Session 3

Chapter 5 Helmkamp
Cost Behavior

Introduction
Cost
estimation

Cost
behavior

Cost
prediction

Process of
determining
cost behavior,
often focusing
on historical
data.

Relationship
between
cost and
activity.

Using knowledge
of cost behavior
to forecast
level of cost at
a particular
activity. Focus
is on the future.
2

Cost Terminology

Variable Costs costs that change in

total in relation to some chosen activity
or output
Fixed Costs costs that do not
change in total in relation to some
chosen activity or output
Mixed Costs costs that have both
fixed and variable components; also
called semivariable costs
3

Cost Behavior Patterns

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.

Unit Variable Cost

Total Variable Cost

Total Fixed Cost

Unit Fixed Cost

Examples of variable costs

Merchandisers

Service Organizations

Cost of Goods Sold

Supplies and travel

Manufacturers

Merchandisers and
Manufacturers

Direct Material, Direct

Labor, and Variable
Manufacturing Overhead

Sales commissions and

shipping costs

Examples of fixed costs

Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising

Types of Fixed Costs

Committed

Discretionary

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

May be altered in the

short-term by current
managerial decisions

Examples

Examples

Depreciation on
Buildings and
Equipment

Advertising and
Research and
Development
7

Trends in Cost Structure

A trend toward more fixed costs because of

Increased automation.
Stable workforce.

Implications
Managers are more locked-in with fewer decision
alternatives.
Planning becomes more crucial: fixed costs are difficult to
change with current operating decisions.
8

Cost Functions

A cost function is a mathematical

representation of how a cost changes
with changes in the level of an activity
relating to that cost (cost driver)

Identifying Cost Drivers

Cost Driver Examples
Activity

Cost Driver

Machining operations
Setup
Production scheduling
Inspection
Purchasing
Shop order handling
Valve assembly support

Machine hours
Setup hours
Manufacturing orders
Pieces inspected
Purchase orders
Shop orders
Customer requisitions
10

The Linear Cost Function

y = a + bX
The Dependent
Variable:
The cost that is
being predicted
The Intercept:
Fixed costs

The Independent
Variable:
The cost driver
The Slope of
the Line:
Variable cost
per unit
11

The total cost line can be expressed

as an equation: Y = a + bX
Where:
Y
Cost

Y = the total mixed cost

a = the total fixed cost (the
vertical intercept of the line)
b = the variable cost per unit of
activity (the slope of the line)
X = the level of activity
Variable Cost

Fixed Cost

Number of Units Produced

12

The Linearity Assumption and

the Relevant Range
1.

2.

Variations in the level of a single

activity (the cost driver) explain the
variations in the related total costs
Cost behavior is approximated by a
linear cost function within the
relevant range

Graphically, the total cost versus the level

of a single activity related to that cost is a
straight line within the relevant rage
13

Total Cost

A straight line
Economists
closely
Curvilinear Cost approximates a
Function
curvilinear

Relevant
Range

variable cost
line within the
relevant range.

Accountants Straight-Line
Approximation (constant
unit variable cost)
Activity

14

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.

Continue
15

Rent Cost in
Thousands of Dollars

90

60

30

00

Relevant
Range

Total cost doesnt

change for a wide
range of activity,
and then jumps to a
new higher cost for
the next higher
range of activity.

1,000
2,000
3,000
Rented Area (Square Feet)
16

Criteria for Classifying Variable

and Fixed Components of a Cost
1.

2.

3.

Choice of Cost Object different objects

may result in different classification of the
same cost
Time Horizon the longer the period, the
more likely the cost will be variable
Relevant Range behavior is predictable
only within this band of activity

17

Cause-and-Effect Relationship
for Cost Drivers

The most important issue in estimating a cost

function is determining whether a cause-and-effect
relationship exists between the level of an activity
and the costs related to that level of activity.
A cause-and-effect relationship might arise as a
result of:

A physical relationship between the level of activity and

costs
A contractual agreement
Knowledge of operations

Note: a high correlation (connection) between

activities and costs does not necessarily mean
causality

18

Question for Discussion 1

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

Methods of Analyzing Cost

Behavior
1.

2.

Visual Fit of a Scatter Diagram

Method
Quantitative Analysis Methods
1.
2.

High-Low Method
Regression Analysis

20

Visual Fit of a Scatter

Diagram Method

Gather data related to the amount of cost

incurred at different activity levels in the past
Plot the data points of cost
Draw a straight line through the data points
that comes as close to as many points
The fixed component of the cost function is
determined by extending the line until it
touches the vertical axis
Compute the variable costs for any level of
activity (see page 199)
21

Direct Labor

Direct Material

Analyze the kind

of work performed.
Estimate the time
required for each labor
skill for each unit.

Material required
for each unit is
obtained from
engineering drawings
and specification sheets.

Use local wage rates to

obtain labor cost
per unit.

Material prices are

determined from
vendor bids.

22

Example

Account
Indirect Labor
Indirect Material
Depreciation
Property Taxes
Insurance
Utilities
Maintenance
Totals

Overhead
Total
Cost
$
450
700
1,000
200
300
400
600
$ 3,650

Costs for 1,000 Units

Variable
Fixed
Cost
Cost
$
450
700
1,000
200
300
350
50
500
100
$ 2,000
$ 1,650

Total Cost = $2 per unit + $1,650

23

Quantitative Analysis

Uses a formal mathematical method to

fit cost functions to past data
observations
Advantage: results are objective

24

Steps in Estimating a Cost Function

Using Quantitative Analysis
1.
2.
3.

4.
5.
6.

Choose the dependent variable (the cost to

be predicted)
Identify the independent variable or cost
driver
Collect data on the dependent variable and
the cost driver
Plot the data
Estimate the cost function using the HighLow Method or Regression Analysis
Evaluate the cost driver of the estimated
cost function
25

The High-Low Method

WiseCo recorded the following production activity
and maintenance costs for two months:
High activity level
Low activity level
Change

Units
8,000
5,000
3,000

Cost
$ 9,800
7,400
$ 2,400

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. 26

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

27

Question for Discussion 2

Sales salaries and commissions are $10,000

when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, 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
28

Question for Discussion 3

Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, what is the fixed portion of sales
salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
29

Regression Analysis

Regression analysis is a statistical method

that measures the average amount of change
in the dependent variable associated with a
unit change in one or more independent
variables
Is more accurate than the High-Low
method because the regression equation
estimates costs using information from all
observations; the High-Low method uses only
two observations
30

Types of Regression

Simple estimates the relationship between

the dependent variable and one independent
variable
Multiple estimates the relationship
between the dependent variable and two or
more independent variables

31

Terminology

Goodness of Fit indicates the

strength of the relationship between the
cost driver and costs
Residual Term measures the
distance between actual cost and
estimated cost for each observation

32

The simple cost model is actually a

regression model:
TC = F + VX
This model will only
be useful within a
relevant range of
activity.

Caution: Before doing

the analysis, take time
to determine if a
logical relationship
between the variables
33
exists.

Simple 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 regression also provides a statistic,
called the R2, that is a measure of the goodness
of fit of the regression line to the data points.
34

R2 is the percentage of the variation in total cost

explained by the activity.
Y
Total Cost

20

* ** *
**

* *
* * R2 for this relationship is near

10

100% since the data points are

very close to the regression line.
0
0

2
3
Activity

X
35

Multiple Regression
Multiple regression includes two or
more independent variables:
TC = FC + V1X1 + V2X2
Terms in the equation have the same
meaning as in simple regression with
only one independent variable.
36

Data Problems

The time period for measuring the

dependent variable does not match the
period for measuring the cost driver
Fixed costs are allocated as if they are
variable
Some data may be missing or are not
uniformly reliable
Extreme values of observations occur from
errors in recording costs
37

There is no homogeneous relationship

between the cost driver and the individual
cost items in the dependent variable-cost
pool.
The relationship between the cost driver and
the cost is not stationary (not stable)
Inflation has affected costs, the driver, or
both

38

Data Adjustment

Corresponding numbers should be causally

related (i.e., if relating supplies to production
units, the figures should be usage of supplies
per some number of units of production NOT
supplies purchased in the same period).
Consider outliers carefully: the object is to
find the relationship that will hold in the
future.
Remember that cost relationships can change
over time (a nonstationary relationship). 39

The Ideal Database

1.

2.

The database should contain

numerous reliably measured
observations of the cost driver and the
costs
In relation to the cost driver, the
database should consider many values
spanning a wide range
40

Absorption Costing versus

Variable Costing

Absorption costing is used for external

financial reporting (GAAP)
Variable costing is used for internal
reporting

41

Absorption
S
CGS
GP
S&A
NI (ABS )

Variable
S
VC
CM
FC
NI (VC)
42

Produced and sold 6,000 units

Sales price $20
Variable mfg costs: $5
Fixed Mfg. Overhead $40,000
Variable S&A costs $4
Fixed S&A costs $20,000
43