Lecture Note: Advanced Cost and Managerial Accounting

CHAPTER I

COST BEHAVIOR AND COST VOLUME PROFIT ANALYSIS

Types of Cost Behavior Patterns

Cost behavior is the manner in which a cost changes as a related activity
changes. The behavior of costs is useful to managers for a variety of
reasons. For example, knowing how costs behave allows managers to predict
profits as sales and production volumes change. Knowing how costs behave
is also useful for estimating costs, which affects a variety of decisions such
as whether to replace a machine.

Understanding the behavior of a cost depends on:

1. Identifying the activities that cause the cost to change. These activities
are called activity bases (or activity drivers).

2. Specifying the range of activity over which the changes in the cost are of
interest. This range of activity is called the relevant range.

There are three main types of costs according to their behavior:

Fixed Costs

Fixed costs are those which do not change with the level of activity within
the relevant range. These costs will incur even if no units are produced. For
example rent expense, straight-line depreciation expense, etc.
Fixed cost per unit decreases with increase in production. Following example
explains this fact:
Total Fixed Cost $30,000 $30,000 $30,000

÷ Units Produced 5,000 10,000 15,000

Fixed Cost per Unit $6.00 $3.00 $2.00

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Types of Fixed Costs

Fixed costs are sometimes referred to as capacity costs because they result
from outlays made for buildings, equipment, skilled professional employees,
and other items needed to provide the basic capacity for sustained
operations. For planning purposes, fixed costs can be viewed as either
committed or discretionary.

Committed Fixed Costs Investments in facilities, equipment, and the basic

organization often can’t be significantly reduced even for short periods of
time without making fundamental changes. Such costs are referred to as
committed fixed costs . Examples include depreciation of buildings and
equipment, real estate taxes, insurance expenses, and salaries of top
management and operating personnel. Even if operations are interrupted or
cut back, committed fixed costs remain largely unchanged in the short term.

During a recession, for example, a company won’t usually eliminate key

executive positions or sell off key facilities—the basic organizational
structure and facilities ordinarily are kept intact. The costs of restoring them
later are likely to be far greater than any short-run savings that might be
realized.

Once a decision is made to acquire committed fixed resources, the company

may be locked into that decision for many years to come. Consequently,
such commitments should be made only after careful analysis of the
available alternatives.

Discretionary Fixed Costs Discretionary fixed costs (often referred to

as managed fixed costs ) usually arise from annual decisions by
management to spend on certain fixed cost items. Examples of discretionary
fixed costs include advertising, research, public relations, management
development programs, and internships for students.

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Two key differences exist between discretionary fixed costs and committed
fixed costs. First, the planning horizon for a discretionary fixed cost is short
term—usually a single year. By contrast, committed fixed costs have a
planning horizon that encompasses many years. Second, discretionary fixed
costs can be cut for short periods of time with minimal damage to the long-
run goals of the organization. For example, spending on management
development programs can be reduced because of poor economic
conditions.

Although some unfavorable consequences may result from the cutback, it is

doubtful that these consequences would be as great as those that would
result if the company decided to economize by laying off key personnel.

Whether a particular cost is regarded as committed or discretionary may

depend on management’s strategy. For example, during recessions when the
level of home building is down, many construction companies lay off most of
their workers and virtually disband operations. Other construction companies
retain large numbers of employees on the payroll, even though the workers
have little or no work to do. While these latter companies may be faced with
short-term cash flow problems, it will be easier for them to respond quickly
when economic conditions improve. And the higher morale and loyalty of
their employees may give these companies a significant competitive
advantage.

The most important characteristic of discretionary fixed costs is that

management is not locked into its decisions regarding such costs.
Discretionary costs can be adjusted from year to year or even perhaps
during the course of a year if necessary.

Variable Costs

Variable costs change in direct proportion to the level of production. This

means that total variable cost increase when more units are produced and

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decreases when less units are produced. Although variable in total, these
costs are constant per unit.

For example

Total Variable Cost $10,000 $20,000 $30,000

÷ Units Produced 5,000 10,000 15,000

Variable Cost per Unit $2.00 $2.00 $2.00

Types of Variable Costs

Not all variable costs have exactly the same behavior pattern. Some variable
costs behave in a true variable or proportionately variable pattern. Other
variable costs behave in a step-variable pattern.

True Variable Costs. Direct material 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. Moreover, any amounts purchased but not
used can be stored and carried forward to the next period as inventory.

Step-Variable Costs. The cost of a resource that is obtained in large

chunks and that increases or decreases only in response to fairly wide
changes in activity is known as a step-variable cost. For example, the
wages of skilled repair technicians are often considered to be a step-variable
cost. 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.

Moreover, any technician’s time not currently used cannot be stored as

inventory and carried forward to the next period. If the time is not used
effectively, it is gone forever. Furthermore, a repair technician can work at a
leisurely pace if pressures are light but intensify his or her efforts if pressures

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build up. For this reason, small changes in the level of production may have
no effect on the number of technicians employed by the company.

Notice that the cost of repair technicians changes only with fairly wide
changes in volume and that additional technicians come in large, indivisible
chunks. Great care must be taken in working with these kinds of costs to
prevent “fat” from building up in an organization. There may be a tendency
to employ additional help more quickly than needed, and there is a natural
reluctance to lay people off when volume declines.

Mixed Costs

Mixed costs or semi-variable costs have properties of both fixed and variable
costs due to presence of both variable and fixed components in them. An
example of mixed cost is telephone expense because it usually consists of a
fixed component such as line rent and fixed subscription charges as well as
variable cost charged per minute cost. Another example of mixed cost is
delivery cost which has a fixed component of depreciation cost of trucks and
a variable component of fuel expense.

Since mixed cost figures are not useful in their raw form, therefore they are
split into their fixed and variable components by using cost behavior analysis
techniques such as High-Low Method, Scatter Diagram Method and
Regression Analysis.

Analysis of Mixed Costs

High Low Method

High-Low method is one of the several techniques used to split a mixed cost
into its fixed and variable components. Although easy to understand,
high low method is relatively unreliable. This is because it only takes
two extreme activity levels (i.e. labor hours, machine hours, etc.) from a set
of actual data of various activity levels and their corresponding total cost

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figures. These figures are then used to calculate the approximate variable
cost per unit (b) and total fixed cost (a) to obtain a cost volume formula:

y=a+
bx

High-Low Method Formulas

Variable Cost per Unit

Variable cost per unit (b) is calculated using the following formula:
y2 −
Variable Cost per Unit y1
= x2 −
x1
Where,
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity
The variable cost per unit is equal to the slope of the cost volume line (i.e.
change in total cost ÷ change in number of units produced).

Total Fixed Cost

Total fixed cost (a) is calculated by subtracting total variable cost from total
cost, thus:
Total Fixed Cost = y2 − bx2 = y1 −
bx1

Example

Company A wants to determine the cost-volume relation between its factory

overhead cost and number of units produced. Use the high-low method to
split its factory overhead (FOH) costs into fixed and variable components and
create a cost volume formula. The volume and the corresponding total cost
information of the factory for past eight months are given below:

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Month Units FOH

1 1,52 $36,37
0 5
2 1,25 38,000
0
3 1,75 41,750
0
4 1,60 42,360
0
5 2,35 55,080
0
6 2,10 48,100
0
7 3,00 59,000
0
8 2,75 56,800
0

Solution:
We have,
at highest activity: x2 = 3,000; y2 = $59,000
at lowest activity: x1 = 1,250; y1 = $38,000
Variable Cost per Unit = ($59,000 − $38,000) ÷ (3,000 − 1,250) = $12 per
unit
Total Fixed Cost = $59,000 − ($12 × 3,000) = $38,000 − ($12 × 1,250)
= $23,000
Cost Volume Formula: y = $23,000 + 12x
Due to its unreliability, high low method is rarely used.

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Scatter Graph Method

Scatter graph method is a graphical technique of separating fixed and

variable components of mixed cost by plotting activity level along x-axis and
corresponding total cost (mixed cost) along y-axis. A regression line is then
drawn on the graph by visual inspection. The line thus drawn is used to
estimate the total fixed cost and variable cost per unit. The point where the
line intercepts y-axis is the estimated fixed cost and the slope of the line is
the average variable cost per unit. Since the visual inspection does not
involve any mathematical testing therefore this method should be applied
with great care.

Procedure

Step 1: Draw scatter graph

Plot the data on scatter graph. Plot activity level (i.e. number of units, labor
hours etc.) along x-axis and total mixed cost along y-axis.

Step 2: Draw regression line

Draw a regression line over the scatter graph by visual inspection and try to
minimize the total vertical distance between the line and all the points.
Extend the line towards y-axis.

Step 3: Find total fixed cost

Total fixed is given by the y-intercept of the line. Y-intercept is the point at
which the line cuts y-axis.

Step 4: Find variable cost per unit

Variable cost per unit is equal to the slope of the line. Take two points (x 1,y1)
and (x2,y2) on the line and calculate variable cost using the following formula:

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y2 −

Variable Cost per Unit = Slope of Regression Line y1

= x2 −
x1

Example

Company A decides to use scatter graph method to split its factory overhead
(FOH) into variable and fixed components. Following is the data which is
provided for the analysis.
Mont Unit FOH
h s
1 1,52 $36,37
0 5
2 1,25 38,000
0
3 1,75 41,750
0
4 1,60 42,360
0
5 2,35 55,080
0
6 2,10 48,100
0
7 3,00 59,000
0
8 2,75 56,800
0

Solution:

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Fixed Cost = y-intercept = $18,000

Variable Cost per Unit = Slope of Regression Line
To calculate slop we will take two points on line: (0,18000) and (3500,68000)
Variable Cost per Unit = (68000 − 18000) ÷ (3500 − 0) = $14.286

Least-Squares Regression Method

Least-squares linear regression is a statistical technique that may be used to

estimate the total cost at the given level of activity (units, labor/machine
hours etc.) based on past cost data. It mathematically fits a straight cost line
over a scatter-chart of a number of activity and total-cost pairs in such a way
that the sum of squares of the vertical distances between the scattered
points and the cost line is minimized. The term least-squares regression
implies that the ideal fitting of the regression line is achieved by minimizing
the sum of squares of the distances between the straight line and all the
points on the graph.

Assuming that the cost varies along y-axis and activity levels along x-axis,
the required cost line may be represented in the form of following equation:

y = a + bx

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In the above equation, a is the y-intercept of the line and it equals the
approximate fixed cost at any level of activity. Whereas b is the slope of the
line and it equals the average variable cost per unit of activity.
By using mathematical techniques beyond the scope of this article, the
following formulas to calculate a and b may be derived:
Unit Variable Cost = b = nΣxy – Σx.Σy

nΣx 2 - (Σx)2

Total Fixed Cost = a = Σy – bΣx

n
Where,
n is number of pairs of units—total-cost used in the calculation;
Σy is the sum of total costs of all data pairs;
Σx is the sum of units of all data pairs;
Σxy is the sum of the products of cost and units of all data pairs; and
Σx2 is the sum of squares of units of all data pairs.
The following example based on the same data as in high-low method tries
to illustrate the usage of least squares linear regression method to split a
mixed cost into its fixed and variable components:

Example

Based on the following data of number of units produced and the

corresponding total cost, estimate the total cost of producing 4,000 units.
Use the least-squares linear regression method .
Month Units Cost
1 1,520 $36,375
2 1,250 38,000
3 1,750 41,750
4 1,600 42,360
5 2,350 55,080
6 2,100 48,100
7 3,000 59,000
8 2,750 56,800

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Solution:
x y x2 xy
1,520 $36,375 2,310,400 55,290,000
1,250 38,000 1,562,500 47,500,000
1,750 41,750 3,062,500 73,062,500
1,600 42,360 2,560,000 67,776,000
2,350 55,080 5,522,500 129,438,000
2,100 48,100 4,410,000 101,010,000
3,000 59,000 9,000,000 177,000,000
2,750 56,800 7,562,500 156,200,000
16,32 377,465 35,990,400 807,276,500
0
We have,
n = 8;
Σx = 16,320;
Σy = 377,465;
Σx2 = 35,990,400; and
Σxy = 807,276,500

Calculating the average variable cost per unit:

B = 8 X 807,276,500 - 16,320 X 377,465 = 13.8

8 X 35,990,400 – (16,320)2

Calculating the approximate total fixed cost:

A = 377,465 - 13.8078 X 16,320 = 19,015

The cost-volume formula now becomes:

y = 19,015 + 13.8x
At 4,000 activity level, the estimated total cost is $74,215 [= 19,015 + 13.8
× 4,000].

Coefficient of Determination

R2 is a statistic that will give some information about the goodness of fit of
a model. In regression, the R2 coefficient of determination is a statistical
measure of how well the regression line approximates the real data
points. An R2 of 1 indicates that the regression line perfectly fits the data.

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The coefficient of determination (denoted by R2) is a key output

of regression analysis. It is interpreted as the proportion of the variance in
the dependent variable that is predictable from the independent variable.

 The coefficient of determination is the square of the correlation (r)

between predicted y scores and actual y scores; thus, it ranges from 0
to 1.

 With linear regression, the coefficient of determination is also equal to

the square of the correlation between x and y scores.

 An R2 of 0 means that the dependent variable cannot be predicted

from the independent variable.

 An R2 of 1 means the dependent variable can be predicted without

error from the independent variable.

 An R2 between 0 and 1 indicates the extent to which the dependent

variable is predictable. An R2 of 0.10 means that 10 percent of the
variance in Y is predictable from X; an R2 of 0.20 means that 20
percent is predictable; and so on.

The formula for computing the coefficient of determination for a linear

regression model with one independent variable is given below.

R2 = { ( 1 / N ) * Σ [ (xi - x) * (yi - y) ] / (σx * σy ) }2

where N is the number of observations used to fit the model, Σ is the

summation symbol, xi is the x value for observation i, x is the mean x value,
yi is the y value for observation i, y is the mean y value, σx is the standard
deviation of x, and σy is the standard deviation of y.

CVP analysis with multiple products

Cost-volume-profit (CVP) analysis is a helpful tool regardless of the number
of products a company sells. CVP analysis is more complex with multiple

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products. Two complications are encountered when multiple products are

sold by companies. First, companies rarely sell exactly the same number of
units of each product. Second, most products differ in their selling price and
variable cost per unit. As a consequence, in order to determine sales levels
at breakeven or target profit levels, these two issues must be addressed.

Sales Mix Break-even Point Calculation

Sales mix is the proportion in which two or more products are sold. For the
calculation of break-even point for sales mix, following assumptions are
made in addition to those already made for CVP analysis:

1. The proportion of sales mix must be predetermined.

2. The sales mix must not change within the relevant time period.

The calculation method for the break-even point of sales mix is based on the
contribution approach method. Since we have multiple products in sales mix
therefore it is most likely that we will be dealing with products with different
contribution margin per unit and contribution margin ratios. This problem is
overcome by calculating weighted average contribution margin per unit and
contribution margin ratio. These are then used to calculate the break-even
point for sales mix.

The calculation procedure and the formulas are discussed via following
example:

Example: Formulas and Calculation Procedure

Following information is related to sales mix of product A, B and C.

Product A B C
Sales Price per Unit $15 $21 $36
Variable Cost per $9 $14 $19
Unit
Sales Mix Percentage 20 20 60
% % %
Total Fixed Cost $40,000

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Calculate the break-even point in units and in dollars.

Calculation

Step 1: Calculate the contribution margin

per unit for each product:
Product A B C
Sales Price per Unit $1 $2 $3
5 1 6
− Variable Cost per Unit $9 $1 $1
4 9
Contribution Margin per Unit $6 $7 $1
7
Step 2: Calculate the weighted-average contribution margin per unit for the
sales mix using the following formula:

Product A CM per Unit × Product A Sales Mix Percentage

+ Product B CM per Unit × Product B Sales Mix Percentage
+ Product C CM per Unit × Product C Sales Mix Percentage
= Weighted Average Unit Contribution Margin

Product A B C
Sales Price per Unit $15 $21 $36
− Variable Cost per Unit $9 $14 $19
Contribution Margin per Unit $6 $7 $17
× Sales Mix Percentage 20 20 60%
% %
$1. $1. $10.
2 4 2
Sum: Weighted Average CM per $12.80
Unit

Step 3: Calculate total units of sales mix required to break-even using the
formula:
Break-even Point in Units of Sales Mix = Total Fixed Cost ÷ Weighted
Average CM per Unit
Total Fixed Cost $40,00
0
÷ Weighted Average CM per Unit $12.80
Break-even Point in Units of Sales 3,125
Mix

Step 4: Calculate number units of product A, B and C at break-even point:

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Product A B C
Sales Mix Ratio 20% 20% 60%
× Total Break-even Units 3,12 3,12 3,12
5 5 5
Product Units at Break-even 625 625 1,87
Point 5

Step 5: Calculate Break-even Point in dollars as follows:

Product A B C
Product Units at Break-even 625 625 1,875
Point
× Price per Unit $15 $21 $36
Product Sales in Dollars $9,37 $13,12 $67,50
5 5 0
Sum: Break-even Point in Dollars $90,000

Assumptions Underlying CVP Analysis

For any cost-volume-profit analysis to be valid, the following important

assumptions must be reasonably satisfied within the relevant range.

1. The behavior of total revenue is linear (straight-line). This implies that

the price of the product or service will not change as sales volume
varies within the relevant range.
2. The behavior of total expenses is linear (straight- line) over the
relevant range. This implies the following more specific assumptions.
a) Expenses can be categorized as fixed, variable, or semi variable.
Total fixed expenses remain constant as activity changes, and
the unit variable expense remains unchanged as activity varies.
b) The efficiency and productivity of the production process and
workers remain constant.
3. In multiproduct organizations, the sales mix remains constant over the
relevant range.

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4. In manufacturing firms, the inventory levels at the beginning and end

of the period are the same. This implies that the number of units
produced during the period equals the number of units sold.

CVP Relationships and the Income statement

The management functions of planning, control, and decision making all are
facilitated by an understanding of cost-volume-profit relationships. These
relationships are important enough to operating managers that some
businesses prepare income statements in a way that highlights CVP issues.

Traditional and contribution margin income statements provide a detailed

picture of a company's finances for a given period of time. While both serve
the purpose of showing whether a company has a net profit or loss, they
differ in the way they arrive at that figure.

Traditional income statement

Also known as a profit and loss statement, a traditional income statement

shows the extent to which a company is profitable or not during a given
accounting period. It provides a summary of how the company generates
revenues and incurs expenses through both operating and non-operating
activities. This income statement is prepared in the traditional manner. Cost
of goods sold includes both variable and fixed manufacturing costs, as
measured by the firm’s product costing system. The gross margin is
computed by subtracting cost of goods sold from sales. Selling and
administrative expense are then subtracted; each expense includes both
variable and fixed costs. The traditional income statement does not disclose
the breakdown of each expense into its variable and fixed components.

Contribution margin income statement

In a contribution margin income statement, a company's variable expenses

are deducted from sales to arrive at a contribution margin. A contribution

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margin is essentially a company's revenues minus its variable expenses, and

it shows how much of a company's revenues are contributing to its fixed
costs and net income. Once a contribution margin is determined, a company
can subtract all applicable fixed costs to arrive at a net profit or loss for the
accounting period in question.

Differences
While a traditional income statement works by separating product costs
(those incurred in the process of manufacturing a product) from period costs
(those incurred in the process of selling products, as opposed to making
them), the contribution margin income statement separates variable costs
from fixed costs. In a contribution margin income statement, variable selling
and administrative periods costs are grouped with variable product costs to
arrive at the contribution margin.

A traditional income statement uses absorption or full costing, where both

variable and fixed manufacturing costs are included when calculating the
cost of goods sold. The contribution margin income statement, by contrast,
uses variable costing, which means fixed manufacturing costs are assigned
to overhead costs and therefore not included in product costs.

Companies are generally required to present traditional income statements

for external reporting purposes. Contribution margin income statements, by
contrast, are often presented to managers and stakeholders to analyze the
performance of individual products or product categories. Companies can
benefit from contribution margin income statements because they can
provide more detail as to the costs and resources needed to produce a given
product or unit of a product. While both income statements ultimately serve
the purpose of showing whether a company is profitable or not over a certain
period of time, the contribution margin income statement can offer
additional insight as how to that net profit or loss came to be.

Cost structure and Operating Leverage

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The cost structure of an organization is the relative proportion of its fixed

and variable costs. Cost structures differ widely among industries and among
firms within an industry. A company using a computer-integrated
manufacturing system has a large investment in plant and equipment, which
results in a cost structure dominated by fixed costs. In contrast, a public
accounting firm’s cost structure has a much higher proportion of variable
costs. The highly automated manufacturing firm is capital intensive, whereas
the accounting firm is labor-intensive.

An organization’s cost structure has a significant effect on the sensitivity of

its profit to changes in volume. To summarize, the greater the proportion of
fixed costs in a firm’s cost structure, the greater the impact on profit will be
from a given percentage change in sales revenue.

Operating Leverage
Operating leverage measures a company’s fixed costs as a percentage of its
total costs. It is used to evaluate the breakeven point of a business, as well
as the likely profit levels on individual sales. The following two scenarios
describe an organization having high operating leverage and low operating
leverage.

1. High operating leverage. A large proportion of the company’s costs are

fixed costs. In this case, the firm earns a large profit on each
incremental sale, but must attain sufficient sales volume to cover its
substantial fixed costs. If it can do so, then the entity will earn a major
profit on all sales after it has paid for its fixed costs.
2. Low operating leverage. A large proportion of the company’s sales are
variable costs, so it only incurs these costs if there is a sale. In this
case, the firm earns a smaller profit on each incremental sale, but does
not have to generate much sales volume in order to cover its lower
fixed costs. It is easier for this type of company to earn a profit at low

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sales levels, but it does not earn outsized profits if it can generate
additional sales.

For example, a software company has substantial fixed costs in the form of
developer salaries, but has almost no variable costs associated with each
incremental software sale; this firm has high operating leverage. Conversely,
a consulting firm bills its clients by the hour, and incurs variable costs in the
form of consultant wages. This firm has low operating leverage.

To a physical scientist, leverage refers to the ability of a small force to move

a heavy weight. To the managerial accountant, operating leverage refers to
the ability of the firm to generate an increase in net income when sales
revenue increases.

The managerial accountant can measure a firm’s operating leverage, at a

particular sales volume, using the operating leverage factor:

Operating leverage factor = Contribution margin

Net income
For example, the Alaskan Barrel Company (ABC) has the following financial
results:

Revenues $100,000
Variable expenses 30,000

Fixed expenses 60,000

Net operating income $10,000

ABC has a contribution margin of 70% and net operating income of $10,000,
which gives it a degree of operating leverage of 7. ABC’s sales then increase
by 20%, resulting in the following financial results:

Revenues $120,000

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Variable expenses 36,000

Fixed expenses 60,000

Net operating income $24,000

The contribution margin of 70% has stayed the same, and fixed costs have
not changed. Because of ABC’s high degree of operating leverage, the 20%
increase in sales translates into a greater than doubling of its net operating
income.

When using the operating leverage measurement, constant monitoring of

operating leverage is more important for a firm having high operating
leverage, since a small percentage change in sales can result in a dramatic
increase (or decrease) in profits. A firm must be especially careful to forecast
its revenues carefully in such situations, since a small forecasting error
translates into much larger errors in both net income and cash flows. On the
other hand, a firm with high operating leverage has a relatively high break-
even point.

Knowledge of the level of operating leverage can have a profound impact on

pricing policy, since a company with a large amount of operating leverage
must be careful not to set its prices so low that it can never generate enough
contribution margin to fully offset its fixed costs.

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