Chapter Two:

Cost Behavior Analysis and Use

• Understand how fixed and variable costs behave and how to use them
to predict costs.
• Analyze a mixed cost using the least-squares regression method.
• Use a scatter-graph plot to diagnose cost behavior.
• Analyze a mixed cost using the high-low method.
• Prepare an income statement using the contribution format.
What is the cost behavior?
• Cost behavior refers to how a cost will change as the level of activity
changes.
• Use cost behavior to predict costs as following.
a. Managers can predict how costs will change under various
alternatives.
b. Attempting to make decisions without understanding of cost behavior
can lead to disaster.
Types of Cost Behavior Patterns
• Three cost behavior patterns:
a. Variable Cost
b. Fixed Cost
c. Mixed Cost (semi-variable cost)

• The relative proportion of each type of cost in an organization is

• A variable cost is constant per unit but varies in total with the activity level is
Cont..
• Exhibit 5–1 illustrates variable cost behavior.

• Note: The graph of the total variable cost is upward to the right. the graph of the per unit
Cont..
The Activity Base
• For a cost to be variable, it must be variable with respect to something.
That “something” is its activity base.
• An activity base is a measure of whatever causes the incurrence of
variable cost. An activity base is sometimes referred to as a cost driver.
• Some of the most common activity bases are:
 Direct labor-hours
 Direct materials
 Units produced
 Units sold
Cont..
Types of Variable Cost
• Not all variable costs have exactly the same behavior pattern.
• Some variable costs behave in a true variable or proportionately variable
pattern. Other variable costs behave in a step-variable pattern.
a. True Variable Costs
• Direct materials is a true or proportionately variable cost because the amount
used during a period will vary in direct proportion to the level of production
activity.
b. Step-Variable Costs
• The cost of a resource that is obtainable only in large chunks and that increases
or decreases only in response to fairly wide changes in activity is known as a
step-variable cost. For example, the wages of skilled repair technicians are often
considered to be a step-variable cost.
Cont..
Fixed Costs
• The total fixed costs remain constant within the relevant range of
activity.
• The fixed costs remain constant in total, the average fixed cost per unit
becomes smaller as the level of activity increases.
• Exhibit 5–5 depicts fixed cost behavior pattern.
Cont..
Types of Fixed Costs
• Fixed costs are sometimes referred to as capacity costs, since they
result from outlays made for buildings, equipment, skilled professional
employees, and other items needed to provide the basic capacity for
sustained operations.
a. Committed Fixed Costs
• Investments in facilities, equipment, and the basic organization that
can’t be significantly reduced even for short periods of time without
making fundamental changes are referred to as committed fixed costs.
• Examples of such costs include depreciation of buildings and
equipment, real estate taxes, and salaries of top management.
Cont..
b. Discretionary Fixed Costs
• Discretionary fixed costs (often referred to as managed fixed costs) usually
arise from annual decisions by management to spend on certain fixed cost
items.
• Examples of discretionary fixed costs include advertising, research, public
relations, management development programs, and internships for students.
• Two key differences exist between discretionary fixed costs and committed
fixed costs.
• First, the planning horizon for a discretionary fixed cost is short term—
usually a single year. By contrast, committed fixed costs have a planning
horizon that encompasses many years.
• Second, discretionary fixed costs can be cut for short periods of time with
Mixed Costs
• A mixed cost contains both variable and fixed cost elements. Mixed
costs are also known as semi-variable costs.
• The following equation for a straight line can be used to express the
relationship between a mixed cost and the level of activity:
Cont..
• Exhibit 5–7 depicts the behavior of the mixed cost.
The Analysis of Mixed Costs
• The fixed portion of a mixed cost represents the minimum cost of
having a service ready and available for use.
• The variable portion represents the cost incurred for actual
consumption of the service.
• The most common methods used for estimating the fixed and variable
components of a mixed cost are:
a. Account analysis.
b. The engineering approach.
1. The High-Low Method
• The high-low method is based on the rise-over-run formula for the slope of a
straight line.
• if the relation between cost and activity can be represented by a straight line, then
the slope of the straight line is equal to the variable cost per unit of activity.
Cont..
• Sometimes the high and low levels of activity don’t coincide with the high and low amounts of
cost. For example, the period that has the highest level of activity may not have the highest
amount of cost. Nevertheless, the costs at the highest and lowest levels of activity are always
used to analyze a mixed cost under the high-low method.
Example One:
XYZ Hospital has found the following total costs associated with the maintenance tools over the
last seven months.
Cont..
Required:
1. Using the high-low method, estimate the variable cost per unit.
2. Estimate Fixed cost
3. Express the variable and fixed costs in the form Y= a + bX.
4. If the level of activity becomes 9000 patients during in coming
month, what total cost would you expect to be incurred?
5. What is interpretation?
Cont..
2. The Least-Squares Regression Method
• The least-squares regression method, unlike the high-low method, uses all of
the data to separate a mixed cost into fixed and variable components.
• The basic idea underlying the least-squares regression method is illustrated in
Exhibit 5–13 using hypothetical data points.
• The vertical deviations are called the regression errors.
Cont..
• Using this formula so as separate mixed cost into fixed and variable
cost.
Cont..
Example Two:
The number of X-rays taken and X-ray costs over the last six weeks in Hayat Hospital are
given below:
Week X-ray Cost
1 4 $18
2 3 17
3 8 25
4 6 20
5 7 24
6 2 16

Required:
1. Using the least square regression method, estimate the variable cost per unit and fixed cost.
2. Express the variable and fixed costs in the form Y= a +bX.
3. If the level of activity becomes 12 X-rays in the coming week, what total cost would you expect to be
Cont..
3. Diagnosing Cost Behavior with a Scatter-graph Plot
• Two things should be noted about the scatter-graph:
1. The total cost, Y, is plotted on the vertical axis. Cost is known as the
dependent variable.
2. The activity, X is plotted on the horizontal axis. Activity is known as
the independent variable.
Cont..
Example Three:
XYZ Hospital has found the following total costs associated with the
maintenance tools over the last seven months:
Cont..
Required:
1. Prepare a scatter-graph using the above data. Plot cost on the vertical
axis and activity on the horizontal axis. Fit a line to your plotted
points using a ruler.
2. Using the quick-and-dirty method, what is the approximate fixed
cost?
3. The approximate variable cost per unit? Show your computations.
4. Express the variable and fixed costs in the form Y= a +bX.
5. If the level of activity becomes 9600 patients in the coming month,
what total cost would you expect to be incurred?
Cont..
Multiple Regression Analysis
• In some situations, the variable cost element may be driven by a
number of factors. For example, shipping costs may depend on both
the number of units shipped and the weight of the units. In a situation
such as this, multiple regression is necessary.
• Multiple regression is an analytical method that is used when the
dependent variable (i.e., cost) is caused by more than one factor.
The Contribution Format Income Statement
• Separating costs into fixed and variable elements helps and constructs
income statements is called the contribution format income
statement.
• Separating costs into fixed and variable elements is also often crucial
in:
a. To predict costs
b. To provide benchmarks
c. To make decisions
Why a New Income Statement Format?
• An income statement prepared in the functional format (Traditional
approach) may be useful for external reporting purposes, it has serious
limitations when used for internal purposes.
• Internally, managers need cost data organized in a format that will
facilitate planning, control, and decision making is called
contribution income statement (Contribution approach).

Example Four:
• (Problem 5-15, Page, 222).
Example Five:
Neptune Rentals operates a boat rental service. Consider the following costs of the company over
the relevant range of 5,000 to 8,000 hours of operating time for its boats:

Required:
1. Compute the missing amounts, assuming that cost behavior patterns remain unchanged
Appendix 5A: Least-Squares Regression Using Microsoft® Excel
Example Six:
XYZ Hospital has found the following total costs associated with the maintenance
tools over the last seven months.
Cont..
Required:
1. Using Microsoft Excel and SPSS for computation of variable cost per
unit, fixed cost and R-Square.
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