Cornerstones

of Managerial Accounting 3e
MOWEN / HANSEN / HEITGER
COPYRIGHT 2009 South-Western/Cengage Learning

Chapter Three Cost Behavior

Learning Objectives
1. Explain the meaning of cost behavior and define and describe fixed and variable costs. 2. Define and describe mixed and step costs.

Learning Objectives
3. Separate mixed costs into their fixed and variable components using the high-low method, the scattergraph method, and the method of least squares 4. (Appendix) Use a personal computer spreadsheet program to perform the method of least squares.
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OBJECTIVE 1
Explain the meaning of cost and behavior, and define and describe fixed and variable costs.

Cost Behavior
The way costs change as the related activity changes. Fixed Cost =

A cost that does not change in total as output changes

Cost Behavior
The way costs change as the related activity changes. Variable Cost = Increases in total with an increase in output and decreases in total with a decrease in output

Measures of Output
To determine if a cost is fixed or variable, we must first determine the underlying business activity and ask ourselves
What causes the cost of this particular activity to go up (or down)?
In other words, we are trying to identify its driver.
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Relevant Range
The range of output over which the assumed cost relationship is valid for the normal operations of a firm.
Avoids extremely high levels of activity Avoids extremely low levels of activity
Lets take a closer look at fixed, variable, and mixed costs, in light of the relevant range.
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Fixed Costs

Cost that in total are constant within the relevant range as the level of output increases or decreases.

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Example
Colley Computers Inc. wants to look at the cost relationship between supervision cost and the number of computers processed.
It process up to 50,000 computers per year. The production-line manager (supervisor) is paid $32,000 per year. The company was established 5 years ago. Currently the factory produces 40,000 50,000 computers per year. Production has never fallen below 20,000 computers in a year.
Lets look at the cost of supervision at several production levels. 11

Example
# of Computers Produced Total Cost of Supervision

Unit Cost

20,000

$32,000 $32,000
$32,000 $32,000
We know the total cost of supervision, but what about per computer? 12

30,000
40,000 50,000

Example
# of Computers Produced Total Cost of Supervision

Unit Cost

20,000

$32,000 $32,000
$32,000 $32,000

$1.60
1.07 0.80 0.64

30,000
40,000 50,000

Unit cost changes! As production increases, the per unit amount of a fixed cost decreases.

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Discretionary Fixed Costs

Fixed costs that can be changed relatively easily at management discretion.

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Committed Fixed Costs

A fixed costs that can not be easily changed. Often these involve a long-term contract.

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Variable Costs

Costs that in total vary in direct proportion to changes in output within the relevant range.

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Variable Cost Behavior Example

Expanding our Colley Computers example. Each computer requires one DVD-ROM drive costing $40. The cost of DVD-ROM drives for various levels of production is as follows:
Lets look at the cost of DVDROMs at several production levels.
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Variable Cost Behavior Example

# of Computers Produced Total Cost of DVD-ROM Drives

Unit Cost

20,000

$800,000 $1,200,000
$1,600,000 $2,000,000
We know the total cost increases as production increases. But what about the cost per computer? 18

30,000
40,000 50,000

Variable Cost Behavior Example

# of Computers Produced Total Cost of DVD-ROM Drives

Unit Cost

20,000

$800,000 $1,200,000
$1,600,000 $2,000,000
Unit cost stays the same! The per unit variable cost of DVD-ROM drives is always $40 per computer.

$40
40 40 40

30,000
40,000 50,000

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Variable Cost Relationship

Total Variable Variable = Cost Rate Amount of x output

Lets look at the DVD-ROM costs for 50,000 computers.

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Variable Cost Relationship

Total Variable Variable = Cost Rate
$2,000,000

Amount of x output

$40 per 50,000 x computer computers

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OBJECTIVE 2
Define and describe mixed and step costs.

Mixed Costs
Costs that have both a fixed and a variable component. Formula: Total Cost =

Total Fixed Cost

Total Variable + Cost

Lets look at an example from the Colley Computers

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Example
Colley Computers has 10 sales representatives Each earns a salary of $30,000 per year. And a commission of $25 per computer sold. Each sales rep sells up to 50,000 computers per year.

Lets plug this into our mixed cost formula.

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Mixed Cost Example

Formula: Total Cost = Total Fixed Cost +

Total Variable Cost

Total Cost

($25 x # of $30,000 + computers sold)

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Step Costs

Display a constant level of cost for a range of output and then jumps to a higher level of cost at some point where it remains for a similar level of output.

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OBJECTIVE 3
Separate mixed costs into their fixed and variable components using the highlow method, the scattergraph method and the method of least squares.

Separating Costs
Accounting records typically show only the total cost and the associated amount of activity of a mixed cost item.
Therefore it is necessary to separate the total cost into its fixed and variable components. How do we separate the costs?
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Separating Costs
Three steps:
1. High-Low method 2. Scattergraph method 3. Method of Least Squares

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Dependent Variable in the Cost Formula

Total Cost = Total Fixed + Cost Total Variable Cost

Variable Rate x Output

Total Cost

Total Fixed Variable x = + Cost Rate

Output

Dependent Variable
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Dependent Variable

A variable whose value depends on the value of another variable.

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Independent Variable in the Cost Formula

Total Cost = Total Fixed + Cost Total Variable Cost

Total Cost

Total Fixed Variable + x Output Cost Rate

Independent Variable

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Independent Variable

A variable that measures output and explains changes in the cost.

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Intersect
Graphically, the intersect is the point at which the cost line intercepts the cost (vertical) axis.

Intercept

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Intercept in the Cost Formula

Total Cost = Total Fixed + Cost Total Variable Cost

Total Cost

Total Fixed Variable + x Output Cost Rate

Intercept
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Slope in the Cost Formula

Total Cost = Total Fixed + Cost Total Variable Cost

Total Cost

Total Fixed Variable + x Output Cost Rate

Slope
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Slope
Corresponds to the variable rate (the variable cost per unit of output). It is the slope of the cost line.
Lets work through an example.

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Cornerstone 3-1
HOW TO Create and Use a Cost Formula

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Example
Information:

The art and graphics department of State College decided to equip each faculty office with an inkjet color printer. Sufficient color printers had monthly depreciation of $250. The department purchased paper in boxes of 10,000 sheets for $35 per box. Ink cartridges cost $30 and will print, on average, 300 sheets.
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Example
Required: Create a formula for the monthly cost of inkjet printing in the arts and graphics department. If the department expects to print 4,400 pages next month, what is the.
Expected fixed cost? Total variable cost? Total printing cost?
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Example
Total Fixed Cost

Total Cost

Total Variable Cost

Total Cost of Printing

$250

Depreciation per month is a fixed cost.

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Example
Total Fixed Cost Total Variable + Cost

Total Cost

Total Cost of Printing

$250 + ($0.1035 x No. of pages)

Paper is $0.0035 per sheet and ink is $0.10 per sheet. Paper and ink are the two variable costs.
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Example
Total Cost of Printing = $250 + ($0.1035 x No. of pages) 4,400

Using 4,400 as the number of pages.

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Example
Total Cost of Printing = $250 + ($0.1035 x No. of pages) $0.1035 x 4,400

$455.40
Total Variable Cost

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Example
Total Cost of Printing = $250 + ($0.1035 x No. of pages) $0.1035 x 4,400

$705.40

= $250

$455.40

Total Fixed Costs

Total Costs for 4,400 pages

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High-Low Method
A method of separating mixed costs into fixed and variable components by using just the high and the low data points.

Step #1 Find the high point and low point.

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High-Low Method
Step #2 Using the high and low points, calculate the variable rate.
High point cost Low point cost Variable rate = High point output Low point output

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High-Low Method
Step #3 Calculate the fixed cost using the variable rate and either the high point or the low point.
Total cost at Fixed Cost = high point (Variable rate x Output at high point)

Or Low Point

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High-Low Method
Step #4 Form the cost formula based on the high-low method.
Cornerstone 3-2 will walk us through an example of the High-Low method.

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Cornerstone 3-2
HOW TO Use the High-Low Method to Calculate Fixed Cost and the Variable Rate and to Construct a Cost Formula

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Example
Information: Blue Denim Company controller wants to calculate the fixed and variable costs associated with electricity used in the factory.

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Example
Required: Using the High-Low method, calculate the fixed cost of electricity, calculate the variable rate per machine hour, and construct the cost formula for total electricity cost.

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Blue Denim Company

Month Electricity Costs Machine Hours

January February March April May June July August

$3,255 3,485 4,100 3,300 3,312 2,575 3,910 4,200

450 500 600 470 470 350 570 590

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Step #1 Identify the high and low points

Blue Denim Company

Month Electricity Costs Machine Hours

January February March April May June July August

$3,255 3,485 4,100 3,300 3,312 2,575 3,910 4,200

High Point

450 500 600 470 470 350 570 590

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Blue Denim Company

Month Electricity Costs Machine Hours

January February March April May June July August

Low Point

$3,255 3,485 4,100 3,300 3,312 2,575 3,910 4,200

450 500 600 470 470 350 570 590

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High-Low Method
Step #2 Using the high and low points, calculate the variable rate.
High point cost Low point cost Variable rate = High point output Low point output Variable rate = $4,100 - $2,575 600 - 350

Variable rate = $6.10 per machine hour

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High-Low Method
Step #3 Calculate the fixed cost using the variable rate and either the high point or the low point.
Total cost at (Variable rate x Output Fixed Cost = high point at high point)
We will choose to use the high point

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High-Low Method
Total cost at (Variable rate x Output Fixed Cost = high point at high point) Fixed Cost = $4,100 ($6.10 x 600)

Fixed Cost = $4,100 - $3,660 Fixed Cost = $440

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High-Low Method
Step #4 Form the cost formula based on the high-low method.
Total electricity cost = $440 + ($6.10 x Machine hrs.)

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Cornerstone 3-3
HOW TO Use the High-Low Method to Calculate Predicted Total Variable Cost and Total Cost for Budgeted Output

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Example
Information: Blue Denims formula for monthly electrical cost: Total electricity cost

$440 + ($6.10 x Machine Hrs)

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Example
Required:

Assume that 550 machine hours are budgeted for the month of September. Using the formula calculate the following: Total variable electricity cost for October Total electricity cost for October

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Example
Monthly Electricity Cost Formula Total electricity cost = $440 + ($6.10 x Machine hrs.)
Total electricity cost = $440 + ($6.10 x 550)
550 machine hours

Example
Monthly Electricity Cost Formula Total electricity cost = $440 + ($6.10 x Machine hrs.)
Total electricity cost = $440 + ($6.10 x 550) Total electricity cost = $440 + $3,355

Total variable electricity cost

Example
Monthly Electricity Cost Formula Total electricity cost = $440 + ($6.10 x Machine Hrs)
Total electricity cost = $440 + ($6.10 x 550) Total electricity cost = $440 + $3,355 Total electricity cost = $3,795

High-Low Method
Disadvantages:
High and low points can be outliers and may represent atypical cost-activity relationships. Even if these points are not outliers, other pairs of points may clearly be more representative.
The scattergraph method does a better job of separating the costs.
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Cornerstone 3-4

HOW TO Use the High-Low Method to Calculate Predicted Total Variable Cost and Total Cost for a Time Period That Differs from the Data Period.

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Example
Information: Blue Denims formula for monthly electrical cost: Total electricity cost

$440 + ($6.10 x Machine hrs.)

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Example
Required:

Assume that 6,500 machine hours are budgeted for the coming year. Use the formula to make the following calculations:
Total variable electricity cost for the year Total fixed electricity cost for the year Total electricity cost for the coming year.
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Example
Total Variable Electricity Cost

= Variable Rate

Machine hours

Total Variable Electricity Cost

$6.10

6,500

Total Variable = $39,650 Electricity Cost

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Example
Total Fixed Cost Total Fixed Cost Monthly Fixed Cost = $440 = x x 12 Months

12 Months

Total Fixed Cost

$5,280

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Example
Total Electricity Cost = Fixed Cost + Variable Cost

Total Electricity Cost

$5,280

$39,650

Total Electricity Cost

= $44,930
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Scattergraph Method
Purpose of the method: To see whether a straight line reasonably describes the cost relationship To reveal one or more points that do not seem to fit the general pattern of behavior

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Scattergraph Method
Applying the method: Draw a graph with units on the x-axis and cost on the y-axis Plot the data points on the graph Visually fit a line to the data points on the graph The intercept is the fixed cost Use the high-low method to determine the variable rate
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Scattergraph Method
Disadvantage: Lack of any objective criterion for choosing the best fitting line.
We need a method that is objective and produces the bestfitting line.

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Method of Least Squares

A statistical way to find the best-fitting line through a set of data points.

What does best fitting mean?

The line is one in which the data points are closer to the line to any other line.

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Method of Least Squares

Measure distance from points to line. Then square the differences. Add up all the squared differences.

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Method of Least Squares

Spreadsheet programs have packages to calculate the bestfitting line (called regression line).

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Cornerstone 3-5
HOW TO Use the Regression Method to Calculate Fixed Cost and the Variable Rate and to Construct a Cost Formula and to Determine Budgeted Cost

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Example
Information:

Blue Denims electricity cost and machine hours data for the past nine months (given in Cornerstone 3-2)
Coefficients shown by regression program: Intercept X Variable 321 6.38
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Example
Required:

Using the results of regression, calculate: The fixed cost of electricity and the variable rate per machine hour. Construct the cost formula for total electricity cost. Calculate the budgeted cost for next month assuming that 550 machine hours are budgeted.
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Example
The fixed cost and the variable rate are given directly by regression. Fixed Cost = $321 Variable Rate = $6.38
X Variable
Intercept

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Example
Total Electricity Cost Total Electricity Cost

Fixed Cost

+ Variable Cost

$321

($6.38 x 550)

Budgeted machine hours

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Example
Total Electricity Cost Total Electricity Cost

Fixed Cost

+ Variable Cost

$321

($6.38 x 550)

Total Electricity Cost

$3,830
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Managerial Judgment

Instead of the three methods previously discussed, many managers simply use their experience and past observation of cost relationships to determine fixed and variable costs.

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Managerial Judgment with Estimation

Managers may use experience and judgment to refine statistical estimation results.
Statistical techniques are highly accurate in depicting the past, but they cannot foresee the future.

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