Chapter 3

Cost Behavior - Analysis and

Use
 Overview – Cost Concepts, terms and
classification
Contents Learning Objectives
• Type of cost behavior pattern • Understand how fixed and variable
• The analysis of mixed cost costs behave and how to use them to
predict costs
• High Low Method • Use a scatter graph plot to diagnose
• Least square regression cost behavior
• The contribution format • Analyze a mixed cost using the high-
low method
• Prepare an income statement using the
contribution margin
• Analyze a mixed cost using the least
square regression method
 Section A –
Cost Behavior Pattern
Types of Cost based on Cost Behavior
Types

Fixed Cost Variable Cost Mixed Cost

Fixed Cost
CIMA Terminology defines Fixed Cost as “cost incurred for an
accounting period, that within certain turnover or output limits,
tends to be unaffected by fluctuations in the level of activity output
or turnover

Period Cost can also be termed as Fixed Cost.

Example of fixed cost includes insurance, salaries, rental premises

etc.
Graphical depiction of Fixed Cost

Activity Fixed Cost

Level Rupees Fixed Cost remain same
Output within relevant range at
Units Total any activity level.
Fixed
1,000 10,000
Cost
2,000 10,000
3,000 10,000

Activity Level
Stepped Fixed Cost
• If activity is expended
beyond the relevant range
Range
to the point where further 3
cost are needed, then this
cost behavior will be termed Total Range
Fixed 2
as Stepped Fixed Cost. Cost Range
1
• Example: Warehouse cost
will be same to certain
range. In longer period, with
increase of business, this
cost will be increase.
Activity Level
Fixed Cost per Unit
• Fixed Cost per unit is Per Unit Fixed Cost
worked out by dividing the decreased with
increase in activity
total fixed cost with the Fixed
level
Cost
activity level units. per
Unit

• Increase in level of activity

units will decrease the per
unit cost.
Activity Level
Variable Cost
• Variable cost means
a cost which varies
with a measure of
activities during the
relevant range. Total
Variable Variable Cost has
Cost positive relationship
• Example: Direct with activity level to
the extent of relevant
Material; Direct range.
Labour, Sales
Commission based
on sales etc.
Activity Level
Variable Cost per Unit
• Variable Cost per
Unit will not
Variable Cost per unit
change with the remain same during
change of activity Variable relevant range.
level during the Cost per
relevant range. Unit

Activity Level
Curvilinear Variable Cost
• The variable cost in most of the cases has positive relation with activity
level. However this is not true in all cases.

• Following diagram may be the actual position for Variable Cost

relationship with activity level.
 Graphical Presentation
Example: Direct labor cost Example: In case of increase in
increases with increase in activity level, Company get
activity if Company pay bonus more discount from suppliers
for higher activity level. relating to raw material, this
situation may arise.

Variable Variable
Cost Cost

Activity Level Activity Level

Semi Variable Cost / Mixed Cost
• Semi Variable Cost Slope = VC per unit
means a cost which
have both components Variable
of fixed and variable Semi Cost
cost. It is also termed Variable
Cost
as Mixed Cost.
Fixed
Cost
• Example of these
types of cost will be
gas, electricity etc.
Activity Level
Mixed Cost Equation
• From the above, we can make an equation for total mixed cost as
under:

Total Mixed Cost = Fixed Cost + Variable Cost per unit x (No of
units)
Or
Y = a + b.X
Methods to Separate Fixed Cost
• Three methods commonly used methods to separate fixed and
variable cost are as under:

Scattered High Low Least square

Diagram Method regression
Activity Data
Month Activity Level Total Cost

January 1,800 36,600

February 2,450 41,150
March 2,100 38,700
April 2,000 38,000
May 1,750 36,250
June 1,950 37,650
Scattered Diagram
• The first step before using any method is to identify the linear
relationship between the cost and activity level.

• If linear relation exist, then mixed cost equation can be worked out
either through High Low method or Least Square regression
method.

• Best way of doing this is to plot the cost and activity level on graph
and visualize the existence of linear relationship. This method is
called Scattered Diagram.
Scattered Diagram
To ta l M ix e d C o st

Scattered Diagram – Mixed Cost

44000

41000

38000

35000
1500 1700 1900 2100 2300 2500 2700 2900

Activity level
High Low Method
• This method is based on RISE over RUN for the slope of straight
line. If the relation between the activity can be represented by
straight line, then the slope of the line is variable cost. Therefore

Variable Cost = [Change in Cost incurred from Highest to lowest) /

(Changes in units from highest to lowest)

Fixed Cost = Total Cost – VC per Unit x Highest or lowest activity

Units
High Low Method - Example
Quick Check
Month Units Produced Total Cost
Jan 20,000 100,000
Feb 35,000 167,000
March 28,000 136,000
April 16,000 82,000

Expected Cost for the month of May if budgeted production is

32,000 units.
Least Square Regression
• High Low method although easier to understand but the method
only consider the highest and lowest instances, which can lead to
inaccurate estimation.

• Regression analysis is therefore, the more accurate method

because it consider the complete set of data while estimating the
Variable Cost per unit.
Least Square Regression
Activity Revised Data
Month Activity Level Total Cost

January 2,300 40,000

February 2,450 41,150

March 2,100 38,700

April 2,200 39,000

May 1,750 36,250

June 1,800 37,650

High Low Method
Least Square Regression
Result Analysis – High Low Method vs Least
Square Regression.

• High Low method failed to catch the changes in data.

However, least square regression method accordingly
adjust variable and fixed cost.
Scattered Diagram for revised data
To ta l M ix e d C o st
Y-Values
42,000

41,000
Scattered Diagram – Mixed Cost
40,000
44,000 Line of Best Fit
39,000

38,000
41,000
37,000

36,000 38,000
35,000
35,000
34,000 1,500 1,700 1,900 2,100 2,300 2,500 2,700 2,900

33,000
1,700 1,800 1,900 2,000 2,100Activity2,200
level 2,300 2,400 2,500
Least Square Regression in Ms. Excel
In Microsoft Excel, slope or value for b in Regression equation can easily be
calculated using Slope Function. Snap Shot for the same is as under:
Traditional & Contribution Format Income
Statement
• Traditional way of income statement is the one which we have
already discussed in detail.

• Under Contribution format, all the variable cost have been

deducted to obtain Contribution Margin. Fixed Cost including Fixed
Manufacturing Overheads will then be deducted to work out profit.