What is cost?

The term cost does not have a definite meaning and its scope is extremely
broad and general;

However cost is defined as;

“The amount of expenditure (actual or national) incurred or attributed to a

given thing”

VARIABLE COST:-
A variable cost is a cost which tends to vary with the level of activity.

 Total variable cost is proportional to the activity level with the

relevant range.

 Variable cost per unit remains the same over wide range of
activity.
 Example of total variable cost
Your total long distance telephone bill is based on how many minutes
you talk.

TOTAL LONG DISTANCE

TELEPHONE BILL

MINUTES TALKED

EXAMPLE OF VARIABLE COST PER UNIT

The cost per minute talked is constant

For example RS.3 per minute.

Per minute telephone

charge

minutes talked
Some variable cost behave in a true variable or proportionately variable
pattern. Other variable cost behave in a step variable pattern.

True variable cost

True variable cost is defined as a type of cost which varies in direct

proportion to the level of production activity.

Example:-

Direct material is a true proportionately variable cost because the amount

used during a period will vary in direct proportion to the level of production
activity. Moreover any amounts purchased but not used can be stored and
carried forward to the next period of inventory.

Step variable cost

The cost of a resource that is obtainable only in large chunks and that
increases or decreases only in response to fairly wide changes in activity is
known as a step variable cost.

Example:-

The wages of skilled repair technician are often considered to be a step

variable cost.

Why we put this example in step variable cost not in true variable cost?

The answer is “such a technician’s time can only be obtained in large

chunks it is difficult to hire a skilled technician on anything other than a full
time basis.

Another reason:-

Moreover any technician’s time not currently used can not be stored as
inventory and carried forward to the next period.

Fixed cost
A fixed cost is a cost which is fixed for a particular period of time and
which within certain activity levels is unaffected by changes in the level of
activity.
Total fixed costs remain constant within the relevant range of
activity but change with per unit.

Since fixed cost remains constant in total the average fixed cost per
unit becomes progressively smaller as the level of activity
increases.

Example of total fixed cost

Your monthly unlimited wateen internet package bill is fixed and does not change
when you open more websites.

Example of unit fixed cost

Your monthly unlimited wateen internet package but as you open more links the per
unit cost of each link decreases or as much you download more the cost of
downloadable reduces.

Types of fixed costs

Committed fixed cost
Investments in facilities ,equipment , and the basic organization that can’t be
significantly reduced even for short periods of time without making fundamental
changes are referred to as committed fixed cost.

Example
1. Deprication of buildings and equipment

2. Real estate Taxes

3. Insurance expenses

4. Salaries of top management

Discretionary fixed cost / managed fixed cost

Discretionary fixed costs usually arise from annual decisions by management to
spend on certain fixed cost items.

The most important characteristic of discretionary fixed cost is that management is

not locked into its decisions regarding such cost.

Discretionary cost can be adjusted from year to year or even perhaps during the
course of a year if necessary.

Examples
1. Advertising

2. Research

3. Public relations

4. Management programs and internships for students

Differences between discretionary fixed and committed fixed cost

Discretionary cost Committed fixed cost

 Planning horizon for discretionary  Planning horizon that

fixed cost is short term. encompasses many years.

Usually a single year

 Cost can be cut for short period of

 time with minimal damage to the  It can not be for short period of
long run goals of the organization. time.

Example

Due to poor economic condition

company can reduced spending on
management development.

Mixed cost
Mixed cost has both fixed and variable components.

Mixed cost is also named as semi variable cost.

Since mixed cost is represented by a straight line, the following equation for
straight line can be used to express the relationship between a mixed cost and the
level of activity.

Y=a+bX
Y = total mixed cost x= the level of activity

a = total fixed cost ( the vertical interpret of the line)

b = the variable cost per unit or activity (the slope of the line)
 Machine hours

The analysis of mixed cost:-

 Accounting analysis

 Engineering approach

 High low method

 Scatter graph method

 Least-square regression line method

Accounting analysis
Each accountant is classified as either fixed or variable cost base on the
analyst’s knowledge of how the account behaves.

Engineering estimates
Cost estimates are based on an evaluation of production methods , the material ,
labour and overhead requirements.

High low method

In high low method using two level of activity high and low inventory compete

The variable cost per unit

Fixed cost and then

Express the cost in equation form Y = a +bX

Algebraic procedure used to separate a semivariable cost or Mixed Cost into the
fixed and the variable components. The high-low method, as the name indicates,
uses two extreme data points to determine the values of a (the fixed cost
portion) and b (the variable rate) in the Cost- Volume. The extreme data points
are the highest and lowest x - y pairs.

Example
Let us take the example of an air conditioner reparing shop using high low
method, we must first identify the periods with the highest and lowest activity in
this case we take the data for the month of june and april. We than use the
activity and cost data from these two periods to estimate the variable cost
component as follows:

No of air conditioners Maintenance cost

come for reparing (days) incurred RS

High activity level(june) 8,000 RS.9,800

Low activity level (april) 5,000 RS.7,400

Change 3,000 RS.2400

Variable cost = change in cost = Rs.2,400 = RS.0.80

Change in activity 3,000

Fixed cost element = total cost – variable cost element

= RS 9,800 – (RS. 0.80 × 8,000 )

= RS. 3,400

Y = RS.3,400 + RS.0.80 X

Y =Total maintenance cost x= total no of air conditioners come for repair in

one day

Scattered graph method

the first step in analyzing the cost and activity data is to plot the data on
scattergraph. This plot immediately reveals any nonlinearities or other
problems with the data. Two things should be noted about this
scattergraph.

The Total maintenance cost ,Y is plotted on the vertical axis. Cost is

known as the dependent variable.

The activity , X is plotted on the horizontal axis. Activity is known as

independent variable , since it causes variations in the cost.
 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.

 The least squares regression method, unlike the high low method, uses
all of the data to separate a mixed cost into its fixed and variable
components.

 The goal of this method is to fit a straight line to the data that
minimizes the sum of squared error.

 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.

R2 is the percentage of the variation in the dependent variable (total

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

Preparing an income statement using contribution

formate
 Total unit

Sales revenue 100,000 50

Less variable cost (60,000) (30)

_______________ __________

Contribution 40,000 20
margin
30,000 ____________
Less fixed cost
______________

10,000
Net operating
income

The contribution margin formate emphasizes cost behavior.

Contribution margin covers fixed costs and provides for income.

Uses of the contribution formate:-

The contribution income statement format is used as an internal
planning and decision-making tool. We will use this approach for:

1. Cost-volume-profit analysis

2. Budgeting

3. Segmented reporting of profit data

4. Special decisions such as pricing and make-or-buy analysis

Comparing results from three method

 The three methods just discussed provide slightly different
estimates of the fixed and variable cost components of the
mixed cost.

 This is to be expected because each method uses differing

amounts of the data points to provide estimates.
 Least-squares regression provides the most accurate estimate
because it uses all the data points.