©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones5 - 1 Chapter 5 Cost Behavior

©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones5 - 2 Learning Objective 1 Describe the differences between fixed costs and variable costs.

5 - 3©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Example Laura Jorgensen is planning a party. She identifies two major costs: 1. Entertainment (a live band) 2. Food and drinks $3,650 was spent last year on this party: ♫ $525 for entertainment ☺ $3,125 for food and drinks

5 - 4©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Example The spending limit for this event, this year, is $5,500. Prices for entertainment and food and drinks are expected to remain the same. 175 guests are expected to attend this year’s party, compared to 125 last year.

5 - 5©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Common Cost Behavior Patterns Cost behavior is the reaction of costs to changes in levels of business activity. Fixed costs remain constant in total regardless of the level of activity. What is the fixed cost per guest?

5 - 6©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Common Cost Behavior Patterns 125 Guests175 Guests Total fixed cost: $525 $ Guests Cost per guest: $525 ÷ 125 = $ Guests Cost per guest: $525 ÷ 175 = $3.00

5 - 7©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Common Cost Behavior Patterns Variable costs are costs that change in direct proportion with changes in the level of activity. What is the variable cost per guest? Cost per guest: $3,125 ÷ 125 = $25.00

5 - 8©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Common Cost Behavior Patterns What is the total variable cost for 175 guests?

©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones5 - 9 Learning Objective 2 Classify costs by cost behavior.

5 - 10©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Comparison of Cost Behaviors The measure of activity is shown on the horizontal axis (the x-axis). The x-axis is the independent variable. The type of cost is shown on the vertical axis (the y-axis). The y-axis is the dependent variable.

5 - 11©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Graph of a Fixed Cost $525 y x Cost of the Band Number of Guests

5 - 12©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Graph of a Variable Cost y x $4, Cost of Catering Number of Guests

5 - 13©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Determining Total Cost Total Costs = Fixed Costs + Variable Costs

5 - 14©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Determining Total Cost What is the total cost for 175 guests? Total variable cost: $25 × 175 = $4,375 Total fixed cost = $525 Total cost: $525 + $4,375 = $4,900

5 - 15©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Graph of Total Costs $4, y x $525

©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Learning Objective 3 Explain the concept of relevant range and its effect on cost behavior information.

5 - 17©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Relevant Range The range of activity within which cost behavior assumptions are valid is called the relevant range.

5 - 18©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Relevant Range of Fixed Costs Fixed Cost Activity y Relevant Range x

5 - 19©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Relevant Range of Fixed Costs Variable Cost Activity y Relevant Range x

©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Learning Objective 4 Describe the characteristics of a mixed cost and the four basic approaches to separating a mix cost into its fixed and variable components.

5 - 21©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Mixed Costs Mixed costs contain elements of both fixed- and variable-cost behavior.

5 - 22©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Graph of Mixed Cost Variable Component Activity Cost y x Fixed Component

5 - 23©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Identifying the Fixed and Variable Elements of a Mixed Cost The engineering approach Scatter graphing The high-low method Regression analysis

5 - 24©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones The Engineering Approach This approach relies on engineers or other professionals who are familiar with the technical aspect of the activity and the associated cost. The engineering approach may employ time-and-motion studies or other aspects of scientific management.

5 - 25©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graphing The scatter graph plots historical activity and cost data on a graph to see how a cost relates to various levels of activity. The analyst places a straight line through the visual center of the points plotted on the graph, so roughly half the dots are above the line and half are below the line.

5 - 26©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones A Scatter Graph Activity Cost y x

5 - 27©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones The High-Low Method 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.

5 - 28©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Regression Analysis Regression analysis, also called the least-squares method or linear regression analysis, is a mathematical approach to determining fixed and variable cost with statistical accuracy.

5 - 29©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Regression Analysis The basic mathematical equation is: Y = a + bX Y =The dependent variable a =The Y intercept, or the amount for Y when X is zero b =The slope coefficient X = The independent variable

5 - 30©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Regression Analysis When applying regression analysis to find the fixed and variable elements of a mixed cost, the variables in the regression equation are defined as follows: Y=total cost a=fixed cost b=unit variable cost X=activity level

5 - 31©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Regression Analysis Microsoft Excel’s Chart Wizard uses a four-step sequence to do the graphing and mathematical computations to approximate costs at various levels of activity.

©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Learning Objective 5 Determine the fixed and variable components of a mixed cost using scatter graphs and the high-low method.

5 - 33©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example The sales manager for Hinds Wholesale Supply Company needs to estimate the expected delivery vehicle operating cost (maintenance) for 2005.

5 - 34©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example ,000 11,000 24,000 30,000 31,000 26,000 20,000 1,200 1,000 1, ,000 2,000 $2,000 $1,600 $2,200 $2,400 $2,600 $2,200 $2,000 Truck Number Miles Driven Packages Delivered Maintenance Cost

5 - 35©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example Estimated Line

5 - 36©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example Total Cost = Fixed Cost + Variable Cost Total Mixed Cost = Fixed Cost Element + Variable Cost Element Total Mixed Cost = $1,100 + Variable Cost Element

5 - 37©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example

5 - 38©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example MilesCost 34,000$2, , ,100 34,000$1,600 $1,600 ÷ 34,000 = $ or 4.7 cents per mile

5 - 39©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example Vehicle maintenance cost = $1,100 + $0.047 per mile driven What is the estimated maintenance cost for a truck that will be driven 28,000 miles? $1,100 + ($0.047 × 28,000) = $2,416

5 - 40©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example ,000 11,000 24,000 30,000 31,000 26,000 20,000 1,200 1,000 1, ,000 2,000 $2,000 $1,600 $2,200 $2,400 $2,600 $2,200 $2,000 Truck Number Miles Driven Packages Delivered Maintenance Cost

5 - 41©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones Scatter Graph Example

5 - 42©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones High-Low Method Example ,000 11,000 24,000 30,000 31,000 26,000 20,000 1,200 1,000 1, ,000 2,000 $2,000 $1,600 $2,200 $2,400 $2,600 $2,200 $2,000 Truck Number Miles Driven Packages Delivered Maintenance Cost

5 - 43©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones High-Low Method Example What is the fixed cost element? $1,00020,000 = $0.05 ($2,600 – $1,600) (31,000 – 11,000) =

5 - 44©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones High-Low Method Example $2,600 = Fixed cost + (31,000 × $0.05) Fixed cost = $2,600 – $1,550 = $1,050 $1,050 is the fixed cost element.

5 - 45©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones High-Low Method Example $1,600 = Fixed cost + (11,000 × $0.05) Fixed cost = $1,600 – $550 = $1,050 What is the estimated maintenance cost for a truck to be driven 28,000 miles? $1,050 + (28,000 × $0.05) = $2,450

©2004 Prentice Hall Business Publishing Introduction to Management Accounting, 2/e Werner/Jones End of Chapter 5