Cost Behavior CHAPTER 6 Professor Garvin JD CPA

Cost Behavior CHAPTER 6 Professor Garvin, JD; CPA – ACG 2071 1

Cost Behavior 2 Cost behavior—how costs change as volume change There are three common cost behaviors: Variable costs Fixed costs Mixed costs

3 Key Characteristics of Variable Costs Total variable costs change in direct proportion to changes in volume V. C. is variable w/respect to an activity base (cost driver) DLHs MHs # of calls handled by tech support at software Co. # of beds occupied in hospital or hotel Variable cost/unit remains constant DM & DL production costs usually variable costs

Direct Labor 4

Total Variable Cost (y) = Variable cost per unit of activity (v) * Volume of activity (x); or y = vx 5 y axis x axis

6 Key Characteristics of Fixed Costs Do not change in response to changes in activity Total fixed costs stay constant over relevant range* S. L. depreciation on manufacturing equipment Property taxes for a retail store Salary of Manager of Production Facility Fixed costs per unit of activity vary inversely with changes in volume *Relevant range is the normal operating range of activity

Total Fixed Costs 7 y axis X Cost equation is y = f axis

8 Type of Costs in Organization Predominantly Variable Fixed Public Utility (like Florida Power) w/large inv. in plant & equipment? √ Manufacturing Co. like Black & Decker? √ Merchandising Co. like Wal-Mart? √

9 Key Characteristics of Mixed Costs Cost that contains both variable & fixed cost elements Total mixed costs increase as volume increases Total mixed costs can be expressed as a combination of the variable and fixed cost equations: Total mixed cost = total variable cost + total fixed cost or Y = vx + f Y = total mixed cost v = variable cost per unit of activity x = volume of activity f = fixed cost over a given period of time

Mixed Costs 10 Ttl Mixed Cost Variable Fixed

11 Ariel Co builds innovative loudspeakers for music & home theater. Identify the following costs as variable or fixed. ___ a. Depreciation on equipment used to cut wood enclosures ___ b. Wood for speaker enclosures ___ c. Patents on crossover relays (internal components) ___ d. Crossover relays ___ e. Grill cloth ___ f. Glue ___ g. Quality inspector’s salary

Following chart shows 3 different costs: Cost A, B & C. For each cost, chart shows the total cost & cost/unit at two different volumes w/in same relevant range. Identify each as fixed, variable or mixed. 12 Cost A Cost B Cost C

Cost Equation 13 Is a mathematical equation for a straight line Used to predict total cost Total mixed cost = total variable cost + total fixed cost or Y = vx + f Where Y = total mixed cost v = variable cost per unit of activity x = volume of activity f = fixed cost over a given period of time

Cost Graphs 14 Vertical (y-axis) always shows total costs Horizontal axis (x-axis) shows volume of Graph 2 activity y Graph 1 Note that the Total Costs x variable cost per customer remains constant in each of graphs. Total volume of activity Slope of total variable cost line is variable cost per unit of activity. The steeper the slope of the line, the higher the variable cost per unit.

Costs and Decisions 15 Committed fixed costs Cannot Rent be easily changed in short run or Insurance Expense on facility Discretionary fixed costs Management Advertising, can easily change in short run Research and Development

Relevant Range 16 When predicting future costs based on cost behavior in past, only valid within limited range of activity Band of volume where total fixed costs remain constant at a certain level Variable costs per unit remain constant at a certain level Difficult to assess (predict) future costs outside relevant range

The Relevant Range 17 0 2000 4000 8000

Other Cost Behaviors 18 Step Costs 3000 6000 9000

Other Cost Behaviors 19 Curvilinear Costs

20 Perreth Drycleaners has capacity to clean up to 5, 000 garments per month. 1. Complete the following schedule. 2, 000 units Total Variable Costs Garments 3, 500 units $2, 625 Total Fixed Costs Total Operating Costs Variable Cost/garment Fixed Cost/garment Average cost/garment $2. 00 5, 000 units

21 Perreth Drycleaners has capacity to clean up to 5, 000 garments per month. 1. Complete the following schedule. 2, 000 Total Variable Costs Total Fixed Costs Total Operating Costs Variable Cost/garment Fixed Cost/garment Average cost/garment $1, 500 7, 000 Garments 3, 500 $2, 625 7, 000 5, 000 $8, 500 $9, 625 $3, 750 7, 000 $10, 750 $. 75 $3. 50 $2. 00 $1. 40 $ 2. 75 $2. 15 $ 4. 25

22 2. Why does the average cost per garment change? 3. Suppose the owner erroneously uses the average cost per unit at full capacity to predict total costs at a volume of 2, 000 garments. Would he overestimate or underestimate his total costs? By how much? Actual costs at 2, 000 garments $8, 500 Total predicted costs ($2. 15 × 2, 000 garments) (4, 300) Underestimated costs $4, 200

Mailbox Magic produces decorative mailboxes. The company’s average cost per unit is $26. 43 when it produces 1, 000 mailboxes. Total fixed costs are $18, 000. 23 a. What is total cost of producing 1, 000 mailboxes? 1, 000 x $26. 43 = $26, 430 b. If $18, 000 of the total costs is fixed, what is the variable cost of producing each mailbox? Total costs $26, 430 Less total fixed costs (18, 000) Total variable costs $8, 430 ÷ 1, 000 Variable cost per mailbox $8. 43

c. What is the cost equation for Mailbox Magic? y = $8. 43 x + $18, 000 24 d. If plant manager uses average cost/unit to predict total costs, what would the forecast be for 1, 200 mailboxes? $26. 43 x 1, 200 mailboxes (= $31, 716) e. If the cost equation is used to predict total costs, what would forecast be for 1, 200 mailboxes? y = ($8. 43 x 1, 200) + $18, 000 = $28, 116 f. What is dollar difference in answers above? Which approach to forecasting costs more appropriate? Using average cost at 1, 000 = $31, 716 Total Product Cost Using cost equation at 1000 = 28, 116 Total Product Cost $3, 600 Difference Why?

Cost Behavior Analysis 25 Four methods to estimate costs & cost behavior Account Analysis Scatter Plots (Scattergraphs) High-Low Method Regression Analysis

Account Analysis 26 Use of judgment to classify each general ledger account as variable, fixed, or mixed Subjective Most common approach to analyzing cost structure

Scatter Plots 27 Use historical data to determine a cost’s behavior Scatter plot is the graph of historical cost data on the y-axis and volume data on the x-axis Helps managers visually determine how strong the relationship is between the cost and the volume of the chosen activity base

Scatter Plot Example 28

High-Low Method 29 Highest volume was 3000 units, lowest volume was 500 units, so connect line. At highest volume (3000 units) cost was $400, 000. At lowest volume (500) cost was $150, 000.

High-Low Method 30 Step 1: Find variable cost per unit (slope) of cost line $400, 000 - $150, 000 = $100 VC/unit of production 3000 units – 500 units Step 2: Find the fixed costs (vertical intercept) Line crosses the vertical intercept at $100, 000 Step 3: Create the cost equation Total mixed cost = VC/unit * volume + TFC y = vx + TFC Advantage: Easy to use/Disadvantage: Only uses 2 data

31 Flower Power is local chain of floral shops. Each shop has its own delivery van. Instead of charging a flat delivery fee, FP want to set delivery fee based on distance driven. FP wants to separate fixed & variable van operating costs to see how distance affects these costs. FP has the following data from past 7 mos. Month Jan Feb Mar April May June July Miles Driven 15, 800 17, 300 14, 600 16, 000 17, 100 15, 400 14, 100 Van Operating Costs $5, 460 5, 680 4, 940 5, 310 5, 830 5, 420 4, 880

Use high-low method to determine FP’s cost equation for van operating costs. 32 Step 1: Find slope of the mixed cost line (variable cost/unit) = Δ in cost (y) / Δ in volume (x) The slope represents the variable cost per unit of activity ($5, 680 -$4, 880) ÷ (17, 300 -14, 100) $800 ÷ 3, 200 = $0. 25

Flower Power (cont) 33 Step 2: Find the vertical intercept (fixed costs) = Total mixed cost – Total variable cost = TFC $5, 680 – ($0. 25 • 17, 300) = $1, 355 TFC or $4, 880 – ($0. 25 • 14, 100) = $1, 355 TFC

34 Flower Power (cont) Step 3: Create and use an equation to show the cost behavior of a mixed cost – our delivery van (Total Delivery Van cost) Y = $0. 25 per mile + $1, 355 What is estimated operating costs at 15, 000 miles: ($0. 25 x 15, 000) + $1, 355 = $5, 105

Regression Analysis 35 Statistical procedure to find line that best fits data (cost equation) Uses all data points, (not just high & low volume) R-square value, Intercept & X Variable 1 co-efficients 3 1 2

36 High. Low Metho d Slope of line is = to change in cost divided by change in activity. Estimate of variable costs (slope) is: $400, 000 - $150, 000 = $250, 000 = $100 VC/ unit 3000 - 500 2, 500

Regression Analysis 37 Regression Analysis computes the regression line that minimizes the sum of the squared errors. What is the best straight line that fits this data? At highest level, regression analysis gives total costs of $365, 000 instead of $400, 000 using high-low method. Total Cost = Fixed Cost + (Variable cost per unit X Activity level in Units). Excel will calculate based on data inputted from last 12 months.

38 Predicting Costs and Data Concerns Only valid within relevant range Seasonal variations Inflation Outliers – abnormal data points

Traditional Income Statement Full (Absorption) Costing Format 39 Sales - Cost of Goods Sold = Gross Margin - Selling, general & administrative costs = Operating Income

Full (Absorption) Costing 40 Inventory (Product) Costs Include: Direct Material Direct Labor All Manufacturing Overhead So full costing, absorption costing I/S does not separate variable and fixed costs Required for GAAP – Why? Matching of expenses of producing product with revenue from selling product

Contribution Margin Income Statement or Variable Costing Income Statement 41 Sales - Variable Costs = Contribution Margin - Fixed Costs = Operating Income

Full (Absorption) Costing 42

43 Variable Costing vs Absorption Costing

Pam’s Quilt Shoppe Traditional Income Statement Month Ended February 28 44 Sales revenue (80 × $350) Less: Cost of goods sold (80 × $250) Gross profit Less: Operating expenses: Sales commissions (5% × $28, 000) Payroll costs Lease Expense Operating income Additional Info: Sales Commission: 5% of sales revenue Lease of shop: $1000/month; Payroll costs: $1, 200/month $28, 000 (20, 000) 8, 000 (1, 400) (1, 200) (1, 000) $ 4, 400

45 With info from traditional I. S. , prepare contribution margin I. S. for Feb. Additional info: Sales Commission-5% of sales revenue; Lease of shop-$1, 000/mo. ; Payroll costs$1, 200/mo. Pam’s Quilt Shoppe Contribution Margin Income Statement Month Ended February 28 Sales revenue (80 × $350) Less: Variable costs: Cost of goods sold (80 × $250) Sales commissions (5% × $28, 000) Contribution margin Less: Fixed costs: Payroll costs Lease Operating income $28, 000 (20, 000) (1, 400) 6, 600 (1, 200) (1, 000) $ 4, 400

Variable Costing 46 Assigns only variable manufacturing costs to products (DM, DL, Variable MOH) Fixed manufacturing overhead treated as a period cost For internal management decisions; Not GAAP

Absorption Costing 47 Required by GAAP for external reporting Assign all manufacturing costs to products (DM, DL, Variable MOH and Fixed MOH) Traditional income statement

48 Following data pertains to Rays, a manufacturer of swimming goggles. (Rays had no beginning inventories) Sales Price $35 Variable Manufacturing expense per unit 15 Sales commission expense per unit 5 Fixed manufacturing overhead 2, 000 Fixed operating expenses 250, 000 Number of goggles produced 200, 000 Number of goggles sold 185, 000 1. Prepare both conventional (absorption costing) & contribution margin (variable costing) income statements

Rays Conventional (Absorption Costing) Income Statement Year Ended December 31, 2011 49 Sales revenue (185, 000 $35) $6, 475, 000 Less: Cost of Goods Sold: Beginning finished goods inventory $ 0 Cost of goods manufactured 5, 000 Cost of goods available for sale 5, 000 Ending finished goods inventory (375, 000) Cost of goods sold 4, 625, 000 Gross profit 1, 850, 000 Operating expenses 1, 175, 000 Operating income $ 675, 000

50 Rays Contribution Margin (Variable Costing) Income Statement Year Ended December 31, 2011 Sales revenue $6, 475, 000 Variable expenses: Variable cost of goods sold $2, 775, 000* Sales commission expense 925, 000 3, 700, 000 Contribution margin $2, 775, 000 Fixed expenses: Manufacturing overhead $2, 000 Operating expenses 250, 000 2, 250, 000 Operating income $ 525, 000 Which statement shows the higher operating income? Why? Op. Inc. w/F. C-$675, 000. Op. Inc. w/V. C-$525, 000 Diff - $150, 000

51 Variable cost of goods sold: Beginning finished goods inventory $0 Variable cost of goods manufactured 3, 000 Variable cost of goods available for sale 3, 000 Ending finished goods inventory (225, 000) Variable cost of goods sold $2, 775, 000 Back

52 Rays’ marketing VP thinks new sales promotion costing $150, 000 would increase sales to 200, 000 goggles. Should Co. proceed w/new promotion? Incremental analysis: Increase in contribution margin* (($35 -20) x 15, 000 goggles) $225, 000 Increase in fixed costs (150, 000) Increase in operating income $75, 000 * Contribution Margin: SP <VC>; CM is what left over after cover all VCs to cover FCs and then generate

53 Absorption Costing and Manager Incentives When inventories increase, absorption costing income is higher than variable costing income When inventories decrease, absorption costing income is lower than variable costing income Therefore…Managers may increase production to build up inventory to maximize income and therefore their own potential bonus (if bonus based on income on GAAP income statements)

Following info for Dorian Inc. for 2012, 1 st yr. of operations 54 Units produced 400, 000; SP/unit DM/unit DL/unit Var MOH/unit Var selling cost/unit Fixed MOH Fixed selling exp. Fixed admin expense Sold 375, 000; $48 $12 $4 $3 $0. 15 $1 m $275, 000 $125, 000 Prepare inc. st. using full costing & variable costing. Reconcile difference between income computed under variable & full costing.

55 Income Statement Using Full Costing Sales ($48 × 375, 000) $ 18, 000 Less Cost of goods sold ($21. 50* × 375, 000) 8, 062, 500 Gross margin 9, 937, 500 Less: Fixed selling expenses 275, 000 Variable selling expense ($0. 15 × 375, 000) 56, 250 Fixed administrative expenses 125, 000 Operating income $9, 481, 250 *Product cost per unit: Direct material $ 12. 00 Direct labor 4. 00 Variable manufacturing overhead 3. 00 Fixed manufacturing o/h ($1, 000 ÷ 400, 000 units)

56 Income Statement Using Variable Costing Sales ($48 × 375, 000) Less Variable Expenses: $18, 000 Production costs ($19* × 375, 000) (7, 125, 000) Selling costs ($0. 15 × 375, 000) (56, 250) Contribution margin 10, 818, 750 Less Fixed Expenses: Manufacturing overhead 1, 000 Selling 275, 000 Administrative 125, 000 Operating income $9, 418, 750 *Variable Production Costs/Unit: DM $12 Op. I. using Full Costing $9, 481, 250 DL 4 Op. I. using Variable Costing (9, 418, 750) Var. MOH 3 Less Op. I using V. C. 62, 500

57 Reconciliation of difference in operating income under full costing & variable costing: Units produced 400, 000 Units sold 375, 000 Units in ending inventory 25, 000 × FMOH per unit $2. 50 FMOH in ending inventory $62, 500 Operating income under full costing $9, 481, 250 Operating inc. under variable costing 9, 418, 750

END OF SEGMENT Professor Garvin, JD; CPA – ACG 2071