ACC406 Chapter 3 Publisher Notes

Chapter 3: Cost Behaviour

Learning Objectives

• Understand cost behaviour: Define both fixed and variable costs, and comprehend how they interact with activity levels in an organization.

• Mixed Costs: Define and describe mixed costs and step costs, emphasizing their components and importance in cost analysis.

• Cost Separation: Learn methods to effectively separate mixed costs into fixed and variable components using:

  • High–low method: A straightforward method using two extreme activity levels to determine variable and fixed costs.

  • Scattergraph method: A visual approach that plots cost data points to assess relationships and delineate fixed and variable components.

  • Method of least squares (Appendix 3A): An advanced statistical method that determines the best-fitting line for a set of data points, minimizing the sum of the squares of the vertical distance of each point from the line.

• Spreadsheet Use: Familiarize with utilizing spreadsheet programs for implementing the least squares method to enhance cost analysis.

CPA Competencies

Competencies Included in this Chapter

• 3.1.1: Evaluates management information requirements to determine accurate and timely decision-making.

• 3.1.2: Documents and assesses business processes, recommending improvements for efficiency and effectiveness.

• 3.1.4: Identifies ethical and privacy issues related to IT systems affecting cost data and management.

• 3.3.1: Evaluates cost classifications and costing methods for management, ensuring the accuracy of financial reporting.

• 3.5.1: Performs sensitivity analysis to ascertain how changes in key variables impact costs and financial outcomes.

Cost Behaviour Basics

Definition

Cost behaviour refers to how a cost reacts to changes in the level of activity, essential for accurate financial forecasting and budgeting.

Types of Costs:

• Variable Costs: Costs that change directly with the volume of production or service provided. These are usually incurred on a per-unit basis.

• Fixed Costs: Costs that remain constant regardless of changes in the level of activity or output.

• Mixed Costs: Costs that contain both variable and fixed elements, complicating their analysis but essential for the complete picture of operation costs.

Importance

Understanding costs is crucial for effective planning, control, and decision-making, influencing pricing, budgeting, and profitability analysis.

Cost Drivers

Definition

A cost driver is defined as a factor that causes costs to change, such as changes in production level or customer demand.

Significance

Identifying and managing cost drivers helps predict and control costs more effectively, leading to enhanced financial performance.

Fixed Costs

Definition and Behavior

Fixed Cost Characteristics:

• Total Fixed Costs: Remain unchanged regardless of variations in activity levels or output.

• Unit Fixed Cost: This decreases as output increases, reflecting the spreading of fixed overhead costs over more units.

Fixed Cost Example

For Custom Bicycles: The supervisory cost of $32,000 remains constant over various production levels, illustrating a classic fixed cost.

Types of Fixed Costs:

• Discretionary Fixed Costs: Such as advertising costs, which can be adjusted based on management’s strategy.

• Committed Fixed Costs: These include long-term contracts, such as leases, which cannot be altered easily.

Variable Costs

Definition and Behavior

Variable Costs are costs that vary directly with output, represented linearly in cost accounting.

Example for Custom Bicycles:

Each bike requires a gear assembly that costs $20, indicating direct variable costs that scale with production.

Mixed and Step Costs

Mixed Costs

Definition:

These are costs that include both fixed and variable components, complicating their treatment in accounting.

Cost Formula:

• Total Cost = Total Fixed Cost + Total Variable Cost

Example:

For Custom Bicycles, sales representatives earn a base salary (fixed) plus commissions (variable), reflecting a mixed cost structure.

Step Costs

Definition:

Step costs are fixed over a certain range of activity but increase in steps to a new fixed cost level at certain output thresholds.

Relevant Range

Definition:

The range of output over which cost relationships are considered valid, ensuring assumptions of cost behaviors hold true.

Implication:

Cost behaviour assumptions only apply within this defined range, important for accurate budgeting and performance predictions.

Methods for Separating Mixed Costs

High-Low Method

Steps:

1. Identify high and low activity levels within the data set.

2. Calculate the variable cost per unit based on these activity levels.

3. Determine the fixed costs using the derived variable costs and total costs.

Scattergraph Method

Procedure:

Graph cost data points to visualize relationships, then fit a line to determine the split between fixed and variable costs.

Method of Least Squares

Description:

This statistical method finds the best-fitting line through a set of data points to explain cost behaviour mathematically.

Steps:

1. Measure distance from each point to the regression line.

2. Identify the line that minimizes the squared deviations of these distances.

Conclusion on Cost Analysis

Managerial Judgement:

Managers typically blend statistical results with professional judgment to form forecasts and strategies concerning costs.

Goodness of Fit:

Determined by the R² value, which indicates the model's reliability in predicting cost behavior, with values closer to 1 suggesting a strong relationship.