Acct 311: Chapter 2

Least Squares Regression Method

uses all of the data to separate a mixed cost into its fixed and variable components. ** Provides more accurate cost estimates than the high low method because it uses all data**

Discretionary Fixed Costs (Managed Fixed Costs)

usually arise from annual decisions by management to spend on certain fixed cost items.

Several Methods to estimate the fixed and variable components of a mixed cost

1. Account Analysis 2. Engineering Approach 3. High-Low Method

What are the cost classifications for decision making?

1. Differential Cost 2. Opportunity Cost 3. Sunk Cost

To Analyze mixed costs with high-low method

1. Identify the period with the lowest level of activity (first point in formula Rise/Run) and the period with the highest (Second Point). Formula Becomes: Cost at the highest activity level - Cost at lowest activity level/ Highest activity level - lowest activity level Variable Cost = Change in Cost/Change in Activity

Tradition Format Income Statement

1. Prepared primarily for external users for reporting purposes 2. Organizes costs into two categories (1) COGS (2) Selling Admin. Expenses 3. Has serious limitations when used for internal purposes. It does not distinguish between fixed and variable costs - Sales (-) COGS = Gross Margin - Gross Margin (-) selling and admin. expenses = Net Operating Income COGS=Beg. Merch. Inventory + Purchases - Ending Inventory

Contribution Format Income Statement

1. Provides managers with an income statement that clearly distinguishes between fixed and variable costs and aids planning, controlling, and decision making. 2. Separates costs into fixed and variable categories. 3. Used in internal planning and as a decision making tool.

Formula for Fixed Cost Element

=Total Cost - Variable Cost Element =$9800 - (.80 patient per day X 8,000 patient days)

Fixed Cost

A cost that remains constant, in total, regardless of changes in the level of activity. Not affected by changes in activity unlike Variable Cost. Examples: Straight line depreciation, insurance, property taxes, rent, supervisory salaries, advertising.

Differential Revenue

A difference in revenue between any two alternatives

Activity Base

A measure of whatever causes the incurrence of a variable cost; sometimes referred to as a cost driver. Most common activity bases are direct labor hours, machine hours, units produced, and units sold.

Step Variable Costs

Cost behavior patterns such as salaried employees. Can often be adjusted quickly as conditions change. Example: $40,000 salary for one employee (0-2,000 hours worked) - $80,000 for two employees. (Page 36)

High-low and Least Squares Regression Methods

Estimate the fixed and variable elements of a mixed cost by analyzing past records of cost and activity data. If a scattergraph reveals linear cost behavior, then it makes sense to perform the high-low or least-squares regression calculations to separate the mixed costs into it variable and fixed components.

Formula to estimate variable cost

Variable Cost= Slope of the Line= Rise/Run= Y2-Y1/X2-X1

Variable Cost

Varies, in total, in direct proportion to changes in the level of activity. Examples: COGS, Direct Materials, Direct Labor, variable elements of manufacturing overhead. For a cost to be a variable, it must be variable with respect to something, that something is its activity base.

Mixed Cost Equation

Y= Total Mixed Cost a= total fixed cost b= variable cost per unit of activity X= Level of Activity Y= a + bX

Sunk Cost

a cost that has already been incurred and that cannot be changed by any decision made now or in the future ** Not differential costs because they cannot be changed by any decision **Should be ignored in current decisions**

Relevant Range

range of activity within which the assumption that cost behavior is strictly linear is reasonably valid.

Committed Fixed Costs

represent organizational investments with a multiyear planning horizon that can't be significantly reduced even for short periods of time without making fundamental changes.

Formula Least Squares Regression Method

Y = a + bX

Differential Cost (incremental cost)

A difference in costs between any two alternatives

Contribution Margin

Amount remaining from sales revenues after variable expenses have been deducted

Account Analysis

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

Opportunity Cost

potential benefit that is given up when one alternative is selected over another

Mixed Cost (Semivariable Costs)

contains both variable and fixed cost elements. (Very Common)

Engineering approach

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 material specifications, labor requirements, equipment usage, production efficiency, power consumption, and so on.