CH 2 Cost Behavior

Fixed Cost Behavior

• Fixed costs remain constant regardless of the number of units sold.

• Example: A band is paid $48,000 regardless of ticket sales.

• Per-unit fixed cost decreases as more units are sold (e.g., $48,000 / 3,000 tickets = $16 per ticket).

• Graphically represented as a horizontal line.

Variable Cost Behavior

• Total variable cost increases in direct proportion to the number of units sold.

• Per-unit variable cost remains constant (e.g., $16 per ticket sold).

• Graphically represented as an upward-sloping line.

Mixed Costs

• Contain both fixed and variable components.

• Example: Janitorial services charge a $1,000 base fee plus $20 per hour.

• Total mixed cost = Fixed cost + (Variable cost per unit * Number of units).

Relevant Range

• Cost behavior assumptions are valid only within a certain range of activity.

• Outside the relevant range, fixed and variable costs may change.

Context-Sensitive Cost Definitions

• Costs may be fixed or variable depending on the context.

• Example: A band's fee is fixed per concert but variable across multiple concerts.

Operating Leverage

• Measures the extent to which fixed costs are used in a business.

• High operating leverage means more fixed costs relative to variable costs.

• When all costs are fixed, every additional sales dollar contributes fully to profit.

Effect of Operating Leverage on Profitability

• Higher fixed costs lead to higher profit sensitivity to changes in revenue.

• Example: 10% revenue increase can lead to a 90% profit increase.

• Formula: (Alternative measure - Base measure) / Base measure = % Change.

Risk and Reward Assessment

• Fixed costs create higher risk but higher potential profit.

• Variable costs reduce risk but limit profit potential.

• Example: A band receiving a fixed $48,000 has more risk than being paid $16 per ticket.

Profit Stability

• Company with highest fixed costs experiences greatest profit variability.

• Example: Company A (high fixed costs), Company B (mixed), Company C (low fixed costs).

• High fixed costs amplify both gains and losses.

Cost Structure & Profit Stability

• Cost structure affects income stability across different sales levels.

• Contribution margin approach helps assess profitability.

Magnitude of Operating Leverage

• Measures impact of sales changes on profitability.

• Formula: Contribution margin / Net income.

• Example: Bragg Company (7), Biltmore Company (4).

• Higher leverage means greater sensitivity to sales changes.

Cost Averaging

• Average cost per unit decreases as production increases.

• Example: Equipment rental ($80/day) reduces per-lesson cost as lessons increase.

• Managers should use caution when interpreting average costs.

High-Low Method

1. Gather sales and cost data.

2. Select high and low points.

3. Calculate variable cost per unit.

4. Determine total fixed cost.

• Example:

  • ($540,000 - $180,000) / (34,000 - 10,000) = $15 per unit

  • Fixed cost = Total cost - (Variable cost * Units) = $30,000.

Regression Method of Cost Estimation

• Uses all data points to estimate fixed and variable costs.

• Regression formula: Y = a + bX.

• R-squared (R2) measures accuracy of fit.

• Steps in Excel:

  1. Enter data in columns.

  2. Use Data Analysis tool.

  3. Select Regression.

  4. Define data range, click Line Fit Plot.

Multiple Regression

• Considers multiple independent variables.

• Increases accuracy of cost estimates.

Study Guide Questions

1. What is the difference between fixed, variable, and mixed costs?

2. How does per-unit fixed cost change as volume increases?

3. What is the relevant range, and why is it important?

4. How does operating leverage affect profitability?

5. What is the formula for calculating percentage change?

6. What are the benefits and risks of having high fixed costs?

7. How does the high-low method determine cost

Study Guide: Cost Behavior and Analysis

1. Fixed Cost Behavior

• Fixed costs remain constant regardless of activity level.

• Example: A band is paid $48,000 regardless of ticket sales.

• Per-unit fixed cost decreases as activity level increases.

• Graphically represented as a horizontal line.

2. Variable Cost Behavior

• Total variable costs increase proportionally with activity level.

• Example: The band receives $16 per ticket sold.

• Per-unit variable cost remains constant.

• Graphically represented as a straight, upward-sloping line.

3. Mixed Costs

• Combination of fixed and variable costs.

• Example: Janitorial service charges a $1,000 base fee + $20 per hour.

• Formula: Total Mixed Cost = Fixed Cost + (Variable Cost per Unit × Number of Units)

4. Relevant Range

• Cost behavior assumptions hold true only within a specified range of activity.

• Fixed costs may change outside this range.

5. Context-Sensitive Cost Definitions

• Costs may be classified differently depending on the activity level.

• Example: A band’s fixed payment for a concert is fixed for that event but variable across multiple concerts.

6. Operating Leverage

• Measures how much fixed costs are used in an organization.

• High operating leverage = greater profit potential but also higher risk.

• Formula: % Change in Profit = % Change in Sales × Operating Leverage Factor

7. Risk and Reward Assessment

• High fixed costs increase profit potential but also increase risk.

• Converting fixed costs into variable costs reduces risk but limits profit potential.

8. Profit Stability and Cost Structure

• Companies with high fixed costs have the highest increase/decrease in profit with sales changes.

• Example: Company A (high fixed cost) has the greatest fluctuations in income.

9. Contribution Margin Approach

• Contribution Margin = Sales Revenue - Variable Costs.

• Used to determine operating leverage and cost behavior impact.

10. Cost Averaging

• Average cost per unit decreases as more units are produced due to spreading fixed costs.

• Managers must be cautious as averages change with different activity levels.

11. High-Low Method

• Estimates fixed and variable costs using the highest and lowest activity points.

• Steps:

  1. Identify high and low points.

  2. Calculate variable cost per unit: (High Cost - Low Cost) / (High Activity - Low Activity).

  3. Calculate total fixed cost: Total Cost - (Variable Cost × Activity Level).

12. Regression Method

• Uses all data points to estimate cost behavior.

• Provides more accurate estimates than the high-low method.

• R-squared (R²) value indicates the reliability of the regression model.

13. Multiple Regression

• Analyzes multiple independent variables affecting cost behavior.

• Improves accuracy of cost predictions.

Flashcard Questions:

1. What is a fixed cost?

2. Give an example of a fixed cost.

3. What happens to per-unit fixed cost as activity increases?

4. What is a variable cost?

5. Does variable cost per unit change with activity level?

6. What is an example of a variable cost?

7. What is a mixed cost?

8. How do you calculate total mixed costs?

9. What is the relevant range?

10. Why is relevant range important for cost behavior?

11. What is operating leverage?

12. How does high operating leverage affect profitability?

13. What is the formula for percentage change in profit?

14. How can companies reduce financial risk?

15. What happens when a company shifts fixed costs to variable costs?

16. Which type of company experiences the largest profit fluctuations?

17. What is contribution margin?

18. How do you calculate contribution margin?

19. What is cost averaging?

20. How does cost averaging affect decision-making?

21. What is the high-low method used for?

22. List the steps of the high-low method.

23. How do you calculate variable cost per unit using the high-low method?

24. How do you determine fixed cost using the high-low method?

25. What is regression analysis?

26. Why is regression analysis more accurate than the high-low method?

27. What does the R-squared (R²) value indicate in regression analysis?

28. What is multiple regression analysis?

29. How does multiple regression improve cost predictions?