39147 cost behaviour
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Cost behaviour: Analysis and
Use
Chapter 5
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Types of Cost behaviourPatterns
Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains
proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Fixed Total fixed cost remains the Fixed cost per unit goes
same even when the activity down as activity level goes up.
level changes within the
relevant range.
Recall the summary of our cost behaviour
discussion from Chapter 2.
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Total Variable Cost Example
Your total long distance telephone bill isbased on how many minutes you talk.
Minutes Talked
T o t a l L o n g D i s t a n c e
T e l e
p h o n e B i l l
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Variable Cost Per UnitExample
Minutes Talked
P e r M i n u t e
T e l e p h
o n e C h a r g e
The cost per minute talked is constant. Forexample, 10 pence per minute.
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Total Fixed Cost Example
Your monthly basic telephone bill isprobably fixed and does not change when
you make more local calls.
Number of Local Calls
M o n t h l y B a s i c
T e l e p h o n e B i l l
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Fixed Cost Per Unit Example
Number of Local Calls M o n t h l y B
a s i c T e l e p h
o n e
B i l l p e r L o c a l C a l l
The fixed cost per local call decreases asmore local calls are made.
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Cost behaviour
Merchandisers
Cost of Goods Sold
Manufacturers Direct Material, Directlabour, and Variable
Manufacturing Overhead
Merchandisers andManufacturers
Sales commissions andshipping costs
Service Organizations
Supplies and travel
Examples of normally variable costs
Examples of normally fixed costsMerchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salariesDepreciation, Advertising
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The Activity Base
Machinehours
Labour hours
Unitsproduced
Milesdriven
A measure of the event
causing the incurrence of a
variable cost – a cost driver
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Step-Variable Costs
Activity
C o
s t
Total cost remains
constant within a
narrow range of
activity.
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Step-Variable Costs
Activity
C o
s t
Total cost increases to anew higher cost for the
next higher range of
activity.
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The Linearity Assumption and
the Relevant Range
Activity
T o t a l C o s t
Economist’s
Curvilinear Cost
Function
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T o t a l C o s t
Economist’s
Curvilinear Cost
Function
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
The Linearity Assumption andthe Relevant Range
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T o t a l C o s t Relevant
Range
The Linearity Assumption andthe Relevant Range
Accountant’s Straight-Line Approximation (constant
unit variable cost)
Economist’s
Curvilinear Cost
Function
A straight line
closely
approximates
a curvilinear
variable costline within the
relevant
range.
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Types of Fixed Costs
Fixed Costs
Discretionary
May be altered in theshort-term by currentmanagerial decisions
Committed
Long-term, cannot bereduced in the short
term.
Examples
Depreciation onBuildings and
Equipment
Examples
Advertising andResearch andDevelopment
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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.
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Example: Office space
is available at a rental
rate of £30,000 per
year in increments of
1,000 square metres.
As the business grows
more space is rented,increasing the total
cost.
Fixed Costs and RelevantRange
Continue
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R e n t C o s t i n
T h o u
s a n d s o f p
o u n d s
0 1,000 2,000 3,000
Rented Area (Square metres)
0
30
60
Fixed Costs and Relevant
Range90
RelevantRange
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.
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How does this type
of fixed cost differ from a step-variable
cost?
Step-variable costscan be adjusted more
quickly and . . .
The width of theactivity steps is much
wider for the fixedcost.
Fixed Costs and RelevantRange
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A mixed cost
has both fixedand variable
components.
Mixed Costs
Consider thefollowing electric
utility example.
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Fixed Monthly
Utility Charge
Variable
Utility Charge
Activity (Kilowatt Hours)
T o t a l U t i l i t y C o s t
Mixed Costs
X
Y
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Fixed Monthly
Utility Charge
Variable
Utility Charge
Activity (Kilowatt Hours)
T o t a l U t i l i t y C o s t
Mixed Costs
X
Y
The total mixed cost line can be expressedas an equation: Y = a + bX
Where: 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
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Fixed Monthly
Utility Charge
Variable
Utility Charge
Activity (Kilowatt Hours)
T o t a l U t i l i t y C o s t
Mixed Costs
bX
a
X
Y
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The Analysis of Mixed Costs
Engineering Approach
Account Analysis
Scattergraph Method
Least-Square Regression Method
High-Low Method
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Account Analysis
Each account is classified as either
variable or fixed based on the analyst’s
knowledge of how the account behaves.
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Engineering Estimates
Cost estimates are based on an evaluationof production methods, and material, labour
and overhead requirements.
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WiseCo recorded the following production activityand 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.
The High-Low Method
Units Cost
High activity level 9,000 9,700£Low activity level 5,000 6,100
Change 4,000 3,600£
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Unit variable cost =Changein cost
Change in units
Units Cost
High activity level 9,000 9,700£
Low activity level 5,000 6,100
Change 4,000 3,600£
The High-Low Method
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Units Cost
High activity level 9,000 9,700£
Low activity level 5,000 6,100
Change 4,000 3,600£
The High-Low Method
Unit variable cost = £3,600 ÷ 4,000 units = £0.90 per unit
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Units Cost
High activity level 9,000 9,700£
Low activity level 5,000 6,100
Change 4,000 3,600£
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
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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
Units Cost
High activity level 9,000 9,700£
Low activity level 5,000 6,100
Change 4,000 3,600£
The High-Low Method
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If sales salaries and commissions are £10,000when 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 unitc. £0.12 per unit
d. £0.125 per unit
The High-Low Method
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If sales salaries and commissions are £10,000when 80,000 units are sold and £14,000 when120,000 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 unitd. £0.125 per unit
The High-Low Method
£4,000 ÷ 40,000 units
= £0.10 per unit
Units Cost
High level 120,000 14,000£
Low level 80,000 10,000 Change 40,000 4,000£
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If sales salaries and commissions are £10,000when 80,000 units are sold and £14,000 when120,000 units are sold, what is the fixed portionof sales salaries and commissions?
a. £ 2,000
b. £ 4,000
c. £10,000
d. £12,000
The High-Low Method
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If sales salaries and commissions are £10,000when 80,000 units are sold and £14,000 when120,000 units are sold, what is the fixed portionof sales salaries and commissions?
a. £ 2,000
b. £ 4,000
c. £10,000
d. £12,000
The High-Low Method
Total cost = Total fixed cost +
Total variable cost
14,000£ = Total fixed cost +
(£0.10 × 120,000 units)
Total fixed cost = £14,000 - £12,000
Total fixed cost = 2,000£
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The Scattergraph Method
Plot the data points on agraph (total cost vs. activity).
0 1 2 3 4
*
T o t a l C o s t i n
1 , 0
0 0 ’ s
o f p o u
n d s
10
20
0
***
* ** **
*
Activity, 1,000’s of Units Produced
X
Y
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The Scattergraph Method
Draw a line through the data points with about an
equal numbers of points above and below the line.
0 1 2 3 4
*
T o t a l C o s t i n
1 , 0
0 0 ’ s
o f p o u
n d s
10
20
0
***
* ** **
*
Activity, 1,000’s of Units Produced
X
Y
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The Scattergraph Method
Estimated fixed cost = £10,000
0 1 2 3 4
*
T o t a l C o s t i n
1 , 0
0 0 ’ s
o f p o u
n d s
10
20
0
***
* ** **
*
Activity, 1,000’s of Units Produced
X
Y
The slope of this line is the variable unitcost. (Slope is the change in total cost for
a one unit change in activity).
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The Scattergraph Method
Slope = Change in costChange in units
Horizontal distance is
the change in activity.
0 1 2 3 4
*
T o t a l C o s t i n
1 , 0 0 0 ’ s
o f p o u
n d s
10
20
0
***
* ** **
*
Activity, 1,000’s of Units Produced
X
Y
Vertical
distanceis the
change
in cost.
S
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• Accountants and managersmay use computer softwareto fit a regression line
through the data points.• The cost analysis objective
is the same: Y = a + bx
Least-Squares RegressionMethod
Least-squares regression also provides a statistic, called
the adjusted R2, that is a measure of the goodness
of fit of the regression line to the data points.
L S R i
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0 1 2 3 4
T o t a l C o s t
10
20
0
Activity
*
***
**
****
Least-Squares RegressionMethod
R2 is the percentage of the variation
in total cost explained by the activity.
R2 for this relationship is near 100% since the data points are
very close to the regression line.
X
Y
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Let’s put our knowledge of cost
behaviour to work
by preparing acontribution format
profit statement.
The Contribution Format
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The Contribution Format
Total UnitSales Revenue 100,000£ 50£
Less: Variable costs 60,000 30
Contribution margin 40,000£ 20£
Less: Fixed costs 30,000
Net profit 10,000£
The contribution margin format emphasizes cost
behaviour. Contribution margin covers fixed costs
and provides for profit.
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The Contribution Format
Used primarily for
external reporting.
Used primarily by
management.
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End of Chapter 5