Managerial accounting garrison norren 11th ed chap005

11th Edition
Chapter 5

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Cost Behavior:
Analysis and Use
Chapter Five

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from an earlier chapter.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


The Activity Base
Units
Units
produced
produced

Machine
Machine
hours
hours
A
Ameasure
measure of
of what
what
causes
causes the
the
incurrence
incurrence of
of aa
variable
variable cost
cost

Miles
Miles
driven
driven
McGraw-Hill/Irwin

Labor
Labor
hours
hours

Copyright © 2006, The McGraw-Hill Companies, Inc.


True Variable Cost Example

Total Long Distance
Telephone Bill

A variable cost is a cost whose total dollar amount
varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is
based on how many minutes you talk.

Minutes Talked
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from an earlier chapter.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Variable Cost Per Unit Example

Per Minute
Telephone Charge

A variable cost remains constant if expressed on a per
unit basis. The cost per minute talked is constant. For
example, 10 cents per minute.

Minutes Talked
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Extent of Variable Costs
The proportion of variable costs differs across
organizations. For example . . .
A public utility with
large investments in
equipment will tend
to have fewer
variable costs.

A manufacturing company
will often have many
variable costs.

A service company
will normally have a high
proportion of variable costs.

A merchandising company
usually will have a high
proportion of variable costs
like cost of sales.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


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.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


True Variable Cost

Cost

Direct materials is a true or proportionately variable

cost because the amount used during a period will
vary in direct proportion to the level of production
activity.

Volume
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Step-Variable Costs

Cost

A resource that is obtainable only in large chunks (such
as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a step-variable cost.
cost

Volume
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Step-Variable Costs

Cost

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

Volume
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Step-Variable Costs

Cost

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

workers employed

Volume
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


The Linearity Assumption and the Relevant Range

Total Cost

A
A straight
straight line
line
Economist’s
closely
closely
Curvilinear Cost approximates
approximates aa
Function
curvilinear
curvilinear

Relevant
Range

variable
variable cost

cost
line
line within
within the
the
relevant
relevant range.
range.

Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Types of Cost Behavior Patterns
Let’s look at fixed cost behavior on the next
screens.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Total Fixed Cost Example

Monthly Basic
Telephone Bill

A fixed cost is a cost whose total dollar amount remains
constant as the activity level changes. Your monthly
basic telephone bill is probably fixed and does not
change when you make more local calls.

Number of Local Calls
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Types of Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from an earlier chapter.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Fixed Cost Per Unit Example

Monthly Basic Telephone
Bill per Local Call

Average fixed costs per unit decrease as the activity
level increases. The fixed cost per local call

decreases as more local calls are made.

Number of Local Calls
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Types of Fixed Costs

Committed
Committed

Discretionary
Discretionary

Long-term,
Long-term, cannot
cannot be
be
significantly
significantly reduced
reduced
in
in the
the short
short term.
term.

May

May be
be altered
altered in
in the
the
short-term
short-term by
by current
current
managerial
managerial decisions
decisions

Examples

Examples
Examples

Depreciation on
Equipment and
Real Estate Taxes

Advertising
Advertising and
and
Research
Research and
and
Development
Development

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


The Trend Toward Fixed Costs
The trend in many industries is toward
greater fixed costs relative to variable costs.
As
As machines
machines take
take over
over
many
many mundane
mundane tasks
tasks
previously
previously performed
performed
by
by humans,
humans,
““knowledge
knowledge workers
workers””
are
are demanded
demanded for

for
their
their minds
minds rather
rather
than
than their
their muscles
muscles
McGraw-Hill/Irwin

Knowledge
Knowledge workers
workers
tend
tend to
to be
be salaried,
salaried,
highly-trained
highly-trained and
and
difficult
difficult to
to replace.
replace. The
The
cost
cost to
to compensate

compensate
these
these valued
valued employees
employees
is
is relatively
relatively fixed
fixed
rather
rather than
than variable.
variable.
Copyright © 2006, The McGraw-Hill Companies, Inc.


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

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.

Rent Cost in
Thousands of Dollars

Fixed Costs and Relevant Range

McGraw-Hill/Irwin

90
Relevant

60

Range

30
0

0

Total
Total cost
cost doesn’t
doesn’t
change
change for
for aa wide
wide
range
range of

of activity,
activity, and
and
then
then jumps
jumps to
to aa new
new
higher
higher cost
cost for
for the
the
next
next higher
higher range
range of
of
activity.
activity.

1,000
2,000
3,000
Rented Area (Square Feet)
Copyright © 2006, The McGraw-Hill Companies, Inc.


Fixed Costs and Relevant Range
The relevant range of activity for a fixed cost

is the range of activity over which the graph
of the cost is flat.
Example: Office space is
available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows
more space is rented,
increasing the total cost.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Fixed Costs and Relevant Range

How does this
type of fixed cost
differ from a stepvariable cost?
McGraw-Hill/Irwin

Step-variable costs
can be adjusted
more quickly and . . .
The width of the
activity steps is
much wider for the
fixed cost.
Copyright © 2006, The McGraw-Hill Companies, Inc.

Quick Check 
Which
Which of
of the
the following
following statements
statements about
about cost
cost behavior
behavior
are
are true?
true?
1.
1. Fixed
Fixed costs
costs per
per unit
unit vary
vary with
with the
the level
level of
of
activity.
activity.
2.
2. Variable
Variable costs

costs per
per unit
unit are
are constant
constant within
within the
the
relevant
relevant range.
range.
3.
3. Total
Total fixed
fixed costs
costs are
are constant
constant within
within the
the
relevant
relevant range.
range.
4.
4. Total
Total variable
variable costs
costs are
are constant
constant within
within the

the
relevant
relevant range.
range.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.