Cost Classification based on

Cost behavior
Objectives
• To understand Variable, fixed and mixed cost and relevant range
concept
• To Determine the components of mixed costs through various
methods
Cost Behavior Analysis is the study of how specific costs respond to changes in
the level of business activity:

 Some costs change; others remain the same.

 Helps management plan operations and decide between alternative courses of

action.

 Applies to all types of businesses and entities.

 Starting point is measuring key business activities.

Cost Behavior Analysis

Cost Behavior Analysis is the study of how specific costs respond to changes in
the level of business activity.

 Activity levels may be expressed in terms of:

► Sales dollars (in a retail company)
► Production units ( in a manufacturing company)
► Miles driven (in a trucking company)
► Room occupancy (in a hotel)
► Dance classes taught (by a dance studio)

LO 1
Cost Behavior Analysis

Cost Behavior Analysis is the study of how specific costs respond to changes
in the level of business activity.

 Changes in the level or volume of activity should be correlated with

changes in costs.

 Activity level selected is called activity or volume index.

 Activity index:
► Identifies the activity that causes changes in the behavior of costs.

► Allows costs to be classified as variable, fixed, or mixed.

LO 1
Cost Terminology- Introduction
• Variable Costs
• Change in proportion to changes in volume or activity
Cost Terminology
• Fixed Costs
• Do not change in response to changes in volume or activity
Variable Cost
Your total texting bill is based on how
many texts you send.

Total Texting Bill

Number of Texts Sent

Variable Cost Per Unit
The cost per text sent is constant at
5 cents per text message.

Cost Per Text Sent

Number of Texts Sent
Fixed Cost
Your monthly contract fee for your cell phone is
fixed for the number of monthly minutes in your
contract. The monthly contract fee does not
change based on the number of calls you make.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
Fixed Cost Per Unit
Within the monthly contract allotment, the average fixed
cost per cell phone call made decreases as more
calls are made.

Monthly Cell Phone

Contract Fee
Number of Minutes Used
Within Monthly Plan
Which of the following is most likely to be a variable
cost?
a. Depreciation
b. Cost of materials
c. Rent
d. Advertising

Answer:
b. Cost of materials
Which of the following is most likely to be a fixed cost?
a. Cost of materials
b. Rent
c. Assembly labor cost
d. Commissions

Answer:
b. Rent
Relevant Range

 Throughout the range of possible levels of activity, a

straight-line relationship usually does not exist for either
variable costs or fixed costs.

 Relationship between variable costs and changes in

activity level is often curvilinear.

 For fixed costs, the

relationship is also nonlinear –
some fixed costs will not change
over the entire range of activities,
while other fixed costs may
change.

LO 1
Relevant Range

Illustration 19-3
Nonlinear behavior of
variable and fixed costs

LO 1
Relevant Range

Range of activity over which a company expects to

operate during a year. Illustration 19-4
Linear behavior within
relevant range

LO 1
Relevant Range

Question
The relevant range is:
a. The range of activity in which variable costs will be
curvilinear.
b. The range of activity in which fixed costs will be
curvilinear.
c. The range over which the company expects to operate
during a year.
d. Usually from zero to 100% of operating capacity.

LO 1
 Semi-Variable (mixed) Costs
All costs which are neither perfectly variable nor
absolutely fixed in relation to volume changes
are called semi-variable (mixed) costs.
They consist of both fixed costs
and variable costs.

Figure 7: Semi-Variable Cost

Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX

Where: Y = The total mixed cost.

a = The total fixed cost (the
Y vertical intercept of the line).
b = The variable cost per unit of
Total Utility Cost

activity (the slope of the line).

X = The level of activity.

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
Helena Company, reports the following total costs at two levels of production.

Classify each cost as variable, fixed, or mixed.

Variable
Fixed
Mixed
Methods of Segregating of
Mixed Costs

Graphic Method High-low Method

Analytical Method of Least

Method Squares
Example 1
The following is an extract of the cost data of Royal Industries Ltd month-wise for
the previous year:

Month Production Repairs and Month Production Repairs and

(units) maintenance (units) maintenance
costs costs

January 200 Rs 1,800 July 350 Rs 3,000

February 200 1,900 August 350 2,950
March 250 2,300 September 400 3,350
April 250 2,250 October 400 3,300
May 300 2,650 November 450 3,750
June 300 2,750 December 450 3,650
 Graphic Method
The graphic method of dividing mixed costs into their fixed and variable
components makes use of all relevant past data pertaining to cost-volume
relationships. The data are plotted on a scatter graph,
as shown in the following figure, on the basis of Example 1.

Figure : Volume of Production (in Units)

 Analytical Method

This method is also called the “degree of variability” technique because the genesis
of this method lies in measuring the extent of variability of costs with volume. In
other words, the technique is based on a careful analysis of each item to determine
how far the cost varies with volume. Some of the mixed cost may have a 40 per cent
degree of variability while others may have only 20 per cent.
Example 2
The analysis of factory overheads of Hypothetical Ltd reveals that on an average there is a 40 per cent
degree of variability at 100 per cent level of activity. Budgeted mixed overheads are Rs 10,000. What would
they be at 50, 70 and 90 per cent levels of activity?
Solution
Variable overheads = (Budgeted mixed overheads × Degree of variability) = Rs 10,000 × 0.40 = Rs 4,000
Fixed overheads at 100 per cent capacity = (Rs 10,000 – Rs 4,000) = Rs 6,000
Variable overheads at 1 per cent capacity = Total variable overheads ÷ 100 = Rs 4,000 ÷ 100 = Rs 40

Flexible Budget (Overheads Costs)

Level of capacity (per cent

50 70 90

Fixed overheads Rs 6,000 Rs 6,000 Rs 6,000

Variable overheads (level of capacity×Rs 40) 2,000 2,800 3,600

Total 8,000 8,800 9,600

 Method of Least Squares
Y = a + bX

Where Y = Total cost

a = Fixed element of mixed cost
b = Variable cost to volume ratio
X = Any measure of volume (production,hours, and so on).

From the above Equation the two simultaneous linear equations:

∑ Y = na + b ∑ X (1)
∑ XY = a ∑ X + b ∑ X2 (2)
Example 3
ABC Ltd furnishes the following overhead cost behaviour of mixed cost for the first 6 months of the current year. You are
required to segregate these costs into fixed and variable.
Month Units produced Cost
(X) (y) XY X2
January 20 Rs 900 Rs 18,000 Rs 400
February 10 700 7,000 100
March 30 1,100 33,000 900
April 20 900 18,000 400
May 00 500 00 00
June 30 1,300 39,000 900
110 5,400 1,15,000 2,700

Substituting the values in Equations

5,400 = 6a + 110b (1)
1,15,000 = 110a + 2,700b (2)
Multiplying Equation 1 by 110 and 2 by 6, we have
5,94,000 = 660a + 12,100b
6,90,000 = 660a + 16,200b
Subtracting Equation 1 from Equation 2,
96,000 = 4,100b
b = 23.41
Substituting b in Equation 1 we have 6a = 2,824.39 or a = 470.73.
Thus, the least squares equation is Y = 470.73 + 23.41 X
The equation indicates that fixed costs are Rs 470.73, when volume X is zero and for each
unit of production beyond zero costs will increase
by Rs 23.41 (variable costs). The results of this equation can be
used to estimate total costs for any volume within the
relevant range. Figure 10 exhibits this relationship.

Figure 10: Total Cost at Various Levels of Production

High-Low Method

 High-Low Method uses the total costs incurred at the high and the low levels
of activity to classify mixed costs into fixed and variable components.

 The difference in costs between the high and low levels represents variable
costs, since only variable-cost element can change as activity levels change.
High-Low Method

STEP 1: Determine variable cost per unit using the following

formula:
High-Low Method

Illustration: Metro Transit Company has the

following maintenance costs and mileage data for
its fleet of buses over a 6-month period.

Change in Costs ($63,000 - $30,000) $33,000

= $1.10
High minus Low (50,000 - 20,000) 30,000 cost per
unit
High-Low Method

STEP 2: Determine the fixed cost by subtracting

the total variable cost at either the high or the low Illustration 19-8
High-low method
activity level from the total cost at that activity level. computation of
fixed costs

LO 2
High-Low Method

Maintenance costs are therefore $8,000 per month of fixed

costs plus $1.10 per mile of variable costs. This is
represented by the following formula:

Maintenance costs = $8,000 + ($1.10 x Miles driven)

Example: At 45,000 miles, estimated maintenance costs would

be:
Fixed $ 8,000
Variable ($1.10 x 45,000) 49,500
$57,500
High-Low Method

Question
Mixed costs consist of a:

a. Variable cost element and a fixed cost element.

b. Fixed cost element and a controllable cost element.

c. Relevant cost element and a controllable cost

element.

d. Variable cost element and a relevant cost element.

LO 2
Byrnes Company accumulates the following data concerning a mixed cost, using
units produced as the activity level.

(a) Compute the variable- and fixed-cost elements using the high-low
method.
(b) Estimate the total cost if the company produces 8,000 units.
 (a) Compute the variable and fixed cost elements using the high-low
method.

Variable cost: ($14,740 - $11,100) / (9,800 - 7,000) = $1.30 per unit

Fixed cost: $14,740 - $12,740 ($1.30 x 9,800 units) = $2,000
or $11,100 - $9,100 ($1.30 x 7,000) = $2,000
 (b) Estimate the total cost if the company produces 8,000 units.

Total cost (8,000 units): $2,000 + $10,400 ($1.30 x 8,000) = $12,400

Q.1. A company furnishes the following schedule of
costs incurred during two successive months.

Particulars January February

Production (units) 12,000 13,500
Inspection 60,000 70,000
Factory rent 25,000 25,000
Maintenance Exp 78,000 84,000
Power and fuel 84,000 94,500

Classify these costs under (i) variable cost (ii) fixed cost,
(iii) semi-variable cost, iv) step cost