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Activity Cost Behavior 7/21/2015 Asst. Prof. Kalyaporn P. Burke 1 1 Define cost behavior for fixed, variable, and mixed costs. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 2 Cost Behavior It is the general term for describing whether costs change as output changes. A cost that stays the same as output changes is a fixed cost. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 3 Fixed Costs A cost that stays the same as output changes is a fixed cost. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 4 Fixed Costs Cutting machines are leased for $60,000 per year and have the capacity to produce up to 240,000 units a year. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 5 Total Costs Total Fixed Cost Graph $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 0 60 120 180 240 Units Produced (000) Lease of Machines 7/21/2015 Fixed Costs F = $60,000 Number of Units $60,000 0 60,000 60,000 60,000 120,000 60,000 180,000 60,000Asst. Prof. Kalyaporn 240,000 P. Burke Units Cost N/A $1.00 0.50 0.33 0.25 6 Cost per Unit Unit Fixed Cost Graph $1.00 $0.50 Fixed Costs $0.33 $0.25 0 60 120 180 240 Units Produced (000) Lease of Machines 7/21/2015 Number of Units $60,000 0 60,000 60,000 60,000 120,000 60,000 180,000 60,000Asst. Prof. Kalyaporn 240,000 P. Burke Units Cost N/A $1.00 0.50 0.33 0.25 7 A variable cost is a cost that, in total, varies in direct proportion to changes in output. Variable Cost 7/21/2015 Asst. Prof. Kalyaporn P. Burke 8 Variable Cost As the cutting machines cut each unit, they use 0.1 kilowatt-hour at $2.00 per kilowatt hour. Thus, the cost of each unit is $0.20 ($2 x 0.1). 7/21/2015 Asst. Prof. Kalyaporn P. Burke 9 Total Variable Cost Graph Total Costs $48,000 $36,000 Yv = .20x Variable Cost $24,000 $12,000 0 60 120 180 240 Units Produced (000) Cost of Power $ 7/21/2015 Number of Units 0 0 12,000 60,000 24,000 120,000 36,000 180,000 48,000Asst. Prof. Kalyaporn 240,000 P. Burke Units Cost $ 0 0.20 0.20 0.20 0.20 10 Unit Variable Cost Graph Cost per Unit $0.40 $0.30 Variable Cost $0.20 $0.10 0 60 120 180 240 Units Produced (000) Cost of Power $ 7/21/2015 Number of Units 0 0 12,000 60,000 24,000 120,000 36,000 180,000 48,000Asst. Prof. Kalyaporn 240,000 P. Burke Units Cost $ 0 0.20 0.20 0.20 0.20 11 A mixed cost is a cost that has both a fixed and a variable component. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 12 Sales representatives often are paid a salary plus a commission on sales. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 13 Total Costs Mixed Cost Behavior $130,000 $110,000 $90,000 $70,000 $50,000 $30,000 0 40 80 120 160 180 200 Units Sold (000) Inserts Sold 7/21/2015 40,000 80,000 120,000 160,000 200,000 Variable Cost of Selling Fixed Cost of Selling $ 20,000 $30,000 40,000 30,000 60,000 30,000 80,000 30,000 Asst. Prof. Kalyaporn P. Burke 100,000 30,000 Total Selling Cost Selling Cost per Unit $ 50,000 70,000 90,000 110,000 130,000 $1.25 0.86 0.75 0.69 0.65 14 Activity Cost Behavior Model Input: Materials Energy Labor Activities Activity Output Capital Changes in Input Cost Cost Behavior 7/21/2015 Asst. Prof. Kalyaporn P. Burke Changes in Output 15 2 7/21/2015 Explain the role of resource usage model in understanding cost behavior. Asst. Prof. Kalyaporn P. Burke 16 Capacity: Definition Capacity for an activity is the amount of an activity a company can perform. Practical capacity is the level at which company can perform efficiently. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 17 How much capacity does a company need? What happens if there is excess capacity? Need for capacity depends on level of performance required. Excess capacity affects cost behavior. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 18 Flexible resources are resources acquired as used and needed. Materials and energy are examples. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 19 Committed resources are supplied in advance of usage. Buying or leasing a building is an example of this form of advance resource acquisition. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 20 A step cost displays a constant level of cost for a range of output and then jumps to a higher level of cost at some point. Step-Cost Behavior 7/21/2015 Asst. Prof. Kalyaporn P. Burke 21 Step-Cost Behavior Cost $500 400 300 200 100 10 7/21/2015 20 30 40 50 Activity Output (units) Asst. Prof. Kalyaporn P. Burke 22 Step-Cost Behavior Cost $150,000 Normal Operating Range (Relevant Range) 100,000 50,000 2,500 7/21/2015 5,000 7,500 Asst. Prof. Kalyaporn P. Burke Activity Usage 23 3 7/21/2015 Separate mixed costs into fixed and variable components using high-low, scatterplot, and least squares. Asst. Prof. Kalyaporn P. Burke 24 Methods for Separating Mixed Costs The High-Low Method The Scatterplot Method The Method of Least Squares Variable Component Fixed Component 7/21/2015 Asst. Prof. Kalyaporn P. Burke 25 The linearity assumption assumes that variable costs increase in direct proportion to the number of units produced (or activity units used). 7/21/2015 Asst. Prof. Kalyaporn P. Burke 26 Linearity Assumption Variable cost assumes a linear relationship between cost and activity driver. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 27 TOTAL COSTS = Fixed cost + (Variable rate x Output) Intercept is fixed cost Slope is variable cost 7/21/2015 Asst. Prof. Kalyaporn P. Burke 28 Methods for Separating Mixed Costs Y = a + bx Variable Number of Units TotalTotal CostFixed Cost Cost per Unit 7/21/2015 Asst. Prof. Kalyaporn P. Burke 29 The High-Low Method Month January February March April May Setup Costs $1,000 1,250 2,250 2,500 3,750 Setup Hours 100 200 300 400 500 Step 1: Solve for variable cost (b) 7/21/2015 Asst. Prof. Kalyaporn P. Burke 30 The High-Low Method Month January February March April May Setup Costs $1,000 1,250 2,250 2,500 3,750 b= Setup Hours 100 200 300 400 500 High Cost – Low Cost High Units – Low Units 7/21/2015 Asst. Prof. Kalyaporn P. Burke 31 The High-Low Method Month January February March April May Setup Costs $1,000 1,250 2,250 2,500 3,750 b= 7/21/2015 Setup Hours 100 200 300 400 500 High $3,750 Cost –– Low LowCost Cost High Units 500 – –Low LowUnits Units Asst. Prof. Kalyaporn P. Burke 32 The High-Low Method Month January February March April May Setup Costs $1,000 1,250 2,250 2,500 3,750 b= Setup Hours 100 200 300 400 500 $3,750 Cost $3,750 ––Low$1,000 500 500 – –Low Units 100 7/21/2015 Asst. Prof. Kalyaporn P. Burke 33 The High-Low Method b= $3,750 – $1,000 500 – 100 b = $6.875 Step 2: Using either the high cost or low cost, solve for the total fixed cost (a). 7/21/2015 Asst. Prof. Kalyaporn P. Burke 34 The High-Low Method Y = a + b (x) $3,750 = a + $6.875 (500) $312.50 = a Y = a + b (x) $1,000 = a + $ 6.875 (100) $312.50 = High End Low End a The cost formula using the high-low method is: 7/21/2015 Total cost = $312.50 ($6.875 x Setup Asst. + Prof. Kalyaporn P. Burkehours) 35 The Scatterplot Method 7/21/2015 Asst. Prof. Kalyaporn P. Burke 36 The Scatterplot Method Nonlinear Relationship Activity Cost * * * * * 0 7/21/2015 Activity Output Asst. Prof. Kalyaporn P. Burke 37 The Scatterplot Method Upward Shift in Cost Relationship Activity Cost * * 0 * * * * Activity Output 7/21/2015 Asst. Prof. Kalyaporn P. Burke 38 The Scatterplot Method Presence of Outliers Activity Cost * * Estimated fixed cost 0 * * * Estimated regression line * Activity Output 7/21/2015 Asst. Prof. Kalyaporn P. Burke 39 4 7/21/2015 Describe the use of managerial judgment in determining cost behavior. Asst. Prof. Kalyaporn P. Burke 40 Managerial judgment is critically important in determining cost behavior, and it is by far the most widely used method in practice. 7/21/2015 Asst. Prof. Kalyaporn P. Burke 41 The End Asst. Prof. Kalyaporn P. Burke 42