1 cost behaviour. 2 introduction determining how cost will change with output or other measurable...

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Cost behaviour

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Introduction

• Determining how cost will change with output or other measurable factors of activity is of vital importance for planning, controlling and decision-making activities.

• Most of planning, control and decision-making activities of management (e.g. the preparation of budgets, the production of performance reports, and the provision of relevant costs for pricing and other decisions) depend on reliable estimates of costs and distinguishing between fixed and variable costs, at different activity levels.

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Cost behaviour and decision making• It is the way in which costs are affected by changes in

the volume of output• Management decisions will often be based on how

costs and revenues vary at different levels of output• For example:-

– What should the planned activity level be for the next period?

– Should selling price be reduced in order to sell more units?

– Should a particular item be reduced in order to sell more units?

– Should a contract be undertaken?

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Cost behaviour and levels of activity

• There are many factors which may influence costs. The major influence is the volume of output, or the level of activity:-– Number of units produced– Value of items sold– Number of items sold– Number of units of electricity consumed

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Fixed cost

• Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so too will be the fixed costs.

• Fixed costs always have a variable element, since an increase or decrease in production may also bring about an increase or decrease in fixed costs

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Example of fixed and variable costs behaviour

• Let’s say you and 2 friends are going to Rodrigues for 4 nights.

• You are going to fly down there and stay in cotton bay hotel.

• The hotel charges Rs100 per night regardless of how many people stay in the room.

• TOTAL Expected Lodging Cost = Rs400

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• Two days before you leave one more friend decides to come along.

• How does this affect your hotel bill?

• No change – total lodging is still Rs400

• This is a fixed cost – The total cost does not change.

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• The day before you leave one friend gets sick and can’t go.

• What happens to your hotel bill now?

• No Change

• This is a fixed cost – The total cost does not change

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How does all this affect you?

• Total Hotel Bill = Rs400• How much do you have to pay?

Fixed Cost Behavior

# of People (a) 2 people 3 people 4 people

Total Lodging (b) Rs400 Rs400 Rs400

Lodging per person (b / a)

Rs200 Rs133 Rs100

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What about the airfare?• You were able to get plane tickets

for Rs200 roundtrip per person.

Variable Cost Behavior

# of tickets (a) 2 3 4

Total Airfare (a * b) Rs400 Rs600 Rs800

Cost per ticket (b) Rs200 Rs200 Rs200

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• Under a variable cost structure the cost per unit stays the same and the total cost changes

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Mixed Cost

• Has characteristics of both a variable and a fixed cost.

• e.g. – Copy machine lease– Cost = Rs1,000 per month– Plus Rs1 for every copy over 2,000

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Cost Behavior Summarized Your monthly basic telephone bill is probably fixed and does not change when you make more

local calls.

Number of Local Calls

Mon

thly

Basic

Tele

ph

on

e B

ill

Total Fixed Cost

15Number of Local Calls

Mon

thly

Basic

Tele

ph

on

e B

ill p

er

Local C

all

The fixed cost per local call decreasesas more local calls are made.

Cost Behavior Summarized

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Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Tota

l Lon

g

Dis

tan

ce

Tele

ph

on

e B

ill

Cost Behavior Summarized

Tota

l Var

iabl

e Cos

t

17Minutes Talked

Per

Min

ute

Tele

ph

on

e C

harg

e

The cost per minute talked is constant.For example, 10 cents per minute.

Cost Behavior Summarized

Variable Cost Per Unit

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Total Cost Cost Per Unit

Fixed CostsRemains Constant

Changes Inversely

Variable CostsChanges in

Direct ProportionRemains Constant

Cost Behavior SummarizedWhen activity level changes . . .

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semi-variable costs (Mixed Costs)

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Mixed Costs

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Mixed Costs

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Mixed Costs

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Assumptions about cost behaviour

• Within the normal range of activity, cost is assumed to be either fixed, variable or semi-variable (Mixed)

• Departmental costs within organization are assumed to be mixed costs

• Departmental costs are assumed to rise in a straight line as the volume of activity increases. In other words costs are said to be linear

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High Low Method

• There are several methods for identifying fixed and variable elements of semi-variable costs.

• One of the methods is the high low method

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High Low Method (Cont…)• Step 1- Review records of costs in previous

periods• Step 2- Determine the following:-

– Total cost at high activity level– Total cost at low activity level– Total units at high activity level– Total units at low activity level

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High Low Method (Cont…)

• Calculate the following:-

• The fixed costs can be determined as follows:- total cost at high level of activity – (total units at high activity level * variable costs per unit)

Total cost at high activity level- total cost at low activity level

Total units at high activity level- total units at low activity level =

VARIABLE COST PER UNIT

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The High-Low Method-Example• WiseCo recorded the following production activity and

maintenance costs for two months:

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The High-Low Method

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The High-Low Method

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The High-Low Method

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The High-Low Method

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The High-Low Method-Exercise (1)

• If sales salaries and commissions are £10,000 when 80,000 units are sold and £14,000 when 120,000 units are sold, what is the variable portion of sales salaries and commission?a. £0.08 per unit

b. £0.10 per unit

c. £0.12 per unit

d. £0.125 per unit

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The High-Low Method-Exercise (2)

• If sales salaries and commissions are £10,000 when 80,000 units are sold and £14,000 when 120,000 units are sold, what is the fixed portion of sales salaries and commissions?

a. £2,000b. £4,000 c. £10,000d. £12,000

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The High-Low Method-drawbacks

• This method ignores all cost observations other than the observations for the lowest and highest activity levels.

• Observations at the extreme ranges of activity levels are not always typical of normal operating conditions, and therefore may reflect abnormal rather than normal cost relationships.

• The method, therefore, gives inaccurate cost estimates

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The Scatter graph Method• This method involves:

– Plotting on a graph the total costs (represented on the vertical axis -Y) for each activity (recorded on the horizontal axis –X).

• Drawing a straight line through the middle of the plotted points by visual approximation.– The point where the straight line cuts the vertical axis

represents the fixed cost.– The unit variable cost is found by observing the

differences (in costs and activity levels) between any two points on the straight line.

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The Scatter graph Method

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The Scatter graph Method

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The Scatter graph Method

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The Scatter graph Method

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Exercise-Plotting scatter graph to estimate fixed and variable costs

Month Production (Units)

Costs (Rs)

July 10,000 44,000

August 15,000 60,000

September 23,000 85,000

October 21,000 75,000

November 19,000 70,000

December 28,000 98,000

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The Scatter graph Method-drawbacks

• This method suffers from the disadvantage that the determination of exactly where the straight line should fall is subjective (i.e. different people will draw different lines with different slopes, giving different cost estimates).