Costs separation copy.ppt

Copyright © 2008 Prentice Hall All rights reserved
6-1
Cost Behavior
Costs separation

6-2
Cost Behavior
There are three common cost behaviors:
1. Variable costs
2. Fixed costs
3. Mixed costs

6-3
Key Characteristics of Variable
Costs
• Total variable costs change in direct proportion to
changes in volume
• The variable cost per unit of activity (v) remains constant
and is the slope of the variable cost line
• Total variable cost graphs always begin at the origin (if
volume is zero, total variable costs are zero)
• Total variable costs can be expressed as:
 y = vx
Where:
Y = total variable cost
V = variable cost per unit of activity
X = volume of activity

6-4
Total Variable Costs
$0
$500
$1,000
$1,500
$2,000
$2,500
$0 $10,000 $20,000 $30,000 $40,000
Total Sales
Total
Sales
Commissions

6-5
Key Characteristics of Fixed Costs
• Total fixed costs stay constant over a wide range of
volume
• Total fixed cost graphs are always flat lines with no slope
• The flat (horizontal) line intersects the y-axis at the level
equal to the fixed cost
• Total fixed cost can be expressed as y = f where
 Y = total fixed cost
 F = fixed cost over a given period of time
• Fixed costs per unit of activity vary inversely with
changes in volume
 Fixed cost per unit of activity increases when volume decreases
 Fixed cost per unit of activity decreases when volume increases

6-6
Total Fixed Costs
$0
$500
$1,000
$1,500
$2,000
$2,500
$0 $10,000 $20,000 $30,000 $40,000
Total Sales
Total
Sales
Salaries

6-7
Key Characteristics of Mixed Costs
• Total mixed costs increase as volume increases because of the
variable cost component
• Total mixed cost graphs slope upwards but do not begin at the
origin; they intersect at the y-axis at the level of the fixed costs
• Total mixed costs can be expressed as a combination of the variable
and fixed cost equations:
 Total mixed costs = variable cost component + fixed cost
• Y = vx + f
• Where
– Y = total mixed cost
– V = variable cost per unit of activity
– X = volume of activity
– F = fixed cost over a given period of time

6-8
Mixed Costs
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
$4,500
$0 $10,000 $20,000 $30,000 $40,000
Total Sales
Sales
Compensation
Variable
Fixed

6-9
E6-16 a. Graph of Variable Costs
$0
$20,000
$40,000
$60,000
$80,000
0 5,000 10,000
Units

6-10
E6-16 b. Graph of Mixed Costs
$0
$20,000
$40,000
$60,000
$80,000
0 5,000 10,000
Units

6-11
E6-16 c. Graph of Fixed Costs
$0
$20,000
$40,000
$60,000
$80,000
0 5,000 10,000
Units

6-12
Relevant Range
• Band of volume where total fixed costs
remain constant at a certain level
• Variable costs per unit remain constant at
a certain level
• If there is a change in cost behavior it
means that the relevant range needs to be
adjusted

6-13
Other Cost Behaviors
Step Costs – Fixed over small range of activity;
then jump to new fixed level
$0
$15,000
$30,000
$45,000
$60,000
Number of Units
Total
Costs

6-14
$0
$15,000
$30,000
$45,000
$60,000
Number of Units
Total
Costs
Other Cost Behaviors
Curvilinear Costs – Are not linear and do not fit
into any neat pattern

6-15
Garments
2,000 3,500 5,000
Total Variable Costs
Total Fixed Costs
Total Operating Costs
Variable Cost/garment
Fixed Cost/garment
Average cost/garment
E6-18. 1.
7,000 7,000 7,000
$1,500 $2,625 $3,750
$8,500 $9,625 $10,750
Garments
2,000 3,500 5,000
Total Variable Costs $1,500 $2,625 $3,750
Total Fixed Costs 7,000 7,000 7,000
Total Operating Costs $8,500 ? $10,750
Variable Cost/garment $0.75 $0.75 $0.75
Fixed Cost/garment 3.50 2.00 1.40
Average cost/garment $4.25 $2.75 ?
What happens to
fixed cost per unit
as the volume
increases if
variable costs per
unit remain
constant? Can
you fill in the
blanks?

6-16
E6-18. 3.
Actual costs at 2,000 garments $8,500
Total predicted costs
($2.15 × 2,000 garments) (4,300 )
Underestimated costs $4,200

6-17
E6-20
a. 1,000 x $26.43 $26,430
b. Total costs $26,430
Less total fixed costs (18,000)
Total variable costs $8,430
÷ 1,000
Variable cost per mailbox $8.43

6-18
E6-20
c. y = $8.43x + $18,000
d. $26.43 x 1,200 mailboxes (=$31,716)
e. y = ? If the cost
equation is used,
what will the cost
be? Remember,
we must add the
fixed component
to the variable
component.

6-19
E6-20
f. Using average at 1,000 $31,716
Using cost equation 28,116
$3,600

6-20
Account Analysis
• Account Analysis as it applies to cost
behavior determination is the use of
judgment to classify each general ledger
account as variable, fixed or mixed cost
• Three common methods used to perform
the analysis:
• Scatter Plots
• High-Low Method
• Regression Analysis

6-21
Scatter Plots
• Use historical data to determine a cost’s
behavior
• A scatter plot is the graph of historical cost
data on the y-axis and volume data on the
x-axis
• Helps managers visually determine how
strong the relationship is between the cost
and the volume of the chosen activity base

6-22
Scatter Plot Example
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
0 5000 10000 15000 20000

6-23
High-Low Method
• Method to separate mixed costs into
variable and fixed components
• Select the highest level and the lowest
level of activity over a period of time
• Uses the selected activity levels to create
a total cost equation that defines the cost
behavior

Dependent variable
Independent variable

6-25
High-Low Method: E6-23
Step 1: Find slope of the mixed cost line
(variable cost/unit) =
Δ in cost (y) / Δ in volume (x)
The slope represents the variable cost per
unit of activity
($5,830-$4,935) ÷ (17,300-14,500)
$895 ÷ 2,800 = $0.32

6-26
Step 2: Find the vertical intercept (fixed
costs) =
Total mixed cost – Total variable cost
$5,830 – ($0.32 • 17,300) = $295
or
$4,935 – ($0.32 • 14,500) = $295

6-27
Step 3: Create and use an equation to show
the behavior of a mixed cost
Y = $0.32 per mile + $1,250
Predicted operating costs at 15,000 miles:
($0.32 • 15,000) + $1,250 = $6,050

6-28
Regression Analysis
• Statistical procedure to find the line that
best fits data
• Uses all data points
• Results in equation of line and an R-
square value

6-29
Three Pieces of Information Needed
for Regression Analysis
1. The Intercept Coefficient – the vertical
intercept; it is the fixed cost component of
the mixed cost
2. The X Variable 1 coefficient is the line’s
slope, or the variable cost per unit.
3. The R-square value – the goodness-of-fit
statistic

6-30
R-Square Value
• “Goodness of fit”
• How well does the line fit the data points?
• Ranges from 0 to 1
 “0” – no relationship between costs and
volume; activity is not a cost driver
 “1” – perfect relationship; activity is a cost
driver

6-31
Data Concerns
• Seasonal variations
• Inflation
• Outliers – abnormal data points

6-32
Traditional Income Statement
Sales
- Cost of Goods Sold
Gross Margin
- Selling,general & administrative costs
Operating Income

6-33
Contribution Margin Income
Statement
Sales
- Variable Costs
Contribution Margin
- Fixed Costs
Operating Income

6-34
Contribution Margin Income
Statement
• Predicts how changes in volume will
affect operating income

6-35
Rachel’s Rock Shop
Income Statement
For the year ending 20XX
Revenue:
Sales Revenue (27,000 + 7,000) $34,000
Rental Revenue 22,000
Lesson Revenue 40,000
Total Revenue $96,000
Less: Cost of Goods Sold (7,500 + 2,000) (9,500)
Gross Margin $86,500
Less Operating Costs:
Depreciation $ 4,000
Employee Salary expenses 30,000
Musician wages 25,000
Lease 12,000
Total operating costs 71,000
Operating Income $15,500
P6-40b

6-36
E6-25
Rachel’s Rock Shop
Contribution Margin Income Statement
For the year ending 20XX
Revenue:
Sales Revenue (27,000 + 7,000) $34,000
Rental Revenue 22,000
Lesson Revenue 40,000
Total Revenue $96,000
Less: Variable Costs
Cost of Goods Sold (7,500 + 2,000) $ 9,500
Musician wages 25,000
Total Variable costs (34,500)
Contribution Margin $61,500
Less Fixed Costs:
Depreciation $ 4,000
Employee Salary expenses 30,000
Lease 12,000
Total fixed costs (46,000)
Operating Income $15,500

6-37
Variable Costing
• Assigns only variable manufacturing costs
to products
 Direct materials
 Direct labor
 Variable manufacturing overhead
• Fixed manufacturing overhead = period
cost
• Contribution margin income statements
 For internal management decisions

6-38
Absorption Costing
• Required by GAAP for external reporting
• Assign all manufacturing costs to product
 Direct materials
 Direct labor
 Variable manufacturing overhead
 Fixed manufacturing overhead
• Traditional income statement

6-39
Rays
Conventional (Absorption Costing) Income Statement
Year Ended December 31, 2008
Sales revenue (185,000  $35) $6,475,000
Less: Cost of Goods Sold:
Beginning finished goods inventory $ 0
Cost of goods manufactured 5,000,000
Cost of goods available for sale 5,000,000
Ending finished goods inventory (375,000)
Cost of goods sold 4,625,000
Gross profit 1,850,000
Operating expenses 1,175,000
Operating income $ ?
E6-32
How do we
derive
operating
income?

6-40
E6-32
Rays
Contribution Margin (Variable Costing) Income Statement
Year Ended December 31, 2008
Sales revenue $6,475,000
Variable expenses:
Variable cost of goods sold $2,775,000*
Sales commission expense 925,000 3,700,000
Contribution margin $2,775,000
Fixed expenses:
Manufacturing overhead $2,000,000
Operating expenses 250,000 2,250,000
Operating income $ ?
* computation of variable
cost of goods sold
What is
difference in
operating
income? How
does it compare
to the operating
income on the
previous slide?

6-42
E6-32
Incremental analysis:
Increase in contribution margin
(($35-20) x 15,000 goggles) $225,000
Increase in fixed costs (150,000)
Increase in operating income $75,000

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