Cost Behavior: Analysis and Use

Chapter 5

2010 The McGraw-Hill Companies, Inc.

Learning Objective 1

Understand how fixed and

variable costs behave and
how to use them to predict
costs.

McGraw-Hill/Irwin

Slide 2

Types of Cost Behavior Patterns Variable

A variable cost is a cost whose total dollar
amount varies in direct proportion to changes
in the activity level.

McGraw-Hill/Irwin

Slide 3

The Activity Base (also called a cost driver)

Machine
hours

Units
produced
A measure of what
causes the
incurrence of a
variable cost
Miles
driven
McGraw-Hill/Irwin

Labor
hours
Slide 4

True Variable Cost An Example

Total Overage
Charges on Cell
Phone Bill

As an example of an activity base, consider

overage charges on a cell phone bill. The activity
base is the number of minutes used above the
allowed minutes in the calling plan.

Minutes Talked
McGraw-Hill/Irwin

Slide 5

Types of Cost Behavior Patterns Variable

Variable costs remain constant if expressed on
a per unit basis.

McGraw-Hill/Irwin

Slide 6

Variable Cost Per Unit An Example

Per Minute
Overage Charge

Referring to the cell phone example, the cost per

overage minute is constant, for example 45 cents per
overage minute.

Minutes Talked
McGraw-Hill/Irwin

Slide 7

True Variable Costs

Cost

The amount of a true variable cost used during the

period varies in direct proportion to the activity level.
The overage charge on a cell phone bill was one
example of a true variable cost.

Volume
McGraw-Hill/Irwin

Direct material is
another example
of a cost that
behaves in a true
variable pattern.
Slide 10

Step-Variable Costs

Cost

A step-variable cost is a resource that is obtainable only

in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.

Volume
McGraw-Hill/Irwin

Slide 11

Step-Variable Costs

Cost

Small changes in the level of production are not

likely to have any effect on the number of
maintenance workers employed.

Volume
McGraw-Hill/Irwin

Slide 12

Step-Variable Costs

Cost

Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
workers employed.

Volume
McGraw-Hill/Irwin

Slide 13

Types of Cost Behavior Patterns Fixed

A fixed cost is a cost whose total dollar amount
remains constant as the activity level changes.

McGraw-Hill/Irwin

Slide 15

Total Fixed Cost An Example

Monthly Basic
Cell Phone Bill

For example, your cell phone bill probably includes a

fixed amount related to the total minutes allowed in
your calling plan. The amount does not change when
you use more or less allowed minutes.

Number of Minutes Used

within Monthly Plan
McGraw-Hill/Irwin

Slide 16

Types of Cost Behavior Patterns Fixed

Average fixed costs per unit decrease as the
activity level increases.

McGraw-Hill/Irwin

Slide 17

Fixed Cost Per Unit Example

Cost Per Cell Phone Call

For example, the fixed cost per minute used

decreases as more allowed minutes are used.

Number of Minutes Used

within Monthly Plan
McGraw-Hill/Irwin

Slide 18

Types of Fixed Costs

Committed

Discretionary

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

May be altered in the

short-term by current
managerial decisions

Examples

Examples

Depreciation on Buildings
and Equipment and Real
Estate Taxes

Advertising and
Research and
Development

McGraw-Hill/Irwin

Slide 19

Rent Cost in Thousands

of Dollars

Fixed Costs and the Relevant Range

McGraw-Hill/Irwin

90
Relevant

60

Range

30
0

The
The relevant
relevant range
range
of
of activity
activity for
for aa fixed
fixed
cost
cost is
is the
the range
range of
of
activity
activity over
over which
which
the
the graph
graph of
of the
the
cost
cost is
is flat.
flat.

1,000
2,000
3,000
Rented Area (Square Feet)
Slide 22

Fixed Costs and the Relevant Range

For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase
in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

McGraw-Hill/Irwin

Slide 23

Fixed Costs and the Relevant Range

How does this

step-function
pattern differ from a
step-variable cost?
McGraw-Hill/Irwin

Step-variable costs can

be adjusted more
quickly as conditions
change and . . .
The width of the activity
steps is much wider for
the fixed cost.
Slide 24

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

McGraw-Hill/Irwin

Slide 25

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

McGraw-Hill/Irwin

Slide 26

Mixed Costs (also called semivariable costs)

A
A mixed
mixed cost
cost contains
contains both
both variable
variable and
and fixed
fixed
elements.
elements. Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Total Utility Cost

al
t
o
T

d
e
x
mi

t
s
o
c
Variable
Cost per KW

Activity (Kilowatt Hours)

Fixed Monthly
Utility
Charge

McGraw-Hill/Irwin

Slide 27

Mixed Costs

Total Utility Cost

al
t
o
T

d
e
x
mi

t
s
o
c
Variable
Cost per KW

Activity (Kilowatt Hours)

Fixed Monthly
Utility
Charge

McGraw-Hill/Irwin

Slide 28

Mixed Costs An Example

If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is
the amount of your utility bill?

McGraw-Hill/Irwin

Slide 29

Analysis of Mixed Costs

Account Analysis and the Engineering Approach
In
In account
account analysis,
analysis, each
each account
account is
is
classified
classified as
as either
either variable
variable or
or fixed
fixed based
based
on
on the
the analysts
analysts knowledge
knowledge of
of how
how
the
the account
account behaves.
behaves.
The
The engineering
engineering approach
approach classifies
classifies
costs
costs based
based upon
upon an
an industrial
industrial
engineers
engineers evaluation
evaluation of
of production
production
methods,
methods, and
and material,
material, labor
labor and
and
overhead
overhead requirements.
requirements.
McGraw-Hill/Irwin

Slide 30

Learning Objective 2

Use a scattergraph plot to

diagnose cost behavior.

McGraw-Hill/Irwin

Slide 31

The Scattergraph Method

Plot
Plot the
the data
data points
points on
on aa graph
graph
(Total
(Total Cost
Cost Y
Y vs.
vs. Activity
Activity X).
X).

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s
McGraw-Hill/Irwin

Slide 32

The Scattergraph Method

Maintenance Cost
1,000s of Dollars

Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about an
an
equal
equal numbers
numbers of
of points
points above
above and
and below
below the
the line.
line.
Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s
McGraw-Hill/Irwin

Slide 33

The Scattergraph Method

Maintenance Cost
1,000s of Dollars

Use
Use one
one data
data point
point to
to estimate
estimate the
the total
total level
level of
of activity
activity
and
and the
the total
total cost.
cost.
Y Total maintenance cost = $11,000
20

* *
* *

10

Intercept = Fixed cost: $10,000

Patient days = 800

McGraw-Hill/Irwin

* ** *
**

Patient-days in 1,000s
Slide 34

The Scattergraph Method

Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per unit
unit and
and
determine
determine the
the cost
cost equation.
equation.

Variable cost per unit = $1,000

800

= $1.25/patient-day

Y = $10,000 + $1.25X
Total maintenance cost
McGraw-Hill/Irwin

Number of patient days

Slide 35

Learning Objective 3

Analyze a mixed cost

using the high-low method.

McGraw-Hill/Irwin

Slide 36

The High-Low Method An Example

Assume the following hours of maintenance work and the total maintenance costs for six months.

McGraw-Hill/Irwin

Slide 37

The High-Low Method An Example

The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $6.00/hour
400

McGraw-Hill/Irwin

Slide 38

The High-Low Method An Example

Total Fixed Cost = Total Cost Total Variable Cost

Total Fixed Cost = $9,800 ($6/hour 850 hours)
Total Fixed Cost = $9,800 $5,100
Total Fixed Cost = $4,700
McGraw-Hill/Irwin

Slide 39

The High-Low Method An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
McGraw-Hill/Irwin

Slide 40

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

McGraw-Hill/Irwin

Slide 41

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

McGraw-Hill/Irwin

Slide 42

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

McGraw-Hill/Irwin

Slide 43

Quick Check
Sales
Sales salaries
salaries and
and commissions
commissions are
are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000 units
units
are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is the
the fixed
fixed
portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
Total
Total cost
cost == Total
Total fixed
fixed cost
cost ++
Total
Total variable
variable cost
cost
b.
b. $$ 4,000
4,000
$14,000
$14,000 == Total
Total fixed
fixed cost
cost ++
c.
c. $10,000
$10,000
($0.10
($0.10 120,000
120,000 units)
units)
d.
d. $12,000
$12,000
Total
Total fixed
fixed cost
cost == $14,000
$14,000 -- $12,000
$12,000
Total
Total fixed
fixed cost
cost == $2,000
$2,000

McGraw-Hill/Irwin

Slide 44

Least-Squares Regression Method

A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.

McGraw-Hill/Irwin

The goal of this method is

to fit a straight line to the
data that minimizes the
sum of the squared errors.
Slide 45

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 regression also provides a statistic, called

the R2, which is a measure of the goodness
of fit of the regression line to the data points.
McGraw-Hill/Irwin

Slide 46

Least-Squares Regression Method

Total Cost

R2 is the percentage of the variation in the dependent

variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20

10

McGraw-Hill/Irwin

* *
* *

* ** *
**

R2 varies from 0% to 100%, and

the higher the percentage the better.

2
3
Activity

X
Slide 47

Comparing Results From the Three

Methods
The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates of
of the
the fixed
fixed and
and
variable
variable cost
cost components
components of
of the
the mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses differing
differing amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because itit uses
uses all
all the
the data
data
points.
points.
McGraw-Hill/Irwin

Slide 48

Learning Objective 4

Prepare an income
statement using the
contribution format.

McGraw-Hill/Irwin

Slide 49

The Contribution Format

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

McGraw-Hill/Irwin

Slide 50

The Contribution Format

The
The contribution
contribution margin
margin format
format emphasizes
emphasizes cost
cost
behavior.
behavior. Contribution
Contribution margin
margin covers
covers fixed
fixed costs
costs
and
and provides
provides for
for income.
income.
McGraw-Hill/Irwin

Slide 51

Uses of the Contribution Format

The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning and
and decision-making
decision-making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1Cost-volume-profit
1Cost-volume-profit analysis
analysis (Chapter
(Chapter 6).
6).
2Budgeting
2Budgeting (Chapter
(Chapter 9).
9).
3Segmented
3Segmented reporting
reporting of
of profit
profit data
data (Chapter
(Chapter 12).
12).
4Special
4Special decisions
decisions such
such as
as pricing
pricing and
and make-or-buy
make-or-buy
analysis
analysis (Chapter
(Chapter 13).
13).
McGraw-Hill/Irwin

Slide 52

The Contribution Format

Used primarily for

external reporting.
McGraw-Hill/Irwin

Used primarily by
management.
Slide 53

Least-Squares Regression
Computations
Appendix 5A

2010 The McGraw-Hill Companies, Inc.

Learning Objective 5

Analyze a mixed cost

using the least-squares
regression method.

McGraw-Hill/Irwin

Slide 55

Simple Regression Using Excel An Example

Here is the
estimate of the
slope of the line.

1. In the Known_ys box, enter C4:C19 for the range.

2. In the Known_xs box, enter D4:D19 for the range.

McGraw-Hill/Irwin

Slide 61

Simple Regression Using Excel An Example

With your cursor in
cell F5, press the =
key and go to the pull
down menu for
Special Functions.
Select Statistical and
scroll down to
highlight the
INTERCEPT function.

McGraw-Hill/Irwin

Slide 62

Simple Regression Using Excel An Example

Here is the
estimate of the
fixed costs.

1. In the Known_ys box, enter C4:C19 for the range.

2. In the Known_xs box, enter D4:D19 for the range.
McGraw-Hill/Irwin

Slide 63

End of Cost Behavior Analysis

McGraw-Hill/Irwin

Slide 66

Breakeven Analysis Defined

Breakeven analysis examines the short run

relationship between changes in volume and
changes in total sales revenue, expenses and
net profit
Also known as C-V-P analysis (Cost Volume
Profit Analysis)

McGraw-Hill/Irwin

Slide 67

Uses of Breakeven Analysis

C-V-P analysis is an important tool in terms
of short-term planning and decision
making
It looks at the relationship between costs,
revenue, output levels and profit
Short run decisions where C-V-P is used
include choice of sales mix, pricing policy
etc.

McGraw-Hill/Irwin

Slide 68

 How

many units must be sold to breakeven?

How many units must be sold to achieve a
target profit?
Should a special order be accepted?
How will profits be affected if we introduce a
new product or service?

Decision making and

Breakeven Analysis:
Examples

McGraw-Hill/Irwin

Slide 69

Key Terminology: Breakeven Analysis

Break even point-the point at which a
company makes neither a profit or a loss.
Contribution per unit-the sales price
minus the variable cost per unit. It
measures the contribution made by each
item of output to the fixed costs and profit
of the organisation.

McGraw-Hill/Irwin

Slide 70

Key Terminology ctd.

Margin of safety-a measure in which the
budgeted volume of sales is compared with
the volume of sales required to break even
Marginal Cost cost of producing one
extra unit of output

McGraw-Hill/Irwin

Slide 71

Breakeven Formula
Fixed Costs
*Contribution per unit

*Contribution per unit = Selling Price per unit

Variable Cost per unit

McGraw-Hill/Irwin

Slide 72

Breakeven Chart

McGraw-Hill/Irwin

Slide 73

Margin of Safety

The difference between budgeted or actual

sales and the breakeven point
The margin of safety may be expressed in
units or revenue terms
Shows the amount by which sales can drop
before a loss will be incurred

McGraw-Hill/Irwin

Slide 74

Example 1
Using the following data, calculate the
breakeven point and margin of safety in
units:
Selling Price = Php50
Variable Cost = Php40
Fixed Cost = Php70,000
Budgeted Sales = 7,500 units

McGraw-Hill/Irwin

Slide 75

Example 1: Solution

Contribution = Php50 Php40 = Php10 per

unit
Breakeven point = 70,000/10 = 7,000 units
Margin of safety = 7500 7000 = 500 units

McGraw-Hill/Irwin

Slide 76

Target Profits

What if a firm doesnt just want to breakeven

it requires a target profit
Contribution per unit will need to cover profit
as well as fixed costs
Required profit is treated as an addition to
Fixed Costs

McGraw-Hill/Irwin

Slide 77

Example 2
Using the following data, calculate the
level of
sales required to generate a profit of
10,000:
Selling Price = 35
Variable Cost = 20
Fixed Costs = 50,000

McGraw-Hill/Irwin

Slide 78

Example 2: Solution

Contribution = 35 20 = 15
Level of sales required to generate profit of
10,000:
50,000 + 10,000
15
4000 units

McGraw-Hill/Irwin

Slide 79

Limitations of B/E analysis

Costs are either fixed or variable
Fixed and variable costs are clearly
discernable over the whole range of output
Production = Sales
One product/constant sales mix
Selling price remains constant
Efficiency remains unchanged
Volume is the only factor affecting costs

McGraw-Hill/Irwin

Slide 80

Breakeven and Shut Down Point

KNOW

The price at which a firm

will breakeven
The price at which a firm
will/should shut down.

That when a firms Total Revenue is

equal to its Total Costs then it will
breakeven.
UNDERSTAND

McGraw-Hill/Irwin

When a firm receives a price that will not

cover at least its variable costs it should
shutdown.

Slide 81

Shutdown point

Recall that Total Cost =FC + VC

If a firm cant even receive a price to cover the VC of
producing a good then it should shutdown.
In this case though it will still have to pay its fixed
costs
At any price point between shutdown (above VC) and
breakeven at least the firm will receive a contribution
to cover FC so it will continue to operate.

SHUTDOWN is where P = VC
McGraw-Hill/Irwin

Slide 82

SHUTDOWN point An example

PRICE $
COST $
REVENUE $

MC

TC
10

VC

300

QUANTITY

This firm is receiving a price of Php8 and is selling a quantity of 300

Its total revenue will be Php8 x 300 = Php2400
Its total variable costs will be Php8 x 300 = Php2400

McGraw-Hill/Irwin

Slide 83

SHUTDOWN point An example

PRICE $
COST $
REVENUE $

MC

ATC
10

AVC

300

QUANTITY

This firm is receiving a price of Php8 and is selling a quantity of 300

Its total revenue will be Php8 x 300 = Php2400
Its total variable costs will be Php8 x 300 = Php2400
It should SHUTDOWN, there is no sense in opening the doors.
McGraw-Hill/Irwin

Slide 84

SHUTDOWN point An example

PRICE $
COST $
REVENUE $

MC

TC
10

VC

300

QUANTITY

What does the shaded area in the diagram

represent?

McGraw-Hill/Irwin

Slide 85

SHUTDOWN point An example

PRICE $
COST $
REVENUE $

MC

TC
10

VC

300

QUANTITY
What does the shaded area in the diagram represent?
If you identified this area as total FC at output 300 you are right! So you will see
that at the Shutdown point of Php8.00 the firm is not covering any of its FC. At
any price between Php8 and Php10 it will at least be able to pay off some of its
Fixed Costs (FC) so it makes sense to keep operating. At least in the short term
and until the price in the market improves.
McGraw-Hill/Irwin

Slide 86

Hopefully you are clear about

Break Even and Shutdown
point?
B/E is where P = C
SHUTDOWN is where P = VC
Feel free to review these slides again if you need to. If you
are ready to move on close this slide show and go to the
next step in the lesson.

McGraw-Hill/Irwin

Slide 87