1 Cost behaviour

2 Introduction Determining how cost will change with output or other measurable factors of activity is of vital importance for planning, controlling and decision- making activities. Most of planning, control and decision-making activities of management (e.g. the preparation of budgets, the production of performance reports, and the provision of relevant costs for pricing and other decisions) depend on reliable estimates of costs and distinguishing between fixed and variable costs, at different activity levels.

3 Cost behaviour and decision making It is the way in which costs are affected by changes in the volume of output Management decisions will often be based on how costs and revenues vary at different levels of output For example:- –What should the planned activity level be for the next period? –Should selling price be reduced in order to sell more units? –Should a particular item be reduced in order to sell more units? –Should a contract be undertaken?

4 Cost behaviour and levels of activity There are many factors which may influence costs. The major influence is the volume of output, or the level of activity:- –Number of units produced –Value of items sold –Number of items sold –Number of units of electricity consumed

5 Fixed cost Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so too will be the fixed costs. Fixed costs always have a variable element, since an increase or decrease in production may also bring about an increase or decrease in fixed costs

6 Example of fixed and variable costs behaviour Let’s say you and 2 friends are going to Rodrigues for 4 nights. You are going to fly down there and stay in cotton bay hotel. The hotel charges Rs100 per night regardless of how many people stay in the room. TOTAL Expected Lodging Cost = Rs400

7 Two days before you leave one more friend decides to come along. How does this affect your hotel bill? No change – total lodging is still Rs400 This is a fixed cost – The total cost does not change.

8 The day before you leave one friend gets sick and can’t go. What happens to your hotel bill now? No Change This is a fixed cost – The total cost does not change

9 How does all this affect you? Total Hotel Bill = Rs400 How much do you have to pay? Fixed Cost Behavior # of People (a)2 people3 people4 people Total Lodging (b)Rs400 Lodging per person (b / a) Rs200Rs133Rs100

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11 What about the airfare? You were able to get plane tickets for Rs200 roundtrip per person. Variable Cost Behavior # of tickets (a)234 Total Airfare (a * b)Rs400Rs600Rs800 Cost per ticket (b)Rs200

12 Under a variable cost structure the cost per unit stays the same and the total cost changes

13 Mixed Cost Has characteristics of both a variable and a fixed cost. e.g. – Copy machine lease –Cost = Rs1,000 per month –Plus Rs1 for every copy over 2,000

14 Cost Behavior Summarized 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 Total Fixed Cost

15 Number of Local Calls Monthly Basic Telephone Bill per Local Call The fixed cost per local call decreases as more local calls are made. Cost Behavior Summarized

16 Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill Cost Behavior Summarized Total Variable Cost

17 Minutes Talked Per Minute Telephone Charge The cost per minute talked is constant. For example, 10 cents per minute. Cost Behavior Summarized Variable Cost Per Unit

18 Cost Behavior Summarized When activity level changes...

19 semi-variable costs (Mixed Costs)

20 Mixed Costs

21 Mixed Costs

22 Mixed Costs

23 Assumptions about cost behaviour Within the normal range of activity, cost is assumed to be either fixed, variable or semi- variable (Mixed) Departmental costs within organization are assumed to be mixed costs Departmental costs are assumed to rise in a straight line as the volume of activity increases. In other words costs are said to be linear

24 High Low Method There are several methods for identifying fixed and variable elements of semi-variable costs. One of the methods is the high low method

25 High Low Method (Cont…) Step 1- Review records of costs in previous periods Step 2- Determine the following:- –Total cost at high activity level –Total cost at low activity level –Total units at high activity level –Total units at low activity level

26 High Low Method (Cont…) Calculate the following:- The fixed costs can be determined as follows:- total cost at high level of activity – (total units at high activity level * variable costs per unit) Total cost at high activity level- total cost at low activity level Total units at high activity level- total units at low activity level = VARIABLE COST PER UNIT

27 The High-Low Method-Example WiseCo recorded the following production activity and maintenance costs for two months:

28 The High-Low Method

29 The High-Low Method

30 The High-Low Method

31 The High-Low Method

32 The High-Low Method-Exercise (1) 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

33 The High-Low Method-Exercise (2) 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

34 The High-Low Method-drawbacks This method ignores all cost observations other than the observations for the lowest and highest activity levels. Observations at the extreme ranges of activity levels are not always typical of normal operating conditions, and therefore may reflect abnormal rather than normal cost relationships. The method, therefore, gives inaccurate cost estimates

35 The Scatter graph Method This method involves: –Plotting on a graph the total costs (represented on the vertical axis -Y) for each activity (recorded on the horizontal axis –X). Drawing a straight line through the middle of the plotted points by visual approximation. –The point where the straight line cuts the vertical axis represents the fixed cost. –The unit variable cost is found by observing the differences (in costs and activity levels) between any two points on the straight line.

36 The Scatter graph Method

37 The Scatter graph Method

38 The Scatter graph Method

39 The Scatter graph Method

40 Exercise-Plotting scatter graph to estimate fixed and variable costs MonthProduction (Units) Costs (Rs) July10,00044,000 August15,00060,000 September23,00085,000 October21,00075,000 November19,00070,000 December28,00098,000

41 The Scatter graph Method-drawbacks This method suffers from the disadvantage that the determination of exactly where the straight line should fall is subjective (i.e. different people will draw different lines with different slopes, giving different cost estimates).