Chapter 5

1. Chapter 5 Cost Behavior and Relevant Costs

2. Introduction What is the nature of costs and how are they used in decision making? Do they increase or decrease as production volume changes? Do they remain stable?

3. The Behavior of Fixed Costs Fixed Costs remain the same in total, but may vary per unit when production volume changes. Examples: Rent, Depreciation, Salary of a Plant Manager, Insurance, Property Taxes Fixed Cost Per Unit $ $ Total Fixed Costs 4 10 2 1.33 50 25 75 25 50 75 Volume Volume

4. The Behavior of Variable Costs Variable Costs vary in direct proportion to changes in production volume, but are fixed when expressed as per-unit amounts. Examples: Direct material, direct labor, and other unit-level costs like factory supplies $ Total Variable Costs Variable Cost Per Unit $ 150 100 20 50 25 50 75 25 50 75 Volume Volume

5. Curvilinear Costs and the Relevant Range Relevant Range Cost Curvilinear Function Straight-Line Approximation Volume

6. The Cost Equation Y = a + bx Y = total direct material costs a = fixed costs b = slope of line (variable costs) x = units produced

7. 0-7,500 desks 1 Janitor $25,000 2 Janitors 7,501-15,000 desks $50,000 Step Costs Step Costs remain constant within a relevant range of production. Example: Janitorial services within a company that manufactures desks

8. Mixed Costs Fixed and Variable Components of Delivery Van Expense Fixed: lease payment each month Variable: Gas, oil, maintenance costs, etc., that vary with the number of deliveries made (and miles driven)

9. Separating Mixed Costs into their Fixed and Variable Components Regression Analysis: A statistical technique used to estimate the fixed and variable components of a mixed cost is called least squares regression. Regression analysis uses statistical methods to fit a cost line (regression line) through a set of points which minimizes the sum of the squared distance from each data point to the line (hence the name least squares regression).

10. Least Squares Regression Analysis Regression Line = Total Overhead Cost Slope represents the change in $ for a 1 unit change in volume Costs ? $ Slope of Regression Line = Variable Cost per unit Fixed Cost 1 unit Volume

11. Estimating Regression Results Using the High-Low Method 1. Use only two data points, the high and low levels of activity and their related total overhead costs. 2. Subtract the smallest from the largest for each and use the changes in the following formula. 3. Change in Cost = Variable cost per unit Change in volume

12. Estimating Regression Results Using the High-Low Method 4. Substitute the total cost of one of the points for “y” in the equation y = a + bx 5. Substitute the variable cost found using high-low for “b” 6. Substitute the number of activity units for the data point chosen for “x” 7. Solve for fixed costs “a” 8. Determine the formula to use in estimating the mixed costs at various levels

13. Relevant Costs and Cost Behavior Merchandising Sales revenue is a common cost driver. Cost of goods purchased is a variable cost. Service Airlines might look at the number of passengers or passenger seat miles as cost drivers.

14. Taxes and Decision Making Three Tax Considerations: 1. Costs of operating businesses are deductible for income tax and revenues are taxable. 2. Form of a transaction may impact the amount of tax paid or whether cost is tax deductible 3. Payment of tax requires cash outflow, thus reducing the amount of cash available for other purposes.

15. After-Tax Costs and Revenues After-Tax Cost of a tax deductible cash expenditure: after-tax cost = pretax cost X (1-tax rate) After-Tax Benefit of a taxable cash receipt: after-tax benefit = pretax receipts X (1-tax rate) $$

16. End of Chapter 5 Analyzing costs has to be a continuous process!