Cost Behavior: Analysis and Use Chapter 5

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Cost Behavior Merchandisers Cost of Goods Sold Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Merchandisers and Manufacturers Sales commissions and shipping costs Service Organizations Supplies and travel Examples of normally variable costs Examples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Types of Fixed Costs Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be reduced in the short term. Examples Depreciation on Buildings and Equipment Examples Advertising and Research and Development

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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. Fixed Costs and Relevant Range Continue

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) Fixed Costs and Relevant Range 90 Relevant Range Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill A mixed cost has both fixed and variable components. Mixed Costs Consider the following electric utility example.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Monthly Utility Charge Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost Mixed Costs X Y Total mixed cost

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Monthly Utility Charge Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost Total mixed cost Y = a + bX Mixed Costs bX a X Y

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill  Unit variable cost = Change  in cost Change in units The High-Low Method

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The High-Low Method  Unit variable cost  Fixed cost = Total cost – Total variable cost

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill  Total cost = Fixed cost + Variable cost (Y = a + bX) The High-Low Method

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, 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 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, 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 The High-Low Method

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 The High-Low Method

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Scattergraph Method Plot the data points on a graph (total cost vs. activity) * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Scattergraph Method Draw a line through the data points with about an equal numbers of points above and below the line * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Scattergraph Method Estimated fixed cost = $10, * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y The slope of this line is the variable unit cost. (Slope is the change in total cost for a one unit change in activity).

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Scattergraph Method Slope = Change in cost Change in units Horizontal distance is the change in units * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y Vertical distance is the change in cost.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Accountants and managers may use computer software to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bx Least-Squares Regression Method

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Least Squares Regression in Excel Enter y-values in one column Enter x-values in adjoining column Use the Function button to compute the slope and intercept of the best-fitting line between the points. For the statistical functions labeled Slope and Intercept, enter the required information in the dialogue boxes. Use the “Help” for instructions.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement. The Contribution Format

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Contribution Format The contribution margin format emphasizes cost behavior. This contribution margin covers fixed costs and provides for income.