1 CHAPTER M4 Cost Behavior © 2007 Pearson Custom Publishing

2 Learning Objective 1: Describe the differences between fixed costs and variable costs. © 2007 Pearson Custom Publishing

3 Fixed Costs Costs that do not change in total as the level of business activity changes are called fixed costs. Costs that do not change in total as the level of business activity changes are called fixed costs. An example of a fixed cost is the insurance on a factory building. The insurance cost does not change as the level of production changes. An example of a fixed cost is the insurance on a factory building. The insurance cost does not change as the level of production changes. © 2007 Pearson Custom Publishing

4 Fixed Cost Per Unit Although the total fixed cost does not change, the fixed cost per unit does change as the activity level changes. Although the total fixed cost does not change, the fixed cost per unit does change as the activity level changes. If the factory insurance cost is $5,000, then the insurance cost is $1.00 per unit when 5,000 units are produced, but only 50 cents per unit when 10,000 units are produced. If the factory insurance cost is $5,000, then the insurance cost is $1.00 per unit when 5,000 units are produced, but only 50 cents per unit when 10,000 units are produced. © 2007 Pearson Custom Publishing

5 Variable Costs Costs that change in direct proportion with changes in the activity level are called variable costs. Costs that change in direct proportion with changes in the activity level are called variable costs. An example of a variable cost is the cost of sales commissions. Each sale results in an increase in the total cost of commissions. An example of a variable cost is the cost of sales commissions. Each sale results in an increase in the total cost of commissions. © 2007 Pearson Custom Publishing

6 Variable Cost Per Unit The variable cost per unit remains the same regardless of the level of activity. The variable cost per unit remains the same regardless of the level of activity. If the sales commission is $5.00 per unit, then that commission rate is assumed to remain unchanged no matter how many units are sold. If the sales commission is $5.00 per unit, then that commission rate is assumed to remain unchanged no matter how many units are sold. © 2007 Pearson Custom Publishing

7 Learning Objective 2: Classify costs by cost behavior. © 2007 Pearson Custom Publishing

8 Cost Behavior Cost behavior is the reaction of costs to changes in the business activity. Cost behavior is the reaction of costs to changes in the business activity. Some costs change when the level of business activity changes and other costs do not. If you consider the total costs of running a business, the cost increases as the activity level (sales, production, or some other measure) increases. Some costs change when the level of business activity changes and other costs do not. If you consider the total costs of running a business, the cost increases as the activity level (sales, production, or some other measure) increases. © 2007 Pearson Custom Publishing

9 Cost Behavior Patterns The three most common cost behavior types are: The three most common cost behavior types are: Fixed costs Fixed costs Variable costs Variable costs Mixed costs Mixed costs © 2007 Pearson Custom Publishing

10 Graphical Analysis When graphing cost behavior, the following conventions are typically followed: When graphing cost behavior, the following conventions are typically followed: The measure of activity is shown on the X axis. The activity base is also called the independent variable. The measure of activity is shown on the X axis. The activity base is also called the independent variable. The measure of cost is shown on the Y axis. The cost is also called the dependent variable. The measure of cost is shown on the Y axis. The cost is also called the dependent variable. © 2007 Pearson Custom Publishing

11 Graphical Analysis A fixed cost graph. A variable cost graph. © 2007 Pearson Custom Publishing

12 Determining Total Cost The basic cost equation is: Total Cost = Fixed Cost + Variable Cost The basic cost equation is: Total Cost = Fixed Cost + Variable Cost The graph at the right shows the combination of a fixed cost line and a variable cost line. © 2007 Pearson Custom Publishing

13 Learning Objective 3: Explain the concept of relevant range and its effect on cost behavior information. © 2007 Pearson Custom Publishing

14 Relevant Range The simplifications that are made with regard to cost behavior patterns are assumed to be reasonable as long as the activity level is within the relevant range. The simplifications that are made with regard to cost behavior patterns are assumed to be reasonable as long as the activity level is within the relevant range. The relevant range usually cannot be specifically determined, but it can be considered to be that range of activity within which the company usually operates. The relevant range usually cannot be specifically determined, but it can be considered to be that range of activity within which the company usually operates. © 2007 Pearson Custom Publishing

15 Graph of a Relevant Range © 2007 Pearson Custom Publishing

16 Mixed Costs Some costs exhibit cost behavior that is a combination of both a fixed element and a variable element. These costs are known as mixed costs. Some costs exhibit cost behavior that is a combination of both a fixed element and a variable element. These costs are known as mixed costs. It is important to separate a total mixed cost into its fixed component and variable component. It is important to separate a total mixed cost into its fixed component and variable component. © 2007 Pearson Custom Publishing

17 Mixed Cost Graph © 2007 Pearson Custom Publishing

18 Discussion Questions On the previous slide, the dashed lines indicate a total cost of $8,000 if 40 breakdowns occur. On the previous slide, the dashed lines indicate a total cost of $8,000 if 40 breakdowns occur. What is the estimated total cost per breakdown? What is the estimated total cost per breakdown? Estimated fixed cost per breakdown? Estimated fixed cost per breakdown? Estimated variable cost per breakdown? Estimated variable cost per breakdown? © 2007 Pearson Custom Publishing

19 Discussion Questions Besides the number of equipment breakdowns, what other measures of activity might work well when trying to predict the amount of equipment repair cost? Besides the number of equipment breakdowns, what other measures of activity might work well when trying to predict the amount of equipment repair cost? Do you think that the selection of an appropriate activity measure is crucial to making a reasonable cost estimate? Do you think that the selection of an appropriate activity measure is crucial to making a reasonable cost estimate? © 2007 Pearson Custom Publishing

20 Discussion Questions Identify at least one cost in each of the three categories (variable, fixed, and mixed) that you incur in your personal life. Identify at least one cost in each of the three categories (variable, fixed, and mixed) that you incur in your personal life. Do you incur more variable costs, more fixed costs, or more mixed costs? Do you incur more variable costs, more fixed costs, or more mixed costs? Do you think a manufacturing company incurs more variable costs, more fixed costs, or more mixed costs? Do you think a manufacturing company incurs more variable costs, more fixed costs, or more mixed costs? © 2007 Pearson Custom Publishing

21 Learning Objective 4: Describe the characteristics of a mixed cost and the four basic approaches to separating a mixed cost into its fixed and variable components. © 2007 Pearson Custom Publishing

22 Identifying Elements of a Mixed Cost The most commonly used techniques for determining the fixed and variable components of a mixed cost are: The most commonly used techniques for determining the fixed and variable components of a mixed cost are: the engineering approach the engineering approach scatter graphing scatter graphing the high-low method the high-low method regression analysis. regression analysis. © 2007 Pearson Custom Publishing

23 Engineering Approach The engineering approach is based on the technical judgment and expertise about the activity with fixed and variable costs. The engineering approach is based on the technical judgment and expertise about the activity with fixed and variable costs. The expert (possibly an engineer) will analyze the cost component much like an investigator. An example of a technique used in the engineering approach would be a time and motion study. The expert (possibly an engineer) will analyze the cost component much like an investigator. An example of a technique used in the engineering approach would be a time and motion study. © 2007 Pearson Custom Publishing

24 Scatter Graphing The scatter graphing technique entails plotting the available cost vs. activity information on a graph. The scatter graphing technique entails plotting the available cost vs. activity information on a graph. The cost analyst draws a line that appears to best fit the data. The line represents the estimated cost behavior pattern. The cost analyst draws a line that appears to best fit the data. The line represents the estimated cost behavior pattern. The accuracy of the line in describing the relationship among the variables is suspect. The accuracy of the line in describing the relationship among the variables is suspect. © 2007 Pearson Custom Publishing

25 High-Low Method In the high-low method, only two of the data points are used to determine the fixed and variable cost components. In the high-low method, only two of the data points are used to determine the fixed and variable cost components. The highest and lowest observations are picked, with the choice being based on the independent variable (machine hours) rather than the dependent variable (overhead cost). The highest and lowest observations are picked, with the choice being based on the independent variable (machine hours) rather than the dependent variable (overhead cost). © 2007 Pearson Custom Publishing

26 Regression Analysis Regression analysis is a statistical approach that can be used to determine the fixed and variable cost components with a high degree of accuracy. Regression analysis is a statistical approach that can be used to determine the fixed and variable cost components with a high degree of accuracy. Calculations done by hand are very tedious. However, many software packages can make these calculations for you. Let’s use the same sample data and view the output from a popular spreadsheet program. Calculations done by hand are very tedious. However, many software packages can make these calculations for you. Let’s use the same sample data and view the output from a popular spreadsheet program. © 2007 Pearson Custom Publishing

27 Learning Objective 5: Determine the fixed and variable components of a mixed cost using scatter graphs, the high-low method, and the results of regression analysis. © 2007 Pearson Custom Publishing

28 Scatter Graph Example We will use the following data in an effort to predict overhead costs on the basis of machine hours. We will use the following data in an effort to predict overhead costs on the basis of machine hours. © 2007 Pearson Custom Publishing

29 Scatter Graph Example © 2007 Pearson Custom Publishing

30 Draw the Best Fit Line © 2007 Pearson Custom Publishing

31 Determine Line Parameters The line appears to intersect the Y axis at about $2,000. This would be our best estimate of the fixed cost component. The line appears to intersect the Y axis at about $2,000. This would be our best estimate of the fixed cost component. The line also goes through the data point for March where X= 2,500 and Y = $6,200. Subtracting the $2,000 fixed cost from $6,200, leaves $4,200 as the estimate of total variable cost at this level of volume. The line also goes through the data point for March where X= 2,500 and Y = $6,200. Subtracting the $2,000 fixed cost from $6,200, leaves $4,200 as the estimate of total variable cost at this level of volume. © 2007 Pearson Custom Publishing

32 Estimate the Total Cost Formula To determine the variable cost per machine hour, simply divide the total variable cost by the number of machine hours: $4,200 / 2,500 hours = $1.68 per hour. To determine the variable cost per machine hour, simply divide the total variable cost by the number of machine hours: $4,200 / 2,500 hours = $1.68 per hour. Thus, our estimated overhead cost is $2,000 per month plus $1.68 per machine hour. Thus, our estimated overhead cost is $2,000 per month plus $1.68 per machine hour. TC = FC + (VC x V) TC = FC + (VC x V) TC = $2,000 + ($1.68 x 2,500 hours) TC = $2,000 + ($1.68 x 2,500 hours) TC = $6,200 TC = $6,200 © 2007 Pearson Custom Publishing

33 High-Low Method Using the same data as before, the high and low activity months are: Using the same data as before, the high and low activity months are: High: September5,000 hours, $10,500 cost High: September5,000 hours, $10,500 cost Low: April2,000 hours, $ 6,000 cost Low: April2,000 hours, $ 6,000 cost The next step is to analyze the data to determine the variable cost (based on the cost change from low to high) and the fixed cost. The next step is to analyze the data to determine the variable cost (based on the cost change from low to high) and the fixed cost. © 2007 Pearson Custom Publishing

34 The High-Low Line © 2007 Pearson Custom Publishing

35 High-Low Calculations Step 1: Calculate the variable cost: Change in cost $10,500 - $6,000 Change in hours 5, ,000 Step 1: Calculate the variable cost: Change in cost $10,500 - $6,000 Change in hours 5, ,000 $4,500 3,000 hrs. = $1.50 per machine hour $4,500 3,000 hrs. = $1.50 per machine hour © 2007 Pearson Custom Publishing

36 High-Low Calculations Step 2: Calculate the fixed cost: (NOTE: you can use either month for this step.) Step 2: Calculate the fixed cost: (NOTE: you can use either month for this step.) TC = FC + (UVC x V) or TC – (UVC x V) = FC TC = FC + (UVC x V) or TC – (UVC x V) = FC April total cost -- variable cost = fixed cost April total cost -- variable cost = fixed cost $6, ($1.50 X 2,000 hours) = $3,000 $6, ($1.50 X 2,000 hours) = $3,000 Thus, the overhead is estimated at $3,000 per month plus $1.50 per machine hour. Thus, the overhead is estimated at $3,000 per month plus $1.50 per machine hour. TC = FC + (UVC x V) TC = FC + (UVC x V) TC = $3,000 + ($1.20 X Machine hours) TC = $3,000 + ($1.20 X Machine hours) © 2007 Pearson Custom Publishing

37 Regression Analysis Output The blue text is used to highlight the variable and fixed cost estimates using regression analysis. © 2007 Pearson Custom Publishing

38 Estimates Using Regression Analysis Based on the output data, the estimate of fixed cost is $2,134 and the estimate of variable cost is $1.62 per machine hour. Based on the output data, the estimate of fixed cost is $2,134 and the estimate of variable cost is $1.62 per machine hour. TC = $2,134 + ($1.62 x Machine hours) TC = $2,134 + ($1.62 x Machine hours) The remaining output data provides information related to the expected accuracy of our overhead cost estimates. The measures of probable error are major advantages of regression analysis over the other methods. The remaining output data provides information related to the expected accuracy of our overhead cost estimates. The measures of probable error are major advantages of regression analysis over the other methods. © 2007 Pearson Custom Publishing

39 Cost Equation The basic format used for cost equations is: The basic format used for cost equations is: Y = a + bX, where Y = a + bX, where Y = estimated total cost X = expected or actual activity level a = estimated fixed cost per period b = estimated variable cost per unit of activity © 2007 Pearson Custom Publishing

40 Comparison of the Methods Each of the three analyses gives us a different cost equation for predicting overhead costs based on 4,000 machine hours. Each of the three analyses gives us a different cost equation for predicting overhead costs based on 4,000 machine hours. Scatter graph:$2,000 + $1.68 x 4,000 = $8,720 Scatter graph:$2,000 + $1.68 x 4,000 = $8,720 High-low:$3,000 + $1.50 x 4,000 = $9,000 High-low:$3,000 + $1.50 x 4,000 = $9,000 Regression:$2,134 + $1.62 x 4,000 = $8,614 Regression:$2,134 + $1.62 x 4,000 = $8,614 © 2007 Pearson Custom Publishing

41 Discussion Questions Of the three cost equations, which one do you think would be most reliable (i.e., gives the most accurate predictions)? Of the three cost equations, which one do you think would be most reliable (i.e., gives the most accurate predictions)? Consider the fact that we only used data from nine months. What implications does this have for your assessment of how accurate our predictions might be? Consider the fact that we only used data from nine months. What implications does this have for your assessment of how accurate our predictions might be? © 2007 Pearson Custom Publishing

42 The End of Chapter M4 © 2007 Pearson Custom Publishing