1. Cost Behavior: Analysis and Use
Chapter 5
Cost Behavior: Analysis and Use
Chapter 5: Cost Behavior: Analysis and Use.
Managers who understand how costs behave are better able to predict costs and make decisions under various circumstances. This chapter explores the meaning of fixed, variable and mixed costs (the relative proportions of which define an organization’s cost structure). It also introduces a new income statement format called the contribution approach.

2. April 16, 2010 A more detailed look at costs and cost behaviour
A detailed understanding of cost behaviour helps in forecasting, budgeting and planning for the future
Walk through a wide variety of account items
Establish formulae for forecasting/budgeting
Contribution analysis
Introduction to Variable Costing

3. Types of Costs & Behaviours
Variable Costs
Total Variable Cost is proportional to activity levels
Variable Cost per unit remains the same regardless of volume (at least within a relevant range)
Variable Costs may become smaller per unit once certain volume thresholds are reached
E.g., paper for a book publisher
True Variable Costs are costs which are completely proportional to volume
Step Variable Costs are those which increase in step functions; e.g., industrial engineers

4. Types of Cost Behaviours
Fixed Costs
Total Fixed Costs remain the same regardless of activity level (again, within a relevant range)
At certain higher levels of activity, fixed costs may need to be stepped up; e.g., new facility
Fixed Cost per unit decreases as activity increases

5. Fixed – Variable Ratio
Different types of companies have different levels of Fixed and Variable Costs
High fixed costs (lower variable) – e.g., power generator
Regardless of output, the huge plant & equipment costs must be borne
High variable costs – e.g., a cleaning company
As activity increases, the company can usually hire more staff easily
As activity decreases, it may however have some difficulty reducing staff levels, depending on labour laws
Companies with high fixed costs must reach a certain volume to “defray” their fixed costs and break even
Are your Group Project companies higher in fixed or variable costs?

6. Fixed Monthly Utility Charge
Mixed Costs
A mixed cost has both fixed and variable components. Consider your utility costs. X Y
Total mixed cost
Total Utility Cost
A mixed cost contains both variable and fixed cost elements. For example, utility bills often contain fixed and variable cost components. The fixed portion of the utility bill is constant regardless of kilowatt hours consumed. This cost represents the minimum cost that is incurred to have the service ready and available for use. The variable portion of the bill varies in direct proportion to the consumption of kilowatt hours.
Variable Cost per KW
Fixed Monthly Utility Charge
Activity (Kilowatt Hours)

7. Committed versus Discretionary
Committed Costs
Those which an organization is committed to; i.e., it cannot easily get out of incurring them
Depreciation on a building
Although you could sell the building to avoid the depreciation, it is a significant undertaking
When budgeting, particularly for downside risk, these costs will likely remain in place and put significant downward pressure on margins

8. Committed versus Discretionary
Discretionary Costs
Costs that can be easily added or removed
A salesman’s meals & entertainment
Others?
These are the costs that can be most easily removed in periods of lower volumes

9. Accounts For each of the following accounts
Identify all cost characteristics - Fixed, Variable, Sunk, Opportunity, Product, etc.
Predict the cost behaviour graphically (X axis = cost; Y axis = volume)
Develop an cost equation for forecasting and budgeting
Assume that (a) Annual revenue growth at 5%; (b) at 20%
Accounts
Direct Labour
Direct Materials
Manufacturing Overhead
COGS

10. Accounts Accounts Direct Labour Direct Materials
Manufacturing Overhead
COGS
Gross Margin
Lease costs
Human Resources IT
Finance and Accounting
Procurement
Customer Service

11. Accounts Accounts Sales Commissions Travel Meals & Entertainment
Shipping
Executives
Clerical Support
Sales and Administration
EBIT or Operating Income
Interest Expense
Taxes
Net Income

12. Three Methods of Modeling Variable Portion of Costs
Scatter graph method
High-low method
Least squares regression analysis

13. Contribution Margin Contribution = Sales less Variable Costs
It is the amount from each unit sold that contributes to first covering fixed costs, then contributes to earnings
In this case, the contribution margin is 60%
Managers know that once break even is reached, every additional sale will increase income by $15

14. Overview of Absorption and Variable Costing
Absorption Costing
Variable Costing
Product Costs
Period Costs
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Product Costs
Period Costs
Absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.
Variable costing treats only those costs of production that vary with output as product costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred.

15. Comparison of Absorption and Variable Costing
In simple terms, the only difference between variable and absorption costing is that fixed overhead is separated and treated as a non-product cost (ie, a period cost)
Variable Costing becomes very useful for analyzing different volume scenarios

16. Review A more detailed look at costs and cost behaviour
A detailed understanding of cost behaviour helps in forecasting, budgeting and planning for the future
Walk through a wide variety of account items
Establish formulae for forecasting/budgeting
Contribution analysis
Introduction to Variable Costing

17. Tutorial