Cost Behavior-Analysis and Use

For a cost be variable, it must be variable with respect to something. That "something" is its _______ __________.

activity base

Variable cost is constant per unit

but varies in total with activity is crucial to understanding cost behavior patterns.

Fixed Costs are also known as

capacity costs

Fixed Costs and the Relevant Range

Discretionary costs are easier to adjust than committed fixed costs. They also tend to be less lumpy. The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat.

Diagnosing Cost Behavior with a Scattergraph Plot

First step: plot data on the scattergraph. 1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the dependent variable because the amount of cost incurred during a period depends on the level of activity for the period. 2. The activity x is plotted on the horizontal axis. Activity is known as the independent variable.

Committed Fixed Costs

Investments in facilities, equipment, and the basic organization can't be significantly reduced even for short periods of time without making fundamental changes. Example: depreciation, real estate taxes, insurance expenses, and salaries of top management and operating personnel.

Error: People get the notion that ifa cost doesn't vary with production or with sales, then it is not a variable cost.

Not correct, costs are caused by many different activities within an organization. Whether a cost is variable or fixed depends on whether it is caused by the activity under consideration.

Relevant Range

That range of activity within which the assumptions made about cost behavior are reasonably valid.

Fixed Costs

The average of fixed cost per unit becomes progressively smaller as the level of activity increases.

The Contribution Approach

The contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. This amount contributes toward covering fixed expenses and then toward profits for the period.

Step-Variable Costs

The cost of a resource that is obtained in large chunks and that increases or decreased only in response to fairly wide changes in activity. Example: the wages of a skilled repair technician.

Variable costs for Merchandising Company

Cost of goods (merchandise) sold

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.

Variable Costs for Manufacturing Company

Direct materials, direct labor, variable elements of manufacturing overhead: indirect materials, lubricants, supplies, power

The Linearity Assumption and Relevant Range

Except in the case of step variable costs, we ordinarily assume a strictly linear relationship between cost and volume.

Multiple Regression Analysis

In some situations the variable cost element may be driven by a number of factors. Multiple regression is an analytical method that is used when the dependent variable (cost) is caused by more than one factor.

The High Low Method

Rise/Run (You know this already)

Variable Costs for Service Organizations

Supplies

The Contribution Format Income Statement-Contribution Approach

The crucial distinction between fixed and variable costs is at the heart of the contribution approach to constructing income statements. It provides managers with an income statement that clearly distinguishes between fixed and variable costs and therefore facilitates planning, control and decision making.

The extent of variable costs differs:

Utilities companies have little variable costs, most of the costs associated with the plant,and these costs tend to be insensitive to changes in levels of service provided. Wal-Mart will have high proportion of variable costs in its cost structure.

Variable Costs for Both merchandising and manufacturing companies

Variable elements of selling and administrative costs: commissions, shipping costs.

Account Analysis

an account is classified as either variable or fixed based on the analyst's prior knowledge of how the cost in the account behaves.

Discretionary Fixed Costs

arise from annual decisions by management to spend on certain fixed cost items. Examples: advertising, research, public relations, management development programs, interships

Examples of activity bases include:

direct labor hours, machine hours, units produced, and units sold. Number of miles driven, the number of pounds of laundry cleaned by a hotel.

Activity base

is a measure of whatever causes the incurrence of variable cost. Can also be known as a cost driver.

Cost behavior is considered _______ whenever a straight line is a reasonable approximation for the relation between cost and activity.

linear

A mixed costs contains both variable and fixed cost elements. They are also known as

semivariable costs

Engineering Approach

to cost analysis involves a detailed analysis of what cost behavior should be, based on an industrial engineer's evaluation of the production methods to be used, the materials specifications, labor requirements, equipment usage, production efficiency, power consumption, and so on. Used when no past experience is available.

The Least Squares Regression Method

Uses all the data to separate a mixed cost into its fixed and variable components. A regression line of the from Y=a + bx. R^2 which is the measure of 'goodness of fit", tells us the percentage of the variation in the dependent variable that is explained by variation in the independent variable. From 0-100%.

Key differences

1. Step variable costs can often be adjusted quickly as conditions change, whereas once fixed costs have been set, they usually can't be changed easily. It can be adjusted up or downward. 2. The second difference is the width of the steps depicted for step-variable costs is much narrowed than the width of the steps depicted for the fixed costs.

Two key differences between discretionary and committed fixed costs

1. The planning horizon for a discretionary fixed cost is short term-usually a single year while committed fixed cost have a planning horizon that encompasses many years. 2. Discretionary fixed costs can be cut for short periods of time with minimal damage to the long-run goals of the organization.

Why a new income statement format?

The traditional format: functional, emphasizing the functions of production, administration, and sales. No attempt is made to distinguish between fixed and variable costs. It HAS SERIOUS LIMITATIONS FOR INTERNAL PURPOSES.

The Trend toward Fixed Costs

The trend in many industries is toward greater fixed costs relative to variable costs. Chores that used to be performed by hand have been taken over by machines. As automation intensifies the demand for knowledge workers has grown tremendously. The costs of compensating these workers is fixed.

Is Labor a Variable or Fixed Cost/?

They can be both depending on labor regulations, labor contracts and custom. Many categorize labor as a fixed cost, laying of valuable employees can lead to losses in the future even with a small down turn in demand. When there is an increase in sales they are also hesitant in hiring, that is why they have part time jobs.