COST BEHAVIOR: ANALYSIS

AND USE
Types of Cost Behavior Patterns
An activity base (also called a cost driver) is a measure of what causes the incurrence of
variable costs. As the level of the activity base increases, the total variable cost increases
proportionally.
Units produced (or sold) is not the only activity base within companies. A cost can be
considered variable if it varies with activity bases such as miles driven, machine hours, or
labor hours.
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.
A variable cost remains constant if expressed on a per unit basis. Referring to the cell phone
example, the cost per overage minute is constant, for example 45 cents per overage minute.
Some examples of variable costs that are likely present in many types of businesses are:
Merchandising companies cost of goods sold.
Manufacturing companies direct materials, direct labor, and variable overhead.
Merchandising and manufacturing companies commissions, shipping costs, and
clerical costs such as invoicing.
Service companies supplies, travel, and clerical.

True Variable Cost vs. Step-Variable 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.
Direct material is an example of a cost that behaves in a true variable pattern. Direct
materials purchased but not used can be stored and carried forward to the next period of
inventory.
A step-variable cost is a resource that is obtainable only in large chucks and whose costs
change only in response to fairly wide changes in activity. For example, maintenance
workers are often considered to be a variable cost, but this labor cost does not behave as a
true variable cost.

The Linearity Assumption and the Relevant Range

Economists correctly point out that many costs which accountants classify as variable costs
actually behave in a curvilinear fashion.

COST BEHAVIOR: ANALYSIS

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Nonetheless, within a narrow band of activity known as the relevant range, a curvilinear cost
can be satisfactorily approximated by a straight line.
The relevant range is that range of activity within which the assumptions made about cost
behavior are valid.
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.
For example, the fixed cost per minute used decreases as more allowed minutes are used.
As you make more and more allowed calls, the basic rate cost per call decreases. If your
basic rate is $39 per month and you make one allowed call per month, the average basic
rate is $39 per call. However, if you make 100 allowed calls per month, the average basic
rate per call drops to 39 cents per call.

Fixed Costs
The relevant range of activity for a fixed cost is the range of activity over which the graph of
the cost is flat.

Mixed Cost
The mixed cost line can be expressed with the equation Y = a + bX. This equation should
look familiar, from your algebra and statistics classes.
In the equation, Y is the total mixed cost; a is the total fixed cost (or the vertical intercept of
the line); b is the variable cost per unit of activity (or the slope of the line), and X is the
actual level of activity.
In our utility example, Y is the total mixed cost; a is the total fixed monthly utility charge; b
is the cost per kilowatt hour consumed, and X is the number of kilowatt hours consumed.

Analyzing Mixed Costs

High-Low Method

To analyze mixed costs with the high-low method, the first step is to choose the data points
pertaining to the highest and lowest activity levels. In the example above, the high level of
activity was in June at 850 hours of maintenance and the low level of activity is in February

COST BEHAVIOR: ANALYSIS

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with 450 hours of maintenance. Notice that this method relies upon two data points to
estimate the fixed and variable portions of a mixed cost.
The second step is to determine the total costs associated with the two chosen points. We
incurred costs of $9,800 at the high level of activity and $7,400 at the low level of activity.
The third step is to calculate the change in cost between the two data points. The change in
maintenance hours was 400 hours and the change in maintenance dollars was $2,400.
Notice, this method relies upon two data points to estimate the fixed and variable portions of
a mixed costs, as opposed to one data point with the scattergraph method.
For this example, we divide $2,400 by 400 and determine that the variable cost per hour of
maintenance is $6.00.
The fourth step is to take the total cost at either activity level (in this case, $9,800).
Deduct the variable cost component ($6 per hour times 850 hours) for the total cost of
$9,800.
The difference represents the estimate of total fixed costs ($4,700).
The fifth step is to construct an equation that can be used to estimate the total cost at any
activity level (Y = $4,700 + $6.00X). The basic equation of Y is equal to $4,700 (the total
fixed cost) plus $6 times the actual level of activity.