Managerial Accounting (lesson 5)

Slide 1: Chapter 5 Cost Behavior: Analysis and Use

Slide 2: Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 2. Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Fixed Total fixed cost remains the Fixed cost per unit goes same even when the activity down as activity level goes up. level changes within the relevant range. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 3: The Activity Base Units Machine produce hours d A measure of the event that causes the incurrence of a variable cost – a cost driver Miles Labor driven hours © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 4: True Variable Cost Example Your total long distance telephone bill is based on how many minutes you talk. Total Long Distance Telephone Bill Minutes Talked © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 5: Variable Cost Per Unit Example The cost per minute talked is constant. For example, 10 cents per minute. Telephone Charge Per Minute Minutes Talked © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 6: Step-Variable Costs Total cost remains constant within a narrow range of activity. Cost Activity © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 7: Step-Variable Costs Total cost increases to a new higher cost for the next higher range of activity. Cost Activity © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 8: Exh. The Linearity Assumption and 5-4 the Relevant Range A straight line Economist’s closely Curvilinear Cost approximates a Function curvilinear variable cost line within the Relevant relevant range. Total Cost Range Accountant’s Straight-Line Approximation (constant unit variable cost) Activity © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 9: Exh. 5-5 Total Fixed Cost Example Your monthly basic telephone bill is probably fixed and does not change when you make more local calls. Telephone Bill Monthly Basic Number of Local Calls © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 10: Exh. 5-5 Fixed Cost Per Unit Example The fixed cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call Number of Local Calls © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 11: Cost Behavior Examples of normally variable costs Service Organizations Merchandisers Supplies and travel Cost of Goods Sold Merchandisers and Manufacturers Manufacturers Direct Material, Direct Sales commissions and Labor, and Variable shipping costs Manufacturing Overhead Examples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 12: Types of Fixed Costs Committed Discretionary Long-term, cannot be May be altered in the reduced in the short short-term by current term. managerial decisions Examples Examples Depreciation on Advertising and Buildings and Research and Equipment Development © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 13: Fixed Costs and Relevant Range Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost. Continue © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 14: Exh. Fixed Costs and Relevant 5-6 Range 90 Thousands of Dollars Total cost doesn’t Rent Cost in change for a wide Relevant 60 range of activity, Range and then jumps to a new higher cost for the next higher 30 range of activity. 00 1,000 2,000 3,000 Rented Area (Square Feet) © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 15: Fixed Costs and Relevant Range Step-variable costs can be adjusted more How does this type quickly and . . . of fixed cost differ The width of the from a step-variable activity steps is much cost? wider for the fixed cost. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 16: Quick Check  Which of the following statements about cost behavior are true? a Fixed costs per unit vary with the level of activity. b Variable costs per unit are constant within the relevant range. c Total fixed costs are constant within the relevant range. d Total variable costs are constant within the relevant range. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 17: Mixed Costs A mixed cost has both fixed and variable components. Consider the example of utility cost. Y Total Utility Cost t os dc ixe al m t To Variable Cost per KW X Fixed Monthly Activity (Kilowatt Utility Charge Hours) © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 18: Mixed Costs Y bX Total Utility Cost + =a Y t os dc ixe al m t To Variable Cost per KW X Fixed Monthly Activity (Kilowatt Utility Charge Hours) © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 19: The Analysis of Mixed Costs Account Analysis Engineering Approach Scattergraph Plot High-Low Method Least-Square Regression Method © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 20: Account Analysis & Engineering Estimates Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves. Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 21: The Scattergraph Method Plot the data points on a graph (total cost vs. activity). Y 20 1,000’s of Dollars * ** * Total Cost in ** ** ** 10 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 22: Quick-and-Dirty Method Draw a line through the data points with about an equal numbers of points above and below the line. Y 20 1,000’s of Dollars * ** * Total Cost in ** ** * * Intercept is the estimated 10 fixed cost = $10,000 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 23: Quick-and-Dirty Method The slope is the estimated variable cost per unit. Slope = Change in cost ÷ Change in units Y 20 1,000’s of Dollars * ** * Total Cost in ** ** ** 10 Horizontal Vertical distance is distance is the change in cost. the change in activity. 0 X 0 1 2 3 4 Activity, 1,000’s of Units Produced © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 24: The High-Low Method WiseCo recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute: the variable cost per unit; the fixed cost; and then express the costs in equation form Y = a + bX. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 25: The High-Low Method  Variable cost per unit = Change Change÷ in cost in units in cost change Change in units © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 26: The High-Low Method  Variable cost per unit = $2,400 ÷ 3,000 units = $0.80 per unit © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 27: The High-Low Method  Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,800 – ($0.80 per unit × 8,000 units) Fixed cost = $9,800 – $6,400 = $3,400 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 28: The High-Low Method  Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,800 – ($0.80 per unit × 8,000 units) Fixed cost = $9,800 – $6,400 = $3,400  Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $3,400 + $0.80X © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 29: Quick Check  Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the variable portion of sales salaries and commission? a. $0.08 per unit Units Cost b. $0.10 per unit High level 120,000 $ 14,000 c. $0.12 per unit Low level 80,000 10,000 d. $0.125 per unit Change 40,000 $ 4,000 $4,000 ÷ 40,000 units = $0.10 per unit © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 30: Quick Check  Sales salaries and commissions are $10,000 when 80,000 units are sold, and $14,000 when 120,000 units are sold. Using the high-low method, what is the fixed portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 31: Least-Squares Regression Method Software can be used to fit a regression line through the data points. The cost analysis objective is the same: Y = a + bx Least-squares regression also provides a statistic, called the R2, that is a measure of the goodness of fit of the regression line to the data points. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 32: Least-Squares Regression Method R2 is the percentage of the variation in total cost explained by the activity. Y 20 * ** * Total Cost ** ** * * R2 for this relationship is near 10 100% since the data points are very close to the regression line. 0 X 0 1 2 3 4 Activity © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 33: Cost Estimation Methods Regression Analysis A statistical method used to create an equation relating independent (or X) variables to dependent (or Y) variables. Past data is used to estimate relationships between costs and activities. Independent variables Dependent variables are are the cost drivers that caused by the are correlated with the independent variables. dependent variables. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 34: Cost Estimation Methods Regression Analysis The simple cost model is actually a regression model: TC = F + VX Caution: Before doing This model will only the analysis, take time be useful within a to determine if a relevant range of logical relationship activity. between the variables exists. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 35: Cost Estimation Methods Regression Analysis A set of data can be regressed using several techniques: •Manual computations •SPSS or SAS Statistical Software •Excel or other spreadsheet Each regression model has The result of the an R-square (R2) measure regression process is a of how good the model is. regression model: Range of R2 = 0 to 1.0 TC = F + VX © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 36: Simple Regression Analysis Example Fasco wants to know it’s average fixed cost and variable cost per unit. Using the data to the right, let’s see how to do a regression using Excel. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 37: Simple Regression Analysis Example You will need three pieces of information from your regression analysis: 2. Estimated Variable Cost per Unit (line slope) 3. Estimated Fixed Costs (line intercept) 4. Goodness of fit, or R2 To get these three pieces of information we will need to use THREE different excel functions. LINEST, INTERCEPT, & RSQ © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 38: Simple Regression Using Excel 2000 First, open the excel file with your data and click on “Insert” and “Function” © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 39: Simple Regression Using Excel 2000 When the function box opens, click on “Statistical”, then on “LINEST” © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 40: Simple Regression Using Excel 2000 By clicking on the buttons to the left, you can highlight the desired cells directly from the spreadsheet. 1. Enter the cell range for the cost amounts in the “Known_y’s” box. 2. Enter the cell range for the quantity amounts in the “Known_x’s” box. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 41: Simple Regression Using Excel 2000 The Slope, or estimated variable cost per unit, is identified here. Click OK to put this value on your spreadsheet. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 42: Simple Regression Using Excel 2000 Repeat the procedure using “Intercept”, to estimate fixed cost. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 43: Simple Regression Using Excel 2000 As previously, enter the appropriate cell ranges in their The estimated fixed cost is identified appropriate here. places. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 44: Simple Regression Using Excel 2000 Finally, determine the “goodness of fit”, or R2, by using the RSQ function. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 45: Simple Regression Using Excel 2000 As previously, enter the appropriate cell ranges in their The estimated R2 for your estimated appropriate cost function is identified here. places. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 46: Let’s put our knowledge of cost behavior to work by preparing a contribution format income statement. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 47: The Contribution Format Total Unit Sales Revenue $ 100,000 $ 50 Less: Variable costs 60,000 30 Contribution margin $ 40,000 $ 20 Less: Fixed costs 30,000 Net operating income $ 10,000 The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 48: The Contribution Format Comparison of the Contribution Income Statement with the Traditional Income Statement Traditional Approach Contribution Approach (costs organized by function) (costs organized by behavior) Sales $ 100,000 Sales $ 100,000 Less cost of goods sold 70,000 Less variable expenses 60,000 Gross margin $ 30,000 Contribution margin $ 40,000 Less operating expenses 20,000 Less fixed expenses 30,000 Net operating income $ 10,000 Net operating income $ 10,000 Used primarily for Used primarily by external reporting. management. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Slide 49: End of Chapter 5 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin