3 -1

CHAPTER

Activity Cost
Behavior
 3 -2

Objectives
Objectives
1. Define cost behavior
After for fixed,
studying this variable, and
After studying this
mixed costs.chapter, you should
chapter, you should
2. Explain the role be
of the
ableresource
to: usage model
be able to:
in understanding cost behavior.
3. Separate mixed costs into their fixed and
variable components using the high-low
method, the scatterplot method, and the
method of least squares.
continued
continued
 3 -3

Objectives
Objectives
4. Evaluate the reliability of a cost equation.
5. Discuss the role of multiple regression in
assessing cost behavior.
6. Describe the use of managerial judgment in
determining cost behavior.
 Next
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3 Click
-4
Classifying Costs Here

By Behavior
Fixed
Variable
By Traceability
Direct
Indirect
By Function
Product
Period
 Cost Classifications
Next
Page
3 Click
-5
Here

by Behavior

Cost
Cost Behavior
Behavior
How
Howaacost
costwill
willreact
reactto
to
changes
changesin
inthe
thelevel
levelof
ofbusiness
businessactivity.
activity.

Total
Total variable
variable costs
costs change
change
when
when thethe level
level of
of activity
activity changes.
changes.
Total
Total fixed
fixed costs
costs remain
remain unchanged
unchanged
when
when thethe level
level of
of activity
activity changes.
changes.
 3 -6

Fixed
Fixed Costs
Costs
A
Acost
cost thatthat stays
stays the
the
same
same asas output
output changes
changes
isis aa fixed
fixed cost.
cost.
 Next
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Total Fixed Cost Here

A fixed cost is one that remains constant in total

even when the volume of activity changes.
Your monthly basic telephone bill probably does not change when you
make more local calls.
Telephone Bill
Monthly Basic

Number of Local Calls

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-8
Fixed Cost Per Unit Here

On a per unit basis, a fixed cost changes

as the volume of activity changes.
The average cost per local call decreases
as more local calls are made.

Telephone Bill per

Monthly Basic

Local Call
Number of Local
Calls
 3 -9

Fixed
Fixed Costs
Costs
Cutting machines are
leased for $60,000 per
year and have the
capacity to produce up
to 240,000 units a year.
 3 -10
Total Fixed Cost Graph
$120,000
Total Costs

$100,000
$80,000
$60,000 F = $60,000
Fixed
Fixed Costs
Costs
$40,000
$20,000
0 60 120 180 240
Units Produced (000)

Lease of Number Units

Machines of Units Cost
$60,000 0 N/A
60,000 60,000 $1.00
60,000 120,000 0.50
60,000 180,000 0.33
60,000 240,000 0.25
 3 -11
Unit Fixed Cost Graph
$1.00
Cost per Unit

$0.50
Fixed
Fixed Costs
Costs
$0.33

$0.25

0 60 120 180 240

Units Produced (000)

Lease of Number Units

Machines of Units Cost
$60,000 0 N/A
60,000 60,000 $1.00
60,000 120,000 0.50
60,000 180,000 0.33
60,000 240,000 0.25
 3 -12

A
Avariable
variable costcost isis aa cost
cost that,
that,
in
in total,
total, varies
varies in in direct
direct
proportion
proportion to to changes
changes in in
output.
output.

Variable
Variable
Cost
Cost
 Next
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3 -13
Total Variable Cost
Click
Here

A variable cost is one that changes in total

in proportion to changes in the volume of activity.
Your total long distance telephone bill
is based on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
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3 -14
Variable Cost Per Unit
Click
Here

On a per unit basis, a variable cost

remains constant over a wide range of activity.
The cost per long distance minute talked is constant.
For example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
 3 -15

Variable
Variable Cost
Cost
As the cutting machines cut each unit,
they use 0.1 kilowatt-hour at $2.00 per
kilowatt hour. Thus, the cost of each
unit is $0.20 ($2 x 0.1).
 3 -16
Total Variable Cost Graph

Total Costs $48,000

Yv = .20x
$36,000
$24,000 Variable
Variable Cost
Cost
$12,000
0 60 120 180 240
Units Produced (000)

Cost of Number Units

Power of Units Cost
$ 0 0 $ 0
12,000 60,000 0.20
24,000 120,000 0.20
36,000 180,000 0.20
48,000 240,000 0.20
 3 -17
Unit Variable Cost Graph

Cost per Unit $0.40

$0.30
$0.20
$0.10
Variable
Variable Cost
Cost
0
60 120 180 240
Units Produced (000)

Cost of Number Units

Power of Units Cost
$ 0 0 $ 0
12,000 60,000 0.20
24,000 120,000 0.20
36,000 180,000 0.20
48,000 240,000 0.20
 3 -18

A
Amixed
mixed cost
cost isis aa cost
cost
that
that has
has both
both aa fixed
fixed and
and
aa variable
variable component.
component.
 3 -19

Sales representatives
often are paid a
salary plus a
commission on sales.
 Mixed Cost Behavior 3 -20

$130,000
$110,000
Total Costs

$90,000
$70,000
$50,000
$30,000

0 40 80 120 160 180 200

Units Sold (000)

Variable Fixed Total Selling

Inserts Cost of Cost of Selling Cost per
Sold Selling Selling Cost Unit
40,000 $ 20,000 $30,000 $ 50,000 $1.25
80,000 40,000 30,000 70,000 0.86
120,000 60,000 30,000 90,000 0.75
160,000 80,000 30,000 110,000 0.69
200,000 100,000 30,000 130,000 0.65
 Cost Classifications for
Next
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3 -21
Click
Here

Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
 Classification of Costs
Next
Page
3 -22
Click
Here

by Traceability
Direct Costs Indirect Costs
Costs that can Costs cannot
be easily and conveniently be easily and conveniently
traced traced
to a unit of product or other to a unit of product or other
cost objective. cost objective.
Examples: Example:
Direct material Manufacturing overhead
Direct labor
 Next
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3 -23
Cost Classification by Function
Click
Here

Product costs Period costs

Include expenditures Include expenditures
that are identified more with a
necessary and integral time period than with
to finished products. finished products.

Capitalized on the Expensed on the

balance sheet until sold. income statement.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 Next
Page
3 -24
Classification of Costs by Function
Click
Here

Product Costs Period Costs

Direct materials Selling
Direct labor General and administrative
expenses
Overhead
 3 -25

Activity Cost Behavior Model

Input:
Materials
Energy Activity
Activities Output
Labor
Capital

Changes
in Input Changes
Cost in Output
Cost Behavior
 3 -26

Flexible
Flexible resources
resources are
are
resources
resources acquired
acquired as
as used
used
and
and needed.
needed. Materials
Materials and
and
energy
energy are
are examples.
examples.
 3 -27

Committed
Committed resources
resources are
are supplied
supplied inin
advance
advance ofof usage.
usage. Buying
Buying or or leasing
leasing aa
building
building isis an
an example
example of
of this
this form
formofof
advance
advance resource
resource acquisition.
acquisition.
 3 -28

A
Astep
step cost
cost displays
displays aa constant
constant level
level
of
of cost
cost for
for aa range
range of
of output
output and
and then
then
jumps
jumps toto aa higher
higher level
level of
of cost
cost at
at some
some
point.
point.

Step-Cost Behavior
 3 -29

Step-Cost Behavior
Cost
$500

400

300

200

100

10 20 30 40 50
Activity Output (units)
 3 -30

Step-Fixed Costs
Cost

$150,000

Normal
100,000 Operating
Range
50,000 (Relevant
Range)

2,500 5,000 7,500

Activity Usage
 3 -31

Step-Cost
Step-Cost Behavior
Behavior
Three engineers hired at $50,000 each

Each engineer is capable of processing 2,500

change orders
$90,000 was spent on supplies for the
engineering activity
There were 6,000 orders processed

The company could process as many as 7,500

orders
 3 -32

Step-Cost
Step-Cost Behavior
Behavior

Available orders = Orders used + Orders unused

7,500 orders = 6,000 orders + 1,500 orders
Fixed engineering rate = $150,000/7,500
= $20 per change order
Variable engineering rate = $90,000/6,000
= $15 per change order
 3 -33

Step-Cost
Step-Cost Behavior
Behavior

The relationship between resources supplied and

resources used is expressed by the following
equation:
Resources available = Resources used + Unused
capacity
 3 -34

Step-Cost
Step-Cost Behavior
Behavior
Cost of orders supplied = Cost of orders used +
Cost of unused orders
= [($20 + $15) x 6,000] + ($20
x 1,500)
= $240,000
The $30,000 of excess engineering capacity
means that a new product could be
Equal to the $150,000 spent on
introducedengineers
without and
increasing current
the $90,000
spending on engineering.
spent on supplies.
 3 -35

Methods
Methods for
for Separating
Separating Mixed
Mixed Costs
Costs
The High-Low Method

The Scatterplot Method

The Method of Least Squares

Variable
Component
Fixed
Component
 3 -36

The linearity assumption

assumes that variable costs
increase in direct proportion to
the number of units produced
(or activity units used).
 3 -37

Methods
Methods for
for Separating
Separating Mixed
Mixed Costs
Costs

Y = a + bx

Total Cost
Total Fixed
Variable
Number of
CostCostUnits
per
Unit
 3 -38

The
The High-Low
High-Low Method
Method

Month Setup Costs Setup Hours

January $1,000 100
February 1,250 200
March 2,250 300
April 2,500 400
May 3,750 500

Step
Step 1:
1: Solve
Solve for
for variable
variable cost
cost (b)
(b)
 3 -39

The
The High-Low
High-Low Method
Method

Month Setup Costs Setup Hours

January $1,000 200
February 1,250 100
March 2,250 300
April 2,500 400
May 3,750 500

High Cost Low Cost

b=
High Units Low Units
 3 -40

The
The High-Low
High-Low Method
Method

Month Setup Costs Setup Hours

January $1,000 100
February 1,250 200
March 2,250 300
April 2,500 400
May 3,750 500

High
$3,750
Cost Low Cost
b=
High500
Units Low
Low Units
Units
 3 -41

The
The High-Low
High-Low Method
Method

Month Setup Costs Setup Hours

January $1,000 100
February 1,250 200
March 2,250 300
April 2,500 400
May 3,750 500

$3,750 Low
$1,000
Cost
b=
500 Low
100
Units
 3 -42

The
The High-Low
High-Low Method
Method
$3,750 $1,000
b=
500 100

bb == $6.875
$6.875

Step
Step 2:
2: Using
Using either
either the
the high
high cost
cost or
or low
low cost,
cost,
solve
solve for
for the
the total
total fixed
fixed cost
cost (a).
(a).
 3 -43

The
The High-Low
High-Low Method
Method

Y = a + b (x) High
$3,750 = a + $6.875(500) End
$312.50 = a
Y = a + b (x) Low
$1,000 = a + $6.875(100) End
$312.50 = a
The cost formula using the high-low method is:
Total cost = $312.50 + ($6.875 x Setup hours)
 3 -44

The
The Scatterplot
Scatterplot Method
Method
 The
The Scatterplot
Scatterplot Method
3 -45

Method
Nonlinear Relationship
Activity
Cost

* *
*

*
*

0 Activity Output
 The
The Scatterplot
Scatterplot Method
3 -46

Method
Upward Shift in Cost Relationship
Activity
Cost

* *
*

*
*
*

0 Activity Output
 The
The Scatterplot
Scatterplot Method
3 -47

Method
Presence of Outliers
Activity
Cost
*
*
*
Estimated
regression
*
line
*
*
Estimated
fixed cost
0 Activity Output
 3 -48

The
The Method
Method of
of Least
Least Squares
Squares
Month Setup Costs Setup Hours
Jan 1,000 100
Feb 1,250 200
Mar 2,250 300
Apr 2,500 400
May 3,750 500

Spreadsheet Data for

Larson Company
 3 -49

The
The Method
Method of
of Least
Least Squares
Squares
Regression Output:
Constant 125
Std. Err of Y Est 299.304749934466
R Squared 0.944300518134715
No. of Observation 5
Degrees of Freedom 3
X Coefficient(s) 6.75
Std. Err of Coef. 0.9464847243

Regression Output for

Larson Company
 3 -50

The
The Method
Method of
of Least
Least Squares
Squares

The results give rise to the following equation:

Setup costs = $125 + ($6.75 x Setup hours)
R2 = .944, or 94.4 percent of the variation in
setup costs is explained by the number of setup
hours variable.
 3 -51

Coefficient
Coefficient of
of Correlation
Correlation
Positive Correlation

r approaches +1

Machine Utilities Machine Utilities

Hours Costs Hours Costs
 3 -52

Coefficient
Coefficient of
of Correlation
Correlation
Negative Correlation

r approaches -1

Hours of Industrial Hours of Industrial

Safety Accidents Safety Accidents
Training Training
 3 -53

Coefficient
Coefficient of
of Correlation
Correlation
No Correlation

r~0

Hair Accounting Hair Accounting

Length Grade Length Grade
 3 -54

Multiple
Multiple Regression
Regression

TC = b0 + ( b1X1) + (b2X2) + . . .
b0 = the fixed cost or intercept

b1 = the variable rate for the first independent variable

X1 = the first independent variable

b2 = the variable rate for the second independent variable

X2 = the second independent variable

 3 -55

Multiple
Multiple Regression
Regression
Month Mhrs Summer Utilities Cost
Jan 1,340 0 $1,688
Feb 1,298 0 1,636
Mar 1,376 0 1,734
April 1,405 0 1,770
May 1,500 1 2,390
June 1,432 1 2,304
July 1,322 1 2,166
August 1,416 1 2,284
Sept 1,370 1 1,730
Oct 1,580 0 1,991
Nov 1,460 0 1,840
Dec 1,455 0 1,833

Data for Phoenix Factory

Utilities Cost Regression
 3 -56

Multiple
Multiple Regression
Regression
Constant 243.1114997159
Std Err of Y Est 55.5082829356447
R Squared 0.96717927255452
No. of Observation 12
Degrees of Freedom 9

X Coefficient(s) 1.0971575051946 510.49073361447

Std Err of Coef. 0.210226332115593 32.5489464532519

Multiple Regression for Phoenix

Factory Utilities Cost
 3 -57

Multiple
Multiple Regression
Regression

The results gives rise to the following equation:

Utilities cost = $243.11 + $1.097(Machine hours) +
($510.49 x Summer)
R2 = .967, or 96.7 percent of the variation in utilities
cost is explained by the machine hours and summer
variables.
 3 -58

Managerial
Managerial Judgment
Judgment

Managerial
Managerial judgment
judgment isis critically
critically
important
important in
in determining
determining cost cost
behavior,
behavior,and
and itit isis by
by far
farthe
themost
most
widely
widely used
used method
method in in practice.
practice.
 3 -59

Chapter Three

The
The End
End
3 -60