1. Management Accounting 1st March 2011
Cost Behaviour
Management Accounting 1st March 2011

2. Basic Cost Revision
Direct or Variable Costs are generally the materials and direct labour which go into making a Cost Object (Product or Service)
Indirect or Fixed Costs are generally the Overheads which are Allocated to the Cost Object
Together these make up the Total Cost of the Cost Object

3. Ctd
Selling Price is the Total Cost plus a Contribution or Revenue from the Cost Object
Revenue is often expressed as a Sales Margin or a percentage (%) of the Total Costs Plus Total Costs

4. Common Abbreviations Variable (Direct) Cost = VC
Fixed (Indirect) Cost = FC
Units of Production = U
Total Costs = TC
Revenue = R
Sales Margin = M (Expressed as a %)
Selling Price = SP
Total Profit = TP

5. Some Relationships
TC = VC + FC (Total Costs = Direct + Indirect Costs)
R = (TC x M%) + TC (Revenue = Total Costs x Margin as a percentage) + Total Cost
SP = TC + M (Selling Price = Total Costs + Margin)

6. Assumptions of Cost Behaviour
We assume that Variable Costs are Linear to Units Produced, as production increases so to does Variable Cost
We Assume that Fixed Costs do not change with production, so as units produced increases Fixed cost remain even

9. True? Sometimes this is true, but only in very simple cases
Fixed and Variable Costs are usually more complex
There are a number of reasons for this
Economies or Dis-economies of scale
Step Effects
Mixed Costs

10. Variable Costs
Most costs are variable, they change in relation to something else
In our simple model the Variable Costs share a Linear Relationship with Units Produced, as units produced increase so too do Variable Costs
In more complicated analysis Variable Costs change in relation to the Activity Base

11. Activity Base The Activity Base is whatever causes the costs to vary
In the simple model the Units Produced are the Activity Base
The Activity Base can be anything
Common Activity Base’s can be:
Batches of Production
Changes to Direct Labour
But there are many more, and often they are unique to the organisation

12. Example
There is a good example of this in your Text (pg 175)

14. Example
A good example of this is the Variable Cost of offering some Services
We are an Electrical Repair Company
Our Allocation base is Number of Repair Jobs Completed per day
We pay our Repairman a daily wage of $10
Our Repairman completes 5 Jobs per day

15. Ctd
Our Allocation Base is therefore not the number of Jobs completed but how many Repairmen we need to employ to service the demand
We can understand this cost by plotting a Graph of $ cost and Jobs completed assuming that each Repairman completes 5 Jobs per day

16. Repairman Step Variable Cost

17. Linearity Assumptions
Economics states that cost behave in a curvilinear way
Accountants assume Linear Relationships (or as we have seen Step Variability)
Who is right?
Its the Economists

19. Why Curvilinear?
There are economies and diseconomies of scale. For instance:
Price per unit of raw material will often fall as larger numbers of units are orders
Prices are subject to discounts for minimum orders
As Volume increases more problems can occur in production or larger units of labour are required than in a strict linear relationship

20. Fixed Costs
In the modern manufacturing environment there is a Trend to Fixed Costs
The Manufacturing Environment has become dominated by Technology
The Price of operating and maintaining highly technical equipment is very high
This has meant that Overheads such as maintenance and depreciation of machinery has become the major cost, rather than Labour or Direct Materials

21. Committed Fixed Costs Types of Committed Fixed Costs
Investment in Facilities, Machinery and Depreciation
Salaries of Managers and Costs of Sales
Committed Fixed Costs generally
Remain relatively constant
Stay stable over fairly long periods of time

22. Discretionary Fixed Costs
Types of Discretionary Fixed Costs
Advertising
Research and Development
Company Relations
Discretionary Fixed Costs will generally
Have a short term planning horizon
Be relatively unique

23. Fixed Costs and the Relevant Range
Fixed costs are subject to the same relevant range idea as Variable costs
Fixed Costs tend to step in line with production
Therefore we need to understand how relevant the range is to our cost assumptions

24. The Relevant Range

25. Cost Analysis
So we need to ‘diagnose’ the costs involved and discover the ‘relevant range’ that applies to our production levels
We can do this by plotting graphs of Dependant Variables and Independent Variables

26. Dependant Variables Dependant Variables are plotted on the Y axis
Dependant Variables are always the cost

27. Independent Variables
Independent Variables are plotted on the X Axis
Independent Variables are the Activity Base

29. Identifying the Relevant Range
The Relevant Range can be identified by plotting a scatter graph and applying linearity where it is seen
You run a hotel, it has enough room for a maximum of 60 Guests, and you have the following cost information

30. Hotel Stays (People)
Cost $ 10 80 15 20 25 30 35 88 40
96.8 45
106.48 50 55 60

32. Seminar Exercises

33. Cost Analysis
1) You Have the following information: Direct Materials $4 per unit Direct Labour $3 per unit Indirect Costs $3 per unit Total Units Produced 20 Sales Margin 25% Provide the following information Total Indirect Costs Total Costs per unit Selling Price Revenue

34. Answers Total Indirect Costs $60 (20 x 3)
Total Cost per unit $10 (4+3+3)
Selling Price =$12.50 (10 x 25% + TC)
Revenue = $12.50 x 20 units = $250

35. Cost Behaviour
Produce a Table of the costs including columns for Units, Fixed, Variable, Total Costs and Revenue

36. Units
Variable
Fixed
Total
Revenue 1 7 60 67
12.5 2 14 74 25 3 21 81
37.5 4 28 88 50 5 35 95
62.5 6 42
102 75 49
109
87.5 8 56
116
100 9 63
123
112.5 10 70
130
125 11 77
137
137.5 12 84
144
150 13 91
151
162.5 98
158
175 15
105
165
187.5 16
112
172
200 17
119
179
212.5 18
126
186
225 19
133
193
237.5 20
140
250

37. Plotting Graphs
Plot a Graph to contain all of the information that you have produced

39. Relevant Ranges
Plot a Graph for the following information and show where the relevant range is
Predicted Costs
Actual Costs 1
0.5 2 3
2.2 4 5 6 7 8 10 9
12.5
15.625

41. Review Questions What is Cost Behaviour? What is Linearity?
Is Linearity true?
What can cause Curvilinear Cost Behaviour?
What is the Relevant Range?
How can we identify the Relevant Range