1. Cost Behavior CHAPTER 6 1 Professor Garvin, JD; CPA – ACG2071

2. Cost Behavior  Cost behavior—how costs change as volume change  There are three common cost behaviors:  Variable costs  Fixed costs  Mixed costs 2

3. Key Characteristics of Variable Costs  Total variable costs change in direct proportion to changes in volume  V.C. is variable w/respect to an activity base (cost driver)  DLHs  MHs  # of calls handled by tech support at software Co.  # of beds occupied in hospital or hotel  Variable cost/unit remains constant  DM & DL production costs usually variable costs 3

4. Direct Labor 4

5. Total Variable Cost (y) = Variable cost per unit of activity (v) * Volume of activity (x); or y = vx x axis y axis 5

6. Key Characteristics of Fixed Costs  Do not change in response to changes in activity  Total fixed costs stay constant over relevant range*  S.L. depreciation on manufacturing equipment  Property taxes for a retail store  Salary of Manager of Production Facility  Fixed costs per unit of activity vary inversely with changes in volume *Relevant range is the normal operating range of activity 6

7. Total Fixed Costs y axis X axis Cost equation is y = f 7

8. Type of Costs in Organization Predominantly Variable Fixed  Public Utility (like Florida Power) w/large inv. in plant & equipment? √  Manufacturing Co. like Black & Decker? √  Merchandising Co. like Wal-Mart? √  Service Co. like Dragonfly Sushi? √ 8

9. Key Characteristics of Mixed Costs  Cost that contains both variable & fixed cost elements  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 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

10. Mixed Costs Variable Fixed 10 Ttl Mixed Cost

11. Ariel Co builds innovative loudspeakers for music & home theater. Identify the following costs as variable or fixed.  ___ 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

12. Following chart shows 3 different costs: Cost A, B & C. For each cost, chart shows the total cost & cost/unit at two different volumes w/in same relevant range. Identify each as fixed, variable or mixed. Cost A Cost B Cost C 12

13. Cost Equation  Is a mathematical equation for a straight line  Used to predict total cost  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 13

14. 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 graphs. y x Graph 1Graph 2 Slope of total variable cost line is variable cost per unit of activity. The steeper the slope of the line, the higher the variable cost per unit. 14

15. Costs and Decisions  Committed fixed costs  Cannot be easily changed in short run Rent or Insurance Expense on facility  Discretionary fixed costs  Management can easily change in short run Advertising, Research and Development 15

16. Relevant Range  When predicting future costs based on cost behavior in past, only valid within limited range of activity  Band of volume where total fixed costs remain constant at a certain level  Variable costs per unit remain constant at a certain level  Difficult to assess (predict) future costs outside relevant range 16

17. The Relevant Range 0 2000 4000 8000 17

18. Other Cost Behaviors  Step Costs 300060009000 18

19. Other Cost Behaviors  Curvilinear Costs 19

20. Perreth Drycleaners has capacity to clean up to 5,000 garments per month. 1. Complete the following schedule. Garments 2,000 units3,500units5,000 units Total Variable Costs $2,625 Total Fixed Costs Total Operating Costs Variable Cost/garment Fixed Cost/garment $2.00 Average cost/garment 20

21. Garments 2,0003,5005,000 Total Variable Costs $2,625 Total Fixed Costs Total Operating Costs Variable Cost/garment$.75 Fixed Cost/garment$3.50 $2.00 $1.40 Average cost/garment 7,000 $1,500 $3,750 $8,500$9,625$10,750 $ 4.25 $ 2.75 $2.15 Perreth Drycleaners has capacity to clean up to 5,000 garments per month. 1. Complete the following schedule. 21

22. Actual costs at 2,000 garments $8,500 Total predicted costs ($2.15 × 2,000 garments) (4,300) Underestimated costs $4,200 2. Why does the average cost per garment change? 22 3. Suppose the owner erroneously uses the average cost per unit at full capacity to predict total costs at a volume of 2,000 garments. Would he overestimate or underestimate his total costs? By how much?

23. a. What is total cost of producing 1,000 mailboxes? 1,000 x $26.43 = $26,430 b. If $18,000 of the total costs is fixed, what is the variable cost of producing each mailbox? Total costs$26,430 Less total fixed costs(18,000) Total variable costs $8,430 ÷ 1,000 Variable cost per mailbox $8.43 23 Mailbox Magic produces decorative mailboxes. The company’s average cost per unit is $26.43 when it produces 1,000 mailboxes. Total fixed costs are $18,000.

24. d. If plant manager uses average cost/unit to predict total costs, what would the forecast be for 1,200 mailboxes? $26.43 x 1,200 mailboxes (= $31,716) e. If the cost equation is used to predict total costs, what would forecast be for 1,200 mailboxes? y = ($8.43 x 1,200) + $18,000 = $28,116 f. What is dollar difference in answers above? Which approach to forecasting costs more appropriate? Using average cost at 1,000 = $31,716 Total Product Cost Using cost equation at 1000 = 28,116 Total Product Cost $3,600 Difference Why? c. What is the cost equation for Mailbox Magic? y = $8.43x + $18,000 24

25. Cost Behavior Analysis  Four methods to estimate costs & cost behavior  Account Analysis  Scatter Plots (Scattergraphs)  High-Low Method  Regression Analysis 25

26. Account Analysis  Use of judgment to classify each general ledger account as variable, fixed, or mixed  Subjective  Most common approach to analyzing cost structure 26

27. 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 27

28. Scatter Plot Example 28

29. High-Low Method Highest volume was 3000 units, lowest volume was 500 units, so connect line. At highest volume (3000 units) cost was $400,000. At lowest volume (500) cost was $150,000. 29

30. High-Low Method  Step 1: Find variable cost per unit (slope) of cost line $400,000 - $150,000 = $100 VC/unit of production 3000 units – 500 units  Step 2: Find the fixed costs (vertical intercept) Line crosses the vertical intercept at $100,000  Step 3: Create the cost equation Total mixed cost = VC/unit * volume + TFC y = vx + TFC  Advantage: Easy to use/Disadvantage: Only uses 2 data points 30

31. 31 Flower Power is local chain of floral shops. Each shop has its own delivery van. Instead of charging a flat delivery fee, FP want to set delivery fee based on distance driven. FP wants to separate fixed & variable van operating costs to see how distance affects these costs. FP has the following data from past 7 mos. MonthMiles Driven Van Operating Costs Jan15,800$5,460 Feb17,300 5,680 Mar14,600 4,940 April16,000 5,310 May17,100 5,830 June15,400 5,420 July14,100 4,880

32. Use high-low method to determine FP’s cost equation for van operating costs. 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 ($5,680-$4,880) ÷ (17,300-14,100) $800 ÷ 3,200 = $0.25 32

33. Step 2: Find the vertical intercept (fixed costs) = Total mixed cost – Total variable cost = TFC $5,680 – ($0.25 17,300) = $1,355 TFC or $4,880 – ($0.25 14,100) = $1,355 TFC Flower Power (cont) 33

34. Step 3: Create and use an equation to show the cost behavior of a mixed cost – our delivery van (Total Delivery Van cost) Y = $0.25 per mile + $1,355 What is estimated operating costs at 15,000 miles: ($0.25 x 15,000) + $1,355 = $5,105 Flower Power (cont) 34

35. Regression Analysis  Statistical procedure to find line that best fits data (cost equation)  Uses all data points, (not just high & low volume)  R-square value, Intercept & X Variable 1 co-efficients 35 3 1212

36. High- Low Method Slope of line is = to change in cost divided by change in activity. Estimate of variable costs (slope) is: $400,000 - $150,000 = $250,000 = $100 VC/ unit 3000 - 500 2,500 36

37. Regression Analysis Total Cost = Fixed Cost + (Variable cost per unit X Activity level in Units). Excel will calculate based on data inputted from last 12 months. Regression Analysis computes the regression line that minimizes the sum of the squared errors. What is the best straight line that fits this data? At highest level, regression analysis gives total costs of $365,000 instead of $400,000 using high-low method. 37

38. Predicting Costs and Data Concerns  Data Concerns Only valid within relevant range Seasonal variations Inflation Outliers – abnormal data points 38

39. Traditional Income Statement Full (Absorption) Costing Format Sales - Cost of Goods Sold = Gross Margin - Selling, general & administrative costs = Operating Income 39

40. Full (Absorption) Costing  Inventory (Product) Costs Include:  Direct Material  Direct Labor  All Manufacturing Overhead  So full costing, absorption costing I/S does not separate variable and fixed costs  Required for GAAP – Why?  Matching of expenses of producing product with revenue from selling product 40

41. Contribution Margin Income Statement or Variable Costing Income Statement Sales - Variable Costs = Contribution Margin - Fixed Costs = Operating Income 41

42. Full (Absorption) Costing 42

43. Variable Costing vs Absorption Costing 43

44. Sales revenue (80 × $350)$28,000 Less:Cost of goods sold (80 × $250) (20,000) Gross profit8,000 Less: Operating expenses: Sales commissions (5% × $28,000)(1,400) Payroll costs(1,200) Lease Expense (1,000) Operating income$ 4,400 44 Pam’s Quilt Shoppe Traditional Income Statement Month Ended February 28 Additional Info: Sales Commission: 5% of sales revenue Lease of shop: $1000/month; Payroll costs: $1,200/month

45. With info from traditional I.S., prepare contribution margin I.S. for Feb. Additional info: Sales Commission-5% of sales revenue; Lease of shop-$1,000/mo.; Payroll costs-$1,200/mo. Pam’s Quilt Shoppe Contribution Margin Income Statement Month Ended February 28 Sales revenue (80 × $350)$28,000 Less: Variable costs: Cost of goods sold (80 × $250)(20,000) Sales commissions (5% × $28,000) (1,400) Contribution margin6,600 Less: Fixed costs: Payroll costs(1,200) Lease (1,000) Operating income$ 4,400 45

46. Variable Costing  Assigns only variable manufacturing costs to products (DM, DL, Variable MOH)  Fixed manufacturing overhead treated as a period cost  For internal management decisions; Not GAAP 46

47. Absorption Costing  Required by GAAP for external reporting  Assign all manufacturing costs to products (DM, DL, Variable MOH and Fixed MOH)  Traditional income statement 47

48. Following data pertains to Rays, a manufacturer of swimming goggles. (Rays had no beginning inventories) Sales Price$35 Variable Manufacturing expense per unit 15 Sales commission expense per unit 5 Fixed manufacturing overhead 2,000,000 Fixed operating expenses 250,000 Number of goggles produced 200,000 Number of goggles sold 185,000 1. Prepare both conventional (absorption costing) & contribution margin (variable costing) income statements 48

49. Rays Conventional (Absorption Costing) Income Statement Year Ended December 31, 2011 Sales revenue (185,000  $35) $6,475,000 Less: Cost of Goods Sold: Beginning finished goods inventory $ 0 Cost of goods manufactured 5,000,000 Cost of goods available for sale 5,000,000 Ending finished goods inventory (375,000) Cost of goods sold 4,625,000 Gross profit 1,850,000 Operating expenses 1,175,000 Operating income $ 675,000 49

50. Rays Contribution Margin (Variable Costing) Income Statement Year Ended December 31, 2011 Sales revenue$6,475,000 Variable expenses: Variable cost of goods sold$2,775,000* Sales commission expense 925,000 3,700,000 Contribution margin$2,775,000 Fixed expenses: Manufacturing overhead$2,000,000 Operating expenses 250,000 2,250,000 Operating income$ 525,000 Which statement shows the higher operating income? Why? Op. Inc. w/F.C-$675,000. Op. Inc. w/V.C-$525,000 Diff - $150,000 50

51. Variable cost of goods sold: Beginning finished goods inventory$0 Variable cost of goods manufactured 3,000,000 Variable cost of goods available for sale 3,000,000 Ending finished goods inventory (225,000) Variable cost of goods sold $2,775,000 Back 51

52. Rays’ marketing VP thinks new sales promotion costing $150,000 would increase sales to 200,000 goggles. Should Co. proceed w/new promotion? Incremental analysis: Increase in contribution margin* (($35-20) x 15,000 goggles)$225,000 Increase in fixed costs(150,000) Increase in operating income $75,000 * Contribution Margin: SP ; CM is what left over after cover all VCs to cover FCs and then generate profit 52

53. Absorption Costing and Manager Incentives  When inventories increase, absorption costing income is higher than variable costing income  When inventories decrease, absorption costing income is lower than variable costing income  Therefore…Managers may increase production to build up inventory to maximize income and therefore their own potential bonus (if bonus based on income on GAAP income statements) 53

54. Units produced 400,000; Sold 375,000; SP/unit$48 DM/unit$12 DL/unit $ 4 Var MOH/unit$ 3 Var selling cost/unit$0.15 Fixed MOH$1m Fixed selling exp. $275,000 Fixed admin expense $125,000 Prepare inc. st. using full costing & variable costing. Reconcile difference between income computed under variable & full costing. Following info for Dorian Inc. for 2012, 1st yr. of operations 54

55. Income Statement Using Full Costing Sales ($48 × 375,000)$ 18,000,000 Less Cost of goods sold ($21.50* × 375,000) 8,062,500 Gross margin 9,937,500 Less: Fixed selling expenses 275,000 Variable selling expense ($0.15 × 375,000) 56,250 Fixed administrative expenses 125,000 Operating income $9,481,250 *Product cost per unit: Direct material$ 12.00 Direct labor 4.00 Variable manufacturing overhead 3.00 Fixed manufacturing o/h ($1,000,000 ÷ 400,000 units) 2.50 Full Costing P.C. per unit$ 21.50 55

56. Income Statement Using Variable Costing Sales ($48 × 375,000)$18,000,000 Less Variable Expenses: Production costs ($19* × 375,000) (7,125,000) Selling costs ($0.15 × 375,000) (56,250) Contribution margin 10,818,750 Less Fixed Expenses: Manufacturing overhead 1,000,000 Selling 275,000 Administrative 125,000 Operating income $9,418,750 *Variable Production Costs/Unit: DM$12Op.I. using Full Costing $9,481,250 DL 4Op.I. using Variable Costing (9,418,750) Var. MOH 3 Less Op.I using V.C. 62,500 $19/unit 56

57. Units produced400,000 Units sold375,000 Units in ending inventory 25,000 × FMOH per unit $2.50 FMOH in ending inventory$62,500 Operating income under full costing $9,481,250 Operating inc. under variable costing 9,418,750 Difference $62,500 57 Reconciliation of difference in operating income under full costing & variable costing:

58. END OF SEGMENT Professor Garvin, JD; CPA – ACG2071