-time workers when sales increases rather than keep them permanently at the company and keep payroll budget in a cost-effective level. Labor costs a mixture of fixed and variable costs

21. 20 IN GENERAL FIXED COSTS CAN CHANGE BUT NOT WHEN SMALL CHANGES OCCUR.THEY ALTER IN LONG RUN WHEN LARGE CHANGES REALIZED IN ACTIVITY BASE.

22. 21  A mixed cost has both fixed and variable components. Consider your utility costs.   Example with expeditions company: €25,000 per year for license €3 per customer If the company has 1000 customers this year € 25000+ € 3x1000= € 28000 If the company has 0 customers this year € 25000+ € 3x0= € 25000 Mixed Costs

23. 22 Mixed Costs

24. 23 Fixed Yearly license Charge Variable Cost per Customer Customers Cost of state license fees X Y Total mixed cost Mixed Costs Example with expeditions company

25. Methods of Measuring Cost Functions  1. Engineering analysis  2. Account analysis  3. High-low analysis  4. Visual-fit analysis Cost estimation is the process of determining how a particular cost behaves 24

26. 25 1.Account Analysis. Each account is classified as either variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves. 2.The engineering Approach Cost analysis involves a detailed analysis of what cost behaviour should be, based on an industrial engineer’s evaluation of the production methods to be used, the materials requirements, labour requirements, equipment usage and so on.

27. Account Analysis Example Supervisor’s salary and benefits $ 3,800$3,800 Hourly workers’ wages and benefits 14,674$14,674 Equipment depreciation and rentals 5,873 5,873 Equipment repairs5,604 5,604 Cleaning supplies 7,472 7,472 Total maintenance costs $37,42 $9,673 $27,750 Monthly cost AmountFixedVariable 26

28. Account Analysis Example Fixed cost per month = $9,673 Variable cost per patient-day = $27,750 ÷ 3,700 = $7.50 per patient-day 3,700 patient-days Y = $9,673 + ($7.50 × patient-days) 27

29. 3. High-Low Method The focus of this method is normally on the highest- and lowest-activity points. The first step is to plot the historical data points on a table. 28 Difference between the costs corresponding Variable Model = to the highest and lowest activity levels Difference between the highest and lowest activity levels

30. High-Low Method Example High month: April Maintenance cost: $47,000 Number of patient-days: 4,900 Low month: September Maintenance cost: $17,000 Number of patient-days: 1,200 What is the variable cost? 29

31. High-Low Method Example ($47,000 – $17,000) ÷ (4,900 – 1,200) = $30,000 ÷ 3,700 = $8.1081 What is the fixed cost? Two ways to find this a)$47,000 = Fixed cost + ($8.1081× 4,900) $47,000 – $39,730 = $7,270 b)$17,000 = Fixed cost + ($8.1081× 1,200) $17,000 – $9,730 = $7,270 30

32.  The mixed cost line equation in this case is:  Y = 7270 + 8.1081*X 31

33. 4. Visual-Fit Method In the visual-fit method, the cost analyst visually fits a straight line through a plot of all of the available data, not just between the high point and the low point, making it more reliable than the high-low method. 32

34.  When the cost has been classified as a semi variable or when the analyst has no clear idea about the behavior of a cost item it is helpful to use the visual fit method to plot (design) recent observations of the cost at various activity levels. So first it makes a table and then a graph- a diagram which displays the results. The resulting diagram helps the analyst to visualize –see and understand- the relationship between cost and the level of activity ( or the cost driver) 33 MonthCost for monthDozen of bakery items sold per month (cost driver) Jan510075000 Feb530078000 Then make a graph with these data

35. 34 e.g. $ 1500 The visual cost line cut off the vertical axis at $1500 so this give us the estimation of the fixed cost component in the semi variable cost approximation. To determine the variable cost per unit deduct the fixed cost from the total cost at any activity level.