CHAPTER 7:

COST BEHAVIOUR ANALYSIS

COST BEHAVIOUR ANALYSIS

 Cost behaviour describes how a cost changes when level of activity changes.
Costs can be broken down into variable, fixed or mixed costs.
Fixed Cost
 A fixed cost is one that does not change as activity changes for example, rent.
You will pay the same amount in rent regardless if you produce 10,000 units
or 1 unit.
 A discretionary fixed cost can be changed or avoided at the discretion of the
manager. For example, advertising which a manager can choose to reduce.
COST BEHAVIOUR ANALYSIS Cont’s
Variable Cost
 A variable cost increases in total with an increase in activity and decreases in
total with a decrease in activity levels.
 For example, as more snowboards are produced, the total cost of gear needed
to make the snowboards increases in proportion to the number produced.
 𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 = 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑋 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡𝑠
Mixed Costs
 These costs have both a fixed and variable component. An example is paying
a sales employee who receives a salary wage in addition to commissions on
sales. The commissions are variable depending on levels of sales (activity
driver) but the salary paid remains the same (fixed).
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 + 𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
COST BEHAVIOUR ANALYSIS Cont’s

 Separating Mixed Costs into Fixed and Variable Components Methods

1. High-low Method
2. Method of Least Squares
3. Scatter Graph Method
 All three of these methods involve expressing cost as equation:
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 + (𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 𝑋 𝑜𝑢𝑡𝑝𝑢𝑡)
 Let us break down the formula:
 Dependent variable: the variable in which its value depends on the value of
another, in this case this is total cost, the total cost of an activity depends on
the fixed and variable cost
COST BEHAVIOUR ANALYSIS Cont’s

 Independent variable: variable that measures output and used to explain

changes in the cost of another variable.
 Intercept: This is the fixed cost, this is also where cost line intercepts the
vertical axis.
 Slope: represents the variable cost per unit of output (variable rate).
High Low Method
 The high-low method separates mixed cost into fixed and variable by using
the high and low data points. Here are the four steps:
1. Find the high point and low point for the data set.
2. Using these high and low points, calculate the variable rate (variable cost per
unit). The variable rate is calculated using this formula:
ℎ𝑖𝑔ℎ 𝑝𝑜𝑖𝑛𝑡 𝑐𝑜𝑠𝑡 − 𝑙𝑜𝑤 𝑝𝑜𝑖𝑛𝑡 𝑐𝑜𝑠𝑡
𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 =
ℎ𝑖𝑔ℎ 𝑝𝑜𝑖𝑛𝑡 𝑜𝑢𝑡𝑝𝑢𝑡 − 𝑙𝑜𝑤 𝑝𝑜𝑖𝑛𝑡 𝑜𝑢𝑡𝑝𝑢𝑡
3. Calculate the fixed cost using the variable rate from step 2 using EITHER the
high or low point using this formula:
𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ 𝑝𝑜𝑖𝑛𝑡 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 𝑋 𝑜𝑢𝑡𝑝𝑢𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ 𝑝𝑜𝑖𝑛𝑡
Or𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑙𝑜𝑤 𝑝𝑜𝑖𝑛𝑡 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 𝑋 𝑜𝑢𝑡𝑝𝑢𝑡 𝑎𝑡 𝑙𝑜𝑤 𝑝𝑜𝑖𝑛𝑡
4. Create a cost formula. We have all the components of a cost formula, the
variable rate and fixed cost so, the cost formula is:𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 +
(𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 𝑋 𝑜𝑢𝑡𝑝𝑢𝑡) .
Example
 Bobby’s Burgers create specialty burgers. The company wants to calculate the
fixed and variable costs associated with labour used in their restaurant. Data
for the past 6 months were collected:

Months Labour Cost (R) Employee Hours

January 6000 360
February 5110 210
March 9010 710
April 6783 540
May 7540 550
June 4580 615

 Using the high-low method, calculate the fixed cost of labour, calculate the
variable rate per employee hour and construct the cost formula for total
labour cost. Then find the cost for 800 hours using the cost formula
Solution

 Step 1: Find the high point and low point for the data set.
The high point is based on hours: March is the highest point with total cost of
9010 and hours of 710. Lowest point is February with 5110 cost and 210 hours.
 Step 2: Using these high and low points, calculate the variable rate (variable
cost per unit). The variable rate is calculated using this formula:
9010 − 5110
𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 = = 7,80 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟
710 − 210
 Step 3: Calculate the fixed cost using the variable rate from step 2 using
EITHER the high or low point using this formula:
𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ 𝑝𝑜𝑖𝑛𝑡 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 𝑋 𝑜𝑢𝑡𝑝𝑢𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ 𝑝𝑜𝑖𝑛𝑡
Let us use the high point which is March, which is 9010 total cost and 710 hours.
We have a variable rate from the previous question which is 7.80 per hour:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 9010 – (7,80 𝑋 710) = 3472
Solution cont’s

 Step 4: Now create a cost formula. We have all the components of a cost
formula, the variable rate and fixed cost so, the cost formula is:
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 + (𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑟𝑎𝑡𝑒 𝑋 𝑜𝑢𝑡𝑝𝑢𝑡)
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 3472 + (7,80 𝑋 𝐻𝑜𝑢𝑟𝑠)
To calculate the total cost for 800 hours. Use the cost formula created in the
previous step and input 800. So:
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 3472 + (7,80 𝑋 800𝐻𝑜𝑢𝑟𝑠) = 9712
Regression Analysis

 Regression analysis is a statistical method that measures the average amount

of change in the dependent variable that is associated with a unit change in
one or more independent variables.
 It has two advantages over high-low:
1. All available data points are used (high-low uses just two data points).
2. Multiple cost drivers can be used to estimate costs.
Least squares regression model

 The regression model formula is given by:

ŷ=a+bx
b → change in y due to change in x
a → value of y when x = 0
𝑆𝑥𝑦
 Where 𝑏 = and 𝑎 = 𝑦ത − 𝑏𝑥ҧ
𝑆𝑥𝑥
1 1 1
 Where 𝑆𝑥𝑥 = σ 𝑥 2 − (σ 𝑥)2 , 𝑆𝑦𝑦 = σ 𝑦 2 − (σ 𝑦)2 , 𝑆𝑥𝑦 = σ 𝑥𝑦 − (σ 𝑥)(σ 𝑦)
𝑛 𝑛 𝑛
Least squares regression model
 Correlation Analysis: Measures the strength of the linear association between
two numeric variables, x and y.
 This measure is called Pearson’s correlation coefficient. It is represented by
the symbol r.
 The following formula is used to calculate the correlation coefficient:
𝑆𝑥𝑦
𝑟=
𝑆𝑥𝑥 𝑆𝑦𝑦

 The coefficient values range between -1 and 1.

 If r = -1 (negative association) or r = +1 (positive association) every point falls
on the regression line.
 If r = 0 there is no linear pattern
Least squares regression model

 The 𝑟 2 coefficient: when correlation coefficient, r, is squared (𝑟 2 ), the

results measured is called the coefficient of determination.
 The coefficient of determination: measures the proportion (or percentage) of
variation in the dependent variable, y, that is explained by the independent
variable, x. The coefficient of determination ranges between 0 and 1 (or 0%
and 100%)
Example
 Bobby’s Burgers create specialty burgers. Data for the past 6 months were
collected:

Months Labour Cost (R) Employee Hours

January 6000 360
February 5110 210
March 9010 710
April 6783 540
May 7540 550
June 4580 615
 Summary output

SUMMARY OUTPUT

Regression Statistics
Multiple R 0,568116615
R Square 0,322756488
Adjusted R Square 0,15344561
Standard Error 1502,314217
Observations 6

ANOVA
df SS MS F Significance F
Regression 1 4302408,811 4302408,811 1,90629505 0,239506739
Residual 4 9027792,023 2256948,006
Total 5 13330200,83

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95,0% Upper 95,0%
Intercept 3964,078317 1939,038707 2,04435234 0,110396206 -1419,556209 9347,712843 -1419,556209 9347,712843
Employee Hours 5,105035209 3,697461679 1,380686441 0,239506739 -5,160764173 15,37083459 -5,160764173 15,37083459
Example

 Regression equation is given by:

𝑙𝑎𝑏𝑜𝑢𝑟 𝑐𝑜𝑠𝑡 = 3964,0783 + 5,1050𝑋
 Correlation coefficient (r)
𝑟 = 0,56811. There is moderate positive relation between Employee hours and
labour cost.
 Coefficient of determination (𝑟 2 )
 𝑟 2 =0,3228 (or 32,28%). 32% of the variation in labour cost is explained by the
employee hours. 68% is unexplained.
 What will be the estimated labour cost if the employee work for 60 hours?
 𝑙𝑎𝑏𝑜𝑢𝑟 𝑐𝑜𝑠𝑡 = 3964,0783 + 5,1050 60 = 4270,3783
Scatter Plot

Scatter plot showing Bobby’s Burgers

10000

9000

8000 y = 5,105x + 3964,1

R² = 0,3228
7000

6000
Labour cost

5000
Series1
4000 Linear (Series1)

3000

2000

1000

0
0 100 200 300 400 500 600 700 800
Employee Hours