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Cost Behavior: Analysis and Use

Chapter 5

Learning Objective 1

Understand how fixed and Understand how fixed and

variable costs behave and variable costs behave and

how to use them to predict how to use them to predict

costs. costs.

The Activity Base (also called a cost driver)

A measure of what

causes the

incurrence of a

variable cost

A measure of what

causes the

incurrence of a

variable cost

Units

produced

Units

produced

Miles

driven

Miles

driven

Machine

hours

Machine

hours

Labor

hours

Labor

hours

Minutes Talked

Total Overage Charges on Cell

Phone Bill

True Variable Cost – An Example

As an example of an activity base, consider

overage charges on a cell phone bill. The activity

base is the number of minutes used above the

allowed minutes in the calling plan.

Minutes Talked

Per Minute Overage Charge

Variable Cost Per Unit – An Example

Referring to the cell phone example, the cost per

overage minute is constant, for example 45 cents per

overage minute.

Extent of Variable Costs

The proportion of variable costs differs across organizations. For example...

A public utility like Florida A public utility like Florida Power and Light, Power and Light, with large investments in with large investments in equipment, will tend to have equipment, will tend to have fewer fewer variable costs.variable costs.

A public utility like Florida A public utility like Florida Power and Light, Power and Light, with large investments in with large investments in equipment, will tend to have equipment, will tend to have fewer fewer variable costs.variable costs.

A manufacturing company A manufacturing company like Black and Decker like Black and Decker will often have will often have manymany variable costs. variable costs.

A manufacturing company A manufacturing company like Black and Decker like Black and Decker will often have will often have manymany variable costs. variable costs.

A merchandising company A merchandising company like Wal-Mart like Wal-Mart usually has a usually has a highhigh proportion proportion of variable costs,of variable costs, like cost of sales. like cost of sales.

A merchandising company A merchandising company like Wal-Mart like Wal-Mart usually has a usually has a highhigh proportion proportion of variable costs,of variable costs, like cost of sales. like cost of sales.

Some service companies Some service companies have have highhigh variable costs,variable costs, while other service while other service companies have companies have highhigh fixed costs. fixed costs.

Some service companies Some service companies have have highhigh variable costs,variable costs, while other service while other service companies have companies have highhigh fixed costs. fixed costs.

Volume

Cost

True Variable Costs

The amount of a true variable cost used during the

period varies in direct proportion to the activity level.

The overage charge on a cell phone bill was one

example of a true variable cost.

Direct material is

another example

of a cost that

behaves in a true

variable pattern.

Step-Variable Costs

A step-variable coststep-variable cost is a resource that is obtainable

only in large chunks (such as maintenance workers)

and whose costs change only in response to fairly

wide changes in activity.

Volume

Cost

Step-Variable Costs

Volume

Cost

Only fairly wide changes

in the activity level will

cause a change in the

number of maintenance

workers employed.

Only fairly wide changes

in the activity level will

cause a change in the

number of maintenance

workers employed.

Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed costs remain the same even when the activity Fixed cost per unit goes Fixed level changes within the down as activity level goes up. relevant range.

A fixed cost is a cost whose total dollar

amount remains constant as the activity level

changes.

Types of Cost Behavior Patterns – Fixed

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains proportional to the activity the same over wide ranges level within the relevant range. of activity. Total fixed costs remain the same even when the activity Average fixed costs per unit Fixed level changes within the decrease as the activity relevant range. level increases.

Average fixed costs per unit decrease as the

activity level increases.

Types of Cost Behavior Patterns – Fixed

Number of Minutes Used within Monthly Plan

Cost Per Cell Phone Call

Fixed Cost Per Unit Example

For example, the fixed cost per minute used

decreases as more allowed minutes are used.

The Trend Toward Fixed Costs

The trend in many industries is toward greater

fixed costs relative to variable costs.

As machines take overAs machines take over

many mundane tasks many mundane tasks

previously performed previously performed

by humans, by humans,

“ “ knowledge workersknowledge workers ””

are demanded for are demanded for

their minds rather their minds rather

than their muscles. than their muscles.

As machines take over As machines take over

many mundane tasks many mundane tasks

previously performed previously performed

by humans, by humans,

“ “ knowledge workersknowledge workers ””

are demanded for are demanded for

their minds rather their minds rather

than their muscles. than their muscles.

Knowledge workersKnowledge workers

tend to be salaried, tend to be salaried,

highly-trained and highly-trained and

difficult to replace. The difficult to replace. The

cost of compensating cost of compensating

these valued employees these valued employees

is is relatively fixedrelatively fixed

rather than variable.1 rather than variable.

Knowledge workers Knowledge workers

tend to be salaried, tend to be salaried,

highly-trained and highly-trained and

difficult to replace. The difficult to replace. The

cost of compensating cost of compensating

these valued employees these valued employees

is is relatively fixedrelatively fixed

rather than variable.1 rather than variable.

Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can differ

across countries , depending on labor regulations,

labor contracts, and custom.

In France , Germany , China , and Japan , management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature.

In France , Germany , China , and Japan , management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature.

In the United States and the United Kingdom , management has greater latitude. Labor costs are more variable in nature.

In the United States and the United Kingdom , management has greater latitude. Labor costs are more variable in nature.

Within countries managers can view labor costs differently depending upon their strategy. Most companies in the United States continue to view direct labor as a variable cost.

Within countries managers can view labor costs differently depending upon their strategy. Most companies in the

United States continue to view direct labor as a variable cost.