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Chapter 5

Chapter 5. Cost Behavior: Analysis and Use. Types of Cost Behavior Patterns. Recall the summary of our cost behavior discussion from Chapter 1. Total Long Distance Telephone Bill. Minutes Talked. Total Variable Cost Example.

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Chapter 5

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  1. Chapter 5 Cost Behavior: Analysis and Use

  2. Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 1.

  3. Total Long DistanceTelephone Bill Minutes Talked Total Variable Cost Example Your total long distance telephone bill is based on how many minutes you talk.

  4. Per MinuteTelephone Charge Minutes Talked Variable Cost Per Unit Example The cost per minute talked is constant.For example, 10 cents per minute.

  5. Monthly Basic Telephone Bill Number of Local Calls Total Fixed Cost Example Your monthly basic telephone bill is probablyfixedand does not changewhen you make more local calls.

  6. Monthly Basic Telephone Bill per Local Call Number of Local Calls Fixed Cost Per Unit Example The fixedcost per local call decreasesas more local calls are made.

  7. Cost Behavior Examples of normally variable costs Service Organizations Supplies and travel Merchandisers Cost of Goods Sold Merchandisers and Manufacturers Sales commissions and shipping costs Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Examples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salariesDepreciation, Advertising

  8. Unitsproduced Machinehours Milesdriven Laborhours The Activity Base A measure of the event causing the incurrence of a variable cost – a cost driver

  9. Total cost remainsconstant within anarrow range ofactivity. Cost Activity Step-Variable Costs

  10. Total cost increases to a new higher cost for the next higher range of activity. Step-Variable Costs Cost Activity

  11. RelevantRange Total Cost Activity The Linearity Assumption and the Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Economist’sCurvilinear Cost Function Accountant’s Straight-Line Approximation (constant unit variable cost)

  12. Examples Depreciation on Buildings and Equipment Examples Advertising and Research and Development Types of Fixed Costs • Committed • Multi-year planning horizon • Cannot be cut for short periods of time • Discretionary • One-year planning horizon • Can be cut for short periods of time

  13. Trend Toward Fixed Costs Increased automation. Increase in salaried knowledge workers who are difficult to train and replace. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions.

  14. Labor Costs: Fixed or Variable? Fixed if work force is stable because managementis reluctant to increase/decrease the number ofemployees in response to short-term fluctuationsin business activity. Variable if size of work force is easily adjusted forshort-term fluctuations in business activity. May be both fixed and variable if temporary workers are employed to accommodate short-termfluctuations in business activity.

  15. Continue Fixed Costs and Relevant Range Example:Office spaceis available at a rental rate of $30,000 per year inincrements of 1,000 squarefeet. As the business grows, more space is rented,increasing the total cost.

  16. Fixed Costs and Relevant Range 90 Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Relevant Range 60 Rent Cost in Thousands of Dollars 30 0 0 1,000 2,000 3,000 Rented Area (Square Feet)

  17. Quick Check  Which of the following statements about cost behavior are true? a. Fixed costs per unit vary with the level of activity. b. Variable costs per unit are constant within the relevant range. c. Total fixed costs are constant within the relevant range. d. Total variable costs are constant within the relevant range.

  18. Quick Check  Which of the following statements about cost behavior are true? a. Fixed costs per unit vary with the level of activity. b. Variable costs per unit are constant within the relevant range. c. Total fixed costs are constant within the relevant range. d. Total variable costs are constant within the relevant range.

  19. Step-variable costs can be adjusted more quickly and . . . • The width of the activity steps is much wider for the fixed cost. How does this type of fixed cost differ from a step-variable cost? Fixed Costs and Relevant Range

  20. Consider thefollowing electric utility example. Mixed Costs A mixed costhas both fixed and variablecomponents.

  21. Y Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge X Activity (Kilowatt Hours) Mixed Costs Total mixed cost

  22. Y Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge X Activity (Kilowatt Hours) Mixed Costs Total mixed cost

  23. Y Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge X Activity (Kilowatt Hours) Mixed Costs Total mixed cost =Y = a+bX bX a

  24. Account Analysis Engineering Approach Scattergraph Plot High-Low Method Least-Squares Regression Method The Analysis of Mixed Costs

  25. Account Analysis Each account is classified as eithervariable or fixed based on the analyst’s knowledge of how the account behaves.

  26. Engineering Estimates Cost estimates are based on an evaluation of production methods, and material, laborand overhead requirements.

  27. Y 20 * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Plot Plot the data points on a graph (total cost vs. activity).

  28. Y 20 * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Plot Draw a line through the data pointswith about an equal numbers ofpoints above and below the line.

  29. The slope of this line is the variable unit cost. (Slope is the change in total cost for a one unit change in activity). Y 20 * * * * * * * Total Cost in1,000’s of Dollars * * 10 Estimated fixed cost = $10,000 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced The Scattergraph Plot

  30. Change in costChange in units Slope = The Scattergraph Plot Y 20 * * Vertical distance is the change in cost. * * * * * * Total Cost in1,000’s of Dollars * * 10 Horizontal distance is the change in activity. 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced

  31. The High-Low Method 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.

  32. Changein costChange in units The High-Low Method • Unit variable cost =

  33. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

  34. The High-Low Method • 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

  35. The High-Low Method • 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

  36. Quick Check  If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit

  37. $4,000 ÷ 40,000 units = $0.10 per unit Quick Check  If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit

  38. Quick Check  If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000

  39. Quick Check  If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000

  40. How does the high-low method work when you have data for more than two periods? Select the two periods with the lowest and highest level of activity. Low month High month Note

  41. Low month High month Quick Check  Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. a. Y = $9,720 + $2.00X b. Y = $7,050 + $3.00X c. Y = $8,385 + $2.50X d. Y = $8,480 + $2.50X

  42. b = = = $2 a = $15,060 – $2 × 2,670 = $15,060 – $5,340 = $9,720 $15,060 – $14,680 2,670 – 2,480 $380 190 Low month High month Quick Check  Using the high-low method, estimate the cost formula Y = a + bX for the patient admitting costs. a. Y = $9,720 + $2.00X b. Y = $7,050 + $3.00X c. Y = $8,385 + $2.50X d. Y = $8,480 + $2.50X

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

  44. Note Problems with the high-low method: • Disregards 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. Always plot the data if you have more than two points to make sure it even makes sense to use the high-low method.

  45. Least Squares Regression • 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 regression also provides a statistic, calledthe adjusted R2, that is a measure of the goodnessof fit of the regression line to the data points.

  46. R2 is the percentage of the variationin total cost explained by the activity. R2 for this relationship is near100% since the data points arevery close to the regression line. Least Squares Regression Y 20 * * * * * * * * * * Total Cost 10 0 X 0 1 2 3 4 Activity

  47. The Contribution Format Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement.

  48. Thecontribution marginformat emphasizes cost behavior.Contribution margincovers fixed costsand provides for income. The Contribution Format

  49. Used primarily forexternal reporting. Used primarily bymanagement. The Contribution Format

  50. End of Chapter 5

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