Chapter 5 Cost behavior patterns outline PDF

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b51eef994b5e6a045ea61b2cce69f622.docx Types of cost behavior patterns Variable costs Variable cost (VC) - total dollar amount varies in direct proportion to changes in the activity level.  An activity base (also called a cost driver) is a measure of what causes the VC. As the level of the activity base increases, the VC increases proportionally. o Units produced (or sold) is not the only activity base within companies o A cost can be considered variable if it varies with other activity bases (e.g., miles driven, machine hours, or labor hours)  VC remain constant if expressed on a per unit basis  The proportion of VC differs across organizations o A public utility like KCP&L, with large investments in equipment, will tend to have fewer variable costs. o A manufacturing company like Black and Decker will often have many variable costs associated with the manufacture and distribution of its products to customers. o A merchandising company like Wal-Mart will usually have a high proportion of variable costs such as the cost of merchandise purchased for resale. o Some service companies, such as restaurants, have a high proportion of variable costs due to their raw material costs.  Other service companies, such as an architectural firm, have a high proportion of fixed costs in the form of highly trained salaried employees. Common examples of VC:  Merchandising companies  cost of goods sold  Manufacturing companies  direct materials, direct labor, and variable overhead.  Merchandising and manufacturing companies  sales commissions  Service companies  supplies, travel, and clerical. We assume a linear relationship between cost and, for example, units produced  The relevant range is that range of activity within which the assumptions made about cost behavior are valid. Fixed costs Fixed cost (FC) - total dollar amount remains constant as the activity level changes  Average FC per unit decrease as the activity level increases We can classify FC:  Committed FC o Long-term in nature (i.e., greater than one year) o Can’t be significantly reduced even for short periods of time without seriously impairing the profitability or long-run goals of the organization.  Examples include depreciation on buildings and equipment, and real estate taxes  Discretionary FC o Usually arise from annual decisions by management to spend in certain FC areas o Can be cut for short periods of time with minimal damage to the long-run goals of the organization… but should be careful…  Examples include advertising and research and development.  A cost may be discretionary or committed depending on management’s strategy. o For example, some construction companies may lay off workers during slow periods; other construction companies may keep their workers year-round The trend is toward FC  The trend in many industries is toward greater FC relative to VC. For example: o H&R Block employees used to fill out tax returns for customers by hand. Now, computer software is used to complete tax returns.  As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles. o Knowledge workers tend to be salaried, highly-trained and difficult to replace; the cost of compensating these valued employees is relatively fixed rather than variable. Is labor a VC or a FC?  The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. o Most companies in the United States continue to view direct labor as a VC.

b51eef994b5e6a045ea61b2cce69f622.docx Mixed costs Mixed cost - both variable and fixed cost elements. o For example, utility bills often contain fixed and variable cost components.  The fixed portion of the utility bill is constant regardless of kilowatt hours consumed = the minimum cost that is incurred to have the service ready and available for use.  The variable portion of the bill varies in direct proportion to the consumption of kilowatt hours An equation can be used to express the relationship between mixed costs and the level of the activity. This equation can be used to calculate what the total mixed cost would be for any level of activity. o The equation is Y = a + bX  Y = The total mixed cost.  a = The total fixed cost (the vertical intercept of the line)  b = The variable cost per unit of activity (the slope of the line)  X = The level of activity  The analysis of mixed costs  Account analysis and the engineering approach  The scattergraph plot (also called the quick-and-dirty method)  The least-squares regression method can be used to analyze mixed costs o This method uses all of the data points to estimate the fixed and variable cost pieces of a mixed cost o Fits a straight line to the data that minimizes the sum of the squared errors o Can easily be done with a software package o Output from the model can be used to estimate total costs at any activity level in the relevant range  The high-low method relies on two data points to estimate the fixed and variable portions of a mixed cost o Identify the data points pertaining to the highest and lowest activity levels o Determine the total costs associated with the two chosen points o Compute the change in cost between the two data points and divide it by the change in activity level between the two data points  The quotient represents an estimate of VC per unit of activity o Use the total cost at either activity level and deduct the VC component  The VC piece = level of activity * the estimated VC per unit of the activity  The residual is the estimate of total FC o Use the equation to estimate the total cost at any activity level The regression method is preferable to the high-low method (since the latter method uses only two data points to estimate the fixed and variable cost components of a mixed cost)  Least-squares regression provides the most accurate estimates because it uses all of the data points.  You will learn more about this method in a later business class The contribution format income statement Format relates to cost behavior as opposed to functional area (on which the traditional format income statement is based)  Separates costs into fixed and variable categories. Sales  variable costs = contribution margin (CM) CM  fixed costs = net operating income 

Used as an internal planning tool - most useful for: o Cost-volume-profit analysis o Budgeting o Special order decisions o Make or buy analysis...