Cornerstones of cost management 3rd edition hansen mowen chapter 3

May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or BASICS OF COST BEHAVIOR Cost Behavior • The

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CHAPTER 3

COST BEHAVIOR

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CHAPTER 3 OBJECTIVES

1 Define and describe fixed, variable, and

mixed costs

2 Explain the use of resources and activities

and their relationship to cost behavior

3 Explain how several methods of cost

estimation can be used

4 Separate mixed costs into their fixed and

variable components using the high-low

method, the scatterplot method, and the

method of least squares

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CHAPTER 3 OBJECTIVES

5 Evaluate the reliability of the cost formula

6 Explain how multiple regression can be

used to assess cost behavior

7 Define the learning curve, and discuss its

impact on cost behavior

8 Discuss the use of managerial judgment

in determining cost behavior

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BASICS OF COST BEHAVIOR

Cost Behavior

• The term used to describe whether a cost

changes when the level of output changes

• Fixed costs do not change as output

changes

• Variable costs increase in total with an

increase in output and decrease in total

with a decrease in output

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Cost Objects

• An item for which managers want cost

information

• For manufacturing or merchandising firms,

it is usually the tangible product

• For service firms, it is usually the service

provided

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Measures of Output

• Activity drivers explain changes in activity

costs by measuring changes in activity

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• Fixed costs are costs that in total are constant within the relevant range as the level of the activity driver varies

Fixed Costs

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JCM Audio Systems, Inc produces speakers for home audio systems One

department produces voice coils There are two production lines that can each make up to 100,000 voice coils per year The production-line manager is paid

$60,000 per year For production up to 100,000 units only one manager is

needed; above that (to 200,000 units) two managers are needed

Fixed Costs

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decreases as production increases.

JCM Audio Systems, Inc.

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Fixed Costs

The total cost of supervision remains the same within the relevant range, but the unit cost

decreases as production increases

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EXHIBIT 3.1—FIXED COST BEHAVIOR

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• Variable costs are costs that in total vary in direct proportion to changes in

an activity driver

• The total cost of direct materials for each level of production varies, but the unit cost stays the same

Variable Costs

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decreases as production increases

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EXHIBIT 3.2—VARIABLE COST

BEHAVIOR

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EXHIBIT 3.3—NONLINEARITY OF

VARIABLE COSTS

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EXHIBIT 3.4—RELEVANT RANGE FOR

VARIABLE COSTS

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• Mixed costs are costs that has both a fixed and a variable component

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JCM’s sales costs are mixed There are 10 sales representatives who each earn

$30,000 plus receive a commission of $5 per speaker sold This function can

be represented by the following equation

Mixed Costs

Y = $300,000 + $5X

Fixed - salaries Variable - commissio

n

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300,000 600,000 900,000 120,000 7.50 300,000 800,000 1,100,000 160,000 6.88 300,000 1,000,000 1,300,000 200,000 6.50

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EXHIBIT 3.5—MIXED COST BEHAVIOR

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RESOURCES, ACTIVITIES, AND COST

BEHAVIOR

Resources

• Economic elements that enable one to perform activities

• When a firm acquires the resources needed to perform an

activity, it obtains activity capacity

• Practical capacity is the activity level where the activity is

performed efficiently

•

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BEHAVIOR

Flexible Resources

• Supplied as needed and used

• Quantity of resource supplied equals quantity

demanded

• No unused capacity

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BEHAVIOR

Committed Resources

• Supplied in advance of usage

• A given quantity is obtained, whether or not that

full amount is used

• Unused capacity is possible

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• Follow a step-cost function

• Exceed the relevant range, and the costs increase “one step”

Step-Cost Behavior

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EXHIBIT 3.6— STEP COST FUNCTION

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EXHIBIT 3.7—STEP-FIXED COSTS

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BEHAVIOR

Activities and Mixed Cost Behavior

• Many activities have characteristics of both

flexible and committed resources

• For example, a power department acquires

long-term capacity for supplying power by

investing in a building and equipment

• It also acquires fuel to produce power on an needed basis

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BEHAVIOR

Need for Cost Separation

• Sometimes it is easy to spot the variable and fixed

portion of a cost

• Other times it is not; thus there is a need

for a method to separate costs into their

fixed and variable components

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METHODS OF DETERMINING COST

BEHAVIOR

The Industrial Engineering Method

• A forward-looking method of determining, through

physical observation and analysis, just what

activities, in what amounts, are needed to

complete a process

The Account Analysis Method

• Used to estimate costs by classifying accounts in

the general ledger as fixed, variable, or mixed

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Y = Total cost (the dependent variable)

F = Fixed cost (the intercept parameter)

V = Variable cost per unit (the slope parameter)

X = Measure of output (the independent variable)

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• Take two points (the high and the low by volume of activity) and determine the slope and intercept

• Slope is variable rate

• Intercept is fixed cost

The High-Low Method

QUANTITATIVE METHODS FOR SEPARATING MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS

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• The high and low points may be “outliers”

• Other pairs of points may clearly be more

representative

The High-Low Method

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• Intercept is fixed cost

• Slope is variable rate

Scatterplot Method

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QUANTITATIVE METHODS FOR SEPARATING MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS

Advantages

• Allows for visual inspection of the data

• Identifies nonlinearity, outliers, and shifts in the cost relationship

Disadvantages

• It is subjective

Scatterplot Method

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EXHIBIT 3.8—SCATTERGRAPH FOR ANDERSON

COMPANY’S MATERIALS HANDLING COSTS

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(CONTINUED)

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(CONTINUED)

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EXHIBIT 3.9—SCATTERGRAPH FOR

VARIOUS COST BEHAVIOR PATTERNS

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EXHIBIT 3.9—SCATTERGRAPH FOR VARIOUS

COST BEHAVIOR PATTERNS (CONTINUED)

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EXHIBIT 3.9—SCATTERGRAPH FOR VARIOUS

COST BEHAVIOR PATTERNS (CONTINUED)

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EXHIBIT 3.10—DEVIATIONS OF DATA

FROM A LINE

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EXHIBIT 3.11—SPREADSHEET DATA FOR ANDERSON

COMPANY’S MATERIALS HANDLING COST

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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

Using Regression Programs

• Enter the data

• Choose the “Tools” menu

• Choose the “Data Analysis” option

• If this is not available, you may have to manage

add-ins

• Scroll down to “Regression”

• Click on “Input Y Range” and highlight the cost cells

• Click on “Input X Range” and highlight the driver cells

• Choose your preferred location for output

• Click ok

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