1. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 14: Cost Behavior Cornerstones of Financial and Managerial Accounting, 2e

2. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Basics of Cost Behavior ► Cost behavior is the foundation upon which managerial accounting is built. ► Cost behavior is the general term for describing whether a cost changes when the level of output changes. ► Costs can be variable, fixed, or mixed. ► A cost that does not change in total as output changes is a fixed cost. ► A variable cost, on the other hand, increases in total with an increase in output and decreases in total with a decrease in output. ► Knowing how costs change as output changes is essential to planning, controlling, and decision making. 1

3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Measures of Output and the Relevant Range ► Fixed and variable costs have meaning only when related to some output measure. ► A cost driver is a causal factor that measures the output of the activity that leads (or causes) costs to change. ► Identifying and managing drivers helps managers better predict and control costs. ► For example, weather is a significant driver in the airline industry. 1

4. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Relevant Range and Cost Relationships ► The relevant range is the range of output over which the assumed cost relationship is valid for the normal operations of a firm. ► The relevant range limits the cost relationship to the range of operations that the firm normally expects to occur. 1 As this graph shows, the concept of the relevant range allows managerial accountants to assume a linear cost relationship.

5. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fixed Costs ► The number of computers produced is called the output measure, or driver. ► Even though fixed costs may change, this possibility does not make them variable. ► They are fixed at a new higher (or lower) rate. ► A graph of Colley’s fixed supervision costs is shown below: 1 Supervision cost is fixed with respect to the number of computers produced.

6. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Discretionary Fixed Costs and Committed Fixed Costs ► Two types of fixed costs are commonly recognized: discretionary fixed costs and committed fixed costs. ► Discretionary fixed costs are fixed costs that can be changed or avoided relatively easily at management discretion. ► Committed fixed costs, on the other hand, are fixed costs that cannot be easily changed. 1 Advertising is a discretionary fixed cost, because it depends on a management decision. Lease cost is a committed fixed cost because it involves a long-term contract.

7. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variable Costs ► Variable costs are costs that in total vary in direct proportion to changes in output within the relevant range. ► Variable costs can also be represented by a linear equation. ► Total variable costs depend on the level of output. ► This relationship can be described by the following equation or graphs: 1 Total variable costs = Variable rate x Amount of output

8. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Reasonableness of Straight-Line Cost Relationships ► Caution should be taken when applying cost behavior assumptions to output levels that fall outside of the company’s relevant range of operations. ► Straight-line cost relationships that are assumed within the relevant range may actually be semi-variable costs. 1 For example, at extremely low levels of output, workers often use more materials per unit or require more time per unit than they do at higher levels of output. Likewise, as the level of output increases, workers learn how to use materials and time more efficiently so that the variable cost per unit decreases as more and more output is produced.

9. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Mixed Costs ► Mixed costs are costs that have both a fixed and a variable component. For example, overhead for a company may consist of a fixed supervisor salary plus the cost of supplies that vary with the quantity of output produced. The formula and graph depiction for a mixed cost is as follows: 2 Total cost = Total fixed cost + Total variable cost Volume

10. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Step Costs: Narrow Steps ► Some cost functions may be discontinuous. ► These costs are known as step costs (or semi-fixed). ► A step cost displays a constant level of cost for a range of output and then jumps to a higher level (or step) of cost at some point, where it remains for a similar range of output. ► If a step cost has relatively narrow steps, it means that the cost changes in response to fairly small changes in output and we can approximate it as a variable cost (i.e., the red line). 2

11. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Step Costs: Wide Steps ► Step cost with relatively wide steps are more characteristic of fixed costs. ► For example, a company may have to lease production machinery. If the machine can only produce 1,000 units and the company grows, they will have to lease additional machines for each 1,000 units of production needed (resulting in the wide steps shown in the graph). 2

12. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Methods for Separating Mixed Costs into Fixed and Variable Components ► Three methods of separating a mixed cost into its fixed and variable components are commonly used: ► the high-low method ► the scattergraph method ► the method of least squares ► Each method requires the simplifying assumption of a linear cost relationship. 3

13. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Methods for Separating Mixed Costs into Fixed and Variable Components (continued) ► Recall the expression of cost as an equation for a straight line is: ► Total cost = Fixed cost + (Variable rate x Output) ► The dependent variable is a variable whose value depends on the value of another variable. In the previous equation, total cost is the dependent variable; it is the cost we are trying to predict. ► The independent variable is a variable that measures output and explains changes in the cost or other dependent variable. ► A good independent variable is one that causes or is closely associated with the dependent variable. ► Therefore, many managers refer to an independent variable as a cost driver. ► The intercept corresponds to fixed cost. ► The slope of the cost line corresponds to the variable rate. 3

14. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Methods for Separating Fixed Costs into Fixed and Variable Components 3

15. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. APPENDIX 14A: Using the Regression Programs ► Computing the regression formula manually is tedious, even with only a few data points. ► As the number of data points increases, manual computation becomes impractical. ► Fortunately, spreadsheet packages like Microsoft Excel have regression routines that perform these computations. ► All you need to do is input the data and the spreadsheet regression program supplies more than the estimates of the coefficients. ► It also provides information that can be used to see how reliable the cost equation is—a feature that is not available for the scattergraph and high-low methods. 4