Cost Behavior

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Chapter Two

• Cost Behavior

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Cost Behavior

• Manner in which a cost changes when the level of
  output changes.
• Classifications of Cost Behavior
• Variable Costs
• Fixed Costs
• Mixed Costs

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Cost Behavior

• Behavior is relative to the context it is
  presented in
• The term fixed or variable is based on the total
  cost.

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What causes a cost to go up or down?

• Cost driver factor that causes or leads to a
  change in a cost or activity
• Examples
• of units
• of labor hours
• of square feet
• of departments

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Spring Break

• Lets say you and 2 friends are going to Cabo San
  Lucas for 4 nights.
• You are going to fly down there and stay in a
  hotel.
• The hotel charges 100 per night regardless of
  how many people stay in the room.
• TOTAL Expected Lodging Cost 400

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• Two days before you leave one more friend decides
  to come along.
• How does this affect your hotel bill?
• No change total lodging is still 400
• This is a fixed cost The total cost does not
  change.

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• Two days before you leave one friend comes down
  with chicken pox and cant go.
• What happens to your hotel bill now?
• No Change
• This is a fixed cost The total cost does not
  change

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How does all this affect you?

• Total Hotel Bill 400
• How much do you have to pay?
• Fixed Cost Behavior

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What about the airfare?

• You were able to get plane tickets
• for 200 roundtrip per person.
• Variable Cost Behavior

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• Under a variable cost structure the cost per unit
  stays the same and the total cost changes
• Using the Variable Cost Structure avoids Fixed
  Cost Risk

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• Whether a cost is fixed or variable depends on
  the underlying circumstances.
• Lets look back at our lodging for spring break.
• What if we decide to stay 5 nights instead of 4?
• What if we come home a day early?

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• Here the lodging is a variable cost.
• The cost per night stays the same and the total
  cost changes.

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Relevant Range

• What happens if three more friends decide to come
  along and you have a total of 6 people?
• You will more than likely have to rent 2 rooms
  each night.
• Now your total lodging is 200 per night.
• The structures work within a relevant range.
• Our range here is 1 to 4 people.

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When the activity level increases, total fixed
costs

• Increases
• Decreases
• Remains constant

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When the activity level increases, fixed cost per
unit

• Increases
• Decreases
• Remains constant

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When the activity level increases, variable cost
per unit

• Increases
• Decreases
• Remains constant

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When the activity level increases, total variable
costs

• Increases
• Decreases
• Remains constant

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Mixed Cost

• Has characteristics of both a variable and a
  fixed cost.
• Most companys costs are typically mixed.
• Cell phone bill
• Base fee 10 cents for each text
• Sales representative
• Salary commission on sales

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Mixed Cost

• Company Z has 10 sales people. Each earns a
  salary of 25,000 per year, plus 10 of sales
  revenue. Sales revenue was 1,000,000 for the
  year.
• What is the companys total sales people expense
  for the year?
• Total Cost Fixed Cost Variable Cost

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Step Cost

• Displays a constant level of cost for a range of
  output and then jumps to a higher level of cost
  at some point.

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Using Fixed Cost to Provide a Competitive
Operating Advantage

• My Company and Your Company provide rafting tours
  on Big Bear River. My Company pays tour guides
  fixed salaries. It budgets salaries expense at
  160,000 per year. Your Company pays tour guides
  40 per rafter served. Rafters are charged 50
  per tour. Both companies expect to carry approx.
  4,000 rafters during the year.

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Lets look at an Income Statement for each Company

• My Co. Your Co.
• Revenue (50 4,000) 200,000 200,000
• Salary Exp. 160,000 160,000
• Net Income 40,000 40,000
• 40 4,000

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• In an effort to lure rafters away from Your
  Company, My Company lowers the price per rafter
  to 39.
• Now My Company serves 6,000 rafters who each pay
  39 per tour.
• Your Company serves only 2,000 rafters who pay
  50 per tour.

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Income Statement

• My Co. Your. Co.
• Revenue(396000) 234,000 (502000)100,000
• Salary Exp. ( 160,000) (402000)( 80,000)
• Net Income 74,000 20,000

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• Now lets say Your Company lowered its price to
  39 per rafter and lured 2,000 rafters from My
  Company that is still charging 50 per rafter.
• Income Statement
• My Co. Your Co.
• Revenue (502000) 100,000 (396000)234,000
• Salary Exp. ( 160,000) (406000)( 240,000)
• Net Income ( 60,000) ( 6,000)

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• What should My Company do?
• My Company matches the 39 price set by Your
  Company.
• Now they each serve 4,000 customer
• Income Statement
• MY CO. YOUR CO.
• Revenue 156,000 156,000
• Salary Exp. ( 160,000) ( 160,000)
• Net Income ( 4,000) ( 4,000)

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Using Fixed Cost to Provide a Competitive
Operating Advantage
I suppose fixed costs arebetter if volume is
increasing,but variable costs may be betterif
business is declining.
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Methods to SeparateFixed and Variable Costs
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High Low Method

• Used to estimate future costs
• Step 1 Find High and Low Points
• Step 2 Use high and low points to calculate
  variable rate (VC per unit)
• Step 3 Calculate fixed cost using variable rate
• Step 4 Form cost formula

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HIGH
HIGH
LOW
LOW
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Step 2

• Use high and low points to calculate variable
  rate.
• (High Cost Low Cost) VC per unit
• (High Output Low Output)
• (450,000 145,000) 12,200 / unit
• (35 10)

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Step 3

• - Calculate the FC using the variable rate and
  either the high or low point.
• FC VC Total Cost
• FC TC VC
• FC 450,000 (35 12,200)
• FC 450,000 427,000
• FC 23,000

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Step 4

• Form cost formula
• TC FC VC
• TC 23,000 (12,200 of units)
• Useful because once you have cost formula, you
  can use it in budgeting and in performance
  control.

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Scattergraph Method

• - Way to see cost relationship by plotting data
  on a graph.
• Plot points on graph.
• Draw line through points.
• Fixed cost is where line intercepts Y-axis.