Overview managerial accounting chapter 05

The total amount of a variable cost varies in direct proportion to changes in the activity level.. Some variable costs, such as direct materials, vary in direct proportion to the level

LO3 Analyze a mixed cost using the high-low method

LO4 Prepare an income statement using the contribution format

LO5 (Appendix 5A) Analyze a mixed cost using the least-squares regression method

New in this Edition

• Many new In Business boxes have been added

• The end-of-chapter materials have been expanded by adding several new shorter exercises

1 Variable Costs The total amount of a variable cost varies in direct proportion to changes

in the activity level When expressed on a per unit basis, variable costs are constant Examples of costs that are normally variable with respect to output volume are listed in Exhibit 5-2 Be careful to point out to students that some of these costs may be fixed in some organizations This is particularly true of direct labor and other employee wages and salaries that may be effectively fixed due to labor laws in a country, custom, labor contracts, or the organization’s personnel policies Exhibit 5-8 in the text points out that in practice there is a wide variation in how some of these costs are classified by individual companies

a Activity base (cost driver) For a cost to be variable, it must be variable with respect to some activity base An activity base is a measure of whatever causes the incurrence of

a variable cost Some of the most common activity bases are machine-hours, units produced, and units sold A measure of activity should be used to allocate a cost for decision-making purposes only if it actually causes the cost

b True variable and step-variable costs Some variable costs, such as direct materials, vary in direct proportion to the level of activity These costs are called true variable

costs A cost that is obtainable only in large chunks and that increases or decreases in response to fairly wide changes in the activity level is known as a step-variable cost For example, direct labor may be a step-variable cost when workers are only hired on a full-time basis The difference between a true variable and a step-variable cost is illustrated in Exhibit 5-3 in the text

c In reality, many costs are curvilinear Most frequently, costs increase less than proportionately with activity Nevertheless, within any given narrow band of activity even a curvilinear cost function is approximately linear This narrow band of activity within which a particular straight line is a reasonable approximation to the true

underlying cost function is called its relevant range

• Thus, within the relevant range, variable cost per unit can be assumed to be constant Exhibit 5-4 in the text illustrates a curvilinear cost and the notion of the relevant range

• The notion of the relevant range often causes confusion Some individuals refer to the relevant range as the range of activity within which the company expects to operate or has operated in the recent past That is not what we mean by the relevant range The relevant range, as we use the term, is the range of activity within which a particular straight line provides a reasonable approximation to the real underlying cost function

2 Fixed Costs A fixed cost remains constant in total dollar amount within the relevant range

Since fixed costs remain constant in total, the amount of cost computed on a per unit basis becomes smaller as the number of units produced increases Care must be exercised in interpreting fixed costs that have been expressed on a per unit basis; they should not be misinterpreted as variable costs

a For planning purposes, fixed costs can be viewed as either committed or discretionary

• Committed fixed costs Committed fixed costs relate to investment in buildings,

equipment, and the basic organizational structure of a company Committed fixed costs are long-term and can’t be significantly reduced even for a short period of time without seriously impairing long-run goals

• Discretionary fixed costs Discretionary fixed costs are those that management

adjusts periodically Examples of discretionary fixed costs include advertising, research, and management development programs The planning horizon for discretionary fixed costs is fairly short—usually a single year Management may be able to adjust these fixed costs as circumstances change

b The relevant range for a fixed cost is that range of activity over which total fixed cost does not change Exhibit 5-6 in the text illustrates this idea

3 Mixed Costs A mixed cost contains both variable and fixed cost elements Many costs are

mixed and can be expressed in terms of the cost formula Y = a + bX, where Y is the total estimated cost, a is the estimated total fixed cost, b is the estimated variable cost per unit of activity, and X is the amount of activity Even when the underlying cost is not linear, this formula can provide a reasonable approximation to the underlying cost function within the

4 Classification of costs A cost that is considered variable in one organization may be

considered fixed in another due, for example, to differing employment policies Exhibit 5-8

in the text shows that there is a lot of variation in how companies classify costs in terms of behavior

B Analysis of Mixed Costs. For planning and control purposes, mixed costs should be broken down into variable and fixed components A number of methods can be used to analyze mixed costs Account analysis and the engineering approach are mentioned briefly in this chapter and are covered in more detail in later chapters This chapter discusses in more depth three techniques for analyzing past records of cost and activity—the scattergraph method, the high-low method, and least-squares regression

1 The Scattergraph Method (Exercises 5-2, 5-9, and 5-10.)

a The data should be plotted no matter what method is ultimately used to estimate fixed and variable costs A graph is constructed with cost on the vertical axis and activity on the horizontal axis Costs at various levels of activity are then plotted on the graph This plot will often provide important insights concerning the underlying relationship and can help in identifying nonlinearities and outliers (unusual points) that should be ignored

b While this is not ordinarily done in practice, a line can be fitted to the plotted points by eye with a straightedge The line should be placed so that approximately equal numbers

of points fall above and below it While not strictly necessary, in the text and in problems we always draw the line through one of the points to simplify calculations This line can then be used to derive what we call “quick-and-dirty” estimates of the fixed and variable costs The fixed cost can be estimated by the vertical intercept The variable cost per unit can be estimated by computing the slope of the line

2 The High-Low Method (Exercises 5-2, 5-4, 5-7, 5-8, 5-9, and 5-11.) The high-low

method of analyzing mixed costs focuses exclusively on the high and low levels of activity The difference in cost observed at these two extremes is divided by the change in activity to estimate the variable cost per unit of activity

A major defect of the high-low method is that it utilizes only two points and ignores all of the other data Generally, two points are not enough to produce accurate results Moreover, the periods in which the high and low activity levels occur are often not typical of most periods

3 The Least-Squares Regression Method (Exercises 5-3 and 5-12.) Using mathematical

formulas, the least-squares regression method fits a regression line that minimizes the sum

of the squared errors Exhibit 5-13 can be used as a basis for discussing the theory of squares regression

least-a We don’t go into the details of the computation of the least-squares regression estimates since computer software is widely used for performing this chore The appendix to the chapter shows how to use Excel to do the necessary calculations

b In addition to estimates of the slope (variable cost per unit) and the intercept (total fixed cost), least-squares regression software can produce a variety of informative

statistics One of the most informative is the R , which is a measure of the goodness of fit of the regression line It tells us the percentage of the variation in the dependent variable (cost) that is explained by variation in the independent variable (activity) We

do not show in the text how the R2 is computed, but you may want to discuss its interpretation with students

c Multiple regression analysis should be used when the cost is caused by more than one

factor

C The Contribution Format. (Exercises 5-5 and 5-6.) Two major approaches can be used

to prepare an income statement The difference between these two approaches centers on the way in which costs are organized

1 The Traditional Approach The traditional approach to the income statement organizes

data in a functional format, based on the functions of production, administration, and sales The emphasis is on the purposes for which the costs were incurred No attempt is made to identify the behavior of costs included under each functional heading This approach is used to prepare income statements for external reporting purposes

2 The Contribution Approach The contribution approach to the income statement

organizes costs by behavior, rather than by function

a The contribution approach separates costs into fixed and variable categories Variable expenses are deducted to obtain the contribution margin Fixed expenses are then deducted from the contribution margin to obtain net operating income

b The contribution approach to the income statement makes it much easier for managers

to understand the relations between volume and expenses, and volume and profits Variable and fixed costs are not lumped together Since planning and decision-making often involve changes in the level of activity, contribution income statements can be very useful Unfortunately, the contribution approach is seldom used in practice

Assignment Materials

Assignment Topic

Level of Difficulty

Suggested Time

Exercise 5-1 Fixed and variable cost behavior Basic 15 min Exercise 5-2 High-low method; scattergraph analysis Basic 45 min Exercise 5-3 (Appendix 5A) Least-squares regression Basic 30 min Exercise 5-4 High-low method Basic 20 min Exercise 5-5 Contribution format income statement Basic 20 min Exercise 5-6 Cost behavior; contribution format income statement Basic 20 min Exercise 5-7 High-low method; predicting cost Basic 30 min Exercise 5-8 High-low method; predicting cost Basic 20 min Exercise 5-9 Scattergraph analysis; high-low method Basic 30 min Exercise 5-10 Scattergraph analysis Basic 30 min Exercise 5-11 Cost behavior; high-low method Basic 20 min Exercise 5-12 (Appendix 5A) Least-squares regression Basic 30 min Problem 5-13 Cost behavior; high-low method; contribution income

statement Basic 45 min Problem 5-14 Contribution format versus traditional income statement Basic 45 min Problem 5-15 (Appendix 5A) Least-squares regression; scattergraph; cost

behavior Basic 45 min Problem 5-16 Identifying cost behavior patterns Medium 30 min Problem 5-17 High-low and scattergraph analysis Medium 45 min Problem 5-18 (Appendix 5A) Least-squares regression method Medium 30 min Problem 5-19 Scattergraph analysis Medium 30 min Problem 5-20 (Appendix 5A) Least-squares regression method Medium 30 min Problem 5-21 (Appendix 5A) Least-squares regression analysis;

contribution income statement Medium 45 min Problem 5-22 High-low method; cost of goods manufactured Difficult 45 min Problem 5-23 High-low method; predicting cost Difficult 45 min Problem 5-24 High-low method; predicting cost Difficult 45 min Case 5-25 (Appendix 5A) Analysis of mixed costs, job-cost system,

and activity-based costing Difficult 90 min Case 5-26 Scattergraph analysis; selection of an activity base Medium 45 min Case 5-27 Analysis of mixed costs in a pricing decision Difficult 90 min Case 5-28 (Appendix 5A) Mixed cost analysis by three methods Difficult 90 min

Essential Problems: Problem 13, Problem 17 or Problem 19, Problem 23 or Problem

5-24

Supplementary Problems: Problem 5-14, Problem 5-16, Problem 5-22, Case 5-25, Case 5-26,

Case 5-27, Case 5-28

Appendix 5A Essential Problems: Problem 5-15

Appendix 5A Supplementary Problems: Problem 5-18, Problem 5-20, Problem 5-21

Linked problems and exercises:

Exercise 5-3 should be assigned in conjunction with Exercise 5-2

Exercise 5-9 should be assigned in conjunction with Exercise 5-8

Problem 5-18 should be assigned in conjunction with Problem 5-17

1 2 3

Chapter 5 Lecture Notes

Helpful Hint: The McGraw-Hill/Irwin Managerial/Cost Accounting video library does not contain a segment that relates to Chapter 5

Chapter theme: Managers who understand how costs

behave are better able to predict costs and make decisions under various circumstances This chapter explores the

meaning of fixed, variable and mixed costs (the relative proportions of which define an organization’s cost

structure) It also introduces a new income statement

called the contribution approach

I Types of cost behavior patterns

A Variable costs

i A variable cost is a cost whose total dollar amount

varies in direct proportion to changes in the

activity level

1 An activity base (also called a cost driver)

is a measure of what causes the incurrence

of variable costs As the level of the activity base increases, the variable cost increases proportionally

a Units produced (or sold) is not the only activity base within companies

A cost can be considered variable if it varies with activity bases such as

2

1

3

3 4 5

6 7

miles driven, machine hours, or labor hours

2 As an example of an activity base, consider your total long distance telephone bill The activity base is the number of minutes that you talk

ii Variable costs remain constant if expressed on a

per unit basis

1 Referring to the telephone example, the cost per minute talked is constant (e.g., 10 cents per minute)

iii Extent of variable costs

1 The proportion of variable costs differs across organizations For example:

a A public utility like Florida Power

and Light, with large investments in equipment, will tend to have fewer variable costs

b A manufacturing company like

Black and Decker will often have many variable costs associated with the manufacture and distribution of its products to customers

c A merchandising company like

Wal-Mart will usually have a high proportion of variable costs such as the cost of merchandise purchased for resale

d Some service companies, such as

restaurants, have a high proportion of variable costs due to their raw

7 8 9

material costs Other service companies, such as an architectural firm, have a high proportion of fixed costs in the form of highly trained salaried employees

iv Common examples of variable costs

1 Merchandising companies − cost of goods sold

2 Manufacturing companies − direct materials, direct labor, and variable overhead

3 Merchandising and manufacturing companies − commissions, shipping costs, and clerical costs such as invoicing

4 Service companies − supplies, travel, and clerical

Helpful Hint: Students tend to assume that a certain type of cost is always variable or fixed They should examine the facts of each situation before deciding whether a cost is fixed or variable For example, a company’s employment policy may determine whether direct labor costs are fixed or variable with respect to volume of output

B True variable versus step-variable costs

i True variable costs − the amount used during the period varies in direct proportion to the activity

9 10 11

12

2 Direct material is another example of a cost that behaves in a true variable pattern

a Direct materials purchased but not used can be stored and carried forward to the next period as inventory

ii Step-variable costs − A resource that is obtainable

only in large chunks and whose costs change only

in response to fairly wide changes in activity

1 For example, maintenance workers are often considered to be a variable cost, but this labor cost does not behave as a true variable cost

a Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed

b Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed

i Maintenance workers are obtainable only in large chunks

of a whole person who is capable

of working approximately 2,000 hours a year

“In Business Insights”

Step-variable costs can change for reasons that have nothing to do with changes in the activity level For example:

9

10

11

12

13

“Coping with the Fallout from September 11” (page 186)

• Filterfresh is a company that services coffee

machines located in commercial offices

• Post September 11, heightened security clearance

measures at customer locations have added about one hour per day to each deliveryman’s route

• This has required Filterfresh to hire 24 more

delivery people to do the same work it did prior

to September 11

C The linearity assumption and the relevant range

i Economists correctly point out that many costs that accountants classify as variable costs actually

behave in a curvilinear fashion

ii Nonetheless, within a narrow band of activity known as the relevant range, a curvilinear cost can

be satisfactorily approximated by a straight line

1 The relevant range is that range of activity

within which the assumptions made about cost behavior are valid

Helpful Hint: Slide 13 can be tied in with economics courses students have taken Ask what happens to average costs when the cost curve bends downward and what economists call this part of the curve Average costs are falling and this is roughly equivalent to what economists call “increasing returns to scale.” You can repeat the same question for the part of the curve that bends upward

13

14 15 16

17 18

D Fixed costs

i A fixed cost is a cost whose total dollar amount

remains constant as the activity level changes

1 For example, your monthly basic telephone bill is probably fixed and does not change when you make more local calls

ii Average fixed costs per unit decrease as the

activity level increases

1 For example, the fixed cost per local call decreases as more local calls are made

E Types of fixed costs

i Committed fixed costs

1 These costs are long-term in nature (i.e.,

greater than one year)

2 These costs cannot be significantly

reduced even for short periods of time

without seriously impairing the profitability

or long-run goals of the organization

a Examples of committed-fixed costs include depreciation on buildings and equipment, and real estate taxes

“In Business Insights”

Committed fixed costs may be more flexible than they would appear at first glance For example:

“Sharing Office Space to Reduce Committed Fixed Costs” (page 191)

18

• Doctors in private practice have been under

enormous pressure in recent years to cut costs

• Dr Edward Betz of California reduced the

committed fixed costs of maintaining his office by letting a urologist use the office on Wednesday afternoons and Friday mornings for $1,500 per month

• Dr Betz uses these times to work on paperwork at

home He also makes up for lost time by treating patients on Saturdays

ii Discretionary fixed costs

1 These costs usually arise from annual

decisions by management to spend in

certain fixed cost areas

2 These costs can be cut for short periods of

time with minimal damage to the long-run

goals of the organization

a Examples of discretionary fixed costs include advertising and research and development

3 A cost may be discretionary or committed depending upon management’s strategy

a For example, some construction companies may layoff workers during months with minimal customer demand However, other construction companies may opt to retain their workers all year

“In Business Insights”

The extent of a company’s discretionary fixed costs is a function of management choices For example:

18

19

“Cost Structure: A Management Choice” (page 184)

• Nucor Steel is the most successful U.S steel

company of recent years due in large part to its cost-efficiency

• Nucor treats all employees alike There are no

management dining rooms, company yachts or airplanes, no first-class travel for executives, and

no support staff to pamper the upper echelons

• All of these management actions serve to lower

discretionary fixed costs for Nucor

• In addition, Nucor relies upon fewer layers of

management In fact, although Nucor is the largest steel company in the U.S., its headquarters employs only 20 people

iii The trend toward fixed costs

1 The trend in many industries is toward

greater fixed costs relative to variable

costs For example:

a H&R Block employees used to fill

out tax returns for customers by hand Now, computer software is used to complete tax returns

b Safeway and Kroger employees

used to key-in prices by hand on cash registers Now, barcode readers enter price and other product information automatically

c As machines take over many mundane tasks previously performed

by humans, “knowledge workers”

are demanded for their minds rather than their muscles

19

19 20

i Knowledge workers tend to be salaried, highly-trained and difficult to replace; consequently, the cost of compensating these valued employees in relatively

fixed rather than variable

“In Business Insights”

By making investments in technology many internet companies have created radically different cost structures from their “bricks and mortar” counterparts For example:

“Selling Online” (page 185)

• Onsale, an internet auctioneer of discontinued

computers and House of Fabrics, a traditional retailer, each has roughly the same revenue of about $250 million per year

• However, House of Fabrics, with 5,500

employees, has revenue per employee of about

$90,000 At Onsale, with only 200 employees, the figure is $1.18 million per employee

• Onsale relies upon investments in technology to

reduce its labor cost

iv Is labor a variable or a fixed cost?

1 The behavior of wage and salary costs can

differ across countries, depending on labor

regulations, labor contracts, and custom For example:

a In France, Germany, China, and Japan management has little flexibility in adjusting the size of the

20

19

20

labor force; hence, labor costs are more fixed in nature

“In Business Insights”

Survey research supports the assertion that labor costs are viewed as more fixed in nature in certain countries For example:

“Cost Behavior in the U.S and Japan” (page 195)

• A total of 257 American and 40 Japanese

manufacturing companies responded to a questionnaire concerning their management practices

• The findings indicate that approximately 40% of

the Japanese companies surveyed viewed production labor as a fixed cost, while approximately 10% of U.S companies surveyed viewed production labor as a fixed cost

b In the United States and the United Kingdom, management typically has much greater latitude; hence, labor costs are more variable in nature

“In Business Insights”

Regulatory requirements can influence the fixed versus variable nature of labor costs in American companies For example:

“The Regulatory Burden” (page 193)

• Peter Drucker claims that “the driving force

behind the steady growth of temps…is the growing burden of rules and regulations for employers.”

20

20

• According to the Small Business Administration,

the owner of a small business spends up to a quarter of his or her time on employment-related paperwork Furthermore, the cost of complying with government regulations is over $5,000 per employee per year

• This motivates small businesses to rely upon

temporary workers, thus converting labor from a fixed cost to a variable cost

2 Within countries managers can view labor

costs differently depending upon their

strategy Nonetheless, most companies in the United States continue to view direct labor as a variable cost

“In Business Insights”

Managers can view labor costs differently depending upon their strategy For example:

“A Twist on Fixed and Variable Costs” (page 191)

• Mission Controls designs and installs automation

systems for food and beverage manufacturers

• When sales drop, the founders of this company slash

their own salaries rather than laying off workers

• This makes their own salaries somewhat variable,

while the wages and salaries of workers act more like fixed costs The payoff is a loyal and committed work force

“Labor at Southwest Airlines” (page 192)

• Southwest Airlines is the most profitable airline in

the United States

20

21 22 23

• Prior to stepping down as President and CEO of the

airline in 2001, Herb Kelleher wrote “The thing that would disturb me the most to see after I’m no longer CEO is layoffs at Southwest Nothing kills your company’s culture like layoffs.”

• Because of Southwest Airline’s commitment to its

employees, all wages and salaries are basically committed fixed costs

F Fixed costs and the relevant range

i The relevant range of activity for a fixed cost is the range of activity over which the graph of the cost is flat

1 For example, assume office space is available at a rental rate of $30,000 per year

in increments of 1,000 square feet

2 Fixed costs would increase in a step fashion

at a rate of $30,000 for each additional 1,000 square feet

ii While this step-function pattern appears similar to

the idea of step-variable costs, there are two

important differences between step-variable costs

and fixed costs

1 Step-variable costs can often be adjusted

quickly as conditions change, whereas fixed

costs cannot be changed easily

2 The width of the steps for fixed costs is

wider than the width of the steps for

step-variable costs

a For example, a step-variable cost such as maintenance workers may have steps with a width of 40 hours a week

21

22

23

23 24 25

26 27

b However, fixed costs may have steps that have a width of thousands or tens

of thousands of hours of activity

Helpful Hint: Discuss with students that over a given level of production, certain costs, such as custodial salaries, would remain fixed However, if activity increases to the point where a second shift is needed, custodial salaries would need to increase since activity

is outside the relevant range

Quick Check − cost behavior patterns

G Mixed costs (also called semivariable costs)

i A mixed cost contains both variable and fixed cost

b The variable portion of the bill varies

in direct proportion to the consumption of kilowatt hours

ii An equation can be used to express the relationship between mixed costs and the level of the activity This equation can be used to calculate what the total mixed cost would be for any level of activity

24-25

26

23

27

27 28 29

1 The equation is Y = a + bX

a Y = The total mixed cost

b a = The total fixed cost (the vertical

intercept of the line)

c b = The variable cost per unit of

activity (the slope of the line)

d X = The level of activity

iii For example, if your fixed monthly utility charge is

$40, your variable cost is 03 per kilowatt hour, and your monthly activity level was 2,000 kilowatt hours, this equation can be used to calculate your

total utility cost of $100

II The analysis of mixed costs

A Account analysis and the engineering approach

i In account analysis, each account under

consideration is classified as variable or fixed based

on the analyst’s prior knowledge about how costs behave

1 This approach is limited in value in the sense that it glosses over the fact that some accounts may have both fixed and variable components

ii The engineering approach classifies costs based

upon an industrial engineer’s evaluation of production methods, material specifications, labor requirements, equipment usage, power

consumption, as so on

27

28

29