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Chapter 4

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Brock University
Norman Chasse

ACTG 1P11 – MA CHAPTER 6 Cost Behaviour – Analysis & Use A. Cost Behaviour - Costs can be described as variable, fixed and mixed, based on how they change in relation to changes in the volume of output - Variable – cost total changes in direct proportion to the change in volume o Variable Cost (VC) is constant on a per-unit basis o When a total variable cost is graphed, it will be a straight upward sloping line starting at the origin (0,0). o Variable Cost per Unit (VCU) is equal to the slope of the total variable cost line o Y = vx; where Y= total cost, v = VCU, x = # of units EXAMPLE: Each bicycle requires one bicycle chain costing $8. (Variable cost is constant on a per-unit basis at $8. Total variable cost when 100 bicycles are produced is equal to $8 *100=$800.) - Fixed – remains constant in total dollar amount through wide ranges of volume o FC decreases on a per-unit basis as the activity level increases o When graphed, a fixed cost is a straight flat (180°) line that does not start at the origin; the FC line intercept’s the Y axis at a level equal to fixed costs o Y = f; where Y = total cost, f = total fixed cost EXAMPLE: Fashion photographer Lori Yang rents studio spaces in a prestige location for $50,000 a year. She measures her firm’s activity in terms of the number of photo sessions. How would you graph the cost of studio rental in relation to firm activity? o Fixed costs are categorized as either committed or discretionary  Committed fixed costs relate to investment in plant, equipment, and basic administrative structure. It is difficult to reduce these fixed costs in the short-term.  Examples: • Depreciation on plant facilities. • Taxes on real estate. • Insurance. • Salaries of key operating personnel.  Discretionary fixed costs arise from annual decisions by management to spend in certain fixed cost areas. These costs can often be reduced in the short-term.  Examples: • Advertising. • Research. • Management development programs. - Mixed - A mixed total cost contains elements of both variable and fixed costs. o Total mixed cost = VC + FC o Both total cost and unit cost vary as the output varies o When a total mixed cost is graphed, it will be an upward sloping line that intersects the Y axis at a point other than zero; the slope of the line is VCU and the intercept is equal to total fixed costs o Y = f + vx; where Y=total costs, f = total FC (intercept), v = VCU (slope) and x = # of units (volume of activity) o Sometimes described as Y = a + bx Example: Lori Yang leases an automated photo developer for $2,500 per year plus 2¢ per photo developed. Q: How would the cost of the photo developer be shown graphically? What is the cost Equation? How much will it cost to develop 10,000 photos? B. Relevant range - Relevant range = range of operations over which the variable/fixed classification is assumed to be valid. In this range: o Total FC remains constant o VCU remains constant - A change in cost behaviour will occur when operating within a different relevant range o An increase in fixed costs shifts the total cost curve upward; the reverse also applies o An increase in UVC causes the slope of the total cost curve to be steeper; the reverse also applies C. Other Cost Behaviours - Many costs are neither purely fixed or purely variable; managers will often approximate these costs as mixed or break them into smaller relevant ranges - Variable/fixed equations – assumes a linear cost function o What happens when the cost is non-linear? o What happens when we have step-costs; step-variable cost or step-fixed cost behaviour? o Ex: A B C E D C B A D. Analysis of Cost Behaviour - Cost estimation methods are used to determine the fixed and variable cost components of various costs; managers can then use this information to predict costs and make business decisions - Methods include: o Account analysis – subjective review using professional judgement  Classify each G/L account as variable, fixed or mixed o Scatter Plots/Scattergraphs – plot cost and activity on a graph and plot line through the data points; line is fitted to the plotted points by eye using a ruler.  Volume data on the x-axis and cost data on the y-axis  If a relationship between the volume and cost data exists, data points will align close to a straight line; if no relationship exists, the data points will appear random  This method allows managers to identify and remove outliers; i.e., abnormal data points  This method lacks precision  Example: Piedmont Wholesale Florists o High-low method – fixes a mixed cost line based on the cost and activity level at the highest and lowest activity level data points  VC per unit est. = (High activity cost - Low activity Cost) / (High activity - Low activity)  FC per unit est. = Total cost at either activity level – Unit variable cost x activity level  A weakness of the method is that only two data points are used to create the cost formula. The high and low points may not be representative of the usual activity and cost.  Example: Kohlson Company o Regression analysis – aka “Least Squares Regression”
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