Chapter 6: Cost Behaviour: Analysis and Use Flashcards
Cost structure
The relative proportion of fixed, variable, and mixed costs found within an organization.
Activity base (cost driver AKA)
A measure of whatever causes the incurrence of a variable cost.
(For example, the total cost of X-ray film in a hospital will increase as the number of X-rays taken increases. Therefore, the number of X-rays is an activity base for explaining the total cost of X-ray film.)
Activity bases can be either
Input-based
Output-based
Common output-based activity measures
Volume of goods or services sold
Number of customers served
Number of patients treated
Common input-based activity measures
Direct labor-hours
Machine-hours
Number of customers service calls
Kilograms of raw materials used
Merchandising companies, such as walmart or Canadian tire
Will usually have high proportion of variable costs in its cost structure
That is, the cost of merchandise purchased for resale (a variable cost) constitutes a large component of total cost
Service companies have _______ cost structures
Service companies involved in consulting, auditing, engineering, dental, medical, and architectural activities have very ______ fixed costs
Diverse
High
True variable costs
Costs that vary in direct proportion to changes in the level of activity.
Step-variable cost
Step variable cost
A cost (such as the cost of a maintenance worker) that is obtainable only in chunks and that increases and decreases only in response to more than a unit change in activity.
Increases or decreases only in more than a unit change in activity
Can change quicker than fixed costs
True vs step-variable costs graphs
True variable costs (direct materials) are a straight line, from bottom left to top right
Step-variable costs are stairs that go from bottom left to top right
Curvilinear
Economists argue that variable costs actually behave in a curvilinear fashion due to the marginal productivity of variable inputs not being constant
curvilinear cost
A relationship between cost and activity that is a curve, rather than a straight line.
Relevant range
The range of activity within which assumptions about variable and fixed cost behaviour are valid.
This is where one can use a straight-line to show curvilinear cost
Per unit fixed cost
Starts in top left corner and curves down to bottom right, looking like an L
As the number of guests increase, the average unit price drops
$5000 rent per month
10 guests : $500 per guest
100 guests: $50 per guests
1000 guests: $5 per guest
Capacity costs
Another name for fixed costs, since they result from outlays made for buildings, equipment, skilled professional employees, and other items needed to provide the basic capacity for sustained operations
Committed fixed costs
Fixed costs that are difficult to adjust in the short term and relate to the investment in facilities, equipment, and the basic organizational structure of a firm.
long-term, cannot be reduced in the short term
Examples: Taxes on real estate, depreciation of buildings and equipment, insurance, salaries of key personnel
Discretionary fixed costs (aka managed fixed cost)
Fixed costs that arise from annual decisions by management to spend in certain fixed cost areas, such as advertising and research.
may be altered in the short term by current managerial decisions
Two key difference between discretionary fixed costs and committed fixed costs
1) Planning horizon for a discretionary fixed cost is short, usually a single year. COmmitted fixed costs have longer planning horizons
2) Discretionary fixed costs can be cut for short periods with minimal damage to the long-term goals of the organization
Example: Management retreats can be cut back due to poor economic conditions
To easy it down, committed fixed costs are commitments for a period of time, such as someone who enters a rental agreement. DIscretionary expenses is like someone seeing a movie or buying new shoes, where no commitments exist
Knowledge workers
Those who work primarily with their minds, rather than muscles.
These are often fixed and committed
Can fixed costs change?
YES!
They just do not change in response to small changes in activity
Mixed cost
A cost that contains both variable and fixed cost elements
Can be expressed as a basic linear equation, and reflected graphically
Equation for a straight line
Y = A + bX
Y =
Total mixed cost
A =
Total fixed costs (vertical intercept of the line)
B =
Variable cost per unit of activity (slope of the line)
X =
level of activity
Example of equation.
Rent is $5000 a month and each person must pay an additional $100 to whoever lives there.
Say 6 people move in together, make an equation
Y = 6(100) + 5000 Y = 600+5000 Y= $5600
The fixed portion of a mixed cost represents:
The basic, minimum cost of just having a service ready and available for use
The variable portion of a mixed cost represents:
The cost incurred for actual consumption of the service
What do you do when there is little or no historical data available for analysis
Account analysis
Engineering approach
When there is a considerable amount historical data available, manager can choose from the following three methods
1) High-low
2) Scattergraph
3) Regression analysis
Account analysis (nonquantitative)
A method for analyzing cost behaviour in which each account is classified as either variable or fixed on the basis of the analyst’s knowledge of how the cost in the account behaves.
Example: Building lease be classified as fixed, and direct materials be considered variable
Engineering approach (nonquantitative)
A detailed analysis of cost behaviour based on an industrial engineer’s evaluation of the inputs that are required to carry out a particular activity and of the prices of those inputs.
Example: Pizza hut using this approach to estimate the cost of serving a particular takeout pizza
High-low method
High low method
A method of separating a mixed cost into its fixed and variable elements by analyzing the change in cost corresponding to the high and low levels of activity.
PRO: Considered easy to understand and apply … CON: Utilizes only 2 data points in the analysis so could be based on abnormal observations and could seriously misrepresent the true cost relationship that holds during normal periods
How to use the High-low method for variable cost
High low method
1) Identify the period with the lowest level of activity
2) Identify the period with the highest level of activity
3) Subtract the large value from the small value, two times and sticking to like terms
ex. Variable cost = change in cost / change in activity
(9800-7450) / (8000-5000) = 2350 / 3000
= 0.783 per day
USE THE HIGHEST ACTIVITY IF COST IS NOT THE HIGHEST
How to use the High-low method for fixed cost
High low method
1) Do variable cost first
2) Fixed cost element = Total cost - Variable cost element
9800 - (0.783 x 8000) = 3536 (notice we use big numbers only for this)
Dependent variable
A variable that reacts or responds to some causal factor; total cost is the dependent variable, as represented by the letter Y in the equation Y = a + bX.
This is COST since the amount of cost depends on the amount of activity in the period
Independent variable
A variable that acts as a causal factor; activity is the independent variable, as represented by the letter X in the equation Y = a + bX.
This is ACTIVITY since it causes variations in the cost
Scattergraph method
A method of separating a mixed cost into its fixed and variable elements. Under this method, a regression line is fitted to an array of plotted points by drawing a line with a straight edge.
PRO: Considered more precise than the High-Low Method … CON: Considered less precise than the more sophisticated Least-Squares Regression Method. Highly subjective in that no two analysts who look at the same scattergraph are likely to draw exactly the same regression line.
Regression line
A line fitted to an array of plotted points. The slope of the line, denoted by the letter b in the linear equation Y = a + bX, represents the variable cost per unit of activity. The point where the line intersects the cost axis, denoted by the letter a in the above equation, represents the total fixed cost.
To do a scattergraph
1) Select two points that lie within the range
2) Draw vertical lines up from those points until it hits the line drawn
3) Draw the lines horizontal to get the point on the left side of the graph (you should have a box drawn)
4) Using the same formula as before (see card 35), determine the slope
Least-squares regression
least squares regression
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.
PRO: Objective and precise, using all data points in the analysis … CON: Highly sophisticated so typically requires computer software for analysis
What method of the three is the best
See exhibit 6-11
In essence, the least-squares method is the best due to the mathematical background
Contribution margin
The amount remaining from sales revenues after all variable expenses have been deducted.
Income statement vs contribution income statement
Income statement: Uses COGS, used for external reporting
Contribution statement: Sales - variable expenses = contribution margin - fixed expenses = net income
Used primarily by management
Contribution margin approach positives
Clearly shows the different between fixed and variable costs
This allows companies to price its products in a way that will ensure they make a profit
Organizes costs according to behavior, rather than function
Contribution margin equation
Sales - VC = CM - FC = NI (net income)
Traditional approach
Gross margin approach
Absorption costing
Sales - COGS = Gross Margin - Operating expense = net income
