Cost Behaviour: Part 2 of 2 Sections 1 and 2 Feb 1, 2013 Professor: Khim Kelly Office: HH386B Office Hours: Mon/Wed 11:30am – 12:30pm and Appointment TA: Kun Huo

1 Feb 2013 Overview Last lecture … – Fixed costs, variable costs, step variable costs, mixed costs – How to use costs behaviour to predict costs – Analyze mixed costs (High-Low Method) Major topics for today… – Analyse mixed costs (Regression) – Another example of High-Low method – The contribution margin approach 2

Regression High-Low method uses only two data points – Improve accuracy of results by considering more data points Regression analysis – Uses all the available data points – “Fits” a line to the data points while attempting to minimize errors. – Develops a similar looking equation to High-Low method Both assume linearity – Need to be aware of potential differences in cost behaviour outside of the relevant range – When predicting costs, you might want to limit analysis to a range around expected activity The next slides plot data (from last lecture Clicker Question #3) with activity on the X axis and the mixed cost on the Y axis.

Last Lecture: Clicker Question #4: Answer $34,500 - $18,750 5, ,800 = $15,750 3,200 = $4.92 per Patient-Day = Month Patient DaysMixed Cost Jan 3,700 27,750 Feb 3,200 22,000 March 4,400 31,000 April 5,000 34,500 May 2,700 28,000 June 2,500 22,500 July 3,600 26,500 Aug 1,800 18,750 Sept 4,650 36,500 Oct 3,900 24,000 Nov 2,100 22,500 Dec 4,500 26,750 $34,500a + ($4.92 * 5,000) = a$9,891 = Answer: D. Y = $9,891 +$4.92X Then:

Scattergram Plot Mixed Cost Patient days

High-Low Method Mixed Cost Patient days HL method: y = $4.92x + $9,891

Least Squares Regression Method Mixed Cost Patient days HL method: y = $4.92x + $9,891 LSR method: y = 4.10x + $12,346

Least Squares Regression Method Mixed Cost Patient days LSR method: y = 4.10x + $12,346 (with outlier) Outlier? Nonlinear?

Least Squares Regression Method Mixed Cost Patient days LSR method: y = 4.10x + $12,346 (with outlier) LSR method: y = 3.51x + $13,890 (without outlier) Outlier? Nonlinear?

Example: High-Low Method and Predicting Cost (P6-15) Prince Company’s total OH costs at various levels of activity are presented below: MonthDL HoursTotal OH Cost September100,000$388,000 October80,000$340,400 November135,000$485,600 December140,000$483,200

Example: High-Low and Predicting Cost (P6-15) Assume OH costs consists of utilities, supervisory salary, depreciation, and maintenance. The breakdown for October at 80,000 DL hour level of activity is: The company wants the breakdown of costs into variable and fixed cost elements. Answer the following required: OHTypeOH Cost UtilitiesVariable$104,000 Salaries & DepreciationFixed$120,000 MaintenanceMixed$116,400 Total OH Cost$340,400

Example: High-Low and Predicting Cost (P6-15) 1. Estimate how much of the $483,200 of OH cost in December was maintenance cost

Example: High-Low and Predicting Cost (P6-15) The company wants the breakdown of costs into variable and fixed cost elements. Answer the following required: OHTypeOH Cost December OHMixed$483,200 December: Salaries & DepreciationFixed($120,000) UtilitiesVariable($182,000) Maintenance (Mixed Cost)$181,200 Variable Cost = $104,000/80,000 * 140,000

It is Clicker Time!! Feel Free to Work Together on Clicker Questions

Q: Use the high-low method to develop the cost formula for maintenance cost (select option that is closest to your answer). Clicker Question #1 (P6-15) A. Y = $15,000 + $23.80X B. Eggs + Plants = Eggplant C. Y = $30,000 + $3.12X D. Y = $30,000 + $1.08X E. Y = $15,000 + $2.38X LOW (October): 80,000 DL $116,400 HIGH (December): 140,000 DL $181,200

Clicker Question #1 LOW (October): 80,000 DL $116,400 HIGH (December): 140,000 DL $181,200 $181,200 - $116, ,000 – 80,000 = $64,800 60,000 = $1.08 per DL hour = $116,400a + ($1.08 * 80,000) = a$30,000 = Answer: D. Y = $30,000+$1.08X Then:

Example: High-Low and Predicting Cost (P6-15) 3. Express the company’s total OH cost in the formula Y = a+ bX: Variable Costs: Utilities ($104,000/80,000 DL)$1.30/DL hour Maintenance$1.08/DL hour Total Variable$2.38/DL hour Fixed Costs: Salaries and depreciation$120,000 Maintenance$30,000 Total Fixed$150,000

Example: High-Low and Predicting Cost (P6-15) 3. Express the company’s total OH cost in the formula Y = a+ bX: Total Variable$2.38/DL hour Total Fixed$150,000 Y = $150,000 + $2.38X

Utilizes our ability to analyze cost behavior – An income statement format that separates expenses into fixed costs and variable costs – Differs from traditional presentation of COGS and operating expenses – Total cost is the same under both methods but only subtotals vary Contribution margin – The amount remaining from sales after all variable costs have been deducted The Contribution Format

To Do: Analyze expense behaviour of the following and develop a contribution income statement: Contribution Income Statement CostCost Formula Number of units sold21,000 Sales revenue1,050,000 COGS$20 / unit Advertising Expense$170,000 Sales Commissions5% of Sales revenue Administrative Salaries$80,000 Shipping Expense$40,000 plus $7.50 / unit Depreciation$50,000

Contribution Income Statement Income Statement Revenue$1,050,00 0 COGS ($20/unit * 21,000)$420,000 Variable shipping expense ($7.50/unit * 21,000)157,500 Commission (5% of sales revenue)52,500 Total Variable Costs$630,000 Contribution Margin$420,000 Contribution Margin per Unit$20

Contribution Income Statement Income Statement Contribution Margin$420,000 Fixed Shipping expense40,000 Advertising expense170,000 Administrative salaries80,000 Depreciation expense50,000 Total Fixed Costs$340,000 Operating Income$80,000

It is Clicker Time! Feel Free to Work Together on Clicker Questions

Clicker Question #2 Q: Contribution margin equals revenues minus _______? A.Product costs B.Period costs C.Variable costs D.Fixed costs E.9 little monkeys jumping on the bed

Clicker Question #2: Answer Q: Contribution margin equals revenues minus _______? Answer: C. Variable costs

Clicker Question #3 Q: What is the contribution margin? CostAmount Sales$300,000 Fixed Manufacturing Overhead$ 55,000 Direct Labour$ 72,500 Fixed Selling Expenses$ 46,250 Variable Manufacturing Overhead$ 41,000 Variable Administrative Expenses$ 48,000 Direct Materials$ 51,500 Fixed Administrative Expenses$ 44,500 Variable Selling Expenses$ 49,750

Clicker Question #3 Q: What is the contribution margin? A.$37,250 B.$100,000, C.$ 87,000 D.$176,000 E.$262,750

Clicker Question #3 - Solution Amount Sales$300,000 Direct Labour($72,500) Direct Materials($51,500) Variable Manufacturing Overhead ($41,000) Variable Administrative Expenses ($48,000) Variable Selling Expenses($49,750) Total Variable Costs($262,750) Contribution Margin$37,250

Clicker Question #3: Answer Q: What is the contribution margin? Answer: A.$37,250

UW … UW is one of Canada’s leading research institution The School of Accounting and Finance has one of the country’s premier PhD programs Every year, I train PhD students in teaching. So, the next 3 classes (Cost-Volume-Profit Relationships) will be taught by Kun Huo, one of our PhD students. I will sit in the class as an observer.

Summary Major topics for today… – Another example of High-Low Method – Contribution margin approach Next class … – Chapter 7 (Cost-Volume-Profit Relationships)