Unit 4: Cost Behavior Patterns
This chapter introduces a new way to evaluate costs and make management decisions. Rather than examining direct materials, direct labor, and manufacturing overhead, we rearrange this information as variable costs, fixed costs, and mixed costs (fixed and variable costs combined).
For example, in the previous unit we classified a factory worker who earns a salary and annual bonus based on company performance as direct labor. In this unit, we allocate salary to fixed costs, and the bonus to variable costs. We also explore how managers make short-term decisions (what needs to occur during the next hour, day, week, or year). Fixed cost restraints, such as plant size, equipment size, and age, often define short-term decisions.
Understanding how these three types of costs variables behave allows business managers to predict revenue, operating income, and changes in sales volume.
Completing this unit should take you approximately 5 hours.
Upon successful completion of this unit, you will be able to:
- identify typical cost behavior patterns;
- estimate costs using account analysis, the high-low method, the scattergraph method, and regression analysis;
- prepare a contribution margin income statement; and
- provide for nonlinear costs that occur outside of a predetermined relevant range for linear costs.
4.1: Cost Behavior Patterns
Read the Chapter 5 introduction, and then click on "Next Section" to read section 5.1. Bikes Unlimited is planning its monthly sales. They have recently concluded a successful advertising campaign and expect that sales will increase 10 to 20%. They need to know what happens if they adjust manufacturing to meet the predicted increase in sales and their predictions of sales are, in fact, true. How will increased sales volumes impact profit? First, you have to identify how costs behave with changes in sales and production—behavior depends upon whether the costs are variable, fixed, or mixed. Once you have classified the costs, you can set up an income statement in a "contribution-margin" format, that will give management a major tool in their decision making.
Variable Costs The key to understanding and being able to classify a variable cost is to remember that you are thinking about how costs behave relative to production. Variable costs will fluctuate based on how much product is sold. The cost of purchasing chrome tubing for Bikes Unlimited is an obvious variable cost, some variable costs are not so obvious. Fixed Costs
Fixed costs are incurred whether Bikes Unlimited sells zero units or a billion units. The payment of the annual lease on Bikes Unlimited's factory/warehouse is a good example of a fixed cost; even if Bikes Unlimited chooses to make no bikes, it would have to continue to pay its lease. There are two kinds of fixed costs: some are "committed," those that must happen, such as the lease payment stated above, and others that are discretionary, such as advertising or research and development. Both of these activities could be suspended in the short term.
Mixed Costs Bikes Unlimited also has mixed costs which have both fixed and variable components. Bikes Unlimited pays its sales staff a base salary plus a commission based on units sold and, finally, a year-end bonus based on overall profitability, which demonstrates all three cost behavior patterns.
These two videos supplement and reinforce what we learned earlier. The first video explores the actual behavior of costs and how you might normalize that behavior and use the costs in developing management decision tools. The second video extends the graphic model to explain cost behavior. Follow along with paper/pencil or your own spreadsheet program.
4.2: Cost Estimation Methods
Chapter 5, Section 2 of your textbook continues the story of Bikes Unlimited. You consider the four principle cost estimation methods to estimate fixed and variable costs. Each method has its advantages and disadvantages. The choice of a method will depend on the situation at hand. Experienced employees may be able to effectively estimate fixed and variable costs by using the account analysis approach. If a quick estimate is needed, the high-low method may be appropriate. The scatter-graph method can be used to identify any unusual data points which can be thrown out when estimating costs. Finally, regression analysis can be run using computer software and its precise results will provide more accurate cost estimates.
4.3: Contribution Margin Income Statement
Section 5.3 considers the contribution margin income statement, which shows fixed and variable components of cost information. Revenue minus variable costs equals the contribution margin. The contribution margin minus fixed costs equals operating profit . This statement provides a clearer picture of which costs change and which costs remain the same with changes in levels of activity.
In Chapter 5, Section 4 of the textbook, you again consider the relevant range. Along with the assumption of linearity, the relevant range must be considered when estimating costs using the methods described in this unit. When costs are estimated for a specific level of activity, the assumption is that the activity level is within the relevant range. Costs are estimated assuming that they are linear. Both assumptions are reasonable as long as the relevant range is clearly identified, and the linearity assumption does not significantly distort the resulting cost estimate.
This video demonstrates how the scattergraph method is applied to Danny Office Supplies to estimate the next month's shipping costs. The scattergraph method has five steps and starts with plotting all points on a graph and fitting a line through the points. This line represents costs throughout a range of activity levels and is used to estimate fixed and variable costs. The scattergraph is also used to identify any outlying or unusual data points.
Regression analysis forms a mathematically determined line that best fits the data points. Software packages like Excel are available to perform regression analysis. This method is also called the Least Squares Regression. In the following video, Bell demonstrates how regression analysis is applied to Danny Office Supplies to estimate the next month's shipping costs. Bell does this by using Microsoft Excel where regression analysis is a built-in function. See the optional appendix to Chapter 5 if you would like to learn how to use this Excel function.
Section 5.5 is optional because it specifically addresses Microsoft Excel software, which you are not required to have in order to take this course. Regardless, regression analysis is an important part of managerial accounting. It provides the best fit between independent variables and allows the best estimations to be made, through extrapolation. The following section provides students with a guide to performing regression analysis with Microsoft Excel. Most spreadsheet programs provide this function.