1. Copyright © 2008 Prentice Hall All rights reserved 6-1 Cost Behavior Chapter 6

2. Copyright © 2008 Prentice Hall All rights reserved 6-2 Objective 1 Describe key characteristics and graphs of various cost behaviors

3. Copyright © 2008 Prentice Hall All rights reserved 6-3 Cost Behavior There are three common cost behaviors: 1.Variable costs 2.Fixed costs 3.Mixed costs

4. Copyright © 2008 Prentice Hall All rights reserved 6-4 Key Characteristics of Variable Costs Total variable costs change in direct proportion to changes in volume The variable cost per unit of activity (v) remains constant and is the slope of the variable cost line Total variable cost graphs always begin at the origin (if volume is zero, total variable costs are zero) Total variable costs can be expressed as:  y = vx Where: Y = total variable cost V = variable cost per unit of activity X = volume of activity

5. Copyright © 2008 Prentice Hall All rights reserved 6-5 Total Variable Costs

6. Copyright © 2008 Prentice Hall All rights reserved 6-6 Key Characteristics of Fixed Costs Total fixed costs stay constant over a wide range of volume Total fixed cost graphs are always flat lines with no slope The flat (horizontal) line intersects the y-axis at the level equal to the fixed cost Total fixed cost can be expressed as y = f where  Y = total fixed cost  F = fixed cost over a given period of time Fixed costs per unit of activity vary inversely with changes in volume  Fixed cost per unit of activity increases when volume decreases  Fixed cost per unit of activity decreases when volume increases

7. Copyright © 2008 Prentice Hall All rights reserved 6-7 Total Fixed Costs

8. Copyright © 2008 Prentice Hall All rights reserved 6-8 Key Characteristics of Mixed Costs Total mixed costs increase as volume increases because of the variable cost component Total mixed cost graphs slope upwards but do not begin at the origin; they intersect at the y-axis at the level of the fixed costs Total mixed costs can be expressed as a combination of the variable and fixed cost equations:  Total mixed costs = variable cost component + fixed cost 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 © 2008 Prentice Hall All rights reserved 6-9 Mixed Costs Variable Fixed

10. Copyright © 2008 Prentice Hall All rights reserved 6-10 S6-1 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 F ? V V F F ? What would you consider grill cloths and glue? Are they fixed or variable costs?

11. Copyright © 2008 Prentice Hall All rights reserved 6-11 E6-16 a. Graph of Variable Costs

12. Copyright © 2008 Prentice Hall All rights reserved 6-12 E6-16 b. Graph of Mixed Costs

13. Copyright © 2008 Prentice Hall All rights reserved 6-13 E6-16 c. Graph of Fixed Costs

14. Copyright © 2008 Prentice Hall All rights reserved 6-14 Objective 2 Use cost equations to express and predict costs

15. Copyright © 2008 Prentice Hall All rights reserved 6-15 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 If there is a change in cost behavior it means that the relevant range needs to be adjusted

16. Copyright © 2008 Prentice Hall All rights reserved 6-16 Other Cost Behaviors Step Costs – Fixed over small range of activity; then jump to new fixed level

17. Copyright © 2008 Prentice Hall All rights reserved 6-17 Other Cost Behaviors Curvilinear Costs – Are not linear and do not fit into any neat pattern

18. Copyright © 2008 Prentice Hall All rights reserved 6-18 Garments 2,0003,5005,000 Total Variable Costs Total Fixed Costs Total Operating Costs Variable Cost/garment Fixed Cost/garment Average cost/garment E6-18. 1. 7,000 $1,500$2,625$3,750 $8,500$9,625$10,750 Garments 2,0003,5005,000 Total Variable Costs$1,500$2,625$3,750 Total Fixed Costs7,000 Total Operating Costs$8,500 ?$10,750 Variable Cost/garment$0.75 Fixed Cost/garment3.502.001.40 Average cost/garment$4.25$2.75 ? What happens to fixed cost per unit as the volume increases if variable costs per unit remain constant? Can you fill in the blanks ?

19. Copyright © 2008 Prentice Hall All rights reserved 6-19 E6-18. 3. Actual costs at 2,000 garments$8,500 Total predicted costs ($2.15 × 2,000 garments)(4,300 ) Underestimated costs$4,200

20. Copyright © 2008 Prentice Hall All rights reserved 6-20 E6-20 a. 1,000 x $26.43 $26,430 b. Total costs$26,430 Less total fixed costs(18,000) Total variable costs$8,430 ÷ 1,000 Variable cost per mailbox $8.43

21. Copyright © 2008 Prentice Hall All rights reserved 6-21 E6-20 c. y = $8.43x + $18,000 d. $26.43 x 1,200 mailboxes(=$31,716) e. y = ? If the cost equation is used, what will the cost be? Remember, we must add the fixed component to the variable component.

22. Copyright © 2008 Prentice Hall All rights reserved 6-22 E6-20 f. Using average at 1,000$31,716 Using cost equation28,116 $3,600

23. Copyright © 2008 Prentice Hall All rights reserved 6-23 Objective 3 Use Account Analysis and Scatter Plots to analyze cost behavior

24. Copyright © 2008 Prentice Hall All rights reserved 6-24 Account Analysis Account Analysis as it applies to cost behavior determination is the use of judgment to classify each general ledger account as variable, fixed or mixed cost Three common methods used to perform the analysis: Scatter Plots High-Low Method Regression Analysis

25. Copyright © 2008 Prentice Hall All rights reserved 6-25 Scatter Plots Use historical data to determine a cost’s behavior A 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

26. Copyright © 2008 Prentice Hall All rights reserved 6-26 Scatter Plot Example

27. Copyright © 2008 Prentice Hall All rights reserved 6-27 Objective 4 Use the High-Low Method to analyze cost behavior

28. Copyright © 2008 Prentice Hall All rights reserved 6-28 High-Low Method Method to separate mixed costs into variable and fixed components Select the highest level and the lowest level of activity over a period of time Uses the selected activity levels to create a total cost equation that defines the cost behavior

29. Copyright © 2008 Prentice Hall All rights reserved 6-29 High-Low Method: E6-23 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 ($5,830-$4,935) ÷ (17,300-14,500) $895 ÷ 2,800 = $0.32

30. Copyright © 2008 Prentice Hall All rights reserved 6-30 High-Low Method: E6-23 Step 2: Find the vertical intercept (fixed costs) = Total mixed cost – Total variable cost $5,830 – ($0.32 17,300) = $295 or $4,935 – ($0.32 14,500) = $295

31. Copyright © 2008 Prentice Hall All rights reserved 6-31 High-Low Method: E6-23 Step 3: Create and use an equation to show the behavior of a mixed cost Y = $0.32 per mile + $1,250 Predicted operating costs at 15,000 miles: ($0.32 15,000) + $1,250 = $6,050

32. Copyright © 2008 Prentice Hall All rights reserved 6-32 Objective 5 Use Regression Analysis to analyze cost behavior

33. Copyright © 2008 Prentice Hall All rights reserved 6-33 Regression Analysis Statistical procedure to find the line that best fits data Uses all data points Results in equation of line and an R- square value

34. Copyright © 2008 Prentice Hall All rights reserved 6-34 Three Pieces of Information Needed for Regression Analysis 1. The Intercept Coefficient – the vertical intercept; it is the fixed cost component of the mixed cost 2. The X Variable 1 coefficient is the line’s slope, or the variable cost per unit. 3. The R-square value – the goodness-of-fit statistic

35. Copyright © 2008 Prentice Hall All rights reserved 6-35 R-Square Value “Goodness of fit” How well does the line fit the data points? Ranges from 0 to 1  “0” – no relationship between costs and volume; activity is not a cost driver  “1” – perfect relationship; activity is a cost driver

36. Copyright © 2008 Prentice Hall All rights reserved 6-36 Data Concerns Seasonal variations Inflation Outliers – abnormal data points

37. Copyright © 2008 Prentice Hall All rights reserved 6-37 Objective 6 Prepare contribution margin income statements for service firms and merchandising firms

38. Copyright © 2008 Prentice Hall All rights reserved 6-38 Traditional Income Statement Sales - Cost of Goods Sold Gross Margin - Selling,general & administrative costs Operating Income

39. Copyright © 2008 Prentice Hall All rights reserved 6-39 Contribution Margin Income Statement Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income

40. Copyright © 2008 Prentice Hall All rights reserved 6-40 Contribution Margin Income Statement Predicts how changes in volume will affect operating income

41. 6-41 Rachel’s Rock Shop Income Statement For the year ending 20XX Revenue: Sales Revenue (27,000 + 7,000)$34,000 Rental Revenue22,000 Lesson Revenue40,000 Total Revenue$96,000 Less: Cost of Goods Sold (7,500 + 2,000) (9,500) Gross Margin$86,500 Less Operating Costs: Depreciation$ 4,000 Employee Salary expenses 30,000 Musician wages25,000 Lease12,000 Total operating costs71,000 Operating Income$15,500 P6-40b

42. Copyright © 2008 Prentice Hall All rights reserved 6-42 E6-25 Rachel’s Rock Shop Contribution Margin Income Statement For the year ending 20XX Revenue: Sales Revenue (27,000 + 7,000)$34,000 Rental Revenue22,000 Lesson Revenue40,000 Total Revenue$96,000 Less: Variable Costs Cost of Goods Sold (7,500 + 2,000)$ 9,500 Musician wages25,000 Total Variable costs (34,500) Contribution Margin$61,500 Less Fixed Costs: Depreciation$ 4,000 Employee Salary expenses 30,000 Lease12,000 Total fixed costs (46,000) Operating Income $15,500

43. Copyright © 2008 Prentice Hall All rights reserved 6-43 Objective 7 Use variable costing to prepare contribution margin income statements for manufacturers (Appendix)

44. Copyright © 2008 Prentice Hall All rights reserved 6-44 Variable Costing Assigns only variable manufacturing costs to products  Direct materials  Direct labor  Variable manufacturing overhead Fixed manufacturing overhead = period cost Contribution margin income statements  For internal management decisions

45. Copyright © 2008 Prentice Hall All rights reserved 6-45 Absorption Costing Required by GAAP for external reporting Assign all manufacturing costs to product  Direct materials  Direct labor  Variable manufacturing overhead  Fixed manufacturing overhead Traditional income statement

46. Copyright © 2008 Prentice Hall All rights reserved 6-46 Rays Conventional (Absorption Costing) Income Statement Year Ended December 31, 2008 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 $ ? E6-32 How do we derive operating income ?

47. Copyright © 2008 Prentice Hall All rights reserved 6-47 E6-32 Rays Contribution Margin (Variable Costing) Income Statement Year Ended December 31, 2008 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$2,000,000 Operating expenses 250,000 2,250,000 Operating income$ ? * computation of variable cost of goods sold What is difference in operating income? How does it compare to the operating income on the previous slide?

48. Copyright © 2008 Prentice Hall All rights reserved 6-48 E6-32 Variable cost of goods sold: Beginning finished goods inventory$ 0 Variable cost of goods manufactured 3,000,000 Variable cost of goods available for sale3,000,000 Ending finished goods inventory (225,000) Variable cost of goods sold$2,775,000 Back

49. Copyright © 2008 Prentice Hall All rights reserved 6-49 E6-32 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

50. Copyright © 2008 Prentice Hall All rights reserved 6-50 End of Chapter 6