ACC 202 Intro to Management Accounting Chapter 5: Cost Behavior: Analysis and Use obj 1 Homework Info Exercise #5-11 (2) –“quick and dirty” method means make a scattergraph Learning Objectives Behavior: variable, step, curvilinear, fixed, and mixed Committed & Discretionary Fixed Costs Analysis of Mixed Costs using a scattergraph & high-low method Contribution Format Income Statement Cost Cost Behavior Structure – relative proportion of types of costs in an organization Variable Costs – vary relative to something, which is called the “Activity Base” Relevant Range – range of activity within which assumptions made about cost behavior are valid Cost Types of Cost Behavior Patterns Summary of cost behavior from chapter 2. Summary of Variable and Fixed Cost Behavior Cost Variable In Total Total variable cost changes as the activity level changes. Total fixed cost remains the same even when the activity level changes within the relevant range. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed cost per unit goes down as activity level goes up. Fixed The Activity Base Units produce d A measure of what causes a variable cost to be incurred Miles driven Labor hours Machine hours A Variable Cost: Is a cost whose total dollar amount varies with changes in the activity level. Ex: your total long distance landline phone bill is based on how many minutes you talk. Total Long Distance Landline Phone Bill Minutes Talked Types of Cost Behavior Patterns Summary of cost behavior from chapter 2. Summary of Variable and Fixed Cost Behavior Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes within the relevant range. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed cost per unit goes down as activity level goes up. Fixed Variable Cost Per Unit A variable cost remains constant if expressed on a per unit basis. The cost per minute talked is constant. For example, 10 cents per minute. Per Minute Telephone Charge Minutes Talked Extent of Variable Costs The proportion of variable costs differs across organizations. For example . . . A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. A service company will normally have a high proportion of variable costs. A merchandising company usually will have a high proportion of variable costs like cost of sales. Examples of Variable Costs 1. Merchandising companies – cost of goods sold. 2. Manufacturing companies – direct materials, direct labor, and variable overhead. 3. Merchandising and manufacturing companies – commissions, shipping costs, and clerical costs such as invoicing. 4. Service companies – supplies, travel, and clerical. True Variable Cost Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Cost Volume True Variable Cost Example Direct materials cost varies in direct proportion to the volume of units produced. So, each additional table produced, incurs an additional $100 of direct materials cost. Cost Volume Step-Variable Costs A resource obtainable only in large chunks (such as maintenance workers) whose costs increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost. Cost Volume Step-Variable Costs Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed. Cost Volume Step-Variable Costs Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed Cost Volume The Linearity Assumption & the Relevant Range A straight line Economist’s closely Curvilinear Cost approximates a Function curvilinear Total Cost Relevant Range variable cost line within the relevant range. Accountant’s Straight-Line Approximation (constant unit variable cost) Activity Types of Cost Behavior Patterns Summary of cost behavior from chapter 2. Summary of Variable and Fixed Cost Behavior Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per Unit Variable cost per unit remains the same over wide ranges of activity. Fixed A Fixed Cost: Is a cost whose total dollar amount remains constant as the activity level changes. Ex: Your monthly basic landline phone bill is probably fixed & doesn’t change when you make more local calls. Monthly Basic Landline Phone Bill Number of Local Calls Types of Cost Behavior Patterns Summary of cost behavior from chapter 2. Summary of Variable and Fixed Cost Behavior Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per Unit Variable cost per unit remains the same over wide ranges of activity. Average fixed cost per unit goes down as activity level goes up. Fixed Fixed Cost Per Unit Average fixed costs per unit decrease as the activity level increases. The fixed cost per local call decreases as more local calls are made. Monthly Basic phone Bill per Local Call Number of Local Calls Types of Fixed Costs Committed Long-term & cannot be significantly reduced in the short term. Discretionary Can be altered in the short-term by current managerial decisions Examples Depreciation on Equipment & Real Estate Taxes Examples Advertising & Research and Development The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. Machines now perform many mundane tasks previously done by human beings. “Knowledge workers” are in demand for their minds rather than their muscles Knowledge workers tend to be salaried, highly-trained & difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable. Is Labor a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In France, Germany, China, and Japan management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. In the United States and the United Kingdom management has greater latitude. Labor costs are more variable in nature. Fixed Costs & Relevant Range The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. Example: Insurance on office space is available at a rate of $10,000 per year in increments of 1,000 square feet. As the business grows and more space is needed, the total cost of insurance increases. Fixed Costs & Relevant Range Insurance Cost in Thousands of Dollars 30 Relevant Range 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. 20 10 0 0 1,000 2,000 3,000 Office Area in Square Feet Fixed Costs and Relevant Range How does this type of fixed cost differ from a stepvariable cost? Step-variable costs can be adjusted more quickly and . . . The width of the activity steps is much wider for the fixed cost. Mixed Costs A mixed cost has both fixed and variable components. Consider the example of utility cost. Y Total Utility Cost Variable Cost per KW X Activity (Kilowatt Hours) Fixed Monthly Utility Charge Mixed Costs fixed portion of a mixed cost is the minimum cost of having a service ready and available for use. The variable portion is the cost incurred for actual consumption of the service, and varies in proportion to the amount of service consumed. The Mixed Cost Equation Y = a + bX = total mixed cost a = total fixed cost b = variable cost per unit of activity X = level of activity Y TC = FC + VC p/u (volume) Mixed Costs The total mixed cost line can be expressed as 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 Y Total Utility Cost Variable Cost per KW X Activity (Kilowatt Hours) Fixed Monthly Utility Charge Mixed Costs Question If your fixed monthly utility charge is $40, your variable cost is $0.03 per kilowatt hour, and your monthly activity level is 2,000 kilowatt hours, what is the amount of your utility bill? Analysis of Mixed Costs Gather and analyze past cost and activity data to estimate variable and fixed cost elements. Account Analysis Method Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. Engineering Method Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. Analysis of Mixed Costs past cost and activity data. Plot the data on a scattergraph to test for linearity. Cost behavior is linear when a straight line can approximately pass through the cost and activity data points. Estimate the variable and fixed cost elements using the scattergragh, highlow, or least squares regression methods. Gather The Scattergraph Method Y Maintenance Cost 1,000’s of Dollars Step 1: Plot the data points on a graph (total cost vs. activity). 20 10 * * * * 0 1 2 * ** * ** X 0 3 4 Patient-days in 1,000’s The Scattergraph Method Step 2: Draw a line through the data points with about an equal numbers of points above and below the line. Y Maintenance Cost 1,000’s of Dollars 20 10 * * * * 0 1 2 * ** * ** X 0 3 4 Patient-days in 1,000’s The Scattergraph Method Step 3: Use one data point to estimate the total level of activity and the total cost. Maintenance Cost 1,000’s of Dollars Y Total maintenance cost = $11,000 20 10 * * * * 0 1 2 * ** * ** X Intercept = Fixed cost: $10,000 0 3 4 Patient-days in 1,000’s Patient days = 800 The Scattergraph Method Step 4: Make a “quick & dirty” 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 $ 11,000 10,000 $ 1,000 Variable cost per unit = $1,000 800 = $1.25/patient-day Y = $10,000 + $1.25(X) Total maintenance cost Number of patient days The High-Low Method Assume the following hours of maintenance work and the total maintenance costs for six months. High – Low Method scattergraph shows linearity: Select highest and lowest activity points (not the highest and lowest cost points) Calculate the variable cost per unit: high cost – low cost high activity – low activity Calculate Use Assuming total fixed cost using either pt: total cost – total variable cost this cost equation to predict the mixed cost. The High-Low Method The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours. $2,400 = $8.00/hour 300 The High-Low Method Total Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $9,800 – ($8/hour × 800 hours) Total Fixed Cost = $9,800 – $6,400 Total Fixed Cost = $3,400 The High-Low Method The Cost Equation for Maintenance TC = $3,400 + $8.00(X) 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. This method uses all of the data points to estimate the fixed and variable cost components of a mixed cost. The goal of this method is to fit a straight line to the data that minimizes the sum of the squared errors. Comparing Results From the Three Methods 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. The Contribution Format Sales Revenue Less: Variable costs Contribution margin Less: Fixed costs Net operating income Total $ 100,000 60,000 $ 40,000 30,000 $ 10,000 Per Unit $ 50 30 $ 20 The contribution margin format emphasizes cost behavior. Contribution margin (CM) covers fixed costs and provides for income. Uses of the Contribution Format 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 (Chapter 6). 2. Budgeting (Chapter 9). 3. Segmented reporting of profit data (Chapter 12). 4. Special decisions such as pricing and make-orbuy analysis (Chapter 13). The Contribution Format Used primarily for external reporting. Used primarily by management.