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Cost Behaviour
CHAPTER 6
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Describe key characteristics and graphs of various
cost behaviours.
OBJECTIVE 1
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Cost behaviour
Cost behaviour — how costs change as volume
change
There are three common cost behaviours:
1. Variable costs
2. Fixed costs
3. Mixed costs
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Key Characteristics of Variable Costs
• Total variable costs change in direct
proportion to changes in volume
• Variable cost per unit remains constant
• Slope
Total variable cost (y) =
Variable cost per unit of activity (v) x Volume of activity (x)
or
y=vx
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Total Variable Costs
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Key Characteristics of Fixed Costs
• Total fixed costs stay constant over relevant
range*
• Fixed costs per unit of activity vary inversely
with changes in volume
*Relevant range is the normal operating range of activity
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Total Fixed Costs
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Key Characteristics of Mixed Costs
• Total mixed costs increase as volume increases
• Total mixed costs can be expressed as a combination of
the variable and fixed cost equations:
Total mixed cost = total variable cost + total fixed cost
or Y = vx + f
Where
Y = total mixed cost
v = variable cost per unit of activity
x = volume of activity
f = fixed cost over a given period of time
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Mixed Costs
Variable
Fixed
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S6-7: Classify Cost Behaviour
F
___
V
___
F
___
V
___
V
___
V
___
F
___
a. Depreciation on equipment used to
cut wood enclosures
b. Wood for speaker enclosures
c. Patents on crossover relays (internal
components)
d. Crossover relays
e. Grill cloth
f. Glue
g. Quality inspector’s salary
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S6-1: Identify Cost Behaviour
Cost A
Cost B
Cost C
Variable Cost
Fixed Cost
Mixed Cost
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Use cost equations to express and predict costs.
OBJECTIVE 2
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Cost Equation
• Is a mathematical equation for a straight line
predict total cost
Total cost = total variable cost + total fixed cost
or Y = vx + f
Where
Y = total mixed cost
v = variable cost per unit of activity
x = volume of activity
f = fixed cost over a given period of time
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Cost Graphs
• Vertical (y-axis) always shows total costs
• Horizontal axis (x-axis) shows volume of activity
Note that the
variable cost
per customer
remains
constant in
each of the
graphs.
Total
Costs
Total volume of activity
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Costs and Decisions
• Committed fixed costs
• Discretionary fixed costs
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Relevant Range
• Band of volume where total fixed costs remain
constant at a certain level
• Variable costs per unit remain constant at a
certain level
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Other Cost behaviours
Step Costs
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Other Cost behaviours
Curvilinear Costs
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E6-22A: Forecast Costs at Different Volumes
2,000
Total Variable Costs
Total Fixed Costs
Total Operating Costs
$1,500
7,000
$8,500
Variable Cost/garment
$0.75
Fixed Cost/garment
$ 3.50
Average cost/garment
$ 4.25
Garments
3,500
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5,000
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E6-22A: Forecast Costs at Different Volumes
2,000
Garments
3,500
5,000
Total Fixed Costs
Total Operating Costs
$1,500
7,000
$8,500
$2,625
7,000
$9,625
$3,750
7,000
$10,750
Variable Cost/garment
$0.75
$0.75
$0.75
Fixed Cost/garment
$ 3.50
$2.00
$ 1.40
Average cost/garment
$ 4.25
$ 2.75
$2.15
Total Variable Costs
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E6-22A (continued)
2. While variable cost remains the same over the
relevant range shown, fixed cost per unit changes as
the volume increases or decreases.
3. Actual costs at 2,000 garments
Total predicted costs
($2.15 × 2,000 garments)
Underestimated costs
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$8,500
(4,300 )
$4,200
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E6-26A
Mailbox Magic produces decorative mailboxes. The
company’s average cost per unit is $26.43 when it
produces 1,000 mailboxes.
a. 1,000 x $26.43
$26,430
b. Total costs
Less total fixed costs
Total variable costs
$26,430
(18,000)
$8,430
÷ 1,000
$8.43
Variable cost per mailbox
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E6-26A (continued)
c. y = $8.43x + $18,000
d. $26.43 x 1,200 mailboxes (= $31,716)
e. y = ($8.43 x 1,200) + $18,000 = $28,116
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E6-26A (continued)
f.
Using average at 1,000
Using cost equation
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$31,716
28,116
$3,600
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Sustainability and Cost Behaviour
E-banking and e-billing serves to reduce variable
costs for both the bank and society at large:
• reduced demand for printed bills reduces both
the demand for paper, ink/toner, shipping and
disposal
• resulting is a reduction in the harvesting of
trees, production of dyes, use of fuel for
transportation and landfill space required
• costs are reduced to business and savings
trickle down to the customer
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Use account analysis and scatter plots to analyze
cost behavior.
OBJECTIVE 3
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Cost Behaviour Analysis
• Three methods to analyze cost behaviour
• Scatter Plots
• High-Low Method
• Regression Analysis
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Account Analysis
• Use of judgment to classify each general
ledger account as variable, fixed, or mixed
• Subjective
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Scatter Plots
• Use historical data to determine a cost’s
behaviour
• Scatter plot is the graph of historical cost data
on the y-axis and volume data on the x-axis
• Helps managers visually determine how strong
the relationship is between the cost and the
volume of the chosen activity base
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Scatter Plot Example
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Use the high-low method to analyze cost behavior.
OBJECTIVE 4
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High-Low Method
Step 1:
Step 2:
Step 3:
Find variable cost per unit (slope) of cost
line
Find the fixed costs (vertical intercept)
Create the cost equation
Advantage:
Easy to use
Disadvantage: Only uses 2 data points
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High-Low Method: E6-30A, p. 350
Step 1: Find slope of the mixed cost line
(variable cost/unit) =
Δ in cost (y) / Δ in volume (x)
The slope represents the variable cost per unit
of activity
($5,680-$4,880) ÷ (17,300-14,100) km
$800 ÷ 3,200 km = $0.25/km
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E6-30A (continued)
Step 2: Find the vertical intercept (fixed costs) =
Total mixed cost – Total variable cost
$5,680 – ($0.25/km • 17,300 km) = $1,355
or
$4,880 – ($0.25/km • 14,100 km) = $1,355
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E6-30A (continued)
Step 3: Create and use an equation to show the
behaviour of a mixed cost
Y = $0.25/km + $1,355
Predicted operating costs at 15,000 km:
($0.25/km • 15,000 km) + $1,355 = $5,105
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Use regression analysis to analyze cost behavior.
OBJECTIVE 5
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Regression Analysis Exhibit 6-15
• Statistical procedure to find the line that best fits
data (cost equation)
• Uses all data points
• R-square, Intercept, X Variable 1
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R-Square Value
• “Goodness of fit”
• How well does the line fit the data points?
• Ranges from 0 to 1
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Predicting Costs and Data Concerns
• Data Concerns
•
•
•
•
Only valid within relevant range
Seasonal variations
Inflation
Outliers – abnormal data points
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Prepare contribution margin income statements for
service firms and merchandising firms.
OBJECTIVE 6
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Traditional Income Statement
Sales
- Cost of Goods Sold
Gross Margin
- Selling, general & administrative costs
Operating Income
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Contribution Margin Income Statement
Sales
- Variable Costs
Contribution Margin
- Fixed Costs
Operating Income
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S6-15: Traditional Income Statement
Pam’s Quilt Shoppe
Traditional Income Statement
Month Ended February 28
Sales revenue (80 × $350)
Less: Cost of goods sold (80 × $250)
Gross profit
Less: Operating expenses:
Sales commissions (5% × $28,000)
Payroll costs
Lease
Operating income
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$28,000
(20,000)
8,000
(1,400)
(1,200)
(1,000)
$ 4,400
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S6-15: Contribution Margin Income Statement
Pam’s Quilt Shoppe
Contribution Margin Income Statement
Month Ended February 28
Sales revenue (80 × $350)
Less: Variable costs:
Cost of goods sold (80 × $250)
Sales commissions (5% × $28,000)
Contribution margin
Less: Fixed costs:
Payroll costs
Lease
Operating income
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$28,000
(20,000)
(1,400)
6,600
(1,200)
(1,000)
$ 4,400
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Use variable costing to prepare contribution margin
income statements for manufacturers.
OBJECTIVE 7
(APPENDIX 6A)
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Variable Costing
• Assigns only variable manufacturing costs to
products (DM, DL, Variable MOH)
• Fixed manufacturing overhead = period cost
• For internal management decisions
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Absorption Costing
• Required by financial reporting standards
(ASPE and IFRS) for external reporting
• Assign all manufacturing costs to products
(DM, DL, Variable MOH and Fixed MOH)
• Traditional income statement
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E6-40A: Conventional Income Statement
Rays
Conventional (Absorption Costing) Income Statement
Year Ended December 31, 2008
Sales revenue (185,000  $35)
$6,475,000
Less: Cost of Goods Sold:
Beginning finished goods inventory
$
0
Cost of goods manufactured
5,000,000
Cost of goods available for sale
5,000,000
Ending finished goods inventory
(375,000)
Cost of goods sold
4,625,000
Gross profit
1,850,000
Operating expenses
1,175,000
Operating income
$ 675,000
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E6-40A: Contribution Margin Income Statement
Rays
Contribution Margin (Variable Costing) Income Statement
Year Ended December 31, 2008
Sales revenue
$6,475,000
Variable expenses:
Variable cost of goods sold
$2,775,000*
Sales commission expense
925,000 3,700,000
Contribution margin
$2,775,000
Fixed expenses:
Manufacturing overhead
$2,000,000
Operating expenses
250,000 2,250,000
Operating income
$ 525,000
* Go to next slide for computation of variable cost of goods sold
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E6-40A: Decision
Incremental analysis:
Increase in contribution margin
(($35-20) x 15,000 goggles)
Increase in fixed costs
Increase in operating income
$225,000
(150,000)
$75,000
Decision?
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Absorption Costing and Manager Incentives
• When inventories increase, absorption costing
income is higher than variable costing income
• When inventories decrease, absorption costing
income is lower than variable costing income
• Therefore…managers may increase production
to build up inventory to maximize income and
therefore their own bonus
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Use segmented reporting to utilize the contribution
margin income statement format in an organization
with two or more divisions.
OBJECTIVE 8
(APPENDIX 6B)
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Segmented Income Statements
• used for internal reporting only
• helps managers to evaluate performance of
different products, services or departments
• evaluates performance based only on costs that
would be saved if the segment (i.e. a specific
product, service or department) ceased to exist
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Traceable Costs vs. Common Fixed Costs
• While fixed costs are often allocated to sub-units in
a traditional income statement, they can lead to
false assumptions such as the belief that
elimination of a segment will result in greater
profits.
• Common fixed costs—which would not be
eliminated in the event of dropping a segment—
should not be included in evaluating segment
performance.
• Only traceable fixed costs will be eliminate if a
segment is dropped.
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Segmented Income Statement – Exhibit 6-26
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Selecting Segments and Levels of
Segmentation
• Which way segments are selected depends on how
useful the information will be to managers.
Options include product lines, geographic regions,
size of outlets, or other distinct groupings.
• The level of detail of information available and
required will largely determine the level of
segmentation. Segments can be subdivided further
as is found to be useful (i.e. Electronics division may
be subdivided into various electronics product
groups such as flat-screen televisions.)
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Quick Check
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1. The cost per unit decreases as volume increases
for which of the following cost behaviours?
a.
b.
c.
d.
variable costs and fixed costs
fixed costs and mixed costs
variable costs and mixed costs
only fixed costs
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1. The cost per unit decreases as volume increases
for which of the following cost behaviours?
a.
b.
c.
d.
variable costs and fixed costs
fixed costs and mixed costs
variable costs and mixed costs
only fixed costs
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2. Which of the following would generally be
considered a committed fixed cost for a retailing
firm?
a. cost of annual sales meeting for all employees
b. cost of sponsoring the local golf tournament for
charity
c. lease payments made on the store building
d. cost of a trip to Cancun given to the employee
who is Employee of the Year
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2. Which of the following would generally be
considered a committed fixed cost for a retailing
firm?
a. cost of annual sales meeting for all employees
b. cost of sponsoring the local golf tournament for
charity
c. lease payments made on the store building
d. cost of a trip to Cancun given to the employee
who is Employee of the Year
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3. Which method is used to see if a relationship
between the cost driver and total cost exists?
a.
b.
c.
d.
scatter plot
variance analysis
outlier
account analysis
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3. Which method is used to see if a relationship
between the cost driver and total cost exists?
a.
b.
c.
d.
scatter plot
variance analysis
outlier
account analysis
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4. How is the high point selected for the high-low
method?
a. The point with the highest total cost is
chosen.
b. The point that has the highest costs and
highest volume of activity is always chosen.
c. The point with the highest volume of
activity is chosen.
d. Both the high point and the low point are
selected at random.
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4. How is the high point selected for the high-low
method?
a. The point with the highest total cost is
chosen.
b. The point that has the highest costs and
highest volume of activity is always chosen.
c. The point with the highest volume of
activity is chosen.
d. Both the high point and the low point are
selected at random.
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5. What is the advantage of using regression
analysis to determine the cost equation?
a. The method is objective.
b. All data points are used to calculate the
cost equation.
c. It is generally more accurate than the
high-low method.
d. All the above statements are true about
regression analysis.
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5. What is the advantage of using regression
analysis to determine the cost equation?
a. The method is objective.
b. All data points are used to calculate the
cost equation.
c. It is generally more accurate than the
high-low method.
d. All the above statements are true about
regression analysis.
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6. The contribution margin income statement
a. arrives at operating income by
subtracting operating expenses from
gross profits.
b. is required for external reporting.
c. provides owners with cash flow
information.
d. is useful to managers in decision-making
and planning.
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6. The contribution margin income statement
a. arrives at operating income by
subtracting operating expenses from
gross profits.
b. is required for external reporting.
c. provides owners with cash flow
information.
d. is useful to managers in decision-making
and planning.
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7. The only difference between variable
costing and absorption costing lies in the
treatment of
a. fixed manufacturing overhead costs.
b. variable manufacturing overhead costs.
c. direct materials and direct labour costs.
d. variable nonmanufacturing costs.
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7. The only difference between variable
costing and absorption costing lies in the
treatment of
a. fixed manufacturing overhead costs.
b. variable manufacturing overhead costs.
c. direct materials and direct labour costs.
d. variable nonmanufacturing costs.
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8. A multinational company that produces three
brands of tires (in both all-season and winter
varieties) and 20 different wheel designs (in
both steel and alloy) in North America and
Europe could segment their income
statements in all of the following segments
except for
a. tires and wheels.
b. winter tires, summer tires, steel wheels, and
alloy wheels.
c. North American Region and European
Region.
d. North American Region and Tires.
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8. A multinational company that produces three
brands of tires (in both all-season and winter
varieties) and 20 different wheel designs (in
both steel and alloy) in North America and
Europe could segment their income
statements in all of the following segments
except for
a. tires and wheels.
b. winter tires, summer tires, steel wheels, and
alloy wheels.
c. North American Region and European
Region.
d. North American Region and Tires.
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