Cost Behavior Analysis

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.
3. Separate mixed costs into their fixed and variable
Cost Behavior Assumptions and Limitations
components using the high-low method, the scatter
graph method, and the method of least squares. ▪ RELEVANT RANGE Assumption
Relevant range refers to the range of activity within
which the cost behaviour patterns are valid. Any level of
Basics of Cost Behavior
activity outside this range may show a different cost
▪ Cost behavior is the relationship between cost and behavior pattern.
activity – as to how costs react to changes in an activity
▪ TIME Assumption
like production. As production increase, some costs
remain the same (i.e. fixed) while some costs increase or The cost behavior patterns identified are true only over a
decrease (i.e. variable). specified period of time. Beyond this, the cost may show
a different cost behavior pattern.
▪ Cost behavior is the foundation upon which managerial
accounting is built. ▪ LINEARITY Assumption
▪ Describes whether a cost changes when the level of The cost is assumed to manifest a linear relationship
output changes. over a relevant range despite its tendency to show
otherwise over the long run.
▪ Costs can be variable, fixed, or mixed.
Fixed Cost
▪ A cost that does not change in total as output changes
is a fixed cost. ▪ Fixed costs are costs that in total are constant within
the relevant range as the level of output increases or
▪ A variable cost, on the other hand, increases in total
decreases.
with an increase in
▪ Example: The rental cost of warehouse space by a
output and decreases in total with a decrease in output.
wholesaler is fixed for the term of the lease. If the
▪ Knowing how costs change as output changes is wholesaler’s sales go up or down, the cost of the leased
essential to planning, controlling, and decision making. warehouse stays the same.
To illustrate fixed cost behavior, consider a
factory operated by Colley Computers, Inc., a company
Measures of Output and the Relevant Range
that produces unlabeled personal computers for small
▪ Fixed and variable costs have meaning only when computer stores across the Midwest. The assembly
related to some department of the factory assembles components into a
completed personal computer. Assume that Colley
output measure. Computer wants to look at the cost relationship between
▪ A cost driver is a causal factor that measures the output supervision cost and the number of computers processed
of the activity that leads (or causes) costs to change. and has the following information:

▪ Identifying and managing drivers helps managers better ▪ The assembly department can process up to 50,000
predict and control costs. computers per year.
▪ The assemblers (direct labor) are supervised by a
production-line manager who is paid $32,000 per year.
Relevant Range and Cost Relationship
▪ The company was established 5 years ago.
▪ Relevant range is the range of output over which the
assumed cost ▪ Currently, the factory produces 40,000 to 50,000
computers per year.
relationship is valid for the normal operations of a firm.
▪ Production has never fallen below 20,000 computers in
▪ Limits the cost relationship to the range of operations a year.
that the firm normally expects to occur.
▪ The number of computers produced is called the output The formula for a mixed cost is as follows:
measure, or
Total cost = Total fixed cost + Total variable cost
driver.
▪ Even though fixed costs may change, this does not
Step Costs: Narrow Steps
make them variable.
▪ Some cost functions may be discontinuous.
▪ They are fixed at a new higher (or lower) rate.
▪ Known as step costs (or semi-fixed).
▪ Displays a constant level of cost for a range of output
and then jumps to a higher level (or step) of cost at some
point, where it remains for a similar range of output.

Discretionary Fixed Cost and Committed Fixed Cost

▪ Two types of fixed costs: discretionary fixed costs and
committed fixed
costs.
▪ Discretionary fixed costs are fixed costs that can be
changed or avoided easily at management discretion.
▪ Committed fixed costs, on the other hand, are fixed
costs that cannot be easily changed.
▪ Advertising is a discretionary fixed cost, because it
depends on a
management decision.
▪ Lease cost is a committed fixed cost because it Step Costs: Wide Step
involves a long-term contract.
▪ Step cost with wide steps are more characteristic of
Variable Cost fixed costs.
▪ Variable costs are costs that vary in direct proportion to ▪ Example: A company may have to lease production
changes in machinery.
output within the relevant range. ▪ If the machine can only produce 1,000 units and the
▪ Variable costs can also be represented by a linear company grows, they will have to lease additional
equation. machines for each 1,000 units of production needed

▪ Total variable costs depend on the level of output.

Total variable costs = Variable rate x Amount of
output

Mixed Cost
▪ Mixed costs are costs that have both a fixed and a
variable component.
For example, sales representative often are paid a salary
plus a commission on sales.
Accounting Records and Need for Cost Separation ▪ The slope of the cost line corresponds to the variable
rate.
▪ Only through a formal effort to separate costs can all
costs be classified FIXED COST (a) VARIABLE COST (bX)
into the appropriate cost behavior categories. Y = a + bX
▪ If mixed costs are a very small percentage of total [Y] – the total costs (dependent variable)
costs, formal cost separation may be more trouble than
[a] – the total fixed costs (vertical/ y-axis intercept)
it’s worth.
[b] – the variable cost per unit (slope of the line)
▪ Mixed costs could be assigned to either the fixed or
variable cost category without much concern for the [X] – the activity or cost driver (independent
classification error or its effect on decision making. variable) [bX] – the total variable cost
▪ Alternatively, the total mixed cost could be divided
between the two cost categories. (This is rarely done and
not a good option.) Creating and Using A cost Formula

▪ Typically, mixed costs for many firms are large enough

to call for separation.

Separating Mixed Cost into Fixed and Variable

Components
▪ Three methods of separating a mixed cost into its fixed
and variable
components:
▪ high-low method
▪ scattergraph method
▪ method of least squares
▪ Each method requires the simplifying assumption of a
linear cost relationship.
▪ Expression of cost as an equation for a straight line is:
Total cost = Fixed cost + (Variable rate x Output)
▪ The dependent variable is a variable whose value
depends on the value of another variable. The High-Low Method
▪ Total cost is the dependent variable; it is the cost we ▪ Given two points, the slope and the intercept can be
are trying to predict. determined.
▪ The independent variable measures output and explains ▪ The high-low method is method of separating mixed
changes in the cost or other dependent variable. costs into fixed and variable components by using just
the high and low data points.
▪ A good independent variable is one that causes or is
closely associated with the dependent variable.
▪ Many managers refer to an independent variable as a
cost driver.
▪ The intercept corresponds to fixed cost.

COSTS TOTAL AMOUNT PER UNIT

AMOUNT
1. FIXED constant decreases as
production
increases
2. VARIABLE Increases as production constant Four steps must be taken in the high-low method:
increases
3. MIXED Increases less decreases less
proportionately as proportionately
Step 1: Find the high point and the low point for a given
production increases as production data set.
increases

Step 2: Using the high and low point, calculate the

variable rate.
Variable rate =(High point cost - Low point cost) ÷
(High point output - Low point output)
Calculate Predicted Total Variable
Variable cost per unit (b) =
Change in Costs (Y -Y ) Cost and Total Cost for Budgeted Output
H L
Recall that BlueDenim Company constructed the
Change in Activity (X -X ) following formula for monthly electricity cost.
H L

Step 3: Calculate the fixed cost Total electricity = $440 + ($6.10 x machine hours)
using the variable rate (from Step
2) and either the high point or low
point.
Fixed cost = Total cost at high
point - (Variable rate x Output at
high point)
Step 4: Form the cost formula for
materials handling based on the
high-low method.

High-Low Method to Calculate

Fixed Cost, Variable Rate and Variable Cost. Total Cost for A Time Period that
Cost Formula Differs from the Data Period
Recall that BlueDenim Company constructed the
following formula for monthly electricity cost.
Total electricity = $440 + ($6.10 x machine hours)

Advantages of High-Low Method

▪ Objectivity – any two people using the high-low
method on a particular data set will arrive at the same
answer.
▪ Quick overview – the high-low method allows a
manager to get a quick fix on a cost relationship by using
only two data points. For example, a manager may have
only two months of data. Sometimes this will be enough
to get a crude approximation of the cost relationship.
▪ Ease of use – the high-low method is simple,
inexpensive and easily communicated to other
individuals, even those who are not comfortable with
numerical analyses.
Disadvantages:
▪ Occurrence of outliers – the high and low points can be
what are known as outliers. They may represent a typical
cost-activity relationship.
▪ Potential for misrepresentative data – Even if the high ▪ An infinite number of lines might go through the data,
and low points are not outliers, other pairs of points may but this one goes through the point for January (100,
be more representative. $2,000) and intersects the y-axis at $800.

Scattergraph Method
▪ The scattergraph method is a way to see the cost
relationship by plotting the data points on a graph.
▪ Our two points are (100, $2,000) and (0, $800). Next,
▪ The first step is to plot the data points so that the use these two points to compute the variable rate (the
relationship between materials handling costs and slope):
activity output can be seen.
▪ Variable rate = ($2,000 - $800)
▪ Inspect the scattergraph to see if it reveals one or
more points (outliers) that do not seem to fit the pattern = $100 - 0
of behavior. = $1,200/100
▪ This might justify their elimination and perhaps = $12
lead to a better estimate of the underlying cost function.

▪ The variable rate is $12 per material move.

▪ The fixed cost and variable rate for materials handling
cost have now been identified.
▪ The cost formula for the materials handling activity can
be expressed as:
Total cost = $800 + ($12 x Number of moves)
▪ Using this formula, the total cost of materials handling
for between 100 and 500 moves can be predicted and
then broken down into fixed and variable components.
▪ For example, assume that 350 moves are planned for
November.
▪ Is the line determined by the high and low points is
Using the Formula from the Scattergraph Method
representative of the overall relationship.
▪ Using the cost formula, the predicted cost is:
▪ Notice that three points lie above the high-low line, but
five points lie below it. $5,000 = $800 + ($12 x 350)
This does not give us confidence in the high-low results ▪ Of this total cost, $800 is fixed, and $4,200 is variable.
for fixed and variable costs. We wonder if the variable
cost (slope) is somewhat higher than it should be and the ▪ Unfortunately, the scattergraph method suffers from
fixed cost is somewhat lower than it should be. the lack of any objective criterion for choosing the best-
fitting line.
This does not give us confidence in the high-low results
for fixed and variable costs. We wonder if the variable ▪ The quality of the cost formula depends on the quality
cost (slope) is somewhat higher than it should be and the of the subjective judgment of the analyst.
fixed cost is somewhat lower than it should be.
▪ Finally, we can use the scattergraph to visually fit a Scattergraph (Scatter Diagram) Method
line to the data points on the graph.
▪ All observed costs at various activity levels are plotted
▪ The manager or cost analyst will choose the line that on a graph. Based on sound judgment, a regression line
appears to fit the points the best. is then fitted to the plotted points to represent the line
function.
The Method of Least Squares CORRELATION ANALYSIS is used to measure the
strength of linear relationship between two or more
▪ The method of least squares (regression) is a statistical
variables.
way to find the
The correlation between two variables can be seen by
best-fitting line through a set of data points.
drawing a scatter diagram:
▪ One advantage is that for a given set of data, it will
▪ If the points seem to form a straight line, there is high
always produce the same cost formula.
correlation
▪ The best-fitting line is the one in which the data points
▪ If the points form a random patter, there is low
are closer to the line than to any other line.
correlation or no correlation at all.
Least Square Regression Method
COEFFICIENT OF CORRELATION (r) measure the
Least-square method is a statistical technique that relative strength of linear relationship between two (2)
investigates the association between dependent and variables. Its value ranges from -1.0 to +1.0
independent variables. This method determines the line
▪ If r = -1.0, there is perfect inverse linear relationship
of best fit for a set of observations by minimizing the
between X and Y.
sum of the squared deviations between cost line and data
points. ▪ If r = 0, no linear relationship
▪ If there is only one independent variable, the analysis is ▪ If r = +1.0, there is perfect direct relationship between
known as SIMPLE REGRESSION. X and Y.
▪ If the analysis involves multiple dependent variable, it COEFFICIENT OF DETERMINATION (r2) is the
is known as MULTIPLE REGRESSION proportion of the total variation in Y that is accounted
for by the regression equation, regardless of whether the
▪ Equation 1 Y =a + bx
relationship between X and Y is direct or inverse. It is a
▪ Equation 2 ∑y = na + b∑x measure of ‘goodness of fit’ in the regression. The
higher the r , the more confidence can have in the
▪ Equation 3 ∑xy = ∑xa + b∑x2 estimated cost formula.
Comparison of Methods for Managerial judgment is critically important in
Separating Fixed Costs into Fixed
and Variable Components determining cost behavior and is by far the most widely
used method in practice.
▪ Many managers simply use their experience and past
observation of cost relationships to determine fixed and
variable costs.
▪ This method may take a number of forms.
▪ Some managers simply assign some costs to the fixed
category and others to the variable category and ignore
the possibility of mixed costs.
▪ Other managers may identify mixed costs and divide
these into fixed and variable components.
▪ Management may use experience and judgment to
refine statistical estimation results.
▪ The experienced manager might ‘‘eyeball’’ the data
Other Cost Estimation Methods: and throw out several points as being highly unusual or
A) Industrial Engineering Method – based on the revise the results of estimation account for projected
relationship between inputs and outputs in physical changes in cost structure or technology.
forms; engineering estimates indicate what and how ▪ The advantage of using managerial judgment to
much costs should be. separate fixed and
B) Account Analysis Method – each account is classified variable costs is its simplicity.
as either fixed or variable based on experience and
judgment of accounting and other qualified personnel in ▪ In situations in which the manager has a deep
the organization. understanding of the firm and its cost patterns, this
method can give good results.
C) Conference Method – costs are classified based on
opinions from various company departments such as ▪ However, if the manager does not have good judgment,
purchasing, process engineering, manufacturing, errors will occur.
employee relations and so on.
Ethical Decision:
▪ There are ethical implications to the use of managerial
judgment.
▪ Managers use their knowledge of fixed and variable
costs to make important decisions, such as whether to
switch suppliers, expand or contract production, or lay
off workers.
▪ These decisions affect the lives of workers, suppliers,
and customers.
▪ Ethical managers will make sure that they have the best
information possible when making these decisions.