- All managerial decisions deal with choices among different activity levels. Managers
must estimate which costs will vary with the activity & by how much.
- Costs that do not change in total as the level of business activity changes
- An example of a fixed cost is the insurance on a factory building. The insurance cost
doesn’t change as the level of production changes.
- Fixed Cost per Unit
o Average fixed costs per unit decrease as the activity level increases. The fixed
cost per local call decreases as more local calls are made.
- Costs that change in total as the level of business activity changes
- An example of a variable cost is salesperson commissions
- Variable Cost per Unit
Total Cost Graph
2,500 5,000 7,50010,000
o 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.
Determining Total Costs
- The basic cost equation is: Total Cost = Fixed Cost + Variable Cost
- This graph shows the ccombination of a fixed cost line and a
variable cost line.
- The assumptions as to cost behavior are valid as long as the activity
level is within the relevant range.
- The relevant range cannot be specifically determined, but is considered the range of
activity at which the company usually operates.
- A mixed cost has both fixed and variable components. E.g. Utility cost The total mixed cost line can be expressed
as an equation:Y = a + bX
Where: 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
Identifying Fixed and Variable Elements of a Mixed Cost
- Four of the most commonly used techniques for determining the fixed and variable
components of a mixed cost are
- 1. The Engineering Approach
o Based on the judgment and experience of an expert in cost analysis.
o The expert (possibly an engineer) will analyze the cost component to determine
which costs are fixed and which are variable, using techniques such as time and
o It is often used when the company has no past experience concerning a cost’s
reaction to activity.
- 2. Scatter Graphing
o This technique plots historical activity and cost information on a graph. The graph
is then analyzed to determine
the fixed and variable
components of the total cost.
o The cost analyst draws a line
that appears to be the “best fit”
to the data. The line
represents the estimated cost
- 3. The High-Low Method
o Assume the following hours of
maintenance work and the
total maintenance costs for six
months, Y = $3,400 + 8X - 4. Least Squares Regression Analysis
o A method used to analyze
mixed costs if a scatter graph plot
reveals an approximate
relationship between X and Y
o This method uses all of the data
points to estimate the fixed and
variable cost components of a
o The goal of this method is to fit
a straight line to the data that minimizes the sum
of the squared errors
o The cost analysis objective is the same: Y = a +
o Least-squares regression also provides a
statistic, called R^2, that is a measure of the
goodness of fit of the regression line to the data
points (or the percentage of the variation in total
cost explained by activity
o Always use this m