chapter 2 notes

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14 May 2011
Chapter 2
Chapter Overview
Managers who understand how costs behave are better able to predict costs and make decisions under
various circumstances. This chapter explores
the meaning of three major classifications of costs fixed, variable and mixed costs
various methods available to estimate fixed and variable cost components
Types of Cost Behaviour Patterns At least three types of cost behaviour patterns—variable, fixed, and
mixed—are found in most organizations. There are many other types of cost behaviour patterns but these
three patterns are fairly common and the mixed cost model can be used to provide approximations to more
complex cost behaviour patterns within a relevant range. It is important for managers to understand the
behaviour of each type of cost.
1. Variable Costs. A variable cost is one whose total dollar amount varies in direct proportion to
changes in the activity level. When expressed on a per unit basis, variable costs are constant.
a.Activity base (cost driver). For a cost to be variable, it must vary with some activity base.
An activity base is a measure of whatever causes the incurrence of a cost. Some of the most
common activity bases are machine-hours, units produced, and units sold. A measure of
activity should be used to allocate a cost for decision-making purposes only if it actually
causes the cost to be incurred.
b. True variable and step-variable costs. Some variable costs, such as direct materials, vary in
direct proportion to the level of activity. These costs are called true variable costs. A cost that
is obtainable only in large chunks and that increases or decreases in response to fairly wide
changes in the activity level is known as a step-variable cost. For example, direct labour may
be a step-variable cost when workers are only hired on a full-time basis.
c.In reality, many costs behave in a curvilinear fashion. Most frequently, costs increase less
than proportionately with activity. Nevertheless, within any given narrow band of activity
even a curvilinear cost function is approximately linear. This narrow band of activity within
which a particular straight line is a reasonable approximation to the true underlying cost
function is called its relevant range .
Thus, within the relevant range, variable cost per unit can be assumed to be constant.
There is often confusion about the meaning of relevant range. Some individuals refer to
the relevant range as the range of activity within which the company expects to operate or
has operated in the recent past. That is not what we mean by the relevant range. The
relevant range, as we use the term, is the range of activity within which a particular
straight line provides a reasonable approximation to the real underlying cost function.
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