Cost Behavior: Analysis and Use

Dr. Emon Kalyan Chowdhury

Ph.D. in Accounting, MBA in Accounting, MBA in Finance, MBA in HRM
Associate Professor & Head
Department of Accounting
CIU Business School
Chittagong Independent University.
 Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from Chapter 1.

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity
level within the relevant range.
Fixed Total fixed cost remains the
same even when the activity
level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.

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 Total Variable Cost Example

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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 Variable Cost Per Unit Example

The cost per minute talked is constant. For

example, 10 cents per minute.

Telephone Charge
Per Minute

Minutes Talked
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 Total Fixed Cost Example
Your monthly basic telephone bill is probably
fixed and does not change when you make
more local calls.
Monthly Basic
Telephone Bill

Number of Local Calls

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 Fixed Cost Per Unit Example
The fixed cost per local call decreases as
more local calls are made.

Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
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 Cost Behavior
Examples of normally variable costs
Merchandisers Service Organizations
Cost of Goods Sold Supplies and travel

Manufacturers Merchandisers and

Direct Material, Direct Manufacturers
Labor, and Variable Sales commissions and
Manufacturing Overhead shipping costs

Examples of normally fixed costs

Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising
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 Types of Fixed Costs
Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
reduced in the short short-term by current
term. managerial decisions

Examples Examples
Depreciation on Advertising and
Buildings and Research and
Equipment Development
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 Mixed Costs

A mixed cost
has both fixed
and variable
components.
Consider the
following electric
utility example.

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 Mixed Costs

Y
Total Utility Cost

ost
d c Variable
i x e
l m Utility Charge
t a
To
Fixed Monthly
Utility Charge
X
Activity (Kilowatt Hours)
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 Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Y
Where: Y = the total mixed cost
bX
Total Utility Cost

a +
a = the total fixed cost (the
Y =
vertical intercept of the line)
ost
d c b = the variable Variable
cost per unit of
i x e
l m activity (the slopeCharge
Utility of the line)
t a
To X = the level of activity

Fixed Monthly
Utility Charge
X
Activity (Kilowatt Hours)
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 Mixed Costs

Y
bX
Total Utility Cost

a +
Y =
ost
d c Variable
i x e bX
l m Utility Charge
t a
To
Fixed Monthly
a Utility Charge
X
Activity (Kilowatt Hours)
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 The Analysis of Mixed Costs

Account Analysis

Engineering Approach

High-Low Method

Scattergraph Method

Least-Square Regression Method

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 Account Analysis

Each account is classified as either

variable or fixed based on the analyst’s
knowledge of how the account behaves.
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 Engineering Estimates

Cost estimates are based on an evaluation

of production methods, and material, labor
and overhead requirements.

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 The High-Low Method
WiseCo recorded the following production activity and
maintenance costs for two months:

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600
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
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = Changein cost

Change in units

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = $1,600 + $0.90X

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 Note
 How does the high-low method work when you
have data for more than two periods?
Patients Costs of
Admitted Admitting
March 2,510 $ 15,204
April 2,550 $ 14,976
Low May 2,480 $ 14,680
June 2,590 $ 15,108
High July 2,670 $ 15,060
 Select the two periods with the lowest and
highest level of activity.
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 The Scattergraph Method
Plot the data points on a
graph (total cost vs. activity).
Y
20
1,000’s of Dollars

* ** *
Total Cost in

* *
**
10 * *

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

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 The Scattergraph Method
Draw a line through the data points with about an
equal numbers of points above and below the line.
Y
20
1,000’s of Dollars

* ** *
Total Cost in

* *
**
10 * *

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

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 The Scattergraph Method
The slope of this line is the variable unit
cost. (Slope is the change in total cost
Y for a one unit change in activity).
20
1,000’s of Dollars

* ** *
Total Cost in

* *
**
10 * *
Estimated fixed cost = $10,000

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

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 The Scattergraph Method
Change in cost
Slope =
Change in units
Y
20
1,000’s of Dollars

* ** * Vertical
Total Cost in

* * distance
** is the
10 * * change
in cost.
Horizontal distance is
the change in activity.
0 X
0 1 2 3 4
Activity, 1,000’s of Units Produced

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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
also provides
providesaastatistic,
statistic, called
called
22
the
the adjusted R ,,that
adjusted R thatis
is aameasure
measure ofof the
thegoodness
goodness
of
of fit
fitof
ofthe
theregression
regressionline
lineto
tothe
thedata
datapoints.
points.
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 Least-Squares Regression Method
R2 is the percentage of the variation
in total cost explained by the activity.
Y
20
* ** *
Total Cost

* * **
10 * *
R2 for this relationship is near
100% since the data points are
0 very close to the regression line.
X
0 1 2 3 4
Activity
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 Least-Squares Regression Method

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 Note
 Let’s plot the data for patient admitting costs.

$15,400
Patient Admitting Costs

$15,200
$15,000
$14,800
$14,600
$14,400
$14,200
$14,000
2,450 2,500 2,550 2,600 2,650 2,700
Patients Admitted

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 Note
 Problems with the high-low method:
 Throws away information contained in all of the data
other than the low and the high points.
 The low and high levels of activity tend to be
unusual.
 You should always plot the data if you have
more than two points to make sure it even
makes sense to be using the high-low method.

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 The Contribution Format

Let’s put our

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

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 The Contribution Format
Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net income $ 10,000

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 Contribution Approach

(costs organized by function) (costs organized by behavior)

Sales $ 100,000 Sales $ 100,000

Less cost of goods sold 70,000 Less variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating expenses 20,000 Less fixed expenses 30,000
Net income $ 10,000 Net income $ 10,000

Used primarily for Used primarily by

external reporting. management.

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 Comparing Merchandising and
Manufacturing Activities

Merchandisers . . . Manufacturers . . .
 Buy finished  Buy raw materials.
goods.  Produce and sell
 Sell finished goods. finished goods.

MegaLoMart

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 Manufacturing Costs

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product

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 Direct Materials

Those materials that become an integral part

of the product and that can be conveniently
traced directly to it.

Example:
Example: AA radio
radio installed
installed in
in an
an
automobile
automobile

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 Direct Labor

Those labor costs that can be easily traced to

individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly
workers
workers
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 Manufacturing Overhead
Manufacturing costs that cannot be traced
directly to specific units produced.

Examples:
Examples: Indirect
Indirect labor
labor and
and indirect
indirect materials
materials

Wages paid to Materials used to

employees who are not
directly involved in
production work.
Examples: maintenance
workers, janitors and security
guards.
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support the production
process.
Examples: lubricants and
cleaning supplies used in the
automobile assembly plant.
© The McGraw-Hill Companies, Inc., 2002
 Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct
Direct Direct
Direct Manufacturi
Manufacturi
Material
Material Labor
Labor ng
ng
Overhead
Overhead

Prime Conversion
Cost Cost

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 Nonmanufacturing Costs

Marketing and Administrative

Selling Cost Cost

Costs necessary to get the All executive,

order and deliver the organizational, and
product. clerical costs.

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 Product Costs Versus Period Costs

Product costs include Period costs are not

direct materials, direct included in product
labor, and costs. They are
manufacturing expensed on the
overhead. income statement.
Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
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 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
 Prepaid expenses  Prepaid Expenses
 Merchandise inventory  Inventories
Raw Materials
Work in Process
Finished Goods

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 Balance Sheet

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
Materials waiting to
 Prepaid expenses be processed.
 Prepaid Expenses
Partially complete
Merchandise inventory  Inventories
products – some Raw Materials
material, labor, or Work in Process
overhead has been Finished Goods
added.
Completed products
awaiting sale.
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 The Income Statement
Cost of goods sold for manufacturers differs only
slightly from cost of goods sold for merchandisers.

Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory $ 14,200
+ Purchases 234,150
Goods available
for sale $ 248,350
- Ending
merchandise
inventory (12,100)
= Cost of goods
sold $ 236,250

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 Manufacturing Cost Flows

Balance Sheet Income

Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process

Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
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 Inventory Flows

Beginning
Beginning Additions
Additions Available
Available
balance
balance + $$$
$$$
= $$$$$
$$$$$
$$
$$

Available
Available _ Withdrawals
Withdrawals
Ending
Ending
$$$$$
$$$$$ $$$
$$$
= balance
balance
$$
$$

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 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw
materials inventory

Beginning
Beginning inventory
inventory is
is
the
the inventory
inventory carried
carried
over
over from
from the
the prior
prior
period.
period.

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 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used As
As items
items are
are removed
removed from from raw raw
in production
materials
materials inventory
inventory and and placed
placed
into
into the
the production
production process,
process, they they
are
are
Irwin/McGraw-Hill called
48 direct materials.
© The McGraw-Hill Companies, Inc., 2002
 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

Conversion
Conversion
materials inventory + Direct labor costs
costs are
are
+ Raw materials + Mfg. overhead
purchased = Total manufacturing
costs
costs incurred
incurred
= Raw materials costs to
to convert
convert thethe
available for use
in production
direct
direct material
material
– Ending raw materials into
into aa finished
finished
inventory
= Raw materials used product.
product.
in production

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 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory All
All manufacturing
manufacturing costs
costs incurred
incurred
= Raw materials used
in production
during
during the
the period
period are
are added
added toto the
the
beginning
beginning balance
balance of
of work
work in
in
process.
process.
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 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending work in
process inventory
Costs
Costs associated
associated with
with the
the goods
goods = Cost of goods
that
that are
are completed
completed during
during thethe manufactured.

period
period are
are transferred
transferred to
to finished
finished
goods
goods inventory.
inventory.
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 Product Costs - A Closer Look

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 Cost Classifications for Predicting
Cost Behavior

How
How aa cost
cost will
will react
react to
to
changes
changes in
in the
the level
level of
of
business
business activity.
activity.
Total
 Totalvariable
variablecosts
costs
change
changewhen
when activity
activity
changes.
changes.
Total
 Totalfixed
fixed costs
costs
remain
remainunchanged
unchanged
when
whenactivity
activitychanges.
changes.

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 Direct Costs and Indirect Costs

Direct costs Indirect costs

 Costs that can be  Costs cannot be easily
easily and conveniently and conveniently traced
traced to a unit of to a unit of product or
product or other cost other cost object.
objective.  Example:
 Examples: direct manufacturing
material and direct labor overhead

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 Differential Costs and Revenues

Costs and revenues that differ among

alternatives.
Example: You have a job paying $1,500 per month in your
hometown. You have a job offer in a neighboring city that pays
$2,000 per month. The commuting cost to the city is $300 per
month.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300
Irwin/McGraw-Hill 55 © The McGraw-Hill Companies, Inc., 2002
 Opportunity Costs
The potential benefit that is
given up when one alternative
is selected over another.

Example: If you were

not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
Irwin/McGraw-Hill 56 © The McGraw-Hill Companies, Inc., 2002
 Sunk Costs
Sunk costs cannot be changed by any decision. They are not
differential costs and should be ignored when making
decisions.

Example: You bought an automobile that cost

$10,000 two years ago. The $10,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $10,000 cost.

Irwin/McGraw-Hill 57 © The McGraw-Hill Companies, Inc., 2002

 Further Classification of Labor
Costs
Treated as
Idle Time manufacturing
overhead cost

Treated as
Overtime Premium
manufacturing
of Factory Workers
overhead cost

Labor Fringe Treated as indirect

Benefits labor or direct labor

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 Cost of Quality
Appendix B

Prevention Costs Appraisal Costs

Four Types of
Quality Costs

Internal External
Failure Costs Failure Costs

ISO 9000 standards have become an international

measure of quality.
Irwin/McGraw-Hill 59 © The McGraw-Hill Companies, Inc., 2002