1. Cost Behaviour: Part 1 of 2 Sections 1 and 2 January 30, 2013 Professor: Khim Kelly Office: HH386B Office Hours: Mon/Wed 11:30am – 12:30pm and Appointment Email: kokelly@uwaterloo.cakokelly@uwaterloo.ca TA: Kun Huo Email: khuo@uwaterloo.ca

2. 30 Jan 2013 Overview Study tip – Do your self-study problems without looking at the solutions! (solutions are posted on LEARN) Last lecture … – Finishing touches to Chapter 5 ABC – A complete ABC example Today’s lecture … – Introduction to cost behaviour (Chapter 6) – How to use costs behaviour to predict costs – Analyze mixed costs 2

3. Fixed costs vs. Variable costs Fixed costs – Committed – Discretionary Step-variable costs Mixed costs Cost Categories

4. From Chapter 2: Fixed vs. Variable Costs Total costs … – Total costs = Fixed costs + Variable costs Fixed costs (i.e. rent, insurance, etc.) – Costs that remain unchanged within a relevant range, regardless of the level of activity – Caveat: Most fixed costs will change if there is a large enough change in activity – Costs per unit of activity decreases as activity level increases Variable costs (i.e. DM, DL, sales commissions, shipping, etc.): – Costs that changes in direct proportion to changes in the level of activity within a relevant range – Costs per unit of activity is constant as activity level changes

5. From Chapter 2: Fixed vs. Variable Cost Activity $ Variable Cost Fixed Cost Relation Between Total Cost and the Level of Activity Activit y Fixed Cost Variable Cost Relation Between Cost per Activity and the Level of Activity

6. It is Clicker Time!! Feel Free to Work Together on Clicker Questions

7. Clicker Question #1 Q: Which of the following does NOT describe a variable cost? A.Variable costs are ALWAYS indirect costs to the cost object B.Variable costs increase in total when the actual level of activity increases. C.Variable costs (with respect to volume of goods produced) include direct labour costs D.Variable costs include costs that can be traced directly to the cost object E.Variable cost per unit does not change with activity level

8. Clicker Question #1: Answer Q: Which of the following does NOT describe a variable cost? Answer: A.Variable costs are ALWAYS indirect costs to the cost object

9. Otherwise known as capacity costs Constant in total dollars within the relevant range – Committed Particularly difficult to adjust, long-term: plants, major equipment, etc. – Discretionary More flexible, short-term: R&D, insurance, advertising More on Fixed Cost …

10. Costs that are incurred in ‘chunks’ – Fixed within a particular range, step in increments. – Be careful to prevent ‘fat’ build-up Examples – Salaried staff – Space – Delivery truck Step-Variable Cost

11. Fixed costs will change with a substantial change in volume/activity. – Isn’t this just a step-variable cost? Two key differences: – Width (volume of activity) of the step – Ease of making the step Fixed Cost vs. Step Variable

12. Elements of both fixed and variable – Some fixed cost even with no activity or regardless of activity level (intercept “a”) – Increasing per unit cost as activity climbs (slope “b”) Y = a + bX a = Fixed Cost b = per unit Variable Cost X = units of activity Y = Total mixed cost Mixed Cost Fixed (a) Variable (b) Y X

13. It is Clicker Time!! Feel Free to Work Together on Clicker Questions

14. Example: Mama Khim’s Kiosk Remember Mama Khim’s Kiosk (diapers and baby snack packs)? She needs your help classifying various costs as fixed or variable with respect to the volume of goods (diapers and snack packs) sold. Calculate the portion of variable and fixed costs.

15. Mama Khim’s Kiosk Example Monthly CostsVariableFixed 1. Mama Khim’s salary and benefits$3,800 2. Cost of diapers and snacks$14,100 3. Depreciation on the kiosk$5,900 4. Cost of packaging for diapers and snack packs$256 5. Cost of lubricant for machine used to seal snack packs (more lubricant needed when I seal more snack packs)$12 Total Costs$24,068??

16. Clicker Question #2 Q: Calculate the total variable and total fixed costs for the month A. Joe Mamma! B. Variable $14,100; Fixed $9,968 C. Variable $14,356; Fixed $9,712 D. Variable $14,368; Fixed $9,700 E. Variable $14,112; Fixed $9,956

17. Mama Khim’s Kiosk Example Monthly CostsVariableFixed 1. Mama Khim’s salary and benefits$3,800 2. Cost of diapers and snacks$14,100 3. Depreciation on the kiosk$5,900 4. Cost of packaging for diapers and snack packs$256 5. Cost of lubricant for machine used to seal snack packs (more lubricant needed when I seal more snack packs)$12 Total Costs$24,068$14,368$9,700

18. Clicker Question #2: Answer Calculate the total variable and total fixed costs for the month? Answer: D. Variable $14,368; Fixed $9,700

19. Mama Khim’s Kiosk Example #2 Mama Khim’s “Healthy” Baby Snack Pack is so popular that it is now shipped all over the world. Mama Khim is relying on you to determine whether the following expenses on her company’s income statement are variable, fixed, or mixed?

20. Mama Khim’s Kiosk Example #2 (P6- 12) AprilMayJune # of Sales units3,0003,7504,500 1. Cost of Goods Sold$168,000$210,000$252,000 2. Shipping Expense$44,000$50,000$56,000 3. Advertising Expense$70,000 4. Salaries and commissions$107,000$125,000$143,000 5. Insurance expense$9,000 6. Depreciation on kiosk$42,000 Information for the last 3 months:

21. Mama Khim’s Kiosk Example #2 (P6- 12) VariableFixedMixed 1. Cost of Goods Sold 2. Shipping Expense 3. Advertising Expense 4. Salaries and commissions 5. Insurance expense 6. Depreciation on kiosk X X Note: Variable cost per unit is constant as activity level increases. Mixed cost per unit tends to decrease as activity level increases due to the fixed cost component.

22. It is Clicker Time!! Feel Free to Work Together on Clicker Questions

23. Mama Khim’s Kiosk Example #2 Clicker Question #3 Q: What type of costs are 1) Advertising and 2) Salaries & Commissions? A. 1) Fixed; 2) Variable B. 1) Variable; 2) Variable C. 1) Fixed; 2) Mixed D. 1) Mixed; 2) Mixed E. 1) Mixed; 2) Variable

24. Mama Khim’s Kiosk Example #2 Clicker Question #3: Answer VariableFixedMixed 1. Cost of Goods Sold 2. Shipping Expense 3. Advertising Expense 4. Salaries and commissions 5. Insurance expense 6. Depreciation on kiosk X X X X Answer: C. 1) Fixed; 2) Mixed

25. Mama Khim’s Kiosk Example #2 (P6-12) VariableFixedMixed 1. Cost of Goods Sold 2. Shipping Expense 3. Advertising Expense 4. Salaries and commissions 5. Insurance expense 6. Depreciation on kiosk X X X X X X

26. How does management estimate both the fixed and variable components of costs? – High-low method – Least-squares regression Both … – Require repeated observations of activity level and cost – Result in an equation that contains a fixed cost and per-unit of activity variable cost – Assume linearity relationship between cost and activity Mixed Cost Analysis

27. High-Low Method Cost at highest activity level - Cost at lowest activity level Highest activity level - Lowest activity level 1.Identify the highest and lowest activity levels (NOT the highest and lowest costs) 2.Calculate variable cost component (b) 3.Use the variable cost component (b) with either the highest or lowest data point to calculate fixed cost component (a) VC per Unit = Mixed Cost: Y = a + b*X

28. Example: High-Low Method Cost at highest activity level - Cost at lowest activity level Highest activity level - Lowest activity level VC per Unit = MonthX-RaysCost Jan6,250$28,000 Feb7,00029,000 Mar5,00023,000 Apr4,25020,000 May4,50022,000 Jun3,00017,000 Jul3,75018,000 Aug5,50024,000 Sep5,75026,000

29. It is Clicker Time!! Feel Free to Work Together on Clicker Questions

30. Q: Use the high-low method to develop the equation for the cost data (select option that is closest to your answer). Clicker Question #4 Month Patient DaysMixed Cost Jan 3,700 27,750 Feb 3,200 22,000 March 4,400 31,000 April 5,000 34,500 May 2,700 28,000 June 2,500 22,500 July 3,600 26,500 Aug 1,800 18,750 Sept 4,650 36,500 Oct 3,900 24,000 Nov 2,100 22,500 Dec 4,500 26,750 A. Y = $5,412 + $10.98X B. Yellow = Go Karts + 9-irons C. Y = $8,887 + $5.12X D. Y = $9,891 + $4.92X E. Y = $11,556 + $2.67X

31. Clicker Question #4: Answer $34,500 - $18,750 5,000 - 1,800 = $15,750 3,200 = $4.92 per Patient-Day = Month Patient DaysMixed Cost Jan 3,700 27,750 Feb 3,200 22,000 March 4,400 31,000 April 5,000 34,500 May 2,700 28,000 June 2,500 22,500 July 3,600 26,500 Aug 1,800 18,750 Sept 4,650 36,500 Oct 3,900 24,000 Nov 2,100 22,500 Dec 4,500 26,750 $34,500a + ($4.92 * 5,000) = a$9,891 = Answer: D. Y = $9,891 +$4.92X Then:

32. Predicting Costs … Month Patient DaysMixed Cost Jan 3,700 27,750 Feb 3,200 22,000 March 4,400 31,000 April 5,000 34,500 May 2,700 28,000 June 2,500 22,500 July 3,600 26,500 Aug 1,800 18,750 Sept 4,650 24,500 Oct 3,900 24,000 Nov 2,100 22,500 Dec 4,500 26,750 What costs do we expect if patient days = 3,900 units? Y = $9,891 + $4.92X Y = $9,891 + $4.92*3,900 Y = $29,079 How did the hospital do?

33. Summary Today’s lecture … – Fixed costs, variable costs, step variable costs, mixed costs – How to use costs behaviour to predict costs – Analyze mixed costs (High-Low Method) Next lecture … – Analyze mixed costs (Regression) – Another example of High-Low method – Contribution margin approach

34. Additional Practice Try this question without using your notes. It is a good test of whether you understand the basics of using the high-low method to predict costs.

35. E6-10 Northern lights Inns have a total of 2,000 rooms. On average, 70% of them are occupied each day. On average, operating costs per room per day are $21 (assuming 30 day months). This contains both variable and fixed cost elements. During Oct, the occupancy rate dropped to 45%. A total of $792,000 in operating cost was incurred during Oct. Estimate variable cost per occupied room per day.

36. E6-10 Monthly operating costs at 70% occupancy: 2,000 rooms x 70% = 1,400 rooms 1,400 rooms x $21/day = $882,000 Monthly operating costs at 45% occupancy (given): = $792,000 Change in monthly costs = $ 90,000

37. E6-10 Rooms occupied at 70% occupancy: 2,000 rooms x 70% = 1,400 rooms Rooms occupied at 45% occupancy: 2,000 rooms x 45%= 900 rooms Change in monthly activity = 500 rooms

38. E6-10 Variable Costs = Change in Cost Change in Activity = 500 rooms $90,000 = $180 per room per month $180 per room 30 days in a month = $6 per room per day