Unit 3: Short-Term Decision Making
This unit 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 6 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;
- describe the assumptions used to estimate costs; and
- perform regression analysis using Excel.
3.1: Cost Behavior Patterns
Bikes Unlimited is planning its monthly sales. They have recently concluded a successful advertising campaign and expect that sales will increase 10 to 20 percent. 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 our 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 chose to make no bikes, it would have to continue to pay its lease. There are two kinds of fixed costs: (1) 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 a fixed and a variable components. You can think of your cell phone bill as a mixed cost. You pay a flat fee (fixed cost) for a certain number of minutes. If you exceed the set amount of minutes, then you have to pay by the minute (variable cost). Bikes Unlimited pays its sales staff based on 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.
Short/Long Term and the Relevant Range
Both short- and long-term costs are important factors in managerial decision-making. This section covers these variables and discusses them in terms of what is called the “relevant range” (also covered in the final section in this unit). The relevant range is the portion of the total cost curve that is beyond increasing returns to scale and before decreasing returns to scale. Within the relevant range, a doubling of variable cost inputs should approximately result in a doubling of output.
The following two video presentations by Tony Bell supplement and reinforce what your text has described. In the first video, Bell explores the actual behavior of costs and how you might normalize that behavior and use the costs in developing management decision tools. In the second video, he extends his graphic model to explain cost behavior. Follow along with paper/pencil or your own spreadsheet program.
Work through this exercise to check your understanding of variable, fixed, and mixed costs.
3.2: 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.
Special Note:
This unit makes extensive use of the algebraic equation of a straight line. Remedial help with the form and use of this equation is available at “Equation of a Straight Line” here.
In this video, Tony Bell demonstrates how the high-low method is applied to Danny Office Supplies to estimate the next month’s shipping costs. The account analysis is a method of cost analysis that requires a review of accounts by experienced employees to determine whether the costs in each account are fixed or variable. This approach is perhaps the most common starting point for estimating fixed and variable costs. The high-low method starts with the highest and lowest activity levels and uses four steps to estimate fixed and variable costs.
In this video, Bell 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 Unit 3 if you would like to learn how to use this Excel function.
3.3: Contribution Margin Income Statement
This section 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.
3.4 The Relevant Range and Nonlinear Costs
In Chapter 5, Section 4 of the textbook, you will return again to 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 section 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.
Unit 3 Conclusion
In this unit you have identified costs as fixed, variable, or mixed. You then examined the behavior of costs to predict future financial patterns. The production of the contribution margin income statement is an important management decision making tool. In the next unit you move on to one of the most useful tools in the managerial accounting tool box cost-volume-profit analysis, or break-even analysis. Every manager needs to know how much has to be produced to generate a profit. A well done break even analysis will also respond to questions about what happens if one or more cost variables changed because you can estimate how sensitive profit is to any of these variables.