Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 1

Cost Behavior Chapter 6 2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objective 1 Describe key characteristics and graphs of various cost behaviors 3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Cost Behavior Cost behavior—how costs change as volume change There are three common cost behaviors: 1.Variable costs 2.Fixed costs 3.Mixed costs 4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Key Characteristics of Variable Costs Total variable costs change in direct proportion to changes in volume Variable cost per unit remains constant Slope Total variable cost (y) = Variable cost per unit of activity (v) x Volume of activity (x) or y=vx 5

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Total Variable Costs 6

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Key Characteristics of Fixed Costs Total fixed costs stay constant over relevant range* Fixed costs per unit of activity vary inversely with changes in volume *Relevant range is the normal operating range of activity 7

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Total Fixed Costs 8

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Key Characteristics of Mixed Costs Total mixed costs increase as volume increases Total mixed costs can be expressed as a combination of the variable and fixed cost equations: Total mixed cost = total variable cost + total fixed cost or Y = vx + f Where Y = total mixed cost v = variable cost per unit of activity x = volume of activity f = fixed cost over a given period of time 9

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Mixed Costs Variable Fixed 10

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. S6-7 Classify Cost Behavior ___a. Depreciation on equipment used to cut wood enclosures ____b. Wood for speaker enclosures ____c. Patents on crossover relays (internal components) ____d. Crossover relays ____e. Grill cloth ___f. Glue ____g. Quality inspector’s salary 11

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. S6-1 Identify cost behavior Cost A Cost B Cost C 12

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objective 2 Use cost equations to express and predict costs 13

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Cost Equation Is a mathematical equation for a straight line predict total cost Total cost = total variable cost + total fixed cost or Y = vx + f Where Y = total mixed cost v = variable cost per unit of activity x = volume of activity f = fixed cost over a given period of time 14

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Cost Graphs Vertical (y-axis) always shows total costs Horizontal axis (x-axis) shows volume of activity Total Costs Total volume of activity Note that the variable cost per customer remains constant in each of the graphs. 15

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Costs and Decisions Committed fixed costs Discretionary fixed costs 16

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Relevant Range Band of volume where total fixed costs remain constant at a certain level Variable costs per unit remain constant at a certain level 17

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Other Cost Behaviors Step Costs 18

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Other Cost Behaviors Curvilinear Costs 19

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. E6-21A: Forecast Costs at Different Volumes Garments Total Variable Costs Total Fixed Costs Total Operating Costs Variable Cost/garment Fixed Cost/garment Average cost/garment 20

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. E6-21A (continued) Actual costs at 2,000 garments Total predicted costs ($2.15 × 2,000 garments) Underestimated costs 2. While variable cost remains the same over the relevant range shown, fixed cost per unit changes as the volume increases or decreases

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. E6-24A (continued) Mailbox Magic produces decorative mailboxes. The company’s average cost per unit is $26.43 when it produces 1,000 mailboxes. a. 1,000 x $26.43 b. Total costs Less total fixed costs Total variable costs Variable cost per mailbox 22

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. E6-24A (continued) c. y = ? d. ? e. y = ? 23

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. E6-24A (continued) f. Using average at 1,000 Using cost equation 24

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objective 3 Use account analysis and scatter plots to analyze cost behavior 25

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Cost Behavior Analysis Three methods to analyze cost behavior Scatter Plots High-Low Method Regression Analysis 26

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Account Analysis Use of judgment to classify each general ledger account as variable, fixed, or mixed Subjective 27

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Scatter Plots Use historical data to determine a cost’s behavior Scatter plot is the graph of historical cost data on the y-axis and volume data on the x-axis Helps managers visually determine how strong the relationship is between the cost and the volume of the chosen activity base 28

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Scatter Plot Example 29

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objective 4 Use the high-low method to analyze cost behavior 30

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. High-Low Method Step 1: Find variable cost per unit (slope) of cost line Step 2: Find the fixed costs (vertical intercept) Step 3: Create the cost equation Advantage: Easy to use Disadvantage: Only uses 2 data points 31

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. High-Low Method: E6-26A Step 1: Find slope of the mixed cost line (variable cost/unit) = Δ in cost (y) / Δ in volume (x) The slope represents the variable cost per unit of activity 32

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. E6-26A (continued) Step 2: Find the vertical intercept (fixed costs) = Total mixed cost – Total variable cost 33

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. E6-26A (continued) Step 3: Create and use an equation to show the behavior of a mixed cost 34

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objective 5 Use regression analysis to analyze cost behavior 35

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Regression Analysis Statistical procedure to find the line that best fits data (cost equation) Uses all data points R-square, Intercept, X Variable 1 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.

R-Square Value “Goodness of fit” How well does the line fit the data points? Ranges from 0 to 1 37

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Predicting Costs and Data Concerns Data Concerns Only valid within relevant range Seasonal variations Inflation Outliers – abnormal data points 38

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objective 6 Prepare contribution margin income statements for service firms and merchandising firms 39

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Traditional Income Statement Sales - Cost of Goods Sold Gross Margin - Selling,general & administrative costs Operating Income 40

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Contribution Margin Income Statement Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income 41

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Pam’s Quilt Shoppe Traditional Income Statement Month Ended February 28 Sales revenue (80 × $350) Less:Cost of goods sold (80 × $250) Gross profit Less: Operating expenses: Sales commissions (5% × $28,000) Payroll costs Lease Operating income S

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. S6-15 (continued) Pam’s Quilt Shoppe Contribution Margin Income Statement Month Ended February 28 Sales revenue (80 × $350) Less: Variable costs: Cost of goods sold (80 × $250) Sales commissions (5% × $28,000) Contribution margin Less: Fixed costs: Payroll costs Lease Operating income 43

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. End of Chapter 6 44