Chapter 6: Cost Behaviour: Analysis and Use

Question 1

Cost structure

Answer 1

The relative proportion of fixed, variable, and mixed costs found within an organization.

Question 2

Activity base (cost driver AKA)

Answer 2

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.)

Question 3

Activity bases can be either

Answer 3

Input-based

Output-based

Question 4

Common output-based activity measures

Answer 4

Volume of goods or services sold
Number of customers served
Number of patients treated

Question 5

Common input-based activity measures

Answer 5

Direct labor-hours
Machine-hours
Number of customers service calls
Kilograms of raw materials used

Question 6

Merchandising companies, such as walmart or Canadian tire

Answer 6

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

Question 7

Service companies have _______ cost structures

Service companies involved in consulting, auditing, engineering, dental, medical, and architectural activities have very ______ fixed costs

Answer 7

Diverse

High

Question 8

True variable costs

Answer 8

Costs that vary in direct proportion to changes in the level of activity.

Question 9

Step-variable cost

Step variable cost

Answer 9

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

Question 10

True vs step-variable costs graphs

Answer 10

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

Question 11

Curvilinear

Answer 11

Economists argue that variable costs actually behave in a curvilinear fashion due to the marginal productivity of variable inputs not being constant

Question 12

curvilinear cost

Answer 12

A relationship between cost and activity that is a curve, rather than a straight line.

Question 13

Relevant range

Answer 13

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

Question 14

Per unit fixed cost

Answer 14

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

Question 15

Capacity costs

Answer 15

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

Question 16

Committed fixed costs

Answer 16

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

Question 17

Discretionary fixed costs (aka managed fixed cost)

Answer 17

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

Question 18

Two key difference between discretionary fixed costs and committed fixed costs

Answer 18

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

Question 19

Knowledge workers

Answer 19

Those who work primarily with their minds, rather than muscles.

These are often fixed and committed

Question 20

Can fixed costs change?

Answer 20

YES!

They just do not change in response to small changes in activity

Question 21

Mixed cost

Answer 21

A cost that contains both variable and fixed cost elements

Can be expressed as a basic linear equation, and reflected graphically

Question 22

Equation for a straight line

Answer 22

Y = A + bX

Question 23

Y =

Answer 23

Total mixed cost

Question 24

A =

Answer 24

Total fixed costs (vertical intercept of the line)

Question 25

B =

Answer 25

Variable cost per unit of activity (slope of the line)

Question 26

X =

Answer 26

level of activity

Question 27

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

Answer 27

Y = 6(100) + 5000
Y = 600+5000
Y= $5600

Question 28

The fixed portion of a mixed cost represents:

Answer 28

The basic, minimum cost of just having a service ready and available for use

Question 29

The variable portion of a mixed cost represents:

Answer 29

The cost incurred for actual consumption of the service

Question 30

What do you do when there is little or no historical data available for analysis

Answer 30

Account analysis

Engineering approach

Question 31

When there is a considerable amount historical data available, manager can choose from the following three methods

Answer 31

1) High-low
2) Scattergraph
3) Regression analysis

Question 32

Account analysis (nonquantitative)

Answer 32

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

Question 33

Engineering approach (nonquantitative)

Answer 33

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

Question 34

High-low method

High low method

Answer 34

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

Question 35

How to use the High-low method for variable cost

High low method

Answer 35

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

Question 36

How to use the High-low method for fixed cost

High low method

Answer 36

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)

Question 37

Dependent variable

Answer 37

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

Question 38

Independent variable

Answer 38

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

Question 39

Scattergraph method

Answer 39

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.

Question 40

Regression line

Answer 40

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.

Question 41

To do a scattergraph

Answer 41

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

Question 42

Least-squares regression

least squares regression

Answer 42

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

Question 43

What method of the three is the best

Answer 43

See exhibit 6-11

In essence, the least-squares method is the best due to the mathematical background

Question 44

Contribution margin

Answer 44

The amount remaining from sales revenues after all variable expenses have been deducted.

Question 45

Income statement vs contribution income statement

Answer 45

Income statement: Uses COGS, used for external reporting

Contribution statement: Sales - variable expenses = contribution margin - fixed expenses = net income
Used primarily by management

Question 46

Contribution margin approach positives

Answer 46

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

Question 47

Contribution margin equation

Answer 47

Sales - VC = CM - FC = NI (net income)

Question 48

Traditional approach
Gross margin approach
Absorption costing

Answer 48

Sales - COGS = Gross Margin - Operating expense = net income