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CHAPTER 5 COST BEHAVIOR: ANALYSIS AND USE

Key Terms and Concepts to Know
Cost Classifications for Predicting Cost Behavior Costs may be classified by how they behave in total when the activity level changes: In Total Varies The same Varies Per Unit The same Varies inversely Varies (often inversely)

Variable Cost Fixed Cost Mixed Cost

The relevant range is the range of activity levels throughout which the assumptions for cost behavior are valid. Outside the relevant range, total fixed costs may change and/or variable costs per unit may change. The activity level or allocation base is a measure of the activity that causes total variable cost to change. Common activity bases are: direct labor hours, machine hours, units produced, and units sold. Committed fixed costs relate to costs that the company will incur over the longterm. These costs, such as depreciation expense, property tax expense and insurance expense, cannot be changed during short periods of time and are only somewhat under the control of management. Discretionary fixed costs usually arise from annual decisions by management and can be changed during short periods of time such as advertising, research and public relations. Mixed costs contain both variable and fixed cost elements. For example, a companys selling expenses may include fixed expenses, such as the advertising costs and the base salary of the sales manager; and variable costs, such as sales commissions paid to the regional salesmen. Contribution Margin Income Statement The traditional income statement separates expenses by function emphasizing the distinction between production, administration and selling expenses. Gross margin is the first key measure of profitability.
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The contribution margin income statement separates expenses by behavior, emphasizing the distinction those revenues and expenses that change when the level of activity changes and those that are unaffected by changes in the level of activity. Contribution margin is the first key measure of profitability.

Key Topics to Know

Separating Mixed Costs into Fixed and Variable Elements
In order to predict the profits of a company, it is necessary to separate all costs into either fixed costs or variable costs. Many costs are clearly variable, such as direct labor, or, clearly fixed, such as rent. Mixed costs must be separated into their fixed and variable elements using one of three methods and a regression line developed to predict total mixed costs at various levels of activity. The equation of the regression line takes the form: Total Cost Y = = Fixed Cost a + + Variable Cost b(X)

Least Squares Regression Method

A rigorous, mathematical approach in which a series of data points are used to develop a regression line to predict total costs.

Scattergraph Method
Plots a series of data points for the mixed costs and the activity which produced these costs. The Y axis is dollars of mixed cost and the X axis is the activity level. A regression line is drawn by best guess through one of the data points and a point on the Y axis with an approximately the same number of data points above and below the line. The point where the line crosses Y axis represents the fixed cost, the only cost incurred at zero activity. For any data point, the difference between the total mixed cost and the fixed cost is total variable cost and total variable cost divided by the activity level for the data point is variable cost per unit.

High-Low Method
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From a series of data points, uses only the high and low data points, based on activity, to develop a regression line to predict total costs. Variable cost per unit (b) is calculated first: Low Point = Change High Point Cost $ $ $ $ Activity activity activity activity Change in Cost $ Change in Activity = Variable cost/unit

Using either the high point or low point, total fixed cost is calculated next: Variable Cost Fixed Cost = Total Cost Y B(X) a = Example # 1: Travis Inc. employed several maintenance engineers to keep the equipment running in peak condition. Over the past eight months, Travis incurred the following maintenance cost for these engineers. Plant activity is best measured by direct labor hours. Month January February March April May June July August Direct Labor Hours 1,700 1,900 1,800 1,600 1,500 1,300 1,100 1,400 Maintenance Cost $14,300 $15,200 $16,700 $14,000 $14,300 $13,000 $12,800 $14,200

Required: Using the high-low method, determine the fixed and variable components of the maintenance costs.

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Solution #1 Cost $ Activity High Point $15,200 1,900 = Low Point $12,800 1,100 = = Change $2,400 800

Change in Cost $ Change in Activity Using either the high Fixed Cost $9,500 OR $9,500

$2,400 800

$3.00 variable cost/unit

point or low point, total fixed cost is calculated next: Variable Cost = Total Cost = $15,200 $5,700 = $3.00 (1,900) = $12,800 $3,300 = $3.00 (1,100)

Contribution Margin Income Statement

The contribution margin income statement separates expenses into fixed and variable categories. Contribution margin income statement takes the form: Sales - Variable costs = Contribution margin - Fixed costs = Operating income

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Example #2: Strummer Inc. manufactures and sells guitars for beginning students. Their income statement for April, 2010 was as follows: Sales Cost of Goods Sold Gross Margin Selling and Administrative Expenses: Selling expense Administrative expense Operating Income $600,000 400,000 200,000 60,000 90,000

150,000 $50,000

The product sells for $300 each. Variable selling expenses are $20 per unit sold with the remaining selling expenses being fixed. The administrative expenses are 40% fixed. The companys manufacturing costs are 75% variable. Required: Prepare an income statement using the contribution margin approach. Solution #2: Units sold Sales Variable Expenses: Cost of goods sold Selling expenses Administrative expenses Contribution Margin Fixed Expenses: Cost of goods sold Selling expenses Administrative expenses Operating Income $600,000/$300 2,000 $600,000 $400,000*75% $20*2,000 $90,000-36,000 $400,000-300,000 $60,000-40,000 $90,000*40% 300,000 40,000 54,000 100,000 20,000 36,000

394,000 $206,000

156,000 $50,000

Variable and Absorption Costing

Absorption costing includes variable and fixed manufacturing costs in unit product costs and inventory. The fixed manufacturing overhead included in inventory is the predetermined fixed overhead rate * units in inventory.
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The fixed manufacturing overhead included in inventory is deferred or not recognized as an expense until the units are sold in a subsequent period. Variable costing includes only variable manufacturing costs in unit product costs and inventory. Variable costing treats fixed manufacturing costs as period costs. Compared to absorption costing, variable costing has a lower product costs per unit and higher period costs. The effect on operating income of treating fixed manufacturing overhead as a product cost (absorption costing) versus a period cost (variable costing) may be summarized as follows: Beginning Finished Goods Inventory = ending Finished Goods Inventory Finished Goods Inventory increases (beginning Finished Goods Inventory < ending Finished Goods Inventory) Income is the same under both methods Absorption costing has higher income than variable costing because manufacturing fixed costs are deferred for the units added to Inventory Finished Goods Inventory decreases Absorption costing has lower (beginning Finished Goods Inventory income than variable costing > ending Finished Goods Inventory) because manufacturing fixed costs are included in the units sold from Inventory

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Practice Problems
Practice Problem #1: Active Company accumulated the following data for a delivery truck. Miles Driven January February Required: 10,000 8,000 Total Cost $15,000 $14,500 March April Miles Driven 9,000 7,500 Total Cost $12,500 $13,000

a) Determine the equation to predict total costs for the delivery truck. b) What should total costs be if 12,187 miles were driven?

Practice Problem #2: The Lawn Mower Shop is a retailer that sells lawn mowers. The income statement for the month of June showed a gross margin of $60,000 and operating income of $20,000. Selling and administrative expenses were 50% fixed. Two hundred mowers were sold at an average price of $750 per unit. All mowers are purchased from Toro and John Deere. Required: a) Prepare an income statement for the month using the contribution approach. b) What is the contribution margin per unit? Practice Problem #3:
When the Tom-Tom Companys controller was asked to budget the cost of manufacturing supplies for the next year, she plotted supplies cost and units produced by month for the year. She then drew a regression line through the point she plotted for November when the supplies cost was $21,000 and 5,000 drum sets were produced. Required: If the regression line intersected the Y axis at $6,000, determine the equation of the regression line.

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Practice Problem #4: The Cords Company manufactures and sells basketball nets in custom colors. The income statement for the month of December showed a gross margin of $60,000 and operating income of $20,000. Selling and administrative expenses were 50% fixed. Two thousand nets in Miami Heat team colors were sold at an average price of $75.00 per unit. During the month, 400 nets in Chicago Bulls colors were manufactured but not sold. Cost of goods sold was 20% fixed and 80% variable (direct material, direct labor and variable manufacturing overhead). Variable manufacturing costs are the same for all nets. Required: a) Prepare an income statement for the month using variable costing. b) Prepare an income statement for the month using absorption costing. c) Reconcile the operating income under variable costing with the operating income under absorption costing.

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Sample True / False Questions

1. The relevant range is the range in which costs remain variable. True False 2. A variable cost increases in total as the volume increases. True False 3. A fixed cost will stay constant on a per unit basis as the volume increases. True False 4. The equation for a mixed cost is total fixed costs + variable cost per unit units of activity. True False 5. Contribution margin is defined as sales revenue less variable costs. True False 6. Contribution margin plus variable cost per unit equals total sales revenue. True False 7. The unit contribution margin tells how much each additional unit sold will contribute to covering variable costs. True False 8. If volume increases, all costs will increase True False

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Sample Multiple Choice Questions

1. A cost that changes in total in direct proportion to changes in activity is a(n) a) absorption cost. b) contribution margin. c) fixed cost. d) variable cost. 2. If sales revenue doubles, variable costs will a) decrease in total. b) increase in total. c) decrease on a per unit basis. d) increase on a per unit basis. 3. A cost that remains the same, in total, regardless of changes in activity level is a a) variable cost. b) fixed cost. c) mixed cost. d) step-variable cost. 4. If sales revenue doubles, fixed costs will a) decrease in total. b) increase in total. c) decrease on a per unit basis. d) increase on a per unit basis. 5. A mixed cost a) is fixed over a wider range of activity than a step cost. b) is a fixed cost over the relevant range and a variable cost everywhere else. c) contains both fixed and variable components. d) always increases on a per unit basis.

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6. The per-unit amount of three different production costs for Jones, Inc., are as follows: Cost A Cost B Cost C Production 20,000 $12.00 $15.00 $20.00 80,000 $12.00 $11.25 $5.00 What type of cost is each of these three costs? a) Cost A is fixed, Cost B is mixed, Cost C is variable. b) Cost A is fixed, Cost B is variable, Cost C is mixed. c) Cost A is variable, Cost B is mixed, Cost C is fixed. d) Cost A is variable, Cost B is fixed, Cost C is mixed. 7. A graph of the relationship between total cost and activity level is called a a) relevant range. b) scattergraph. c) contribution margin graph. d) dependent variable. 8. Bud uses the high-low method of estimating costs. Bud had total costs of $50,000 at its lowest level of activity, when 5,000 units were sold. When, at its highest level of activity, sales equaled 12,000 units, total costs were $78,000. Bud would estimate variable cost per unit as a) $10.00 b) $6.50 c) $4.00 d) $7.53 9. Smith, which uses the high-low method, had average costs per unit of $10 at its lowest level of activity when sales equaled 10,000 units and average costs per unit of $6.50 at its highest level of activity when sales equaled 24,000 units. Smith would estimate fixed costs as a) $60,000 b) $16.50 c) $8.25 d) $100,000. 10. Arnold Corp has a selling price of $20, variable costs of $15 per unit, and fixed costs of $25,000. Arnold expects profit of $300,000 at its anticipated level of production. What is Arnold's unit contribution margin? a) $5.00 b) $10.00 c) $27.50 d) $20.00.
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11. Cost behavior is a) the way in which costs change when the activity level changes. b) the difference between sales revenue and fixed costs. c) the same as absorption costing. d) the amount of sales necessary to achieve a specific profit. 12. When Stella, Inc. sells 40,000 units, its total variable cost is $96,000. What is its total variable cost when it sells 45,000 units? a) $84,000 b) $96,000 c) $108,000 d) It cannot be determined from the information given. 13. Which of the following is a variable cost? a) A cost that is $20,000 when production production is 70,000. b) A cost that is $20,000 when production production is 70,000. c) A cost that is $20,000 when production production is 70,000. d) A cost that is $40,000 when production production is 70,000. 14. Which of the following is a mixed cost? a) A cost that is $20.00 per unit when when production is 80,000. b) A cost that is $20.00 per unit when when production is 80,000. c) A cost that is $20.00 per unit when when production is 80,000. d) A cost that is $40.00 per unit when when production is 80,000. is 50,000, and $20,000 when is 50,000, and $28,000 when is 50,000, and $40,000 when is 50,000, and $40,000 when

production is 50,000, and $20.00 per unit production is 50,000, and $12.50 per unit production is 50,000, and $16.25 per unit production is 50,000, and $40.00 per unit

15. The slope of the cost line on a scattergraph represents a) fixed cost per unit. b) total fixed cost. c) variable cost per unit. d) sales price per unit.

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Solutions to Practice Problems

Practice Problem #1 a) High Point Cost $ $15,000 Activity 10,000 Change in Cost $ Change in Activity Using either the high Fixed Cost $7,000 OR $7,000 b) Total Cost Y $16,750 Practice Problem #2
a) Units sold Sales Variable expenses: Cost of goods sold S & A expenses Contribution margin Fixed expenses: Cost of goods sold S & A expenses Operating income b) $200.00 Per Unit 1 $750.00 $150,000 60,000 $60,000-20,000 x 50% All variable for a retailer $60,000-20,000 x 50% 450.00 100.00 200.00 Total 200 $150,000 90,000 20,000 $40,000 0 20,000 $20,000

Low Point $13,000 7,500 =

Change $2,000 2,500

$2,000 2,400

$.80 variable cost/unit

point or low point, total fixed cost is calculated next: Variable Cost = Total Cost = $15,000 $8,000 = $.80 (10,000) = $13,000 Fixed Cost a $7,000 + + + $6,000 = $.80 (7,500) Variable Cost B(X) $9,750 = $.80 (12,187)

= = =

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Practice Problem #3:

Since the Y intercept is known, use the quick-and-dirty method to solve for the variable cost per unit: Variable Cost b (X) b (X) = $15,000 b = $3.00 = = = = Total Cost Y $21,000 $15,000 5,000 Fixed Cost a $6,000

Practice Problem #4:

a) Absorption costing income statement Units produced Units sold Sales Variable expenses: Cost of goods sold S & A expenses Contribution margin Fixed expenses: Cost of goods sold S & A expenses Operating income $75.00 x 2,000 ($150,000 60,000)x80% $60,000-20,000 x 50% ($150,000 60,000)x20% $60,000-20,000 x 50% Total 2,400 2,000 $150,000 72,000 20,000 $58,000 18,000 20,000 $20,000

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Revised Summer 2010 b) Variable costing income statement Fixed overhead in cost of goods sold: Sales - Gross margin = Cost of goods sold X Fixed % = Fixed overhead in cost of goods sold / Units sold = Fixed overhead rate per unit X Units produced = Total fixed overhead $150,000 60,000 90,000 20% 18,000 2,000 $9.00 2,400 $21,600

Units produced Units sold Sales Variable expenses: Cost of goods sold S & A expenses Contribution margin Fixed expenses: Cost of goods sold S & A expenses Operating income c) Variable costing operating income Less: fixed overhead deferred in inventory Absorption costing operating income $75.00 x 2,000 ($150,000 60,000)x80% $60,000-20,000 x 50% See schedule $60,000-20,000 x 50%

Total 2,400 2,000 $150,000 72,000 20,000 $58,000 21,600 20,000 $16,400

$9.00 x 400 nets manufactured and not sold

$16,400 3,600 $20,000

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Solutions to True / False Problems

1. 2. 3. 4. 5. 6. False because not only do total variable costs remain variable, but both variable costs per unit and total fixed costs remain constant. True False because fixed costs remain constant in total and decrease per unit as volume increases. True True False because both revenue and contribution margin are stated in total whereas variable cost is stated per unit. The statement would be true if all three were stated per unit or in total. False because contribution margin contributes to covering fixed costs. False because if volume increases, only variable costs will increase.

7. 8.

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Solutions to Multiple Choice Questions

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. D B B C C C B C A A A C B C C

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