Cost Behavior: Analysis and Use Chapter McGraw­Hill/Irwin    Copyright © 2010 by The McGraw­Hill Companies, Inc. All rights reserved The Activity Base (also called a cost driver) Machine hours Units produced A measure of what causes the incurrence of a variable cost Miles driven Labor hours 5-2 True Variable Cost – An Example Total Overage Charges on Cell Phone Bill As an example of an activity base, consider overage charges on a cell phone bill The activity base is the number of minutes used above the allowed minutes in the calling plan Minutes Talked 5-3 Variable Cost Per Unit – An Example Per Minute Overage Charge Referring to the cell phone example, the cost per overage minute is constant, for example 45 cents per overage minute Minutes Talked 5-4 Examples of Variable Costs Merchandising companies – cost of goods sold Manufacturing companies – direct materials, direct labor, and variable overhead Merchandising and manufacturing companies – commissions, shipping costs, and clerical costs such as invoicing Service companies – supplies, travel, and clerical 5-5 True Variable Costs Cost The amount of a true variable cost used during the period varies in direct proportion to the activity level The overage charge on a cell phone bill was one example of a true variable cost Volume Direct material is another example of a cost that behaves in a true variable pattern 5-6 Step-Variable Costs Cost A step-variable cost is a resource that is obtainable only in large chunks (such as maintenance workers) and whose costs change only in response to fairly wide changes in activity Volume 5-7 The Linearity Assumption and the Relevant Range Total Cost Economist’s Curvilinear Cost Function Relevant Range A A straight straight line line closely closely approximates approximates aa curvilinear curvilinear variable variable cost cost line line within within the the relevant relevant range range Accountant’s Straight-Line Approximation (constant unit variable cost) Activity 5-8 Total Fixed Cost – An Example Monthly Basic Cell Phone Bill For example, your cell phone bill probably includes a fixed amount related to the total minutes allowed in your calling plan The amount does not change when you use more or less allowed minutes Number of Minutes Used within Monthly Plan 5-9 Fixed Cost Per Unit Example Cost Per Cell Phone Call For example, the fixed cost per minute used decreases as more allowed minutes are used Number of Minutes Used within Monthly Plan 5-10 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 Within countries managers can view labor costs differently depending upon their strategy Most companies in the United States continue to view direct labor as a variable cost 5-11 Rent Cost in Thousands of Dollars Fixed Costs and the Relevant Range 90 Relevant 60 Range 30 0 The The relevant relevant range range of of activity activity for for aa fixed fixed cost cost is is the the range range of of activity activity over over which which the the graph graph of of the the cost cost is is flat flat 1,000 2,000 3,000 Rented Area (Square Feet) 5-12 Mixed Costs Total Utility Cost Y ed x i lm a t To t s o c Variable Cost per KW Activity (Kilowatt Hours) X Fixed Monthly Utility Charge 5-13 The Scattergraph Method Maintenance Cost 1,000’s of Dollars Use Use one one data data point point to to estimate estimate the the total total level level of of activity activity and and the the total total cost cost Y Total maintenance cost = $11,000 20 * ** * ** * * * * 10 Intercept = Fixed cost: $10,000 0 Patient days = 800 X Patient-days in 1,000’s 5-14 The High-Low Method – An Example The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours $2,400 = $6.00/hour 400 5-15 The High-Low Method – An Example Total Fixed Cost = Total Cost – Total Variable Cost Total Fixed Cost = $9,800 – ($6/hour × 850 hours) Total Fixed Cost = $9,800 – $5,100 Total Fixed Cost = $4,700 5-16 The High-Low Method – An Example The Cost Equation for Maintenance Y = $4,700 + $6.00X 5-17 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 5-18 Least-Squares Regression Method  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 regression also provides a statistic, called the R22, which is a measure of the goodness of fit of the regression line to the data points 5-19 End of Chapter 5-20 ... Method – An Example The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours $2,400 = $6.00/hour 400 5-15 The High-Low Method – An Example Total Fixed