Cost Behavior

Management Accounting: The Cornerstone for

Business Decisions

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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 components using the high-low method, the scattergraph method, and the least squares method.

Learning Objectives

4. (Appendix) Use a personal computer spreadsheet program to perform the method of least squares.

Match Definitions

Relevant Range

Driver

Cost Behavior

A cost that does not change as output changes

A cost that changes in the same direction as changes in output

The range of output over which the assumed cost relationships are valid for normal operations

Variable Cost

Fixed Cost A factor that changes or leads to a change in a cost or activity

Whether a cost changes when the level of output changes

Illustrate Relevant Range

Define Mixed and Step Costs

◙ Mixed Cost◙ Has both a fixed and variable

component◙ Step Cost

◙ Has constant level of cost for a range of output then jumps to a new higher cost for a similar range of output

Mixed Cost Step Cost

What is the cost formula?

◙ The dependent variable, depends on the value of another variable. Here it is the cost we want to predict. The independent variable, the output, explains the change in cost; the intercept is the fixed cost; and the slope is the variable cost.

Total Cost = Fixed Cost + Variable Rate x

Output in

Units

How to create and use a cost formula.

The Accounting Department of State College decided to attend the State Business Leaders of Tomorrow Conference (SBLTC) to recruit new students. They must rent a display table space and have chosen to advertise in the program for a total cost of $500. In addition every student who enters the raffle receives a free calculator that costs $0.50.

REQUIRED: 1. Create a cost formula for recruiting

accounting majors at SBLTC.

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Calculation: The cost formula takes the following form Total Cost = Fixed cost + (Variable rate x Number of students entering the raffle)

Fixed cost = $500 (Table rental and Advertisement) since this does not vary based on the number of student that enter the raffle.

Variable cost = The total cost of calculators does vary with the number of students who enter the raffle. Cost per entry = $0.50

The cost formula is: Total Cost of SBLTC = $500 + ($0.50 x # of

Entries)

How to create and use a cost formula.3-1

REQUIRED: 2. If the Accounting Department expects to have 1,500 students enter the raffle at the SBLTC, what is the expected fixed cost? Total variable cost? Total conference cost?

Calculation: Expected fixed cost for the SBLTC = $500Expected variable cost for the SBLTC = $0.50 x 1,500 = $750Expected conference cost = $500 + $750 =

$1,250

How to create and use a cost formula.3-1

What are the 4 steps of the High-Low Method?

1. Find the highest & lowest activity or output points. (a) Subtract the cost associated with the lowest activity point from the cost associated with the highest activity point to get the change in cost. (b) Subtract the lowest activity from the highest activity to get the change in activity.

2. Calculate the variable rate. Divide the change in cost from part a by the change in activity from part b.

What are the 4 steps?

3. Calculate the fixed costs. Set up the cost formula. TC = FC + (VR x Activity) Substitute the variable rate calculated in step 2 into the formula. Pick the information in the high or the low. Substitute the cost into total cost and the activity into activity. This leaves fixed costs, solve for it.

4. Form the cost equation.

How to use the high-low method.

BlueDenim makes jeans. The controller has assigned you to calculate fixed costs, variable rate and the cost formula associated with the electricity rate with the data collected in the last year.

REQUIRED: Using the high-low method calculate the fixed cost of electricity, calculate the variable rate of electricity per machine hour, and construct the cost formula for total electricity cost.

3-2

How to use the high-low method.3-2

Month Electricity Cost Machine Hours

January $ 3,255 460

February 3,485 500

March 4,100 600

April 3,300 470

May 3,312 470

June 2,575 350

July 3,910 570

August 4,200 590

September 2,514 340

October 3,485 500

High

Low

Calculation:Step 1: - Find the high and low points: The

high machine hours occurs in March and the low occurs in September.

Step 2: - Calculate the variable rate: variable rate = (high cost – low cost) /

(high activity – low activity)=($4,100 - $2,514) / (600 – 340) = $1,586 /

260=$6.10 per machine hour

How to use the high-low method.3-2

Step 3: – Calculate the fixed cost:Fixed cost = total cost – (variable rate x

machine hours)Let’s choose the low point with cost of $2,514

and machine hours of 340.Fixed costs = $2,514 – ($6.10 x 340) = $2,514 -

$2,074= $440Step 4: - Construct a cost formula: If the

variable rate is $6.10 per machine hour and the fixed cost is $440 per month then the monthly cost formula for electricity is

Total electricity cost = $440 + ($6.10 x machine hours)

How to use the high-low method.3-2

Using the high-low method to predict total variable and

total cost for budgeted output.

BlueDenim constructed the following cost formula for electricity cost in Cornerstone 3-2

Total electricity cost = $440 + ($6.10 x machine hours)

Assume that 620 hours are budgeted for the month of October. Use the above cost formula for the following calculations:

1. Calculate the total variable electricity cost for October.

2. Calculate the total electricity cost for October.

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Calculation:1. Total variable electricity cost =

variable rate x machine hours = $6.10 x 620= $3,782

2. Total electricity cost = fixed cost + (variable rate x machine hours)=$440 + ($6.10 x 620) = $440 + $3,782=$4,222

The high-low method of predicting total variable

and total cost for budgeted output.

3-3

Using the high-low method to predict costs when the time period differs from

that of the data.BlueDenim constructed the following:Total electricity cost = $440 + ($6.10 x machine

hours)Required: Assume that 7,200 machine hours are

budgeted for the next year. Use the above cost formula to make the following calculations:

1. Calculate total variable electricity cost for the year.

2. Calculate total fixed electricity cost for the year.

3. Calculate total electricity cost for the next year.

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Calculation:1. Total variable electricity cost = variable rate

x machine hours = $6.10 x 7,200 = 43,9202. There’s a trick here; the cost formula is for

the month, but we are being asked to budget for the year so we need to multiple the fixed cost for month by 12 (number of months in a year). Total fixed electricity cost = fixed cost x 12 months in a year = $440 x 12 = $5,280

3. Total electricity cost = 12($440) + ($6.10 x 7,200)= $5,280 + $43,920 = $49,200

Using the high-low method to predict costs when the time period differs from

that of the data3-4

Discuss the Scattergraph Method

◙ It allows you to see if there is a relationship between the data

◙ Cost goes on the vertical or Y axis and the driver or output measure goes on the horizontal or X axis

◙ After plotting the data points, draw a line so about half the data points are above and half the data points are below the line.

Scattergraph Method

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Maintenance Hours

Overh

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Using regression to calculate fixed cost,

variable rate, construct a cost formula & budgeted

cost.The controller assigned you to calculate fixed and variable costs associated with electricity used in the factory. Data for the last nine months was collected and is presented on the following slide.

REQUIRED: Using the results of the 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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Using regression to calculate fixed cost, variable

rate, construct a cost formula & budgeted cost.

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Month Electricity Cost Machine Hours

January $ 3,255 460

February 3,485 500

March 4,100 600

April 3,300 470

May 3,312 470

June 2,575 350

July 3,910 570

August 4,200 590

Using regression to calculate fixed cost,

variable rate, construct a cost formula & budgeted

cost.Coefficients shown by the regression program are:

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  Coefficients

Intercept $ 321.03

X Variable 1 $ 6.38

1.The fixed cost and the variable rate are solved by the regression.2.The cost formula is:Total electricity cost = $321 + ($6.38 x Machine hours3.Budgeted electricity cost = $321 + ($6.38 x 550) =

$3,830

Comment on Managerial Judgment

◙ Critically Important

◙ Most Widely Used Method

◙ Relies on Experience and Past Observation

◙ Appeal is its Simplicity