Cost Behavior 2

CHAPTER 2
Cost Behavior
This chapter expands the discussion of cost behavior in Chapter 2 and it focuses on activity cost
behavior. In addition, several methods to estimate and evaluate the cost equation are discussed.

LEARNING OBJECTIVES
After studying Chapter 2, students should be able to:
1. Explain the meaning of cost behavior and define and describe fixed and variable costs.
2. Define and describe mixed and step costs.
3. Separate mixed costs into their fixed and variable components using the high-low method,
the scattergraph method, and the method of least squares.
4. (Appendix) Use a personal computer spreadsheet program to perform the method of least
squares.

KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for
each topic).
1. The basics of cost behavior (Learning Objective 1)
2. Mixed and Step Costs (Learning Objective 2)
3. Methods for separating mixed costs into fixed and variable components (Learning Objective
3)

CORNERSTONES
Cornerstone 2-1 Create and Use a Cost Formula
Cornerstone 2-2 Use the High-Low Method to Calculate Fixed Cost, the Variable Rate,
and to Construct a Cost Formula
Cornerstone 2-3 Use the High-Low Method to Calculate Predicted Total Variable Cost
and Total Cost for Budgeted Output
Cornerstone 2-4 Use the High-Low Method to Calculate Predicted Total Variable Cost
and Total Cost for a Time Period that Differs from the Data Period
Cornerstone 2-5 Use the Regression Method to Calculate Fixed Cost and the Variable
Rate, and to Construct a Cost Formula and to Determine Budgeted
Cost

CHAPTER OUTLINE
Discussion Question: After students read the opening “Experience Managerial Decisions with
Zingerman’s Deli,” ask them to select what they considered to be the most important point in the
opening scenario.
20 Chapter 2

After students have viewed the video, ask them to answer questions listed within video
integration guide at the end of this section.

1. BASICS OF COST BEHAVIOR

Cost behavior describes how a cost behaves or changes as the amount of output changes.
Relevant range is the range over which the cost relationships are expected to be valid for the
normal operations of the firm.
Three cost behavior patterns are summarized below:

Cost Behavior

Fixed Costs Variable Costs Mixed Costs

Description: in total, are constant within in total, vary in direct have both a fixed and a
the relevant range as activity proportion to changes in variable component
output changes activity output

Examples: factory rent direct materials lease payment of $1,000 per

month plus $10 per machine
hour used

Per unit: changes as activity level remains constant per unit of

changes activity

Formula: Total variable cost = Variable Total mixed cost = Fixed

cost per unit × Units of activity costs + Variable costs

The following two graphs illustrate how variable costs increase with activity while fixed costs
remain the same.
Total Total
Fixed
Variable
Costs
Costs

Activity Activity

2. MIXED COSTS AND STEP COSTS

Mixed costs are costs that have both a fixed and a variable component.
The formula for a mixed cost is:
Total cost = Total fixed cost + Total variable cost
A step cost has a constant level of cost for a range of output, then jumps to a higher level of cost
where it remains for a range of output.
Cost Behavior 2

Step costs with narrow ranges of activity are usually treated as a variable cost.

Steps costs with steps that cover wide ranges of activity can be treated as fixed costs.

3. METHODS FOR SEPARATING MIXED COSTS INTO FIXED

AND VARIABLE COMPONENTS
Three widely used methods for separating a mixed cost into fixed and variable components are:
1. the high-low method
2. the scattergraph method, and
3. the method of least squares.
Costs can be estimated using the following equation for a straight line:
Total cost = Fixed cost + Variable rate × Output

Total cost is called the dependent variable because it is dependent on the value of another
variable, the activity level.
The intercept of the line (where the line intersects the vertical or cost axis) is an estimate of the
fixed cost.
The slope of the line is an estimate of the variable cost per unit of activity.
A major goal of cost behavior analysis is to develop cost functions so costs can be estimated at
various levels of activity.

Cornerstone 2-1: How to Create and Use a Cost Formula

The Cornerstones can be implemented in your classes in several different ways:
1. Demonstrate Cornerstone 2-1 in the Mowen/Hansen text as an example in class.
2. Use Exercise 2-18 as a demo, in-class exercise. Students can work the exercise
individually or in teams.

A. The High-Low Method

The high-low method uses two points (the high activity level and the low activity level) to
determine the cost formula.
22 Chapter 2

The high-low method consists of 4 steps:

Step 1: Find the high point (highest activity or output level) and the low point (the lowest
activity or output level) for a given set of data.

Step 2: Using the high and low points, calculate the variable cost per unit of activity:
Change in cost between high point and low point
Variable rate =
Change in output between high point and low point

 Total variable costs can be calculated for different activity levels as follows:
Total variable costs = Variable rate × Output

Step 3: Calculate the fixed cost using total cost at either the high point or the low point:
Fixed costs = Total (mixed) cost at high point – (Variable rate × High output)
or
Fixed costs = Total (mixed) cost at low point – (Variable rate × Low output)

Step 4: Create the cost formula using the variable rate from Step 2 and fixed costs from
Step 3:
Total cost = Total fixed cost + (Variable rate × Output)

A weakness of the high-low method is that it uses only two observations to develop the cost
formula and the two points could be outliers (points that do not represent typical cost-activity
relationships). It is important that the high and low levels of activity used are representative of the
general cost-activity pattern.

Cornerstone 2-2: How to Use the High-Low Method to Calculate Fixed Cost and
the Variable Rate and to Construct a Cost Formula
The Cornerstones can be implemented in your classes in several different ways:
1. Demonstrate Cornerstone 2-2 in the Mowen/Hansen text as an example in class.
2. Use Exercise 2-23 as a demo, in-class exercise. Students can work the exercise
individually or in teams.

Cornerstone 2-3: How to Use the High-Low Method to Calculate Predicted Total
Variable Cost and Total Cost for Budgeted Output
The Cornerstones can be implemented in your classes in several different ways:
1. Demonstrate Cornerstone 2-3 in the Mowen/Hansen text as an example in class.
2. Use Exercise 2-23 as a demo, in-class exercise. Students can work the exercise
individually or in teams.
Cost Behavior 2

Cornerstone 2-4: How to Use the High-Low Method to Calculate Predicted Total
Variable Cost and Total Cost for a Time Period that Differs from the Data Period
The Cornerstones can be implemented in your classes in several different ways:
1. Demonstrate Cornerstone 2-4 in the Mowen/Hansen text as an example in class.
2. Use Exercise 2-27 as a demo, in-class exercise. Students can work the exercise
individually or in teams.

B. Scattergraph Method
A scattergraph contains a vertical axis indicating the total cost being analyzed (the depen dent
variable) and a horizontal axis indicating the activity level (the independent variable). Past cost
observations are plotted as data points on the scattergraph.
The scattergraph method involves visually fitting a line to the points on the scattergraph by
selecting two points on the scattergraph that seem to best represent the relationship between
cost and activity.
One purpose of the scattergraph is to see if there is a linear relationship. Also, the scattergraph
may reveal points (observations) that do not seem to fit the general pattern of behavior (outliers)
and perhaps should be eliminated.
The scattergraph method involves 4 steps:
Step 1: Plot post cost observations at different activity levels on a graph. Select two
points on the scattergraph that appear to best represent the relationship between
cost and activity.
Step 2: Calculate the variable cost per unit of activity as:
Change in cost between Point 1 and Point 2
Variable rate =
Change in output between Point 1 and Point 2

 Total variable costs can be calculated for different activity levels as follows:
Total variable costs = Variable rate × Output

Step 3: Calculate the fixed cost component as:

Fixed costs = Total (mixed) cost at Point 1 – Total variable costs at Point 1
or
Fixed costs = Total (mixed) cost at Point 2 – Total variable costs at Point 2

Step 4: Create the cost formula for total costs:

Total cost = Total fixed cost + (Variable rate × Output)

The difference between the high-low method and the scatterplot method is the way the two
points are selected.
24 Chapter 2

C. The Method of Least Squares

The method of least squares (regression) is a statistical method to find the best-fitting line
through a set of data points.
The formula used to predict costs is the formula for a straight-line:
Total cost = Fixed costs + (Variable rate × output)

The method of least squares arrives at values for fixed costs and variable cost per unit of
activity that result in a line that fits the points (cost observations) better than any other line.
Electronic spreadsheets, such as Microsoft Excel ®, have features to perform regression
calculations.
Teaching Tip: The emphasis in presenting the method of least squares in this course is on using
the results generated by spreadsheet software and other software programs.

Cornerstone 2-5: How to Use the Regression Method to Calculate Fixed Cost
and the Variable Rate and to Construct a Cost Formula and to Determine
Budgeted Cost
The Cornerstones can be implemented in your classes in several different ways:
1. Demonstrate Cornerstone 2-5 in the Mowen/Hansen text as an example in class.
2. Use Exercise 2-28 as a demo, in-class exercise. Students can work the exercise
individually or in teams. .

APPLICATIONS
Applications for the chapter include the following:
A. In-class Group Practice Tests. See the end-of-chapter multiple-choice questions provided in
the text for an in-class, group test or for use with a personal response system. With a group
test, each student takes the quiz or test individually. Then ask students to break into teams of
four or five to grade the test and discuss answers.

B. Video Integration. See the guide at the end of this chapter for a description of video and
additional discussion questions and demonstration problems.

C. End-of-Chapter Exercises, Problems, and Cases.

Learning Difficult AACSB IMA Content

Exercise Objective1 Cornerstone2 y Time Skills3 Specification4
2-15 LO 1 Easy 5 A BE
2-16 LO 1 Easy 7 A BE
2-17 LO 1 Easy 5 A BE
2-18 LO 1 Cornerstone 2-1 Easy 10 A BE
Cost Behavior 2

Learning Difficult AACSB IMA Content

Exercise Objective1 Cornerstone 2
y Time Skills3 Specification4

2-19 LO 1 Cornerstone 2-1 Easy 10 A BE

2-20 LO 2 Easy 10 A BE
2-21 LO 2 Easy 10 A, R BE
2-22 LO 3 Cornerstone 2-1 Easy 5 A BE
2-23 LO 3 Cornerstone 2-2, Medium A BE
2-3 10
2-24 LO 3 Easy 5 A BE
2-25 LO 3 Cornerstone 2-5 Easy 5 A, T BE, QM
2-26 LO 3 Cornerstone 2-2, Medium A BE, BP
2-3 15
2-27 LO 3 Cornerstone 2-4 Easy 15 A BE, BP
2-28 LO 3 Cornerstone 2-5 Easy 10 A BE, BP, QM
2-29 LO 3 Cornerstone 2-4 Easy 5 A BE, BP, QM
2-30 LO 3 Cornerstone 2-1 Easy 10 A BE, BP
2-31 LO 4 Cornerstone 2-5 Medium 20 A BE, BP, QM
2-32 LO 4 Cornerstone 2-5 Medium 20 A, T, R BE, QM

Problem
/ Learning Difficult AACSB IMA Content
Case Objective1 Cornerstone2 y Time Skills3 Specification4
2-33 LO 1, 2 Easy 5 A. R BE
2-34 LO 3 Easy 8 A BE, QM
2-35 LO 1 Easy 5 A BE, QM
2-36 LO 3 Cornerstone 2-1, Medium A BE, BP
2-2, 2-3, 2-4 15
2-37 LO 3 Cornerstone 2-5 Medium 15 A, T BE, BP, QM
2-38 LO 4 Cornerstone 2-5 Hard 35 A, R, T BE, QM
2-39 LO 3, 4 Cornerstone 2-1, Hard A, R, T BE, QM
2-2, 2-3, 2-4, 2-5 40
2-40 LO 1, 2, 3 Cornerstone 2-1, Medium A BE, BP
2-2, 2-3, 2-4 30
2-41 LO 3, 4 Cornerstone 2-1, Hard A, R BE, BP, DA
2-2, 2-3, 2-4, 2-5 40
2-42 LO 1, 2, 3 Medium 30 A, R BE, BP, DA
2-43 LO 1, 3 Cornerstone 2-1, Medium A BE, DA
2-2, 2-3, 2-4 30
2-44 LO 1, 2 Medium 20 A, R BE
26 Chapter 2

Problem
/ Learning Difficult AACSB IMA Content
Case Objective1 Cornerstone2 y Time Skills3 Specification4
2-45 LO 1, 2, 3, Hard A, R BE, BP
4 40
2-46 LO 1 Hard 30 E BA

1
Learning Objectives

1. Explain the meaning of cost behavior and define and describe fixed and
variable costs.
2. Define and describe mixed and step costs.
3. Separate mixed costs into their fixed and variable components using the
high-low method, the scattergraph method, and the method of least
squares.
4. (Appendix) Use a personal computer spreadsheet program to perform the
method of least squares.

2
Cornerstones

Cornerstone 2-1 Create and Use a Cost Formula

Cornerstone 2-2 Use the High-Low Method to Calculate Fixed Cost, the
Variable Rate, and to Construct a Cost Formula
Cornerstone 2-3 Use the High-Low Method to Calculate Predicted Total
Variable Cost and Total Cost for Budgeted Output
Cornerstone 2-4 Use the High-Low Method to Calculate Predicted Total
Variable Cost and Total Cost for a Time Period that Differs
from the Data Period
Cornerstone 2-5 Use the Regression Method to Calculate Fixed Cost and the
Variable Rate, and to Construct a Cost Formula and to
Determine Budgeted Cost
3
AACSB Skills
C Communication abilities
E Ethical understanding and reasoning abilities
A Analytic skills
T Use of technology
D Multicultural and diversity understanding
R Reflective thinking skills

4
IMA Content Specification
BE Business economics
GB Global business
IC Internal control
QM Quantitative methods
FSA Financial statement and accounting standards
Cost Behavior 2

BP Budget preparation
CM Cost management
IM Information management
PM Performance management
R Reporting
SP Strategic planning
SM Strategic marketing`
CF Corporate finance
DA Decision analysis
ID Investment decisions
BA Business applications

VIDEO INTEGRATION GUIDE

Video Case: Experience Accounting with Zingerman’s Community of Businesses: Cost
Behavior
Video Running Time: 7:41
Organization Discussed: Zingerman’s Deli

Video Case Learning Goals

 Explains the meaning of cost behavior
 Demonstrates and explains examples of fixed, step, mixed, and variable costs within different
areas of the business
 Discusses the importance of separating mixed costs into fixed and variable costs for
budgeting, setting pricing, and planning for growth
 Provides examples of how employees’ understanding about cost behavior enhances overall
company performance and its success

Chapter Concepts Spotlighted in Video

 Cost behavior
 Fixed costs
 Mixed costs
 Step costs
 Variable costs

Video Case Synopsis

The video demonstrates how a deli in Ann Arbor, Michigan makes sound business decisions
based on its understanding of cost behavior in each of its seven different, food related
businesses. The company’s vision includes a proactive, positive approach. Its success and
28 Chapter 2

wise business management is contributed to its understanding of cost behavior. The bake
house business clearly demonstrates fixed, step, and variable costs associated with baking
cakes. The mail order business depicts a seasonal business with additional fixed and
variable costs during its peak months. The online website generates 50-60% of its sales but
results in minimal increases in costs as taking the sales via a website incurs minimal costs
and the normal staff processes these additional sales. Finally, the company discusses its
support staff and provides examples of fixed and variable costs. All employees are trained to
gain an understanding of the business and the nature of costs so they can actively participate
in identifying ways to effectively reduce costs.

Video Case Discussion Questions and Suggested Answers

1. Why is knowledge of cost behavior important to Zingermans?
Zingermans has seven different food companies, each with costs that behave differently. By
understanding the behavior of costs in each of its autonomous businesses, Zingerman is able
to successfully budget, set prices, plan for growth, and evaluate performance. As the
company hires employees, these individuals are trained to learn about the company and
understand how the business operates so they can actively participate in identifying ways to
effectively reduce costs.
2. Give examples of fixed and variable costs in Zingerman’s Bakehouse business.
Fixed costs include the oven and costs to pay a shift of bakers. Variable costs include the
ingredients to bake cakes.
3. Give an example of a step cost in Zingerman’s Bakehouse business. What is the relevant
range for the cost?
The ovens are a step cost because an oven can bake only 144 cakes in one day. To bake
the 145th cake, Zigerman’s must purchase another oven. This increase in the fixed costs
represents a step cost. This higher level of cost will remain constant until the company
determines it needs a third oven to bake the 289 th cake in one day. A relevant range for the
oven costs is 1 to 144 cakes or 145 to 288 cakes.
4. What is a driver? Give an example of a cost and its corresponding output measure or driver
for Zingerman’s mail order business.
A driver is a factor that causes or leads to a change in a cost or activity. Within the mail order
business, the number of orders will causes a need for additional labor. As the orders
increase during the months of September through January, employees increase from 30 to
300.
5. What is a mixed cost? Give an example of a mixed cost for Zingerman’s.
A mixed cost has both a fixed and a variable component. Zingerman’s labor costs are mixed
as more employees work more hours, labor costs increase. However, benefits such as
medical or dental are fixed and cost remains the same for the pay period regardless of the
number of hours worked.
Follow-up Experiential Exercises
1. Obtain published financial statements of a manufacturing and a service organization.
Compare their income statements and balance sheets. Provide examples of fixed, variable,
mixed, and step costs.
Cost Behavior 2

2. Obtain published financial statements of a manufacturing company. Based on its income

statement, estimate a cost formula for its product. Note, students may have to assume a level of
output to calculate a variable rate per unit if the company does not provide any indicators of its
volume of business.
3. Have students review their own expenses and categorize the expenses as variable, fixed or
mixed. For a mixed expense, use the high low method to identify the variable and fixed
components.