Cost Behavior:

Analysis and Use

UAA ACCT 202
Principles of Managerial Accounting
Dr. Fred Barbee
$
Volume (Activity Base)
As the volume of
activity goes up
How does the
cost react?
Why do I need to
know this
information?
Good question.
Here are some
examples of when
you would want to
know this.
$
Volume (Activity Base)
For decision making purposes, its
important for a manager to know the
cost behavior pattern and the relative
proportion of each cost.
Knowledge of Cost Behavior
Setting Sales
Prices
Entering new
markets
Introducing new
products
Buying/Replacing
Equipment
Make-or-Buy
decisions
Total Variable Costs
$
Volume (Activity Base)
Per Unit Variable Costs
$
Volume (Activity Base)
Variable Costs - Example
A company manufacturers microwave ovens.
Each oven requires a timing device that costs
$30. The per unit and total cost of the timing
device at various levels of activity would be:
# of Units Cost/Unit Total Cost
1 $30 $30
10 30 300
100 30 3,000
200 30 6,000
Linearity is assumed
Variable Costs
The equation for total VC:
TVC = VC x Activity Base
Thus, a 50% increase in volume
results in a 50% increase in total VC.
Step-Variable Costs
But different
between ranges
of activity
$
Volume (Activity Base)
Step Costs are constant within
a range of activity.
Total Fixed Costs
$
Volume (Activity Base)
$
Volume (Activity Base)
Per-Unit Fixed Costs
Fixed Costs - Example
A company manufacturers microwave ovens.
The company pays $9,000 per month for rental
of its factory building. The total and per unit
cost of the rent at various levels of activity
would be:
# of Units Monthly Cost Average Cost
1 $9,000 $9,000
10 9,000 900
100 9,000 90
200 9,000 45





Relevant
Range

Curvilinear Costs & the Relevant Range
$
Volume (Activity Base)
Accountants
Straight-Line
Approximation
Economists Curvilinear
Cost Function
Mixed Costs
$
Volume (Activity Base)
Variable
costs
Fixed
costs
Intercept
Slope
This is probably how
you learned this
equation in algebra.
Total Costs
VC Per Unit
(Slope)
Fixed Cost
(Intercept)
Level of
Activity
Total Costs
VC Per Unit
(Slope)
Fixed Cost
(Intercept)
Level of
Activity
Dependent
Variable
Independent
Variable
20
Account Analysis
Engineering Approach
High-Low Method
Scattergraph Plot
Regression Analysis
Methods of Analysis
Account Analysis
Each account is classified as either
variable or
fixed
based on the analysts prior knowledge
of how the cost in the account
behaves.
Engineering Approach
Detailed analysis of cost behavior
based on an industrial engineers
evaluation of required inputs for
various activities and the cost of
those inputs.
Plot the data points on a
graph (total cost vs. activity).
0 1 2 3 4
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Activity, 1,000s of Units Produced
X
Y
The Scattergraph Method
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Activity, 1,000s of Units Produced
X
Y
Quick-and-Dirty Method
Intercept is the estimated
fixed cost = $10,000
Draw a line through the data points with about an
equal numbers of points above and below the line.
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Activity, 1,000s of Units Produced
X
Y
Quick-and-Dirty Method
The slope is the estimated variable cost per unit.
Slope = Change in cost Change in units
Vertical distance is
the change in cost.
Horizontal
distance is
the change in
activity.
Advantages
One of the principal advantages
of this method is that it lets us
see the data.
What are the advantages of
seeing the data?
Nonlinear Relationship
Activity
Cost
0
Activity Output
*

*
*


*


*
Upward Shift in Cost Relationship
Activity
Cost
0
Activity Output
*


*


*


*

*
*
Presence of Outliers
Activity
Cost
0
Activity Output
*


*


*


*
*
*
Month
Activity Level:
Patient Days
Maintenance
Cost Incurred
January 5,600 $7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
June 8,000 9,800
July 6,200 7,800
Brentline Hospital Patient Data
Textbook Example
Brentline Hospital Patient Data
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Patient-Days
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Brentline Hospital Patient Data
y = 0.7589x + 3430.9
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Patient-Days
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Brentline Hospital Patient Data
y = 0.7589x + 3430.9
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12000
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Patient-Days
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Brentline Hospital Patient Data
y = 0.7589x + 3430.9
R
2
= 0.8964
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Patient-Days
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From Algebra . . .
If we know any two points on a
line, we can determine the slope
of that line.
High-Low Method
A non-statistical method whereby
we examine two points out of a
set of data . . .
The high point; and
The low point
High-Low Method
Using these two points, we
determine the equation for that
line . . .
The intercept; and
The Slope parameters
High-Low Method
To get the variable costs . . .
We compare the difference in
costs between the two periods
to
The difference in activity
between the two periods.
Month
Activity Level:
Patient Days
Maintenance
Cost Incurred
January 5,600 $7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
June 8,000 9,800
July 6,200 7,800
Brentline Hospital Patient Data
Textbook Example
High/
Low
Month
Patient
Days
Maint.
Cost
High June 8,000 $9,800
Low March 5,000 7,400
Difference 3,000 $2,400
Change in Cost
V = ------------------
Change in Activity
(Y
2
- Y
1
)
V = ------------
(X
2
- X
1
)
High/
Low
Month
Patient
Days
Maint.
Cost
High June 8,000 $9,800
Low March 5,000 7,400
Difference 3,000 $2,400
The Change
in Cost
Divided by the
change in
activity
Change in Cost
V = ------------------
Change in Activity
$2,400
V = ------------
3,000
= $0.80 Per Unit
Total Cost (TC) = FC + VC
- FC = - TC + VC
FC = TC - VC
FC = $9,800 - (8,000 x $0.80)
= $3,400
FC = $7,400 - (5,000 x $0.80)
= $3,400
TC = $3,400 + $0.80X
Month
Activity Level:
Patient Days
Maintenance
Cost Incurred
January 5,600 $7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
June 8,000 9,800
July 6,200 7,800
We have taken Total
Costs which is a
mixed cost and we
have separated it into
its VC and FC
components.
So what? You say! Thank you
for asking! Now I can use this
formula for planning purposes.
For example, what if I believe my
activity level will be 6,325 patient
days in February. What would I
expect my total maintenance cost
to be?
What is the estimated total cost if
the activity level for February is
expected to be 6,325 patient days?
Y = a + bx
TC = $3,400 + 6,325 x $0.80
TC = $8,460
Some Important Considerations
We have used historical cost to
arrive at the cost equation.
Therefore, we have to be careful
in how we use the formula.
Never forget the relevant range.





Relevant Range



$
Volume (Activity Base)
Strengths of High-Low Method
Simple to use
Easy to understand
Weaknesses of High-Low
Only two data points are used in
the analysis.
Can be problematic if either (or
both) high or low are extreme
(i.e., Outliers).
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Extreme values -
not necessarily
representative
Representative
High/Low Values
.
Weaknesses of High-Low
Other months may not yield the
same formula.
FC = $8,500 - (7,100 x $0.80)
= $2,820
FC = $7,800 - (6,200 x $0.80)
= $2,840
Regression Analysis
A statistical technique used to
separate mixed costs into fixed
and variable components.
All observations are used to fit a
regression line which represents
the average of all data points.
Regression Analysis
Requires the simultaneous
solution of two linear equations
So that the squared deviations
from the regression line of each of
the plotted points cancel out (are
equal to zero).
Production
Cost
Actual Y
Estimated y
Error
2
) ( y Y
The objective is to find
values of a and b in the
equation y = a + bX that
minimize
y = a + bX
The equation for a linear
function (straight line) with
one independent variable is . . .
Where:
y = The Dependent Variable
a = The Constant term (Intercept)
b = The Slope of the line
X = The Independent variable

y = a + bX
The equation for a linear
function (straight line) with
one independent variable is . . .
Where:
y = The Dependent Variable
a = The Constant term (Intercept)
b = The Slope of the line
X = The Independent variable

The
Dependent
Variable
The
Independent
Variable
Regression Analysis
With this equation and given a set
of data.
Two simultaneous linear
equations can be developed that
will fit a regression line to the
data.
Where: a = Fixed cost
b = Variable cost
n = Number of observations
X = Activity measure (Hours, etc.)
Y = Total cost


2
x b x a xy

x b na y
) )( ( ) (
) )( ( ) )( (
2
2
Y X X n
XY X X Y
a

) )( ( ) (
) )( ( ) (
2
X X X n
Y X XY n
b

Fixed
Costs
Variable
Costs
R
2
, the Coefficient of Determination is
the percentage of variability in the
dependent variable being explained by
the independent variable.
This is referred to as a goodness of fit
measure.
R, the Coefficient of Correlation is
square root of R
2
. Can range from -1 to
+1. Positive correlation means the
variables move together. Negative
correlation means they move in opposite
directions.
Method
Fixed
Cost
Variable
Cost
High-Low
Scattergraph
Regression
$3,400
$3,300
$3,431
$0.80
$0.79
$0.76
Coefficient of Determination
R
2
is the percentage of
variability in the dependent
variable that is explained by the
independent variable.
Coefficient of Determination
This is a measure of goodness-of-
fit.
The higher the R
2
, the better the
fit.
Coefficient of Determination
The higher the R
2
, the more
variation (in the dependent
variable) being explained by the
independent variable.
Coefficient of Determination
R
2
ranges from 0 to 1.0
Good Vs. Bad R
2
s is relative.
There is no magic cutoff
Coefficient of Correlation
The relationship between two
variables can be described by a
correlation coefficient.
The coefficient of correlation is
the square root of the coefficient
of determination.

Coefficient of Correlation
Provides a measure of strength
of association between two
variables.
The correlation provides an index
of how closely two variables go
together.

Machine
Hours
Utility
Costs
Machine
Hours
Utility
Costs
Hours of
Safety
Training
Industrial
Accidents
Industrial
Accidents
Hours of
Safety
Training
Hair
Length
202
Grade
Hair
Length
202
Grade