Chapter 6 Cost Behaviour.docx

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University of Waterloo
Accounting & Financial Management
AFM 102
Tom Vance

06 – Cost Behaviour: Analysis andUse Chapter 6: Cost Behaviour  cost behaviour refers to how a cost will react/change as changes take place in the level of business activity  managers who understand how costs behave are better able to predict what costs will be under various operating circumstances  contribution format: an income statement in which costs are organized by behaviour rather than by the traditional functions of productions, sales, and administration  mixed/semi variable cost is a third behaviour pattern (variable and fixed are the first 2)  cost structure: the relative proportion of fixed, variable, and mixed costs found within an organization Types of Cost Behaviour Patterns Variable Costs  total dollar amount varies in direct proportion to changes in the activity level  remains constant if expressed on a per unit basis  activity base: a measure of whatever causes the incurrence of a variable cost  the total cost of X-ray film in a hospital will increase as the number of X-rays taken increases  the plan and control variable costs, a manager must understand the various activity bases with the firm  can assume that the activity base under consideration is the total volume of goods and services produced or sold by the organization  extent of variable cost: the number and type of variable costs present in an organization will depend in large part of the organization’s structure and purpose TrueVariable vs.Step-Variable Costs  true variable costs: direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity  graph is a straight line  step-variable costs: a cost that is obtainable only large chunks and that increases and decreases only in response to fairly wide changes in the activity level  graph has steps The LinearityAssumption and the Relevant Range  curvilinear costs: a relationship between cost and activity that is a curve rather than a straight-line  relevant range: the range of activity within which assumptions about variable and fixed cost behaviour are valid  outside the relevant range, the accountant’s straight-line approximation is a poor approximation Fixed Costs  total fixed costs remains constant within the relevant range of activity  fixed cost per unit becomes progressively smaller as the level of activity increases Typesof Fixed Costs  committed fixed costs: those fixed costs that are difficult to adjust and that relate to the investment in facilities, equipment, and the basic organizational structure of a firm  depreciation of buildings and equipment  real estate taxes  insurance expenses  salaries of top management and operating personnel  discretionary fixed costs: fixed costs which arise from annual decisions by management to spend in certain fixed costs areas, such as advertising and research  2 key differences between discretionary fixed costs: page 1 of 4 06 – Cost Behaviour: Analysis andUse  the planning horizon for a discretionary fixed cost is short term (1 year)  the planning horizon for committed fixed costs is long term, many years  the trend in many companies is toward greater fixed costs relative to variable costs  most stores are equipped with bar code readers that enter price and other product info automatically  as machines take over more and more of the tasks that were performed by humans, the overall demand for labour hasn’t gone down  the demand for ‘knowledge’ workers has grown a lot (those who work with their minds rather than muscles)  costs of compensating these workers are relatively fixed and are committed rather than discretionary  wages and salaries can be fixed or variable, depending on the behaviour of wage and salary costs  manager may choose to treat employee compensation as a fixed cost because  companies have become more reluctant to decrease the workforce in response to short-term decline in sales  managers don’t want to be caught with a bloated payroll in an economic downturn  assume that direct labour is a variable cost Fixed Costs and the Relevant Range  the planned level of activity may affect total discretionary fixed costs  once the total discretionary fixed costs have been budgeted, they are unaffected by the actual level of activity  cost is fixed with respect to the actual number of units sold  committed fixed costs tend to consist of costs of buildings, equipment, and the salaries of key personnel  the relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat  differences between step-variable cost and discretionary/committed fixed costs:  step-variable costs can often be adjusted quickly as conditions change  fixed costs have been set and can’t be changed easily  the width of the steps depicted for step-variable costs is much narrower than the width of the steps for the fixed costs Mixed Costs  mixed costs: contains both variable and fixed costs elements  aka semi variable costs  ex – license fee of $25 000 plus $3 per rafting party  represented by a straight line Y = a + bX  Y = total mixed costs  a = total fixed cost (y-intercept)  b = the variable cost per unit (slope)  X = the level of activity  ex – Y = 25 000 + 3X
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