3 -1

CHAPTER

Activity Cost
Behavior
 3 -2

Objectives
1. Define cost behavior for fixed,
After studying this variable, and
mixed costs.chapter, you should
2. Explain the role be
of the
ableresource
to: usage model
in understanding cost behavior.
3. Separate mixed costs into their fixed and
variable components using the high-low
method, the scatterplot method, and the
method of least squares.
continued
 3 -3

Objectives
4. Evaluate the reliability of a cost equation.
5. Discuss the role of multiple regression in
assessing cost behavior.
6. Describe the use of managerial judgment in
determining cost behavior.
 3 -4

Fixed Costs
A cost that stays the
same as output changes
is a fixed cost.
 3 -5

Fixed Costs
Cutting machines are
leased for $60,000 per
year and have the
capacity to produce up
to 240,000 units a year.
 3 -6
Total Fixed Cost Graph
$120,000
Total Costs

$100,000
$80,000
F = $60,000
Fixed Costs
$60,000
$40,000
$20,000
0 60 120 180 240
Units Produced (000)

Lease of Number Units

Machines of Units Cost
$60,000 0 N/A
60,000 60,000 $1.00
60,000 120,000 0.50
60,000 180,000 0.33
60,000 240,000 0.25
 3 -7
Unit Fixed Cost Graph
$1.00
Cost per Unit

$0.50 Fixed Costs

$0.33

$0.25
0 60 120 180 240
Units Produced (000)

Lease of Number Units

Machines of Units Cost
$60,000 0 N/A
60,000 60,000 $1.00
60,000 120,000 0.50
60,000 180,000 0.33
60,000 240,000 0.25
 3 -8

A variable cost is a cost

that, in total, varies in
direct proportion to
changes in output.

Variable
Cost
 3 -9

Variable Cost
As the cutting machines cut each unit,
they use 0.1 kilowatt-hour at $2.00 per
kilowatt hour. Thus, the cost of each
unit is $0.20 ($2 x 0.1).
 3 -10
Total Variable Cost Graph

Total Costs $48,000

Yv = .20x
$36,000
$24,000 Variable Cost
$12,000
0 60 120 180 240
Units Produced (000)

Cost of Number Units

Power of Units Cost
$ 0 0 $ 0
12,000 60,000 0.20
24,000 120,000 0.20
36,000 180,000 0.20
48,000 240,000 0.20
 3 -11
Unit Variable Cost Graph

Cost per Unit $0.40

$0.30
$0.20 Variable Cost
$0.10
0
60 120 180 240
Units Produced (000)

Cost of Number Units

Power of Units Cost
$ 0 0 $ 0
12,000 60,000 0.20
24,000 120,000 0.20
36,000 180,000 0.20
48,000 240,000 0.20
 3 -12

A mixed cost is a cost

that has both a fixed
and a variable
component.
 3 -13

Sales representatives
often are paid a
salary plus a
commission on sales.
 Mixed Cost Behavior 3 -14

$130,000
$110,000
Total Costs

$90,000
$70,000
$50,000
$30,000
0 40 80 120 160 180 200
Units Sold (000)

Variable Fixed Total Selling

Inserts Cost of Cost of Selling Cost per
Sold Selling Selling Cost Unit
40,000 $ 20,000 $30,000 $ 50,000 $1.25
80,000 40,000 30,000 70,000 0.86
120,000 60,000 30,000 90,000 0.75
160,000 80,000 30,000 110,000 0.69
200,000 100,000 30,000 130,000 0.65
 3 -15

Activity Cost Behavior Model

Input:
Materials
Energy Activity
Activities Output
Labor
Capital

Changes
in Input Changes
Cost in Output
Cost Behavior
 3 -16

Flexible resources are

resources acquired as used and
needed. Materials and energy
are examples.
 3 -17

Committed resources are supplied in

advance of usage. Buying or leasing a
building is an example of this form of
advance resource acquisition.
 3 -18

A step cost displays a constant level

of cost for a range of output and then
jumps to a higher level of cost at
some point.

Step-Cost Behavior
 3 -19

Step-Cost Behavior
Cost
$500

400

300

200

100

10 20 30 40 50
Activity Output (units)
 3 -20

Step-Fixed Costs
Cost

$150,000

Normal
100,000 Operating
Range
50,000 (Relevant
Range)

2,500 5,000 7,500

Activity Usage
 3 -21

Step-Cost Behavior
Three engineers hired at $50,000 each

Each engineer is capable of processing 2,500

change orders
$90,000 was spent on supplies for the
engineering activity
There were 6,000 orders processed

The company could process as many as 7,500

orders
 3 -22

Step-Cost Behavior

Available orders = Orders used + Orders unused

7,500 orders = 6,000 orders + 1,500 orders
Fixed engineering rate = $150,000/7,500
= $20 per change order
Variable engineering rate = $90,000/6,000
= $15 per change order
 3 -23

Step-Cost Behavior

The relationship between resources supplied and

resources used is expressed by the following
equation:
Resources available = Resources used + Unused
capacity
 3 -24

Step-Cost Behavior
Cost of orders supplied = Cost of orders used +
Cost of unused orders
= [($20 + $15) x 6,000] + ($20
x 1,500)
= $240,000
The $30,000 of excess engineering capacity
means that a new product could be
Equal to the $150,000 spent on
introducedengineers
without and
increasing current
the $90,000
spending on engineering.
spent on supplies.
 3 -25

Methods for Separating Mixed Costs

The High-Low Method
The Scatterplot Method
The Method of Least Squares

Variable
Component
Fixed
Component
 3 -26

The linearity assumption

assumes that variable costs
increase in direct proportion to
the number of units produced
(or activity units used).
 3 -27

Methods for Separating Mixed Costs

Y = a + bx

Total Cost
Total Fixed
Variable
Number of
CostCostUnits
per
Unit
 3 -28

The High-Low Method

Month Setup Costs Setup Hours

January $1,000 100
February 1,250 200
March 2,250 300
April 2,500 400
May 3,750 500

Step 1: Solve for variable cost (b)

 3 -29

The High-Low Method

Month Setup Costs Setup Hours

January $1,000 100
February 1,250 200
March 2,250 300
April 2,500 400
May 3,750 500

High Cost Low Cost

b=
High Units Low Units
 3 -30

The High-Low Method

Month Setup Costs Setup Hours

January $1,000 100
February 1,250 200
March 2,250 300
April 2,500 400
May 3,750 500

High Cost Low Cost

$3,750
b=
Units Low
High500 Low Units
Units
 3 -31

The High-Low Method

Month Setup Costs Setup Hours

January $1,000 100
February 1,250 200
March 2,250 300
April 2,500 400
May 3,750 500

$3,750 Low
$1,000
Cost
b=
500 Low
100
Units
 3 -32

The High-Low Method

$3,750 $1,000
b=
500 100

b = $6.875

Step 2: Using either the high cost or low cost,

solve for the total fixed cost (a).
 3 -33

The High-Low Method

Y = a + b (x) High
$3,750 = a + $6.875(500) End
$312.50 = a
Y = a + b (x) Low
$1,000 = a + $6.875(100) End
$312.50 = a
The cost formula using the high-low method is:
Total cost = $312.50 + ($6.875 x Setup hours)
 3 -34

The Scatterplot Method

 3 -35
The Scatterplot Method
Nonlinear Relationship
Activity
Cost

* *
*

*
*

0 Activity Output
 3 -36
The Scatterplot Method
Upward Shift in Cost Relationship
Activity
Cost

* *
*

*
*
*

0 Activity Output
 3 -37
The Scatterplot Method
Presence of Outliers
Activity
Cost
*
*
*
Estimated
regression
*
line
*
*
Estimated
fixed cost
0 Activity Output
 3 -38
The Method of Least Squares
Month Setup Costs Setup Hours
Jan 1,000 100
Feb 1,250 200
Mar 2,250 300
Apr 2,500 400
May 3,750 500

Spreadsheet Data for

Larson Company
 3 -39
The Method of Least Squares
Regression Output:
Constant 125
Std. Err of Y Est 299.304749934466
R Squared 0.944300518134715
No. of Observation 5
Degrees of Freedom 3
X Coefficient(s) 6.75
Std. Err of Coef. 0.9464847243

Regression Output for

Larson Company
 3 -40
The Method of Least Squares

The results give rise to the following equation:

Setup costs = $125 + ($6.75 x Setup hours)
R2 = .944, or 94.4 percent of the variation in
setup costs is explained by the number of setup
hours variable.
 3 -41

Coefficient of Correlation
Positive Correlation

r approaches +1

Machine Utilities Machine Utilities

Hours Costs Hours Costs
 3 -42

Coefficient of Correlation
Negative Correlation

r approaches -1

Hours of Industrial Hours of Industrial

Safety Accidents Safety Accidents
Training Training
 3 -43

Coefficient of Correlation
No Correlation

r~0

Hair Accounting Hair Accounting

Length Grade Length Grade
 3 -44

Multiple Regression

TC = b0 + ( b1X1) + (b2X2) + . . .
b0 = the fixed cost or intercept

b1 = the variable rate for the first independent variable

X1 = the first independent variable

b2 = the variable rate for the second independent variable

X2 = the second independent variable

 3 -45

Multiple Regression
Month Mhrs Summer Utilities Cost
Jan 1,340 0 $1,688
Feb 1,298 0 1,636
Mar 1,376 0 1,734
April 1,405 0 1,770
May 1,500 1 2,390
June 1,432 1 2,304
July 1,322 1 2,166
August 1,416 1 2,284
Sept 1,370 1 1,730
Oct 1,580 0 1,991
Nov 1,460 0 1,840
Dec 1,455 0 1,833

Data for Phoenix Factory

Utilities Cost Regression
 3 -46

Multiple Regression
Constant 243.1114997159
Std Err of Y Est 55.5082829356447
R Squared 0.96717927255452
No. of Observation 12
Degrees of Freedom 9

X Coefficient(s) 1.0971575051946 510.49073361447

Std Err of Coef. 0.210226332115593 32.5489464532519

Multiple Regression for Phoenix

Factory Utilities Cost
 3 -47

Multiple Regression

The results gives rise to the following equation:

Utilities cost = $243.11 + $1.097(Machine hours) +
($510.49 x Summer)
R2 = .967, or 96.7 percent of the variation in utilities
cost is explained by the machine hours and summer
variables.
 3 -48

Managerial Judgment

Managerial judgment is critically

important in determining cost behavior,
and it is by far the most widely used
method in practice.
 3 -49

Chapter Three

The End
3 -50