Cost Behavior: Analysis and Use Chapter 5 Cost Behavior: Analysis and Use Chapter 5: Cost Behavior: Analysis and Use. Managers who understand how costs behave are better able to predict costs and make decisions under various circumstances. This chapter explores the meaning of fixed, variable and mixed costs (the relative proportions of which define an organization’s cost structure). It also introduces a new income statement format called the contribution approach.

April 16, 2010 A more detailed look at costs and cost behaviour A detailed understanding of cost behaviour helps in forecasting, budgeting and planning for the future Walk through a wide variety of account items Establish formulae for forecasting/budgeting Contribution analysis Introduction to Variable Costing

Types of Costs & Behaviours Variable Costs Total Variable Cost is proportional to activity levels Variable Cost per unit remains the same regardless of volume (at least within a relevant range) Variable Costs may become smaller per unit once certain volume thresholds are reached E.g., paper for a book publisher True Variable Costs are costs which are completely proportional to volume Step Variable Costs are those which increase in step functions; e.g., industrial engineers

Types of Cost Behaviours Fixed Costs Total Fixed Costs remain the same regardless of activity level (again, within a relevant range) At certain higher levels of activity, fixed costs may need to be stepped up; e.g., new facility Fixed Cost per unit decreases as activity increases

Fixed – Variable Ratio Different types of companies have different levels of Fixed and Variable Costs High fixed costs (lower variable) – e.g., power generator Regardless of output, the huge plant & equipment costs must be borne High variable costs – e.g., a cleaning company As activity increases, the company can usually hire more staff easily As activity decreases, it may however have some difficulty reducing staff levels, depending on labour laws Companies with high fixed costs must reach a certain volume to “defray” their fixed costs and break even Are your Group Project companies higher in fixed or variable costs?

Fixed Monthly Utility Charge Mixed Costs A mixed cost has both fixed and variable components. Consider your utility costs. X Y Total mixed cost Total Utility Cost A mixed cost contains both variable and fixed cost elements. For example, utility bills often contain fixed and variable cost components. The fixed portion of the utility bill is constant regardless of kilowatt hours consumed. This cost represents the minimum cost that is incurred to have the service ready and available for use. The variable portion of the bill varies in direct proportion to the consumption of kilowatt hours. Variable Cost per KW Fixed Monthly Utility Charge Activity (Kilowatt Hours)

Committed versus Discretionary Committed Costs Those which an organization is committed to; i.e., it cannot easily get out of incurring them Depreciation on a building Although you could sell the building to avoid the depreciation, it is a significant undertaking When budgeting, particularly for downside risk, these costs will likely remain in place and put significant downward pressure on margins

Committed versus Discretionary Discretionary Costs Costs that can be easily added or removed A salesman’s meals & entertainment Others? These are the costs that can be most easily removed in periods of lower volumes

Accounts For each of the following accounts Identify all cost characteristics - Fixed, Variable, Sunk, Opportunity, Product, etc. Predict the cost behaviour graphically (X axis = cost; Y axis = volume) Develop an cost equation for forecasting and budgeting Assume that (a) Annual revenue growth at 5%; (b) at 20% Accounts Direct Labour Direct Materials Manufacturing Overhead COGS

Accounts Accounts Direct Labour Direct Materials Manufacturing Overhead COGS Gross Margin Lease costs Human Resources IT Finance and Accounting Procurement Customer Service

Accounts Accounts Sales Commissions Travel Meals & Entertainment Shipping Executives Clerical Support Sales and Administration EBIT or Operating Income Interest Expense Taxes Net Income

Three Methods of Modeling Variable Portion of Costs Scatter graph method High-low method Least squares regression analysis

Contribution Margin Contribution = Sales less Variable Costs It is the amount from each unit sold that contributes to first covering fixed costs, then contributes to earnings In this case, the contribution margin is 60% Managers know that once break even is reached, every additional sale will increase income by $15

Overview of Absorption and Variable Costing Absorption Costing Variable Costing Product Costs Period Costs Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Product Costs Period Costs Absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred. Variable costing treats only those costs of production that vary with output as product costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred.

Comparison of Absorption and Variable Costing In simple terms, the only difference between variable and absorption costing is that fixed overhead is separated and treated as a non-product cost (ie, a period cost) Variable Costing becomes very useful for analyzing different volume scenarios

Review A more detailed look at costs and cost behaviour A detailed understanding of cost behaviour helps in forecasting, budgeting and planning for the future Walk through a wide variety of account items Establish formulae for forecasting/budgeting Contribution analysis Introduction to Variable Costing

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