Cost Behaviour: Analysis and Use

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Chapter 6

• Cost Behaviour Analysis and Use

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The Activity Base
A measure of what causes the incurrence of a
variable cost

• Common cost drivers

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Total Variable Cost

• Variable Costs vary in total or portion to
  changes in the level of activity

Increase of units produced the costs increase
even though per unit the costs remain the same
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True Variable Cost Example

• A variable cost is a cost whose total dollar
  amount varies in direct proportion to changes in
  the activity level. Your total long distance
  telephone bill is based on how many minutes you
  talk.

Total Long DistanceTelephone Bill
Minutes Talked
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True Variable Cost

• To be variable cost need to be variable with
  respect to something (activity base)
• Costs do not need to vary by production or sales
  to be variable
• It will depend on the activity under consideration

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Variable Cost Per Unit

• The cost per unit produced is constant.

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Variable Cost Per Unit Example

• A variable cost remains constant if expressed
  on a per unit basis. The cost per minute talked
  is constant. For example, 10 cents per minute.

Per MinuteTelephone Charge
Minutes Talked
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Examples of Variable Costs

• Merchandising companies cost of goods sold.
• Manufacturing companies direct materials,
  direct labour, and variable overhead.
• Merchandising and manufacturing companies
  commissions, shipping costs, and clerical costs
  such as invoicing.
• Service companies supplies, travel, and
  clerical.

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True Variable Cost

• 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.
• Any amounts not used can be stored and carried
  forward

Cost
Volume
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Step-Variable Costs

• A resource that is obtainable only in large
  chunks (such as maintenance workers) and whose
  costs increase or decrease only in response to
  fairly wide changes in activity

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Step-Variable Costs

• Maintenance
• Cant store the time
• Management needs to obtain the fullest use of
  services possible for each step
• Step-variable
• Dont want to build up costs within company
• Dont want to have to lay people off and re-hire
  in good times

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Step-Variable Costs
Small changes in the level of production are not
likely to have any effect on the number of
maintenance workers employed.
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Step-Variable Costs
Only fairly wide changes in the activity level
will cause a change in the number of maintenance
workers employed
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Total Fixed Cost

• Your monthly costs probably does not change
  when you produce more units.

Costs that remain constant in total regardless
of the level of activity. The level increases or
decreases, there is no change in the total costs.

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Total Fixed Cost Example

• A fixed cost is a cost whose total dollar amount
  remains constant as the activity level changes.
  Your monthly basic telephone bill is probably
  fixed and does not change when you make more
  local calls.

Monthly Basic Telephone Bill
Number of Local Calls
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Fixed Cost Per Unit

• The fixed cost will decrease as more additional
  units are produced

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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.

Monthly Basic Telephone Bill per Local Call
Number of Local Calls
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Cost Classifications for Predicting Cost
Behaviour
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Types of Fixed Costs
Discretionary May be altered in the short-term by
current managerial decisions (1 year)
Committed Long-term, cannot be significantly
reduced in the short term.
Examples Depreciation on equipment, real estate
taxes, management salary, insurance
Examples Advertising, research and development,
training programs
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Discretionary Costs

• Not unnecessary costs
• Can adjust in the short term

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The Trend Toward Fixed Costs
The trend in many industries is toward greater
fixed costs relative to variable costs.
As machines take overmany mundane
taskspreviously performedby humans, knowledge
workersare demanded fortheir minds ratherthan
their muscles
Knowledge workerstend to be salaried,highly-trai
ned anddifficult to replace. Thecost to
compensatethese valued employeesis relatively
fixedrather than variable.
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Is Labour a Variable or a Fixed Cost?

• Reasons compensation would be a fixed cost?
• Not willing to adjust workforce for short-term
  fluctuations in sales
• Need skilled/trained employees and not easy to
  replace
• Decreases morale
• Dont want to add too many workers when increase
  sales
• Use part time temporary workers to take up slack

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Is Labour a Variable or a Fixed Cost?

• Contract staffing handles increase workloads
  without responsibility and expense of hiring full
  time
• Variable cost
• Depends on management flexibility and strategy
• Textbook assumes direct labour is a variable cost

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Fixed Costs and Relevant Range
Total cost doesnt change for a wide range of
activity, and then jumps to a new higher cost for
the next higher range of activity.
Relevant Range
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Rent Cost in Thousands of Dollars
30
0
0 1,000 2,000
3,000 Rented Area (Square Feet)
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Fixed Costs and Relevant Range
The relevant range of activity for a fixed cost
is the range of activity over which the graph of
the cost is flat.

• 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.

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Fixed Costs and Relevant Range
Step-variable costs can be adjusted more quickly
and . . . The width of the activity steps is much
wider for the fixed cost.
How does this type of fixed cost differ from a
step-variable cost?
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Fixed Costs and Relevant Range

• Discretionary costs are decided at the beginning
  of the year
• Dependent on sales volume
• Planned level of activity would impact
  discretionary costs
• Actual level wont impact discretionary costs

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Fixed Costs and Relevant Range

• Discretionary and committed costs are similar to
  step variable costs
• Differ
• Step VC adjusted quickly as conditions change FC
  once set often cannot be changed quickly
• Lease-locked in
• Width of steps-step VC narrower than FC
• Width relates to volume/activity level

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Quiz

• Which of the following statements about cost
  behaviour are true? You can select more than 1.
• Fixed costs per unit vary with the level of
  activity.
• Variable costs per unit are constant within the
  relevant range.
• Total fixed costs are constant within the
  relevant range.
• Total variable costs are constant within the
  relevant range.

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Quiz Solution

• Which of the following statements about cost
  behaviour are true?
• Fixed costs per unit vary with the level of
  activity.
• Variable costs per unit are constant within the
  relevant range.
• Total fixed costs are constant within the
  relevant range.
• Total variable costs are constant within the
  relevant range.

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Mixed Costs
A mixed cost has both fixed and
variablecomponents. Consider the example of
utility cost.
Total mixed cost
Variable Cost per KW
Total Utility Cost
Fixed MonthlyUtility Charge
Activity (Kilowatt Hours)
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Mixed Cost

• Fixed portion represents basic minimum cost of
  having a service ready and available for use
• Variable portion represents the cost incurred for
  actual consumption of service
• Vary in proportion to the amount of service that
  is consumed

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Mixed Costs
Total mixed cost
Variable Cost per KW
Total Utility Cost
Fixed MonthlyUtility Charge
Activity (Kilowatt Hours)
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Mixed Costs Example
If your fixed monthly utility charge is 40, your
variable cost is 0.03 per kilowatt hour, and
your monthly activity level is 2,000 kilowatt
hours, what is the amount of your utility bill?
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Analysis of Mixed Costs
Account Analysis and the Engineering Approach
Each account is classified as eithervariable or
fixed based on the analysts knowledge of how
the account behaves.
Cost estimates are based on an evaluation of
production methods, and material, labour and
overhead requirements.
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Mixed Costs

• How to estimate fixed and variable components in
  mixed cost
• Account analysis
• Each account classified as variable or fixed
  based on knowledge of how the cost behaves
• Variable cost-total variable/ activity

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Mixed Costs

• Engineering approach
• Detailed analysis of what cost behaviour should
  be based on an engineers evaluation of the
  production methods used-material specifics,
  labour requirements, equipment usage, efficiency
  of production
• Used when no past experience concerning
  costs/activities
• May use with other methods to improve accuracy of
  cost analysis

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The Scattergraph Method
Plot the data points on a graph (total cost vs.
activity).
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The Scattergraph Method

• Activity-independent-causes variations in cost
• Total costs-dependent-cost depends on level of
  activity

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The Scattergraph Method
Draw a line through the data points with about
anequal numbers of points above and below the
line.
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The Scattergraph Method

• Linear if draw a straight line as an approximate
  of the relationship between the cost and the
  activity
• Dont have to fall exactly on straight line

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The Scattergraph Method
Use one data point to estimate the total level of
activity and the total cost.
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The Scattergraph Method
Make a quick estimate of variable cost per unit
and determine the cost equation.
Y 10,000 1.25X
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The High-low Method

• Quick estimate only
• Plot data to help see if there is a relationship
• If the scattergraph indicates that there is a
  relationship then you can use high-low method
• Use formula to calculate the slope of the
  straight-line
• VC Y2-Y1 Cost at high level - cost at low
  level
• X2-X1 High activity level low
  activity level

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High-Low Method

• Steps
• Identify the periods with the highest activity
  and lowest activity
• Calculate the VC
• Using the VC determine the FC
• You can use either the high or low activity
  period
• FC Total Cost- VC
• Express the results as an equation
• Y FC VC x X

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High-Low Method

• Always use high and low activity levels even if
  it doesnt result in the highest and lowest costs
• Weaknesses
• Only looks at 2 data points-may not be fully
  accurate
• Periods with unusually low/high activity points
  may produce inaccurate results
• Methods that use a greater number of points will
  be more accurate

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The High-Low Method
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The High-Low Method
The variable cost per hour of maintenance is
equal to the change in cost divided by the change
in hours.
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The High-Low Method
Total Fixed Cost Total Cost Total Variable
Cost
Total Fixed Cost 9,800 (8/hour 800 hours)
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The High-Low Method
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Quiz

• Sales salaries and commissions are 10,000
  when 80,000 units are sold, and 14,000 when
  120,000 units are sold. Using the high-low
  method, 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

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Quiz Solution

• Sales salaries and commissions are 10,000
  when 80,000 units are sold, and 14,000 when
  120,000 units are sold. Using the high-low
  method, 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

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Quiz

• Sales salaries and commissions are 10,000
  when 80,000 units are sold, and 14,000 when
  120,000 units are sold. Using the high-low
  method, what is the fixed portion of sales
  salaries and commissions?
• a. 2,000
• b. 4,000
• c. 10,000
• d. 12,000

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Quiz Solution

• Sales salaries and commissions are 10,000
  when 80,000 units are sold, and 14,000 when
  120,000 units are sold. Using the high-low
  method, what is the fixed portion of sales
  salaries and commissions?
• a. 2,000
• b. 4,000
• c. 10,000
• d. 12,000

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Least-Squares Regression Method
A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of thedata points to
estimatethe fixed and variablecost components
of amixed cost.
The goal of this method isto fit a straight line
to thedata that minimizes thesum of the squared
errors.
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Least-Squares Regression Method

• Software can be used to fit a regression line
  through the data points.
• The cost formula
• Y a bX

Least-squares regression also provides a
statistic, called the R2, that is a measure of
the goodnessof fit of the regression line to the
data points.
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Least-Squares Regression Method

R2 is the percentage of the variation in total
cost explained by the activity.
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Y










Total Cost
10
R2 varies from 0 to 100, andthe higher the
percentage the better.
0
0 1 2 3 4
X
Activity
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Least-Squares Regression Method

• R2 varies from 0 to 100, andthe higher the
  percentage the better
• 0 no fit achieved
• 100 - perfect fit
• 90 - 90 of the variation in the cost is
  explained by the variation in the activity
• Use when cost is caused by more than 1 factor
• Shipping sales (units) but also weight

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Least Squares Regression Method

• Can use excel
• Formula
• b n(?XY)-( ?X)( ?Y)
• n (?X2)-( ?X) 2
• a (?Y) - b( ?X)
• n

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Comparing Results From the Three Methods
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Comparing Results From the Three Methods

• Scattergraph- judgmental interpretation of visual
  fit of data points
• High-low method- 2 values highest and lowest
  activity
• Least squares-most accurate because uses all data
  available

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Comparing Results From the Three Methods

• Limitations
• Based on past info
• Future conditions change-inaccurate
• Begin with scattergraph to see if linear
  relationship
• Time or data is short use reasonable
  approximation high-low
• Complex data-statistical analysis techniques (use
  multiple regression)

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The Contribution Format
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The Contribution Format