Cost Behavior: Analysis and Use Chapter 5

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 2.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Total Variable Cost Example Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Variable Cost Per Unit Example Minutes Talked Per Minute Telephone Charge The cost per minute talked is constant. For example, 10 cents per minute.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Total Fixed Cost Example Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. Number of Local Calls Monthly Basic Telephone Bill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Cost Per Unit Example Number of Local Calls Monthly Basic Telephone Bill per Local Call The fixed cost per local call decreases as more local calls are made.

© 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 The Activity Base Machine hours Labor hours Units produced Miles driven A measure of the event causing the incurrence of a variable cost – a cost driver

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Linearity Assumption and the Relevant Range Activity Total Cost Economist’s Curvilinear Cost Function

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Activity Total Cost Economist’s Curvilinear Cost Function Accountant’s Straight-Line Approximation (constant unit variable cost) The Linearity Assumption and the Relevant Range

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Activity Total Cost Relevant Range The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost) Economist’s Curvilinear Cost Function A straight line closely approximates a curvilinear variable cost line within the relevant range.

© 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 Trend Toward Fixed Costs Increased automation. Increase in salaried knowledge workers who are difficult to train and replace. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions.

© 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 Total cost has both fixed and variable components. Total Costs

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Costs Variable Costs Activity Cost Total Costs X Y Total cost

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Fixed Costs Variable Costs Activity Cost Total cost Y = a + bX Total Costs bX a X Y

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Analysis of Total Costs Engineering Approach Account Analysis Scattergraph Method Least-Square Regression Method High-Low Method

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Account Analysis Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Engineering Estimates Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill WiseCo recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute:  the variable cost per unit;  the fixed cost; and then  express the costs in equation form Y = a + bX. The High-Low Method

© 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 = $3,600 ÷ 4,000 units = $0.90 per unit

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The High-Low Method  Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill  Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600  Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $1,600 + $0.90X 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 activity * 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 Least-squares regression also provides a statistic, called the adjusted R 2, that is a measure of the goodness of fit of the regression line to the data points.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Total Cost Activity * * * * * * * * * * Least-Squares Regression Method R 2 is the percentage of the variation in total cost explained by the activity. R 2 for this relationship is near 100% since the data points are very close to the regression line. X Y

© 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. Contribution margin covers fixed costs and provides for income.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Contribution Format Used primarily for external reporting. Used primarily by management.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill End of Chapter 5