|
Cost Behavior: Analysis and
Use
Learning Objectives
1. Explain the effect of a change in
activity on both total variable costs and per unit
variable costs.
2. Explain the effect of a change in activity on both
total fixed costs and fixed costs expressed on a per unit
basis.
3. Use a cost formula to predict costs at a new level of
activity.
4. Analyze a mixed cost using the high-low method.
5. Prepare an income statement using the contribution
format.
Lecture Notes
A. Types of Cost Behavior Patterns. Three
cost behavior patterns-variable, fixed, and mixed-are found
in most organizations. Of course, there are many other types
of cost behavior patterns but these three patterns are
fairly common and the mixed cost model can be used to
provide approximations to more complex cost behavior
patterns within a relevant range. It is important for
managers to understand the behavior 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. Examples of costs that are normally variable
with respect to output volume are listed in Exhibit 5-2.
Be careful to point out to students that some of these
costs may be fixed in some organizations. This is
particularly true of direct labor and other employee
wages and salaries that may be effectively fixed due to
labor laws in a country, custom, labor contracts, or the
organization's personnel policies. Exhibit 5-8 in the
text points out that there is wide variation in practice
in how some of these costs are classified by individual
firms.
a. Activity base (cost
driver). For a cost to be variable, it must be
variable with some activity base. An activity base
is a measure of whatever causes the incurrence of a
variable 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.
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 labor may
be a step-variable cost when workers are only hired
on a full-time basis. The difference between a true
variable and a step-variable cost is displayed in
Exhibit 5-3 in the text.
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. Exhibit 5-4 in the text illustrates a
curvilinear cost and the notion of the relevant
range.
- 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.
2. Fixed Costs. A fixed cost remains
constant in total dollar amount within the relevant
range. Since fixed costs remain constant in total, the
amount of cost computed on a per unit basis will become
progressively smaller as the number of units produced
increases. Care must be exercised in interpreting fixed
costs that have been expressed on a per unit basis; they
should not be misinterpreted as variable costs.
a. For planning purposes,
fixed costs can be viewed as either committed or
discretionary.
- Committed fixed costs. Committed fixed costs
relate to investment in buildings, equipment,
and the basic organizational structure of a
firm. Committed fixed costs are long-term in
nature and can't be significantly reduced even
for a short period of time without seriously
impairing long-run goals.
- Discretionary fixed costs. Discretionary
fixed costs are those which management adjusts
periodically. Examples of discretionary fixed
costs include advertising, research, and
management development programs. The planning
horizon for discretionary fixed costs is fairly
short-usually a single year. Management may be
able to adjust these fixed costs as
circumstances change.
b. The relevant range for a fixed cost is
that range of activity over which total fixed cost
does not change. Exhibit 5-6 in the text illustrates
this idea.
3. Mixed Costs. A mixed cost is one that
contains both variable and fixed cost elements. Many
costs are mixed and can be expressed in terms of the cost
formula Y = a + bX, where Y is the total estimated cost,
a is the estimated total fixed cost, b is the estimated
variable cost per unit of activity, and X is the number
of units of activity. Even when the underlying cost is
not linear, this formula can provide a reasonable
approximation to the underlying cost function within the
relevant range.
4. Classification of costs. A cost that
is considered variable in one firm may be considered
fixed in another due, for example, to differing
employment policies. Exhibit 5-8 in the text shows that
there is a great deal of variation in how firms classify
costs in terms of behavior.
B. Analysis of Mixed Costs. For planning and
control purposes, mixed costs should be broken down into
variable and fixed components. A number of methods can be
used to analyze mixed costs. Account analysis and the
engineering approach are mentioned briefly in this chapter
and are covered in more detail in later chapters. This
chapter discusses in more depth three techniques for
analyzing past records of cost and activity-the high-low
method, the scattergraph method, and least-squares
regression. We are going to focus on the High-Low method
only.
1. The High-Low Method. The
high-low method of analyzing mixed costs focuses
exclusively on the high and low levels of activity. The
difference in cost observed at these two extremes is
divided by the change in activity in order to determine
the amount of variable cost involved.
A major defect of the high-low method is that it
utilizes only two points and ignores all of the other
data. Generally, two points are not enough to produce
accurate results. Moreover, the periods in which the high
and low activity levels occur are often not typical of
most periods.
C. The Contribution Format. There are two
major approaches to preparing an income statement. The
difference between these two approaches centers on the way
in which costs are organized.
1. The Traditional Approach. The
traditional approach to the income statement organizes
data in a functional format, based on the functions of
production, administration, and sales. No attempt is made
to identify the behavior of costs included under each
functional heading. This approach is used to prepare
income statements for external reporting purposes.
2. The Contribution Approach. The
contribution approach to the income statement organizes
costs by behavior, rather than by function.
a. The contribution approach separates
costs into fixed and variable categories. Variable
expenses are deducted to obtain the contribution
margin. Fixed expenses are then deducted from the
contribution margin to obtain net income.
b. The contribution approach to the income
statement makes it much easier for managers to
understand the relations between volume and expenses,
and volume and profits. Variable and fixed costs are
not lumped together. Since planning and
decision-making often involve changes in the level of
activity, contribution income statements can be very
useful to managers.
|
