Chapter 5

Cost Behavior:
Analysis and Use

Cost Behavior
How a cost will react or change as the
level of business activity changes
Cost can be either variable, fixed or mixed
Understanding cost behavior allows
managers to predict what costs will be at
various business activity levels
This information is essential for managing
your business efficiently

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Types of Cost Behavior

Patterns
Recall the summary of our cost behavior
discussion from Chapter 2.
Summary of Variable and Fixed Cost Behavior
Cost

In Total

Per Unit

Variable

Total variable cost is

proportional to the activity
level within the relevant range.

Variable cost per unit remains

the same over wide ranges
of activity.

Fixed

Total fixed cost remains the

same even when the activity
level changes within the
relevant range.

Fixed cost per unit goes

down as activity level goes up.

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The Activity Base

Units
Units
produced
produced

Machine
Machine
hours
hours
A
Ameasure
measure of
of the
the
event
event that
that causes
causes
the
the incurrence
incurrence of
of aa
variable
variable cost
cost aa
cost
cost driver
driver

Miles
Miles
driven
driven
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Labor
Labor
hours
hours

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True Variable Cost Example

Total Long Distance

Telephone Bill

Your total long distance telephone bill is

based on how many minutes you talk.

Minutes Talked
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Variable Cost Per Unit Example

Per Minute
Telephone Charge

The cost per minute talked is constant. For

example, 10 cents per minute.

Minutes Talked
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Step-Variable Costs

Cost

Total
Totalcost
cost remains
remains
constant
constantwithin
withinaa
narrow
narrow range
rangeof
of
activity.
activity.

Activity
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Step-Variable Costs

Cost

Total
Totalcost
cost increases
increasesto
toaa
new
new higher
highercost
costfor
for the
the
next
nexthigher
higherrange
rangeof
of
activity.
activity. i.e.,
i.e.,hiring
hiringan
an
additional
additional supervisor
supervisoror
or
maintenance
maintenanceworker.
worker.

Activity
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Relevant Range
A range of business activity within which
the assumptions made about cost
behavior are valid.
Variable costs on a per unit basis remain
the same within the relevant range, and in
total vary directly with the level of activity
Fixed costs in total remain fixed within the
relevant range, but will change on a per
unit basis as the level of activity changes
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Total Fixed Cost Example

Exh.
5-5

Monthly Basic
Telephone Bill

Your monthly basic telephone bill is

probably fixed and does not change when
you make more local calls.

Number of Local Calls

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Fixed Cost Per Unit Example

Exh.
5-5

Monthly Basic Telephone

Bill per Local Call

The fixed cost per local call decreases as

more local calls are made.

Number of Local Calls

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Cost Behavior - Examples

Examples
Examples of
of normally
normally variable
variable costs
costs
Merchandisers
Merchandisers

Service
ServiceOrganizations
Organizations

Cost
Costof
ofGoods
GoodsSold
Sold

Supplies
Suppliesand
andtravel
travel

Manufacturers
Manufacturers

Merchandisers
Merchandisers and
and
Manufacturers
Manufacturers

Direct
DirectMaterial,
Material,Direct
Direct
Labor,
Labor,and
andVariable
Variable
Manufacturing
ManufacturingOverhead
Overhead

Sales
Salescommissions
commissionsand
and
shipping
shippingcosts
costs

Examples
Examples of
of normally
normally fixed
fixed costs
costs
Merchandisers,
Merchandisers, manufacturers,
manufacturers, and
and
service
serviceorganizations
organizations

Real
Realestate
estatetaxes,
taxes,Insurance,
Insurance,Sales
Salessalaries,
salaries,
Depreciation,
Depreciation,Advertising
Advertising
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Types of Fixed Costs

Committed
Committed

Discretionary
Discretionary

Long-term,
Long-term, cannot
cannot be
be
reduced
reducedin
in the
theshort
short
term.
term.

May
Maybe
bealtered
altered in
inthe
the
short-term
short-term by
bycurrent
current
managerial
managerial decisions
decisions

Examples
Examples

Examples
Examples

Depreciation
Depreciationon
on
Buildings
Buildingsand
and
Equipment,
Equipment,
Property
PropertyTaxes
Taxes

Advertising
Advertisingand
and
Research
Research and
and
Development
Development

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Fixed Costs and Relevant

Range
Example: Office space
is available at a rental
rate of $30,000 per year
in increments of 1,000
square feet. As the
business grows more
space is rented,
increasing the total
cost.
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Continue

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Rent Cost in
Thousands of Dollars

Fixed Costs and Relevant

Range

Exh.
5-6

90

60

30
00

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Relevant
Range

Total
Totalcost
costdoesnt
doesnt
change
changefor
foraawide
wide
range
rangeof
ofactivity,
activity,
and
andthen
thenjumps
jumpsto
toaa
new
newhigher
highercost
costfor
for
the
thenext
nexthigher
higher
range
rangeof
ofactivity.
activity.

1,000
2,000
3,000
Rented Area (Square Feet)

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Fixed Costs and Relevant

Range

How does this type

of fixed cost differ
from a step-variable
cost?

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Step-variable costs
can be adjusted more
quickly and . . .
The width of the
activity steps is much
wider for the fixed
cost.

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Quick Check
Which
Which of
of the
the following
following statements
statements about
about
cost
cost behavior
behavior are
are true?
true?
Fixed
Fixedcosts
costsper
perunit
unitvary
varywith
withthe
the level
levelof
of activity.
activity.
bb Variable costs per unit are constant within the
Variable costs per unit are constant within the
relevant
relevantrange.
range.
cc Total fixed costs are constant within the relevant
Total fixed costs are constant within the relevant
range.
range.
dd Total variable costs are constant within the
Total variable costs are constant within the
relevant
relevantrange.
range.
aa

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Mixed Costs
AAmixed
mixedcost
cost has
hasboth
bothfixed
fixed and
andvariable
variable
components.
components. Consider
Consider the
the example
example of
of utility
utilitycost.
cost.
Total Utility Cost

ta
o
T

xe
i
lm

os
c
d

t
Variable
Cost per KW

Activity (Kilowatt
Hours)
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Fixed Monthly
Utility Charge

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Mixed Costs

Total Utility Cost

ta
o
T

xe
i
lm

s
o
dc

a
=
Y

X
b
+

Variable
Cost per KW

Activity (Kilowatt
Hours)
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Fixed Monthly
Utility Charge

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Separating Variable and Fixed Costs

There are a number of methods for
separating variable and fixed costs for a
mixed cost total
Scattergraph
High-Low Method
Least Squares Regression

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The Scattergraph Method

Plot
Plot the
thedata
datapoints
pointson
onaa
graph
graph(total
(totalcost
cost vs.
vs. activity).
activity).

Total Cost in
1,000s of Dollars

Y
20

10

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* *
* *

* ** *
**
X

0
1
2
3
4
Activity, 1,000s of Units Produced

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Quick-and-Dirty Method
Draw
Draw aaline
linethrough
throughthe
thedata
datapoints
pointswith
withabout
aboutan
an
equal
equalnumbers
numbersof
ofpoints
points above
aboveand
and below
below the
the line.
line.
Total Cost in
1,000s of Dollars

Y
20

10

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* ** *
**

* *
*
* Intercept
is the estimated

Intercept is the estimated

fixed
fixedcost
cost==$10,000
$10,000

0
1
2
3
4
Activity, 1,000s of Units Produced

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Quick-and-Dirty Method
The
Theslope
slopeis
isthe
theestimated
estimatedvariable
variable cost
cost per
per unit.
unit.
Slope
Slope==Change
Changein
in cost
cost Change
Changein
inunits
units
Total Cost in
1,000s of Dollars

Y
20

10

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* *
*
*Horizontal
Horizontal

distance
distanceis
is
the
thechange
changein
in
activity.
activity.

* ** *
**
Vertical
Verticaldistance
distanceis
is
the
thechange
changein
incost.
cost.

0
1
2
3
4
Activity, 1,000s of Units Produced

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Calculating the Total Cost

Y = a + bX
a is the intersection of the slope line and
the y axis (fixed cost)
To find b, find a data point on the slope
line, and determine the level of activity (x
axis) and total cost (y axis)
Solve for b using the above equation
See example on page 204-05
Disadvantages: Outliers, accuracy of line
drawn through the dots
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The High-Low Method

(Use example on page 204)
WiseCo recorded the following production activity and
maintenance costs for two months:

Using these two levels of activity, compute:

the variable cost per unit;
the fixed cost; and then
express the costs in equation form Y = a + bX.

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The High-Low Method

cost in units
Variable cost per unit = Change Changein
in cost change
Change in units

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The High-Low Method

Variable cost per unit = $2,400 3,000 units

= $0.80 per unit

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The High-Low Method

Variable cost = $2,400 3,000 units = $0.80 per unit

Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)
Fixed cost = $9,800 $6,400 = $3,400
(or do the same calculation with the low activity level)

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The High-Low Method

Variable cost = $2,400 3,000 units = $0.80 per unit

Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)
Fixed cost = $9,800 $6,400 = $3,400

Total cost = Fixed cost + Variable cost (Y = a + bX)

Y = $3,400 + $0.80X
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Quick Check
Sales
Salessalaries
salariesand
and commissions
commissions are
are $10,000
$10,000when
when
80,000
80,000units
unitsare
aresold,
sold, and
and$14,000
$14,000when
when120,000
120,000units
units
are
aresold.
sold. Using
Using the
thehigh-low
high-low method,
method,what
what is
is the
the
variable
variable portion
portion of
of sales
salessalaries
salaries and
and commission?
commission?
a.
a. $0.08
$0.08per
perunit
unit
Units
Cost
b.
b. $0.10
$0.10per
perunit
unit
High level
120,000
$ 14,000
c.
c. $0.12
$0.12per
perunit
unit
Low level
80,000
10,000
d.
d. $0.125
$0.125per
perunit
unit Change
40,000
$ 4,000
$4,000 40,000 units
= $0.10 per unit
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Quick Check
Sales
Salessalaries
salariesand
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000units
unitsare
aresold,
sold, and
and$14,000
$14,000 when
when 120,000
120,000units
units
are
aresold.
sold. Using
Usingthe
thehigh-low
high-low method,
method,what
whatis
isthe
the
fixed
fixed portion
portionof
of sales
salessalaries
salariesand
andcommissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

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Mixed Cost Equation

If variable cost per unit is $.10 and fixed
cost is $2,000 then what is the Total cost
equation?
Y = $2,000 + $.10(X)

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Hi-Lo Disadvantages
Utilizes only two data points out of the
entire data base; not enough for accurate
results in cost analysis
Outliers could cause a major discrepancy
if they are selected as a high or low

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Least-Squares Regression
Method
Software can be used to fit
a regression line through
the data points.
The cost analysis objective
is the same: Y = a + bx

Least-squares
Least-squaresregression
regressionalso
alsoprovides
providesaa statistic,
statistic,
22
called
the
R
called the R ,,that
that is
is aameasure
measure of
of the
thegoodness
goodness
of
of fit
fitof
ofthe
theregression
regression line
lineto
tothe
thedata
data points.
points.
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Least-Squares Regression
Method
RR22 is
isthe
thepercentage
percentage of
ofthe
the variation
variation in
in total
total cost
cost
explained
explainedby
bythe
theactivity.
activity.
Y
Total Cost

20

* ** *
**

* *
* * R2 for this relationship is near

10

0
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100% since the data points are

very close to the regression line.
X
2
3
4
Activity

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Total Cost Formula using Least

Squares Method
Use the data provided by the least squares
for points a and b
See example on page 210
Result of least squares method:
Y = $3,431 + $0.759(X)

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Least Squares Disadvantages

Outliers can also cause least squares to
come up with a wrong answer.
Always use least squares on conjunction
with scatter grade to identify, and
eliminate if necessary, outliers that may
erroneously impact the results.

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Comparison of Methods
Scatter Graph
Y = $3,300 + $0.79(X)
High Low
Y = $3,400 + $0.80(X)
Least Squares
Y = $3,431 + $0.759(X)
Which one would you choose? Why?
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Lets put our

knowledge of cost
behavior to work by
preparing a
contribution format
income statement.

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Contribution Margin Approach

Provides the internal manager with an
income statement geared directly to cost
behavior; can predict future results
Contribution margin is what is left after
you subtract variable costs from sales
This allows you to determine if you are
selling enough product to cover your fixed
costs and, therefore, earn a profit
Provides ability to analyze profitability by
product line, operation, etc.
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The Contribution Format

(Requires Segregation of variable and fixed cost)
Sales Revenue
Less: Variable costs
Contribution margin
Less: Fixed costs
Net operating income

Total
$ 100,000
60,000
$ 40,000
30,000
$ 10,000

Unit
$ 50
30
$ 20

The contribution margin format emphasizes cost

behavior. Contribution margin covers fixed costs
and provides for income.
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The Contribution Format

Comparison of the Contribution Income Statement
with the Traditional Income Statement
Traditional Approach
(costs organized by function)

Contribution Approach
(costs organized by behavior)

Sales
$ 100,000
Less cost of goods sold
70,000
Gross margin
$ 30,000
Less operating expenses
20,000
Net operating income
$ 10,000

Sales
$ 100,000
Less variable expenses
60,000
Contribution margin
$ 40,000
Less fixed expenses
30,000
Net operating income
$ 10,000

Used primarily for

external reporting.
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Used primarily by
management. Not GAAP

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End of Chapter 5

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