Com 317 - Chapter 3

What is the next step after creating the scattergram plot?

- then make a quick estimate of variable cost permit and determine the cost equation - then if correlation do the high low method.

Fixed cost on a total basis?

- total fixed cost remains the same eve when the activity level changes within the relevant range.

Variable cost - on a total basis?

- total variable cost is proportional to the activity level within the relevant range - varies in total with the activity level.

Variable cost - on a per unit basis?

- variable cost per unit remains the same over wide range of activity - remains constant For example, consider Sledding Adventures, a small company based in Whistler, British Columbia, that provides dog sled tours. After every tour, which lasts about two hours, the company gives each customer a drink (coffee, tea, or hot chocolate) and a light snack. The drinks and snacks ("refreshments") cost Sledding Adventures $10 per person. If we look at the cost of the refreshments on a per person basis, the cost is constant at $10. This $10 cost per person will not change, regardless of how many customers are served by Sledding Adventures.

What type of industry would have high fixed costs?

Hotels

Total Fixed Cost Example?

- A fixed cost is a cost whose total dollar amount remains constant with the relevant range of activity as the activity level changes. - Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. To continue the Sledding Adventures example, assume the company decides to lease a van for $400 per month to pick up customers at their hotel and return them there after the tour. The total amount of the lease payments is the same regardless of the number of customers the company takes on its sledding tours during any given month

What type of industries would have high variable costs?

- A manufacturing company like Paradigm, by contrast, often has many variable costs; these costs are associated with both manufacturing and distributing its products to customers. - Merchandising companies like Future Shop and Canadian Tire usually have a high proportion of variable costs in their cost structure

Least Squares regression method?

- A method of separating a mixed cost into its fixed and variable elements by fitting a regression line that minimizes the sum of the squared errors. - regression line of the form Y = a + bX is fitted to the data, where a represents the total fixed cost and b represents the variable cost per unit of activity. - A regression line of the form Y = a + bX is fitted to the data, where a represents the total fixed cost and b represents the variable cost per unit of activity. - regression line of the form Y = a + bX is fitted to the data, where a represents the total fixed cost and b represents the variable cost per unit of activity. - Manually performing the calculations required by the formulas is tedious and prone to errors. Fortunately, statistical software packages such as SPSS and SAS are widely available that quickly and accurately perform the calculations automatically. Spreadsheet software, such as Microsoft Excel, can also be used to do least-squares regression, as can some handheld calculators. CHECK WHAT WE SHOULD KNOW FOR THIS.

Mixed Costs?

- A mixed cost has both fixed and variable components. - Consider the example of utility cost. - Example of this - phone bill, fixed cost for baseline number of texts and then additional amount for additional text messages. Can also do this with utilities (baseline amount them charged for extra). - Want to get formula Y = a + bx - X axis will always be activity level that drives the cost (yaxis) - Where line hits the y axis is your fixed cost, if have no activity have to pay the fixed cost. (Vertical intercept) - Y = total mixed cost - b = rise/run = slop, how much line goes up when activity changes. Change in Y axis/Change in x axis. The variable cost per unit of activity. - If activity is 1, and electricity is 3c/kilowat hour and 40 dollars is fixed cost = $40.03. - If activity is 2, then $40.06. - The goal is always to get the formula.

Step-Variable Costs?

- A resource obtainable only in large chunks & whose costs increase or decrease only in response to fairly wide changes in activity is known as a step-variable - Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed. In class analogy given: Can higher one maintenance worker until get to certain point and then have to hire another and another. When higher another variable costs take a big jump. Need to be careful when you take the jumps, if production goes back down you scale back down, have to fire some workers. But so easy to keep them. Takes a long time to lay them off. As accountant have to be able to say we need to lay these people off.

True Variable Cost Example?

- A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level within the relevant range of activity. - Your total long distance telephone bill is based on how many minutes you talk Direct materials is a true or proportionately variable cost because the amount used during a period varies in direct proportion to the level of production activity. Moreover, any amounts purchased but not used can be stored and carried forward to the next period as inventory..

Variable Cost Per Unit Example?

- A variable cost remains constant if expressed on a per unit basis. - The cost per minute talked is constant. For example, 10 cents per minute.

If you saw a scattergram plot with no correlation what would the interpretation be?

- As another example, suppose that Hamilton Hotel management is interested in the relationship between the hotel's telephone costs and occupancy-days. - Guests are billed directly for their use of telephones, so those costs do not appear on the hotel's cost records. - The telephone costs of concern to management are the charges for the staff 's use of telephones. - The data for this cost are plotted in Exhibit 3-10. - It is evident from that plot that while the telephone costs do vary from month to month, they are not related to occupancy-days. - Something other than occupancy-days is driving the telephone costs. - Therefore, it does not make sense to analyze these costs any further by attempting to estimate a variable cost per occupancy-day for telephone costs. - Plotting the data helps diagnose such situations.

Fixed Cost Per Unit Example?

- Average fixed costs per unit decrease as the activity level increases. - The fixed cost per local call decreases as more local calls are made. If Sledding Adventures has only 100 customers in a month, the $400 fixed rental cost amounts to an average of $4 per customer. If there are 800 customers, the fixed rental cost averages only 50 cents per customer

What are the two types of fixed costs?

- Committed - once you buy equipment you can'd get rid of it without changing operation. Are those investments in facilities, equipment, and the basic organizational structure that cannot be significantly reduced, even for short time periods, without making fundamental changes that would impair a firm's ability to attain its long-term objectives. - Discretionary: can change within the year. often called managed fixed costs, are those costs that arise from annual decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed costs are advertising, research and development, and management training programs

What are two key differences between committed and discretionary costs?

- First, the planning horizon for a discretionary fixed cost is short term—usually a single year. - By contrast, committed fixed costs have a planning horizon that extends several years. - Second, unlike committed costs, discretionary fixed costs can be reduced in the short run with minimal damage to the long-run organizational objectives. - For example, spending on management training programs can be reduced because of poor economic conditions.

The activity base?

- For a cost to be variable, it must be variable with respect to something. - That "something" is its activity base. - An activity base is a measure of whatever causes a variable cost to be incurred. - Some of the most common activity bases are direct labour-hours, machine-hours, units produced, and units sold. - Other examples of activity bases are the number of kilometres driven by salespeople, the number of kilograms of laundry processed by a hotel, the number of calls handled by a customer service department, and the number of occupied beds in a hospital. People sometimes think that if a cost doesn't vary with production or with sales, then it is not really a variable cost. This is incorrect. Might just have different activity driver. For example, if a manager is analyzing the cost of service calls for a product warranty, the relevant activity measure is the number of service calls made. Nevertheless, unless stated otherwise, you can assume that the activity base under consideration is the total volume of goods and services produced or sold by the organization. So, for example, if we ask whether the cost of direct materials at Cervélo is a variable cost, the answer is yes, since the cost of direct materials is variable with respect to Cervélo's total volume of production.

Why do we have to break down the costs into fixed and variable costs?

- For example, if introducing a new model requires Cervélo to expand its production facilities, some of the costs related to maintaining the new plant, such as indirect materials, will vary with production volume. - However, other types of maintenance costs, such as the salary of the maintenance supervisor, will remain constant across a fairly wide range of production volumes. - Thus, it is important to break down some categories of costs, such as maintenance, into fixed and variable components to estimate how they will behave in total. Moreover, they must use this understanding of cost behaviour to predict the total costs that will be incurred under different assumptions about the demand for the new model.

But what happens once the variable cost per unit is outside a certain range?

- However, it is possible for the variable cost per unit to change once activity levels are outside the relevant range. - In the above example, if Sledding Adventures needed 1,500 refreshments, the unit cost might drop below $10 per refreshment if a quantity discount is provided by the supplier of the drinks or snacks. - Similarly, if fewer than 100 refreshments were required, the unit cost per refreshment might be more than $10.

Curvilinear Costs and the Relevant Range?

- In dealing with variable costs, we have assumed a strictly linear relationship between cost and volume, except in the case of step-variable costs. - Economists correctly point out that many costs classified by accountants as variable actually behave in a curvilinear fashion. - The behaviour of curvilinear costs is shown in Exhibit 3-4. - Economist have curved function. - Accountants have straight line - both are noted in the picture - Where two costs are the same = relevant range - the costs act the way we think they are going to act if in this range. - If outside the range then accountants and economists will think different numbers - A straight line closely approximates a curvilinear variable cost line within the "relevant range" - The relevant range is that range of activity within which the assumptions made about cost behaviour are valid - Managers should always keep in mind that a particular assumption about cost behaviour may be invalid if activity falls outside the relevant range.

Comparison of the Contribution Income with Traditional Income Statement?

- Net income and sales the same - Expenses are different - break down to variable and fixed. - Won't share this statement with competitors.

What would have diverse cost structures?

- Service companies. - Some service companies, such as the restaurant chain Harvey's, have significant variable costs because of their raw material costs. - On the other hand, service companies involved in consulting, auditing, engineering, dental, medical, software development, and architectural activities have very large fixed costs in the form of expensive facilities and highly trained salaried employees.

What two types of patterns cab variable costs have?

- Some variable costs behave in a true variable or proportionately variable pattern. - Other variable costs behave in a step-variable pattern.

How does this type of fixed cost differ from a step-variable cost? (previous slide)

- Step-variable costs can be adjusted more quickly and . . . - The width of the activity steps is much wider for the fixed cost.

Purpose of the scattergram plot?

- The first step in analyzing a mixed cost is to prepare a scattergram to permit a visual inspection of the relationship between the cost and the activity. Costs are plotted on the vertical axis and activity levels on the horizontal axis of the scattergram. - If the scattergram indicates that the relationship between cost and activity is linear, the variable and fixed components of the mixed cost can be estimated using the high-low method or the least-squares regression method

The Scattergram Plot?

- The first step in analyzing the cost and activity data is to plot the data on a scattergram. - This plot immediately reveals any non-linearities or other problems with the data. - Scattergrams can easily be produced using software packages such as Microsoft Excel using the charts commands - plot activity levels against costs. - costs are plotted on Y axis (dependent variable) - activity (independent variable) is plotted on the X axis. - Use one data point to estimate the total level of activity and the total cost. - Take a bunch of months of costs and analyze them, take every month of year note the activity level (x axis) and then the total costs (Y axis). And graph it. - Stars are it graphed for every single month. - try to draw best fit line through. Point of scattergram: - See if any correlation between activity driver and the cost. - If everywhere, then say these costs don't correlate. - If do correlate, then can do next step high/low method. "Linear cost behaviour" occurs whenever a straight line is a reasonable approximation for the relationship between cost and activity. Note that the data points do not fall exactly on the straight line. This almost always happens in practice; the relationship is seldom perfectly linear

The High-Low Method?

- The high-low method estimates the variable and fixed cost components by analyzing the change in cost between the high and low levels of activity. The method is based on the rise-over-run formula for the slope of a straight line - The variable cost per hour of maintenance is equal to the change in cost divided by the change in hours. - is based on the rise-over-run formula for the slope of a straight line. - If the relationship between cost and activity can be represented by a straight line, then the slope of the straight line is equal to the variable cost per unit of activity.

Cost structure?

- The relative proportion of fixed, variable, and mixed costs found in an organization.

Fixed Costs and Relevant Range?

- The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat, as in Exhibit 3-6. - As a company expands its level of activity, it may outgrow its facilities, or the key management team may need to be expanded. - The result, of course, will be increased committed fixed costs as larger facilities are built and as new management positions are created. - the width of the steps depicted for step-variable costs is much narrower than the width of the steps depicted for the fixed costs in Exhibit 3-6. - The width of the steps relates to the volume or level of activity. - For step-variable costs, the width of a step may be 40 hours of activity or less when dealing with a cost such as maintenance labour. However, for fixed costs, the width of a step may be thousands or even tens of thousands of hours of activity when dealing with a committed cost related to production equipment. - Costs are fixed in relevant range until you move into the next spot. - The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat. - Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows, more space is rented, increasing the total cost. Can have factory for certain time period, but if production changes and need bigger place this is a big jump. Fixed cost in place over more long period of time in comparison to variable

The Trend Toward Fixed Costs?

- The trend in many industries is toward greater fixed costs relative to variable costs. - As machines take over many mundane tasks previously performed by humans, "knowledge workers" are demanded for their minds rather than their muscles. - Knowledge workers tend to be salaried, highly-trained and difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable.

The first two methods to determine equation .. ?

- The two methods just discussed provide slightly different estimates of the fixed and variable cost components of the mixed cost. - This is to be expected because each method uses differing amounts of the data points to provide estimates. - Least-squares regression provides the most accurate estimate because it uses all the data points. This method is discussed in the appendix to this chapter

Where does the contribution come from and what does it provide?

- This crucial distinction between fixed and variable costs is at the heart of the contribution approach to constructing income statements. - The unique thing about the contribution approach is that it provides managers with an income statement that clearly distinguishes between fixed and variable costs and therefore facilitates planning, control, and decision making. - "An income statement format where costs are separated into variable and fixed categories"

The Contribution Format - Why a New Income Statement Format?

- Traditional format income statement is organized by function and fixed and variable costs are not distinguished - Separating costs into fixed and variable elements is often crucial in making decisions - Contribution format facilitates planning, control, and decision making - Notice that the contribution approach separates costs into fixed and variable categories, first deducting variable expenses from sales to obtain what is known as the contribution margin. - The contribution margin is the amount remaining from sales revenues after variable expenses have been deducted. This amount contributes toward covering fixed expenses and then toward profits for the period. - The contribution format income statement is used as an internal planning and decision-making tool.

Fixed cost - per unit basis?

- fixed cost per unit goes down as acivtity level goes up.

Cost behaviour?

- refers to how a cost will react or change as changes take place in the level of business activity. - An understanding of cost behaviour is key to many decisions in an organization. - For example, a decision to drop a particular product line might result in far lower cost savings than managers had assumed—leading to a decline in profits. To avoid such problems, a manager must be able to accurately predict what costs will be at various activity levels.

What are the three classifications of cost?

variable, fixed, and mixed