Sketching Cost Curves

Objectives:

construct cost curves

LETS RECAP.

Remember costs include:

Fixed

costs
Variable costs
Mixed costs

Fixed Cost

Fixed costs are the costs that are independent of

the number of goods you produce, or more simply
the costs you incur when you do not produce any
goods.

Total Variable Costs

These are just the opposite of fixed costs; these

are the costs that do change when we produce
more.

Mixed Cost
Other cost act like a combination of fixed
and variable cost.
These kinds of costs are called mixed costs.
Like a fixed cost it has an amount even
when volume is at zero.
Then unlike a fixed cost it increases
steadily in production to the increase in
volume.

The simpliest of handling mixed cost is to

separate them into fixed and variable
components.
The fixed component is added to other fixed
costs for the planning period and the variable
component is added to the other variable costs
for the planning period.

Cost Classifications for

Predicting Cost Behavior
How a cost will react to
changes in the level of
activity within the relevant
range.

Total variable costs change

when activity changes.

Total fixed costs remain

unchanged when activity
changes.

Cost Classifications for

Predicting Cost Behavior
Behavior of Cost (within the relevant range)
Cost

In Total

Per Unit

Variable

Total variable cost changes

as activity level changes.

Variable cost per unit remains

the same over wide ranges
of activity.

Fixed

Total fixed cost remains

the same even when the
activity level changes.

Average fixed cost per unit goes

down as activity level goes up.

Examples of Variable Costs

1. Merchandising companies cost of goods sold.
2. Manufacturing companies direct materials, direct
labour, and variable overhead.
3. Merchandising and manufacturing companies
commissions, shipping costs, and clerical costs such as
invoicing.

4. Service companies supplies, travel, and clerical.

Types of Fixed Costs

Committed

Discretionary

Long-term, cannot be
significantly reduced
in the short term.

May be altered in the shortterm by current managerial

decisions

Examples

Examples

Depreciation on
Equipment and
Real Estate

Advertising and
Research and
Development

Mixed Costs

Total Mobile Phone Cost

Variable Monthly
Phone Charge

X
Activity (minutes)

Fixed Monthly

Phone Charge

Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:

Total Mobile Phone Cost

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

Variable
Cost per minute

Activity (minutes)

Fixed Monthly
Phone Charge

The Scattergraph Method

Plot the data points on a graph
(total cost vs. activity).

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s

The Scattergraph Method

Draw a line through the data points with about an
equal numbers of points above and below the line.
Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s

The Scattergraph Method

Draw a line through the data points with about an
equal numbers of points above and below the line.
Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s

The Scattergraph Method

Make a quick estimate of variable cost per unit and
determine the cost equation.
Total maintenance at 800 patients
Less: Fixed cost
Estimated total variable cost for 800 patients

Variable cost per unit =

$1,000
800

$11000
$10000
$1000

= $1.25/patient-day

Y = $10,000 + $1.25X
Total maintenance cost

Number of patient days

Now lets get down to business

SKETCHING COST CURVES

Introduction:

The most important building block for cost

accounting is the characterization of how costs
change as output volume changes.

Output volume can refer to production, sales, or

any other principle activity that is appropriate
for the organization under consideration (e.g.:
for a school, number of students enrolled; for a
health clinic, number of patient visits; for an
airline, number of passenger miles).

The following discussion examines the volume

of production in a factory, but the same
principles apply regardless of the type of
organization and the appropriate measure of
activity

Variable Costs:

Variable costs vary in a linear fashion with the

production level. However, when stated on a per
unit basis, variable costs remain constant across
all production levels within the relevant range.
The following two charts depict this relationship
between variable costs and output volume.

CASE 1

A good example of a variable cost is materials. If

one pair of pants requires $10 of fabric, then
every pair of pants requires $10 of fabric, no
matter how many pairs are made.
The fabric cost is $10 per unit at every level of
production. If one pair is made, the total fabric
cost is $10; if two pairs are made, the total fabric
cost is $20; and if 1,000 pairs are made, the total
fabric cost is $10,000. Hence, the total cost is
increasing and linear in the production level.
(SEE THE TWO GRAPHS BELOW)

Variable Cost Per Unit

Total Variable Cost Curve

Fixed Costs:

Fixed costs do not vary with the production

level. Total fixed costs remain the same, within
the relevant range.
However, the fixed cost per unit decreases as
production increases, because the same fixed
costs are spread over more units. The following
two charts depict this relationship between fixed
costs and output volume.

Case 2

In this example, fixed costs are $50,000. The

first chart shows that fixed costs remain $50,000
at all production levels from 100 units to 1,000
units. The second chart shows that the fixed
cost per unit decreases as production increases.
Hence, when 100 units are manufactured, the
fixed cost per unit is $500 ($50,000 100).
When 500 units are manufactured, the fixed cost
per unit is $100 ($50,000 500)

Total Fixed Cost

Fixed Cost Per Unit

Mixed Costs:

If, within a relevant range, a cost is neither fixed

nor variable, it is called semi-variable or mixed.
Following are two common examples of mixed
costs.

Case 3

In this example, although the total cost line

increases in production, it does not pass through
the origin because there is a fixed cost
component. An example of a cost that fits this
description is electricity. A fixed amount of
electricity is required to run the factory air
conditioning, computers and lights. There is also
a variable cost component related to running the
machines on the factory floor.

The fixed component in this example is $3,000

per month. The variable cost component is $10
per unit of output. Hence, at a production level
of 500 units, the total electric cost is $8,000
[$3,000 + ($10 x 500)].

Mixed costs

What is meant by relevant

range

The relevant range is the range of activity (e.g.,

production or sales) over which these
relationships are valid.
Or
Relevant range: Relevant range is a term that
relates to machinery and equipment. Think of
relevant range as the maximum level of use for
the item you operate in your business.

Case 4

The mixed cost illustrated in the chart below is

called a step function.

An example of such cost behaviour would be the total

salary expense for shift supervisors.
If the factory runs one shift, only one shift supervisor is
required. In order for the factory to produce above the
maximum capacity of a single shift, the factory must
add a second shift and hire a second shift supervisor, so
that total shift supervisor salary expense doubles. If the
factory runs three shifts, three shift supervisors are
required

Step Fixed Cost Curve

Step-variable costs

Step-variable costs are costs that stay fixed

over a range of activity and then change after
this range is overcome. In other words, these
costs change in increments.

Step-variable costs

Step-variable costs include characteristic of both

variable and fixed costs in a way that (a) step-variable
costs do change as production level changes, and (b)
step-variable costs change only when a production level
(range of activity) is overcome.
Within that range of activity step-variable costs remain
fixed. The major differences between step-variable
costs and fixed costs are that step-variable costs are
changed by activity (rather than by a management
decision) and step-variable costs are more easily
changed compared to fixed costs.

Step-variable Costs

To illustrate step-variable costs, let us use the example

with valve production. One employee can operate
equipment to produce 100 valves per day. If 320 valves
need to be produced, Friends Company would hire four
employees (three employees won't be enough because
three employees can only produce 300 valves). If the
valve production requirement is increased to 400 units,
four workers will still be able to cope with the work load.
However, for 410 valves, an additional, fifth employee
would be needed. Thus, the company's payroll costs
change in steps, from costs for four employees at 320 or
400 units, to payroll costs for five employees at 410 units

Step Variable Cost Curve

Assignment

Worksheet no. 1