Chap 005

11th Edition
Chapter 5
McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Cost Behavior:
Analysis and Use
Chapter Five

Types of Cost Behavior Patterns
Recall the summary of our cost behavior

discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.

The Activity Base
Units
Units Machine
Machine
produced
produced hours
hours
A
A measure
measure ofof what
what
causes
causes the
the
incurrence
incurrence ofof aa
variable
variable cost
cost
Miles
Miles Labor
Labor
driven
driven hours
hours
True Variable Cost Example
A variable cost is a cost whose total dollar amount

varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is
based on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked


relevant range.

Variable Cost Per Unit Example
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.
Telephone Charge
Per Minute
Minutes Talked
Extent of Variable Costs
The proportion of variable costs differs across

organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.
A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
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
Step-Variable Costs
A resource that is obtainable only in large chunks (such

as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a step-variable cost.
cost
Cost
Volume
Step-Variable Costs
Small
Small changes
changes in the level of
of production are
not
not likely
likely to
to have
have any
any effect
effect on
on the
the number of
maintenance
maintenance workers
workers employed.
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 and the Relevant Range
A
A straight
straight line
line
Economist’s
closely
closely
Curvilinear Cost approximates
approximates aa
Function curvilinear
curvilinear
variable
variable cost
cost
line
line within
within the
the
Relevant
Total Cost
relevant
relevant range.
range.
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
Let’s look at fixed cost behavior on the next

screens.

relevant range.

Total Fixed Cost Example
A fixed cost is a cost whose total dollar amount remains

constant as the activity level changes. Your monthly
basic telephone bill is probably fixed and does not
change when you make more local calls.
Telephone Bill
Monthly Basic
Number of Local Calls



relevant range.

Fixed Cost Per Unit Example
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 Telephone

Bill per Local Call
Number of Local Calls

Types of Fixed Costs
Committed
Committed Discretionary
Discretionary
Long-term,
Long-term, cannot
cannot bebe May
May be
be altered
altered in
in the
the
significantly
significantly reduced
reduced short-term
short-term byby current
current
in
in the
the short
short term.
term. managerial
managerial decisions
decisions
Examples Examples
Examples
Depreciation on Advertising
Advertising and
and
Equipment and Research
Research and
and
Real Estate Taxes Development
Development
The Trend Toward Fixed Costs
The trend in many industries is toward

greater fixed costs relative to variable costs.
As
As machines
machines take
take over
over Knowledge
Knowledge workers
workers
many
many mundane
mundane tasks
tasks tend
tend toto be
be salaried,
salaried,
previously
previously performed
performed highly-trained
highly-trained andand
by
by humans,
humans, difficult
difficult to
to replace.
replace. The
The
““knowledge
knowledge workers
workers”” cost
cost toto compensate
compensate
are
are demanded
demanded for for these
these valued
valued employees
employees
their
their minds
minds rather
rather is
is relatively
relatively fixed
fixed
than
than their
their muscles
muscles rather
rather than
than variable.
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 and Relevant Range
90
Thousands of Dollars
Total
Total cost
cost doesn’t
doesn’t
Rent Cost in
Relevant change
change for
for aa wide
wide
60 range
range of
of activity,
activity,
Range
and
and then
then jumps
jumps to to aa
new
new higher
higher cost
cost for
for
30 the
the next
next higher
higher
range
range of
of activity.
activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)

The relevant range of activity for a fixed cost

is the range of activity over which the graph of
the cost is flat.
Example: Office space is
available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows
more space is rented,
increasing the total cost.

Step-variable costs
can be adjusted
How does this more quickly and . . .
type of fixed cost The width of the
differ from a step- activity steps is
much wider for the
variable cost? fixed cost.

Quick Check 
Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.

Quick Check 
Which
Which of
of the
the following
following statements
statements about
about cost
cost
behavior
behavior are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs
costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.

Mixed Costs
A
A mixed
mixed cost
cost has
has both
both fixed
fixed and
and variable
variable
components.
components. Consider
Consider the
the example
example of
of utility
utility cost.
cost.
Y
Total Utility Cost
s t
co
d
i xe
l m
t a
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
Mixed Costs
Y
Total Utility Cost
s t
co
d
i xe
l m
t a
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
Mixed Costs Example
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?
Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
Analysis of Mixed Costs
Account Analysis and the Engineering Approach
Each
Each account
account isis classified
classified as
as either
either
variable
variable or
or fixed
fixed based
based on
on the
the analyst’s
analyst’s
knowledge
knowledge of of how
how the
the account
account behaves.
behaves.
Cost
Cost estimates
estimates are
are based
based on
on an
an
evaluation
evaluation of
of production
production methods,
methods, and
and
material,
material, labor
labor and
and overhead
overhead
requirements.
requirements.
The Scattergraph Method
Plot
Plot the
the data
data points
points on
on aa graph
graph
(total
(total cost
cost vs.
vs. activity).
activity).
Y
20
Maintenance Cost
* ** *
1,000’s of Dollars
* *
**
10 * *
0 X
0 1 2 3 4
Patient-days in 1,000’s

Draw
Draw aa line
line through
through the
the data
data points
points with
with about
about anan
equal
equal numbers
numbers of of points
points above
above and
and below
below the
the line.
line.
Y
20
Maintenance Cost
* ** *
* *
**
10 * *
0 X
0 1 2 3 4

Use
Use one
one data
data point
point to
to estimate
estimate thethe total
total level
level of
of activity
activity
and
and thethe total
total cost.
cost.
Y Total maintenance cost = $11,000
20
Maintenance Cost
* ** *
* *
**
10 * *
Intercept = Fixed cost: $10,000
0 X
0 1 2 3 4
Patient days = 800
Make
Make aa quick
quick estimate
estimate of
of variable
variable cost
cost per
per unit
unit and
and
determine
determine the
the cost
cost equation.
equation.
Total maintenance at 800 patients $ 11,000
Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000
$1,000
Variable cost per unit = = $1.25/patient-day
800
Y = $10,000 + $1.25X
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.

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

Y = $3,400 + $8.00X

Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions areare $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the variable
variable portion
portion of
of sales
sales salaries
salaries and
and
commission?
commission?
a.
a. $0.08
$0.08 per
per unit
unit
b.
b. $0.10
$0.10 per
per unit
unit
c.
c. $0.12
$0.12 per
per unit
unit
d.
d. $0.125
$0.125 per
per unit
unit

Quick Check 
Sales
Sales salaries
salaries and
and commissions
commissions are are $10,000
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the variable
variable portion
portion of
of sales
sales salaries
salaries and
and
commission?
commission? Units Cost
a.
a. $0.08
$0.08 per
per unit
unit High level 120,000 $ 14,000
b.
b. $0.10
$0.10 per
per unit
unit Low level 80,000 10,000
c.
c. $0.12
$0.12 per unit Change
per unit 40,000 $ 4,000
d.
d. $0.125
$0.125 per
per unit
unit $4,000 ÷ 40,000 units
= $0.10 per unit

Quick Check 
Sales
Sales salaries
salaries and
and commissions
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

Quick Check 
Sales
Sales salaries
salaries and
and commissions
$10,000 when
when
80,000
80,000 units
units are
are sold,
sold, and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold.
sold. Using
Using the
the high-low
high-low method,
method, what
what is
is
the
the fixed
fixed portion
portion of
of sales
sales salaries
salaries and
and commissions?
commissions?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

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.

• Software can be used to fit

a regression line through
the data points.
• The cost analysis objective
is the same: Y = a + bX
Least-squares
Least-squares regression
regression also
also provides
provides aa statistic,
statistic,
2
called
called the
the RR2,, that
that is
is aa measure
measure ofof the
the goodness
goodness
of
of fit
fit of
of the
the regression
regression line
line to
to the
the data
data points.
points.

2
R2 is
R is the
the percentage
percentage of
of the
the variation
variation in
in total
total cost
cost
explained
explained by
by the
the activity.
activity.
Y
20
* ** *
Total Cost
* * **
10 * *
R2 varies from 0% to 100%, and
the higher the percentage the better.
0 X
0 1 2 3 4
Activity
Comparing Results From the Three Methods
The
The three
three methods
methods just
just discussed
discussed provide
provide
slightly
slightly different
different estimates
estimates ofof the
the fixed
fixed and
and
variable
variable cost
cost components
components of of the
the mixed
mixed cost.
cost.
This
This is
is to
to be
be expected
expected because
because each
each method
method
uses
uses differing
differing amounts
amounts of
of the
the data
data points
points to
to
provide
provide estimates.
estimates.
Least-squares
Least-squares regression
regression provides
provides the
the most
most
accurate
accurate estimate
estimate because
because itit uses
uses all
all the
the data
data
points.
points.

Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.

The Contribution Format
Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000
The
The contribution
contribution margin
margin format
format emphasizes
emphasizes
cost
cost behavior.
behavior. Contribution
Contribution margin
margin covers
covers fixed
fixed
costs
costs and
and provides
provides for
for income.
income.
Uses of the Contribution Format
The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning and
and decision
decision making
making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.
1. Cost-volume-profit
Cost-volume-profit analysis
analysis (Chapter
(Chapter 6).
6).
2.
2. Budgeting
Budgeting (Chapter
(Chapter 9).
9).
3.
3. Segmented
Segmented reporting
reporting of
of profit
profit data
data (Chapter
(Chapter 12).
12).
4.
4. Special
Special decisions
decisions such
such as
as pricing
pricing and
and make-or-
make-or-
buy
buy analysis
analysis (Chapter
(Chapter 13).
13).

The Contribution Format
Comparison of the Contribution Income Statement

with the Traditional Income Statement
Traditional Approach Contribution Approach

(costs organized by function) (costs organized by behavior)
Sales $ 100,000 Sales $ 100,000

Less cost of goods sold 70,000 Less variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating expenses 20,000 Less fixed expenses 30,000
Net operating income $ 10,000 Net operating income $ 10,000
Used primarily for Used primarily by

external reporting. management.

Appendix 5A
Least-Squares
Regression Using
Microsoft Excel.

Simple Regression Analysis Example
Matrix,
Matrix, Inc.
Inc. wants
wants to
to
know
know itsits average
average
fixed
fixed cost
cost and
and
variable
variable cost
cost per
per unit.
unit.
Using
Using the
the data
data to
to the
the
right,
right, let’s
let’s see
see how
how toto
do
do aa regression
regression using
using
Microsoft
Microsoft Excel.
Excel.

Simple Regression Using Excel
You
You will
will need
need three
three pieces
pieces of
of
information
information fromfrom youryour
regression
regression analysis:
analysis:
1.
1. Estimated
Estimated Variable
Variable CostCost per
per
Unit
Unit (line
(line slope)
slope)
2.
2. Estimated
Estimated FixedFixed Costs
Costs (line
(line
intercept)
intercept)
3.
3. Goodness
Goodness of of fit,
fit, or
or R
R22
To
To get
get these
these three
three pieces
pieces
information
information wewe will
will need
need to
to
use
use three
three different
different Excel
Excel
functions.
functions.
LINEST,
LINEST, INTERCEPT,
INTERCEPT, && RSQ
RSQ

Place
Place your
your cursor
cursor in in
cell
cell F4
F4 and
and press
press the the
== key.
key. Click
Click on
on the the
pull
pull down
down menu
menu and and
scroll
scroll down
down toto “More
“More
Functions
Functions .. .. .”.”

Scroll
Scroll down
down to
to the
the
““Statistical
Statistical”,”,
functions.
functions. Now
Now
scroll
scroll down
down the
the
statistical
statistical
functions
functions until
until you
you
highlight
highlight
““LINEST
LINEST””

1.
1. In
In the
the Known_y’s
Known_y’s box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_x’s
Known_x’s box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.

Here is the
estimate of the
slope of the line.
1.
1. In
In the
the Known_y’s
Known_y’s box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_x’s
Known_x’s box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.

With
With you
you cursor
cursor in in cell
cell
F5,
F5, press
press the
the == key
key
and
and go
go to
to the
the pull
pull
down
down menu
menu forfor
special
special functions.
functions.
Select
Select Statistical
Statistical and
and
scroll
scroll down
down to to
highlight
highlight the
the
INTERCEPT
INTERCEPT function.
function.

Here is the
estimate of the
fixed costs.
1.
1. In
In the
the Known_y’s
Known_y’s box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_x’s
Known_x’s box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.
Finally,
Finally, we we will
will
determine
determine the the
““goodness
goodness of of
fit
fit”, or R ,, by
”, or R22
by
using
using the the RSQ
RSQ
function.
function.

Here is the
estimate of R2.
1.
1. In
In the
the Known_y’s
Known_y’s box
box enter
enter C4:C19
C4:C19 for
for the
the range.
range.
2.
2. In
In the
the Known_x’s
Known_x’s box
box enter
enter D4:D19
D4:D19 for
for the
the range.
range.

End of Chapter 5

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11th Edition

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Recall the summary of our cost behavior

Variable Total variable cost is Variable cost per unit remains

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

A variable cost is a cost whose total dollar amount

Recall the summary of our cost behavior

Variable Total variable cost is Variable cost per unit remains

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

A variable cost remains constant if expressed on

The proportion of variable costs differs across

1. Merchandising companies – cost of goods sold.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Direct materials is a true or proportionately variable

A resource that is obtainable only in large chunks (such

Only fairly wide changes in the activity level will

Let’s look at fixed cost behavior on the next

Variable Total variable cost is Variable cost per unit remains

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

A fixed cost is a cost whose total dollar amount remains

Number of Local Calls

Recall the summary of our cost behavior

Variable Total variable cost is Variable cost per unit remains

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Average fixed costs per unit decrease as the activity

Monthly Basic Telephone

Number of Local Calls

The trend in many industries is toward

The behavior of wage and salary costs can

In France, Germany, China, and Japan management has

In the United States and the United Kingdom management

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

The relevant range of activity for a fixed cost

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

If your fixed monthly utility charge is $40, your

Account Analysis and the Engineering Approach

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

Total maintenance cost Number of patient days

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

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The variable cost

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Total Fixed Cost = Total Cost – Total Variable Cost

The Cost Equation for Maintenance

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A method used to analyze mixed costs if a

This method uses all of the

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• Software can be used to fit

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Comparison of the Contribution Income Statement