Chapter 6 Cost Behavior How costs change as volume changes 1 Cost Behavior How do Changes in Volume Affect Costs a Variable Costs Costs that change in total in direct proportion to changes in volume i Costs in that increase decrease in total with the number of units ii Origin zero costs and zero volume iii Slope Variable cost per unit of activity 1 Higher the variable cost of the activity steeper the slope will be iv Cost Equation Variable Cost Per Unit v x Volume of Activity x 1 Y vx b Fixed Costs Costs that do not change in total despite wide changes in volume i Committed Fixed Costs Organizations are locked into these costs because of previous management decisions Management has no control over these costs in the short run ii Discretionary Fixed Costs Costs that are the result of annual management decisions such as advertising costs These costs can be adjusted as necessary in the short run iii Cost Equation Fixed amount of a period of time f 1 Y f iv Fixed cost per unit does depend on the number of units 1 Divide the fixed cost by the number of units 2 Fixed cost per unit is inversely proportional to the number of guests a As volume increases fixed cost per unit decreases c Mixed Costs Costs that change in total but NOT in direct proportion to changes in volume i Have both variable and fixed components ii Example Utility costs at a hotel Costs are incurred no matter how many guests stay the night but will change depending on how often for how long guests use the water air conditioning etc iii Total Mixed Costs Variable Cost Component Fixed Cost Component 1 Y vx f iv Costs increase as volume increases but not in direct proportion to changes in volume because of the fixed cost component d Relevant Range Band of volume where the following remain constant total fixed costs and the e Step Costs Fixed over a small range of activity and then jump to a new fixed level with variable cost per unit moderate changes in volume i Step up to a new relevant range with relatively small changes in volume while fixed costs hold constant over much larger ranges of volume 2 How do Managers Determine Cost Behavior a Account Analysis Managers use their judgment to classify each general ledger account as a variable fixed or mixed cost b Scatter Plots Graphs cost data on the y axis and volume data on the x axis in order to help managers realize the relationship between the cost and the volume of activity i If data points fall in a linear pattern there is a fairly strong relationship between them ii High Low Method Easy way to estimate the variable and fixed cost components of a mixed cost 1 Fits a mixed cost line through the highest and lowest volume data points in order to produce an equation that describes the mixed cost line 2 Find the slope of the mixed cost line that connects the high and low data points a Slope variable cost per unit of activity b y high y low x high x low 3 Find the vertical intercept or the place where the line intersects the y axis a X Intercept fixed cost component of the mixed cost b Enter the data from either the high or the low month into the equation in order to find the fixed cost component 4 Write an equation representing the cost s behavior iii Regression Analysis Statistical procedure for determining the line and cost equation that best fits the data by using all of the data points not just the high volume and low volume data points 1 R 2 when r 2 is closer to zero the data has a weaker relationship a Higher the r 2 the stronger the relationship between cost and volume b R 2 over 8 generally indicates that the cost equation is very reliable for predicting costs at other volumes within the relevant range c R 2 below 5 indicates that the manager should use a different activity base for cost analysis 3 What is a Contribution Margin Income Statement a Traditional Income Statements are Organized by Cost Function i Traditional income statements provide managers with little if any cost behavior information This is because they are organized by function not by cost behavior ii Sales Revenue Cost of Goods Sold Gross Profit Operating Expenses Operating Income b Contribution Margin Income Statements are Organized by Cost Behavior i Contribution Margin Income Statements Provide managers with cost behavior information that can be used internally GAAP does not allow companies to use the contribution margin format for external reporting purposes 1 Organize costs by behavior rather than by function 2 Presents all variable costs above the contribution margin line and all fixed costs below the contribution margin line Contribution margin instead of gross profit is the dividing line a Sales Revenue Variable Expenses Contribution Margin Fixed Expenses Operating Income 3 Can use contribution margin statements to predict how changes in volume will affect operating income 4 Since changes in volume will affect variable expenses and not fixed expenses the contribution margin income statement distinguishes the financial figures that will change from those that will not change 4 How Does Variable Costing Differ from Absorption Costing REFER TO TEXTBOOK a Variable Costing Assigns only variable manufacturing costs direct materials direct labor and manufacturing overhead to products i Used to product contribution margin income statements ii Treats fixed manufacturing costs as period costs b Absorption Costing Products absorb fixed manufacturing costs as well as variable manufacturing costs aka both costs are treated as inventoriable product costs i GAAP requires managers to use this kind of costing resulting in traditional income statements for external reporting c When inventories increase more units are produced than sold absorption costing income is higher than variable costing income When inventories decline fewer units are produced than sold absorption income is lower than variable costing income
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