Cost Behaviour: Part 2 of 2

Sections 1 and 2 Feb 1, 2013

Professor: Khim Kelly Office: HH386B Office Hours: Mon/Wed 11:30am – 12:30pm and Appointment

Email:

[email protected]

TA: Kun Huo Email: [email protected]

1 Feb 2013 Overview

• • Last lecture … – Fixed costs, variable costs, step variable costs, mixed costs – How to use costs behaviour to predict costs – Analyze mixed costs (High-Low Method) Major topics for today… – Analyse mixed costs (Regression) – Another example of High-Low method – The contribution margin approach 2

Regression

• • • High-Low method uses only two data points – Improve accuracy of results by considering more data points Regression analysis – Uses all the available data points – “Fits” a line to the data points while attempting to minimize errors.

– Develops a similar looking equation to High-Low method Both assume linearity – Need to be aware of potential differences in cost behaviour outside of the relevant range – When predicting costs, you might want to limit analysis to a range around expected activity

The next slides plot data (from last lecture Clicker Question #3) with activity on the X axis and the mixed cost on the Y axis.

Last Lecture: Clicker Question #4: Answer Month Jan Feb March April May June July Aug Sept Oct Nov Dec Patient Days 3,700 3,200 4,400 5,000 2,700 2,500 3,600 1,800 4,650 3,900 2,100 4,500 Mixed Cost 27,750 22,000 31,000 34,500 28,000 22,500 26,500 18,750 36,500 24,000 22,500 26,750 = $34,500 - $18,750 5,000 - 1,800 = $15,750 3,200 = $4.92 per Patient-Day

Then:

$34,500 a = = a + ($4.92 * 5,000) $9,891

Answer: D. Y = $9,891 +$4.92X

Scattergram Plot

40 000 35 000 30 000 25 000 20 000 15 000 10 000 5 000 1 000 2 000 3 000 Patient days 4 000 5 000 6 000

High-Low Method

40 000 35 000 30 000 25 000 20 000 15 000 10 000 5 000 HL method: y = $4.92x + $9,891 1 000 2 000 3 000 Patient days 4 000 5 000 6 000

Least Squares Regression Method 40 000 35 000 30 000 25 000 20 000 15 000 10 000 5 000 1 000 HL method: y = $4.92x + $9,891 LSR method: y = 4.10x + $12,346 2 000 3 000 Patient days 4 000 5 000 6 000

Least Squares Regression Method 40 000 Outlier?

Nonlinear?

35 000 30 000 25 000 20 000 15 000 10 000 5 000 1 000 LSR method: y = 4.10x + $12,346 (with outlier) 2 000 3 000 Patient days 4 000 5 000 6 000

Least Squares Regression Method 40 000 Outlier?

Nonlinear?

35 000 30 000 25 000 20 000 15 000 10 000 5 000 LSR method: y = 4.10x + $12,346 (with outlier) LSR method: y = 3.51x + $13,890 (without outlier) 1 000 5 000 6 000 2 000 3 000 Patient days 4 000

Example: High-Low Method and Predicting Cost (P6-15) Prince Company’s total OH costs at various levels of activity are presented below:

Month

September October November December

DL Hours

100,000 80,000 135,000 140,000

Total OH Cost

$388,000 $340,400 $485,600 $483,200

Example: High-Low and Predicting Cost (P6-15) Assume OH costs consists of utilities, supervisory salary, depreciation, and maintenance. The breakdown for October at 80,000 DL hour level of activity is:

OH

Utilities Salaries & Depreciation Maintenance

Type

Variable Fixed Mixed

Total OH Cost OH Cost

$104,000 $120,000 $116,400

$340,400

The company wants the breakdown of costs into variable and fixed cost elements. Answer the following required:

Example: High-Low and Predicting Cost (P6-15) 1. Estimate how much of the $483,200 of OH cost in December was maintenance cost

Example: High-Low and Predicting Cost (P6-15)

OH

December OH December: Salaries & Depreciation

Type

Mixed Fixed

OH Cost

$483,200 ($120,000)

Variable Cost = $104,000/80,000 * 140,000

It is Clicker Time!!

Feel Free to Work Together on Clicker Questions

Clicker Question #1 (P6-15)

LOW (October): 80,000 DL hours @ $116,400 HIGH (December): 140,000 DL hours @ $181,200 Q: Use the high-low method to develop the cost formula for maintenance cost (select option that is closest to your answer).

A. Y = $15,000 + $23.80X

B. Eggs + Plants = Eggplant C. Y = $30,000 + $3.12X

D. Y = $30,000 + $1.08X

E. Y = $15,000 + $2.38X

Clicker Question #1

LOW (October): 80,000 DL hours @ $116,400 HIGH (December): 140,000 DL hours @ $181,200

Answer: D. Y = $30,000+$1.08X

= $181,200 - $116,400 140,000 – 80,000 = $64,800 60,000 = $1.08 per DL hour

Then:

$116,400 = a = a + ($1.08 * 80,000) $30,000

Example: High-Low and Predicting Cost (P6-15) 3. Express the company’s total OH cost in the formula Y = a+ bX: Variable Costs: Utilities ($104,000/80,000 DL) Maintenance Total Variable $1.30/DL hour $1.08/DL hour $2.38/DL hour Fixed Costs: Salaries and depreciation Maintenance Total Fixed $120,000 $30,000 $150,000

Example: High-Low and Predicting Cost (P6-15) 3. Express the company’s total OH cost in the formula Y = a+ bX: Total Variable Total Fixed $2.38/DL hour $150,000 Y = $150,000 + $2.38X

The Contribution Format

• • Utilizes our ability to analyze cost behavior – An income statement format that separates expenses into fixed costs and variable costs – Differs from traditional presentation of COGS and operating expenses – Total cost is the same under both methods but only subtotals vary Contribution margin – The amount remaining from sales after all variable costs have been deducted

Contribution Income Statement

To Do: Analyze expense behaviour of the following and develop a contribution income statement:

Cost

Number of units sold Sales revenue COGS Advertising Expense Sales Commissions Administrative Salaries Shipping Expense Depreciation

Cost Formula

21,000 1,050,000 $20 / unit $170,000 5% of Sales revenue $80,000 $40,000 plus $7.50 / unit $50,000

Contribution Income Statement

Income Statement

Revenue $1,050,00 0 COGS ($20/unit * 21,000) Variable shipping expense ($7.50/unit * 21,000) Commission (5% of sales revenue) Total Variable Costs Contribution Margin Contribution Margin per Unit $420,000 157,500 52,500 $630,000 $420,000 $20

Contribution Income Statement

Income Statement

Contribution Margin Fixed Shipping expense Advertising expense Administrative salaries Depreciation expense Total Fixed Costs Operating Income 40,000 170,000 80,000 50,000 $420,000 $340,000 $80,000

It is Clicker Time!

Feel Free to Work Together on Clicker Questions

Clicker Question #2

Q: Contribution margin equals revenues minus _______?

A. Product costs B. Period costs C. Variable costs D. Fixed costs E. 9 little monkeys jumping on the bed

Clicker Question #2: Answer

Q: Contribution margin equals revenues minus _______?

Answer: C. Variable costs

Clicker Question #3

Q: What is the contribution margin?

Cost

Sales Fixed Manufacturing Overhead Direct Labour Fixed Selling Expenses Variable Manufacturing Overhead Variable Administrative Expenses Direct Materials Fixed Administrative Expenses Variable Selling Expenses

Amount

$300,000 $ 55,000 $ 72,500 $ 46,250 $ 41,000 $ 48,000 $ 51,500 $ 44,500 $ 49,750

Clicker Question #3

Q: What is the contribution margin?

A. $37,250 B. $100,000,000.23

C. $ 87,000 D. $176,000 E. $262,750

Clicker Question #3 - Solution

Amount

$300,000 Sales Direct Labour Direct Materials Variable Manufacturing Overhead Variable Administrative Expenses Variable Selling Expenses Total Variable Costs Contribution Margin ($72,500) ($51,500) ($41,000) ($48,000) ($49,750) ($262,750) ($262,750) $37,250

Clicker Question #3: Answer

Q: What is the contribution margin?

Answer: A. $37,250

UW …

• • • • • UW is one of Canada’s leading research institution The School of Accounting and Finance has one of the country’s premier PhD programs Every year, I train PhD students in teaching. So, the next 3 classes (Cost-Volume-Profit Relationships) will be taught by Kun Huo, one of our PhD students. I will sit in the class as an observer.

Summary

• Major topics for today… – Another example of High-Low Method – Contribution margin approach • Next class … – Chapter 7 (Cost-Volume-Profit Relationships)