CORNERSTONES OF COST

MANAGEMENT, 3E
HANSEN/MOWEN

COST BEHAVIOR
CHAPTER 3

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CHAPTER 3 OBJECTIVES
1. Define and describe fixed, variable, and
mixed costs
2. Explain the use of resources and activities
and their relationship to cost behavior
3. Explain how several methods of cost
estimation can be used
4. Separate mixed costs into their fixed and
variable components using the high-low
method, the scatterplot method, and the
method of least squares
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CHAPTER 3 OBJECTIVES
5. Evaluate the reliability of the cost formula
6. Explain how multiple regression can be
used to assess cost behavior
7. Discuss the use of managerial judgment
in determining cost behavior

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BASICS OF COST BEHAVIOR

Cost Behavior
The term used to describe whether a cost
changes when the level of output changes
Fixed costs do not change as output
changes
Variable costs increase in total with an
increase in output and decrease in total
with a decrease in output

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BASICS OF COST BEHAVIOR

Cost Objects
An item for which managers want cost
information
For manufacturing or merchandising firms,
it is usually the tangible product
For service firms, it is usually the service
provided

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BASICS OF COST BEHAVIOR

Measures of Output
Activity drivers explain changes in activity
costs by measuring changes in activity
output (usage)
The two general categories of activity
drivers
Unit-level drivers
Non-unit-level drivers

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BASICS OF COST BEHAVIOR

Fixed
Fixed Costs
Costs

Fixed costs are costs that in total are

constant within the relevant range as the
level of the activity driver varies

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BASICS OF COST BEHAVIOR

Fixed
Fixed Costs
Costs

JCM Audio Systems, Inc. produces speakers

for home audio systems. One department
produces voice coils. There are two
production lines that can each make up to
100,000 voice coils per year. The productionline manager is paid $60,000 per year. For
production up to 100,000 units only one
manager is needed; above that (to 200,000
units) two managers are needed.
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BASICS OF COST BEHAVIOR

Fixed
Fixed Costs
Costs
JCM Audio Systems, Inc.

The total cost of supervision remains the same

within the relevant range, but the unit cost
decreases as production increases.

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BASICS OF COST BEHAVIOR

Fixed
Fixed Costs
Costs
JCM Audio Systems, Inc.

The total cost of supervision remains the same

within the relevant range, but the unit cost
decreases as production increases

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EXHIBIT 3.1FIXED COST BEHAVIOR

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BASICS OF COST BEHAVIOR

Variable
Variable Costs
Costs

Variable costs are costs that in total vary

in direct proportion to changes in an
activity driver
The total cost of direct materials for each
level of production varies, but the unit cost
stays the same
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BASICS OF COST BEHAVIOR

Variable
Variable Costs
Costs
JCM Audio Systems, Inc.

The total cost of supervision remains the same

within the relevant range, but the unit cost
decreases as production increases.

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EXHIBIT 3.2VARIABLE COST BEHAVIOR

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EXHIBIT 3.3NONLINEARITY OF VARIABLE

COSTS

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EXHIBIT 3.4RELEVANT RANGE FOR

VARIABLE COSTS

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BASICS OF COST BEHAVIOR

Mixed
Mixed Costs
Costs

Mixed costs are costs that has both a fixed

and a variable component
Y = Fixed cost + Total variable
cost
Y = F + VX
where
Y = Total cost (Usually a mixed
cost)

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BASICS OF COST BEHAVIOR

Mixed
Mixed Costs
Costs
JCMs sales costs are mixed. There are 10 sales
representatives who each earn $30,000 plus
receive a commission of $5 per speaker sold. This
function can be represented by the following
equationY = $300,000 + $5X

Fixed salaries

Variable commissio
n

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BASICS OF COST BEHAVIOR

Mixed
Mixed Cost
Cost
JCM Audio Systems, Inc.
Fixed Cost
of Selling

$300,000
300,000
300,000
300,000
300,000

Speakers Selling Cost

Variable Cost
Total Cost Sold
Per Unit
of Selling
$200,000
400,000
600,000
800,000
1,000,000

$ 500,000
700,000
900,000
1,100,000
1,300,000

40,000
80,000
120,000
160,000
200,000

$12.50
8.75
7.50
6.88
6.50
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EXHIBIT 3.5MIXED COST BEHAVIOR

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RESOURCES, ACTIVITIES, AND COST

BEHAVIOR
Resources
Economic elements that enable one to perform activities
When a firm acquires the resources needed to perform an activity,
it obtains activity capacity
Practical capacity is the activity level where the activity is
performed efficiently

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RESOURCES, ACTIVITIES, AND COST

BEHAVIOR
Flexible Resources
Supplied as needed and used
Quantity of resource supplied equals quantity
demanded
No unused capacity

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RESOURCES, ACTIVITIES, AND COST

BEHAVIOR
Committed Resources
Supplied in advance of usage
A given quantity is obtained, whether or not that
full amount is used
Unused capacity is possible

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RESOURCES, ACTIVITIES, AND COST BEHAVIOR

Step-Cost
Step-Cost Behavior
Behavior

A step cost function displays a constant

level of cost for a range of output and then
jumps to a higher level of cost at some
point

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RESOURCES, ACTIVITIES, AND COST BEHAVIOR

Step-Cost
Step-Cost Behavior
Behavior

Step-variable Costs
Follow a step-cost behavior with narrow steps

Step-fixed Costs
Follow a step-cost function
Exceed the relevant range, and the costs increase
one step

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EXHIBIT 3.6 STEP COST FUNCTION

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EXHIBIT 3.7STEP-FIXED COSTS

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RESOURCES, ACTIVITIES, AND COST

BEHAVIOR
Activities and Mixed Cost Behavior
Many activities have characteristics of both
flexible and committed resources
For example, a power department acquires
long-term capacity for supplying power by
investing in a building and equipment
It also acquires fuel to produce power on an asneeded basis

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RESOURCES, ACTIVITIES, AND COST

BEHAVIOR
Need for Cost Separation
Sometimes it is easy to spot the variable
and fixed portion of a cost
Other times it is not; thus there is a need for a
method to separate costs into their fixed and
variable components

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METHODS OF DETERMINING COST

BEHAVIOR
The Industrial Engineering Method
A forward-looking method of determining, through
physical observation and analysis, just what
activities, in what amounts, are needed to
complete a process

The Account Analysis Method

Used to estimate costs by classifying accounts in
the general ledger as fixed, variable, or mixed

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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

Y = F + VX
where
Y = Total cost (the dependent variable)
F = Fixed cost (the intercept parameter)
V = Variable cost per unit (the slope parameter)
X = Measure of output (the independent variable)

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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

The
The High-Low
High-Low Method
Method

Take two points (the high and the low by

volume of activity) and determine the
slope and intercept
Slope is variable rate
Intercept is fixed cost

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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

The
The High-Low
High-Low Method
Method

Advantages
It is objective
It is simple to calculate

Disadvantages
The high and low points may be outliers
Other pairs of points may clearly be more
representative
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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

Scatterplot
Scatterplot Method
Method

Uses a scattergraph to visually assess the

relationship between cost and output
Intercept is fixed cost
Slope is variable rate

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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

Scatterplot
Scatterplot Method
Method

Advantages
Allows for visual inspection of the data
Identifies nonlinearity, outliers, and shifts
in the cost relationship
Disadvantages
It is subjective
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EXHIBIT 3.8SCATTERGRAPH FOR ANDERSON

COMPANYS MATERIALS HANDLING COSTS

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EXHIBIT 3.8SCATTERGRAPH FOR ANDERSON

COMPANYS MATERIALS HANDLING COSTS (CONTINUED)

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EXHIBIT 3.8SCATTERGRAPH FOR ANDERSON

COMPANYS MATERIALS HANDLING COSTS (CONTINUED)

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EXHIBIT 3.9SCATTERGRAPH FOR

VARIOUS COST BEHAVIOR PATTERNS

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EXHIBIT 3.9SCATTERGRAPH FOR VARIOUS

COST BEHAVIOR PATTERNS (CONTINUED)

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EXHIBIT 3.9SCATTERGRAPH FOR VARIOUS

COST BEHAVIOR PATTERNS (CONTINUED)

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EXHIBIT 3.10DEVIATIONS OF DATA FROM

A LINE

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EXHIBIT 3.11SPREADSHEET DATA FOR ANDERSON

COMPANYS MATERIALS HANDLING COST

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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

Using Regression Programs

Enter the data
Choose the Tools menu
Choose the Data Analysis option
If this is not available, you may have to manage addins
Scroll down to Regression
Click on Input Y Range and highlight the cost cells
Click on Input X Range and highlight the driver cells
Choose your preferred location for output
Click ok
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EXHIBIT-3.12 REGRESSION RESULTS FOR ANDERSON

COMPANYS MATERIALS HANDLING COST

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QUANTITATIVE METHODS FOR SEPARATING MIXED

COSTS INTO FIXED AND VARIABLE COMPONENTS

Using Regression Programs

Interpreting the results
Under coefficients in the bottom left of the
output find the intercept and the slope
Write the equation
Y = $12.39X + $854.50

Use the equation to make a point estimate

At a point of 350 moves, total cost is predicted
Y = $12.39(350) + $854.50
Y = $4,336.50
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RELIABILITY OF COST FORMULAS

Three statistical assessments concerning
the cost formulas reliability
Hypothesis test of cost parameters
Goodness of fit
Confidence intervals

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RELIABILITY OF COST FORMULAS

Hypothesis Test of Cost Parameters
The t Stat tests the hypothesis that the
parameters are different from zero
The P-value is the level of significance
achieved
Generally, a P-value of 0.05 or less is needed for
significance

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RELIABILITY OF COST FORMULAS

Goodness of Fit Measures
The coefficient of determination, or R2, shows the
percentage of variability in the dependent variable
explained by the independent variable
Since R2 is the percentage of variability explained,
it always has a value between 0 and 1.00
Typically, the Adjusted R Square is used because
this value has been adjusted for the number of
variables included in the equation
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RELIABILITY OF COST FORMULAS

Coefficient of Correlation
It is the square root of the coefficient of
determination when there is one independent
variable
Range between 1 and +1
The higher the magnitude, the greater the
correlation
A coefficient of correlation value close to zero
indicates no correlation
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EXHIBIT 3.13CORRELATION ILLUSTRATED

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RELIABILITY OF COST FORMULAS

Confidence Intervals
Yf tSe

This is the formula for calculating the desired level of

confidence
Yf is the predicted cost for a given level of activity
t is the t distribution (get this from the table in your
book
Se is the standard error shown in the regression output

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EXHIBIT 3.14TABLE OF SELECTED

VALUES: T DISTRIBUTION

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MULTIPLE REGRESSION
Whenever least squares is used to fit an equation
involving two or more independent variables, the
method is called multiple regression
In the case of two explanatory variables, the
linear equation is expanded to include the
additional variable
Y = F + V1X1 + V2X2
where
X1 = Number of moves
X2 = Number of pounds moved
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MULTIPLE REGRESSION
Adding another independent variable
might increase the explanatory power of
our model
Performing the regression is very similar to
simple regression
Input the data make sure the two independent
variables are side by side.
Follow the same directions, but select both
independent variable columns for the input X
range
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MULTIPLE REGRESSION
Month

Materials
Handling
Cost

Number
of
Moves

Pounds
Moved

January

$2,000

100

6,000

February

3,090

125

15,000

March

2,780

175

7,800

April

1,990

200

600

May

7,500

500

29,000

June

5,300

300

23,000

July

4,300

250

17,000

August

6,300

400

25,000

September

5,600

475

12,000

October

6,240

425

22,400

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EXHIBIT 3.15MULTIPLE REGRESSION RESULTS FOR

ANDERSON COMPANYS MATERIALS HANDLING COST

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MULTIPLE REGRESSION
Interpreting the results
Under coefficients in the bottom left of the
output find the intercept and the slope
Write the equation
Y = $507.31 + $7.84X1 + $0.11X2

Examine reliability of the new model

Adjusted R2 is 99% - a significant improvement
The p-values are all very good as well
the t statistic drops to 7 degrees of freedom
because another independent variable is used
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MANAGERIAL JUDGMENT
The most widely used method in practice
Managers may just use their experiences
and observations to determine fixed and
variable costs
Managers may identify mixed costs and
use experience to determine what part is
fixed thus denoting the rest as variable

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MANAGERIAL JUDGMENT
This is a simple method and can yield
good results when the manager has a
good understanding of the processes
However poor judgment yields poor results

END OF CHAPTER 3
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