Chapter 5

Lecture Notes

Chapter theme: Managers who understand how costs

behave are better able to predict costs and make decisions
under various circumstances. This chapter explores the
1 meaning of fixed, variable and mixed costs (the relative
proportions of which define an organization’s cost
structure). It also introduces a new income statement
called the contribution approach.

I. Types of cost behavior patterns

“In Business Insights”

“Cost Structure: A Management Choice” (see page
198)

“In Business Insights”

“Selling Online” (see page 199)

Learning Objective 1: Understand how fixed and

2
variable costs behave and how to use them to predict
costs.

A. Variable costs

i. A variable cost is a cost whose total dollar amount

3
varies in direct proportion to changes in the
activity level.

1. An activity base (also called a cost driver)

is a measure of what causes the incurrence
4 of variable costs. As the level of the activity
base increases, the variable cost increases
proportionally.

157
 a. Units produced (or sold) is not the
only activity base within companies.
4 A cost can be considered variable if it
varies with activity bases such as
miles driven, machine hours, or labor
hours.

2. As an example of an activity base, consider

your total long distance telephone bill. The
5 activity base is the number of minutes that
you talk.

ii. Variable costs remain constant if expressed on a

6 per unit basis.

1. Referring to the telephone example, the cost

7 per minute talked is constant (e.g., 10 cents
per minute)

iii. Extent of variable costs

1. The proportion of variable costs differs

across organizations. For example:
a. A public utility like Florida Power
and Light, with large investments in
equipment, will tend to have fewer
variable costs.
8 b. A manufacturing company like
Black and Decker will often have
many variable costs associated with
the manufacture and distribution of
its products to customers.
c. A merchandising company like
Wal-Mart will usually have a high
proportion of variable costs such as

158
 the cost of merchandise purchased for
resale.
d. Some service companies, such as
restaurants, have a high proportion of
variable costs due to their raw
8 material costs. Other service
companies, such as an architectural
firm, have a high proportion of fixed
costs in the form of highly trained
salaried employees.

iv. Common examples of variable costs

1. Merchandising companies  cost of goods

sold
2. Manufacturing companies  direct materials,
9 direct labor, and variable overhead.
3. Merchandising and manufacturing
companies  commissions, shipping costs,
and clerical costs such as invoicing.
4. Service companies  supplies, travel, and
clerical.

Helpful Hint: Students tend to assume that a certain

type of cost is always variable or fixed. They should
examine the facts of each situation before deciding
whether a cost is fixed or variable. For example, a
company’s employment policy may determine whether
direct labor costs are fixed or variable with respect to
volume of output.

159
 B. True variable versus step-variable costs

i. True variable costs  the amount used during the

period varies in direct proportion to the activity
level.

1. The long distance phone bill was one

10
example of a true variable cost.
2. Direct material is another example of a cost
that behaves in a true variable pattern.
a. Direct materials purchased but not
used can be stored and carried
forward to the next period as
inventory.

ii. Step-variable costs  A resource that is obtainable

only in large chunks and whose costs change only
in response to fairly wide changes in activity.
11
1. For example, maintenance workers are often
considered to be a variable cost, but this
labor cost does not behave as a true variable
cost.
a. Small changes in the level of
12 production are not likely to have any
effect on the number of maintenance
workers employed.
b. Only fairly wide changes in the
activity level will cause a change in
the number of maintenance workers
13 employed.
i. Maintenance workers are
obtainable only in large chunks
of a whole person who is capable

160
 of working approximately 2,000
13 hours a year.

“In Business Insights”

“Coping with the Fallout from September 11” (see
page 202)

C. The linearity assumption and the relevant range

i. Economists correctly point out that many costs that

accountants classify as variable costs actually
behave in a curvilinear fashion.

14 ii. Nonetheless, within a narrow band of activity

known as the relevant range, a curvilinear cost can
be satisfactorily approximated by a straight line.

1. The relevant range is that range of activity

within which the assumptions made about
cost behavior are valid.

Helpful Hint: Slide 13 can be tied in with economics

courses students have taken. Ask what happens to
average costs when the cost curve bends downward
and what economists call this part of the curve.
Average costs are falling and this is roughly equivalent
to what economists call “increasing returns to scale.”
You can repeat the same question for the part of the
curve that bends upward.

D. Fixed costs

i. A fixed cost is a cost whose total dollar amount

15 remains constant as the activity level changes.

161
 1. For example, your monthly basic telephone
16 bill is probably fixed and does not change
when you make more local calls.

ii. Average fixed costs per unit decrease as the

17 activity level increases.

1. For example, the fixed cost per local call

18 decreases as more local calls are made.

“In Business Insights”

“Costing the Trek” (see page 203)

E. Types of fixed costs

i. Committed fixed costs

1. These costs are long-term in nature (i.e.,

greater than one year).
2. These costs cannot be significantly
reduced even for short periods of time
without seriously impairing the profitability
or long-run goals of the organization.
a. Examples of committed-fixed costs
include depreciation on buildings and
19 equipment, and real estate taxes.

“In Business Insights”

“Sharing Office Space” (see page 204)

ii. Discretionary fixed costs

1. These costs usually arise from annual

decisions by management to spend in
certain fixed cost areas.

162
 2. These costs can be cut for short periods of
time with minimal damage to the long-run
goals of the organization.
a. Examples of discretionary fixed costs
include advertising and research and
development.
3. A cost may be discretionary or committed
19
depending on management’s strategy.
a. For example, some construction
companies may layoff workers
during months with minimal
customer demand. However, other
construction companies may opt to
retain their workers all year.

“In Business Insights”

“A Twist on Fixed and Variable Costs” (see page 205)

iii. The trend toward fixed costs

1. The trend in many industries is toward

greater fixed costs relative to variable
costs. For example:
a. H&R Block employees used to fill
out tax returns for customers by
hand. Now, computer software is
used to complete tax returns.
20 b. Safeway and Kroger employees
used to key-in prices by hand on cash
registers. Now, barcode readers enter
price and other product information
automatically.
c. As machines take over many
mundane tasks previously performed
by humans, “knowledge workers”

163
 are demanded for their minds rather
than their muscles.
i. Knowledge workers tend to be
salaried, highly-trained and
20 difficult to replace; consequently,
the cost of compensating these
valued employees is relatively
fixed rather than variable.

iv. Is labor a variable or a fixed cost?

1. The behavior of wage and salary costs can

differ across countries, depending on labor
regulations, labor contracts, and custom.
For example:
a. In France, Germany, China, and
Japan management has little
21 flexibility in adjusting the size of the
labor force; hence, labor costs are
more fixed in nature.
2. Within countries managers can view labor
costs differently depending on their
strategy. Nonetheless, most companies in
the United States continue to view direct
labor as a variable cost.

“In Business Insights”

“The Regulatory Burden” (see page 206)

“In Business Insights”

“Labor at Southwest Airlines” (see page 207)

164
 F. Fixed costs and the relevant range

i. The relevant range of activity for a fixed cost is the

22 range of activity over which the graph of the cost is
flat.

1. For example, assume office space is

available at a rental rate of $30,000 per year
in increments of 1,000 square feet.
23 2. Fixed costs would increase in a step fashion
at a rate of $30,000 for each additional 1,000
square feet.

ii. While this step-function pattern appears similar to

the idea of step-variable costs, there are two
important differences between step-variable costs
and fixed costs.

1. Step-variable costs can often be adjusted

quickly as conditions change, whereas fixed
costs cannot be changed easily.
2. The width of the steps for fixed costs is
24 wider than the width of the steps for step-
variable costs.
a. For example, a step-variable cost
such as maintenance workers may
have steps with a width of 40 hours a
week.
b. However, fixed costs may have steps
that have a width of thousands or tens
of thousands of hours of activity.

Helpful Hint: Discuss with students that over a given

level of production, certain costs, such as custodial
salaries, would remain fixed. However, if activity

165
23
 increases to the point where a second shift is needed,
custodial salaries would need to increase since activity
is outside the relevant range.

25-26 Quick Check – cost behavior patterns

G. Mixed costs (also called semivariable costs)

i. A mixed cost contains both variable and fixed cost

elements.

1. For example, utility bills often contain fixed

and variable cost components.
27 a. The fixed portion of the utility bill is
constant regardless of kilowatt hours
consumed. This cost represents the
minimum cost that is incurred to have
the service ready and available for
use.
b. The variable portion of the bill varies
in direct proportion to the
consumption of kilowatt hours.

ii. An equation can be used to express the relationship

between mixed costs and the level of the activity.
This equation can be used to calculate what the
total mixed cost would be for any level of activity.

28 1. The equation is Y = a + bX
a. Y = The total mixed cost.
b. a = The total fixed cost (the vertical
intercept of the line).
c. b = The variable cost per unit of
activity (the slope of the line).
d. X = The level of activity.

166
 iii. For example, if your fixed monthly utility charge is
$40, your variable cost is .03 per kilowatt hour, and
29 your monthly activity level was 2,000 kilowatt
hours, this equation can be used to calculate your
total utility cost of $100.

II. The analysis of mixed costs

A. Account analysis and the engineering approach

i. In account analysis, each account under

consideration is classified as variable or fixed based
on the analyst’s prior knowledge about how costs
behave.

1. This approach is limited in value in the

sense that it glosses over the fact that some
accounts may have both fixed and variable
30 components.

ii. The engineering approach classifies costs based

on an industrial engineer’s evaluation of production
methods, material specifications, labor
requirements, equipment usage, power
consumption, as so on.

1. This approach is particularly useful when no

past experience is available concerning
activity and costs.

“In Business Insights”

“Operations Drive Costs” (see page 211)

167
 Learning Objective 2: Use a scattergraph plot to
31 diagnose cost behavior.

B. The scattergraph plot (also called the quick-and-dirty

method)

i. The first step when using this method to analyze a

mixed cost is to plot the data on a scattergraph.

1. The cost, which is known as the dependent

variable, is plotted on the Y axis.
2. The activity, which is known as the
independent variable, is plotted on the X
32 axis.

ii. The second step is to examine the dots on the

scattergraph to see if they are linear, such that a
straight line can be drawn that approximates the
relation between cost and activity.

1. If the dots are not linear, do not analyze the

data any further. Instead, search for another
independent variable that bears a stronger
linear relationship with the dependent
variable.

iii. The third step is to draw a straight line where,

roughly speaking, an equal number of points reside
above and below the line. Make sure that the
33
straight line goes through at least one data point on
the scattergraph.

168
 iv. The fourth step is to identify the Y intercept.

1. This intercept represents the estimated fixed

cost portion of the mixed cost ($10,000 in
this example).

34 v. The fifth step is to estimate the variable cost per

unit of the activity.

1. Select one point on the scattergraph that

intersects the straight line.
2. Determine the total cost and the total
activity level at the chosen point.
3. Subtract the fixed costs from the total costs
to arrive at the total variable costs for the
chosen activity level.
4. Divide the total variable costs by the activity
35 level at the chosen point. This is the variable
cost per unit of activity.
5. Construct an equation that can be used to
estimate total costs at any activity level.

Learning Objective 3: Analyze a mixed cost using the

36
high-low method.

C. The high-low method

i. This method can be used to analyze mixed costs if

a scattergraph plot reveals a linear relationship
37 between the X and Y variables. For illustrative
purposes, assume the following information.

ii. The first step is to choose the data points

38 pertaining to the highest and lowest activity levels
(high = 800 units; low = 500 units).

169
 1. Notice, this method relies on two data
points to estimate the fixed and variable
portions of a mixed cost, as opposed to one
data point with the scattergraph method.

iii. The second step is to determine the total costs

associated with the two chosen points (high =
$9,800; low = $7,400).

Helpful Hint: Emphasize that the high and low points

38 are identified by the level of activity and not by the
level of the cost.

iv. The third step is to calculate the change in cost

between the two data points ($2,400) and divide it
by the change in activity level between the two data
points (300 units).

1. The quotient represents an estimate of

variable cost per unit of activity ($8.00 per
unit).

v. The fourth step is to take the total cost at either

activity level (in this case, $9,800) and deduct the
variable cost component ($6,400). The residual
represents the estimate of total fixed costs ($3,400).
39 1. The variable cost component ($6,400) is
determined by multiplying the level of
activity (800 units) by the estimated
variable cost per unit of the activity ($8.00
per unit).

170
 vi. The fifth step is to construct an equation that can
40 be used to estimate the total cost at any activity
level (Y = $3,400 + $8.00X).

41-44 Quick Check – the high-low method

D. The least-squares regression method

i. This method can be used to analyze mixed costs if

a scattergraph plot reveals an approximately linear
relationship between the X and Y variables.

ii. This method uses all of the data points to estimate

the fixed and variable cost components of a mixed
cost. This method is superior to the scattergraph
45 plot method that relies on only one data point and
the high-low method that uses only two data
points to estimate the fixed and variable cost
components of a mixed cost.

iii. The basic goal of this method is to fit a straight line

to the data that minimizes the sum of the squared
errors. The regression errors are the vertical
deviations from the data points to the regression
line.

iv. The formulas that are used for least-squares

regression are complex. Fortunately, computers
can perform the calculations quickly. The observed
values of the X and Y variables are entered into the
46
computer and the software does the rest.

1. The output from the regression analysis can

be used to create an equation that enables

171
 you to estimate total costs at any activity
46 level.

E. Comparing results from the three methods

i. The three methods just discussed provide slightly

different estimates of the fixed and variable cost
components of the mixed cost. This is to be
47 expected because each method uses differing
amounts of the data points to provide estimates.
Least-squares regression provides the most accurate
estimates because it uses all of the data points.

III. The contribution format income statement

Learning Objective 4: Prepare an income statement

48 using the contribution format.

A. The contribution approach provides an income

49 statement format geared directly to cost behavior,
which has been the focus of discussion in this chapter.

i. This approach separates costs into fixed and

variable categories. Sales  variable costs =
50 contribution margin. The contribution margin 
fixed costs = net operating income.

ii. This approach is used as an internal planning and

decision making tool. For example, this approach
is useful for:
51 1. Cost-volume-profit analysis (chapter 6).
2. Budgeting (chapter 7).
3. Special decisions such as pricing and make
or buy analysis (chapter 11).

172
 iii. The contribution approach differs from the
traditional approach illustrated in chapter 1.

1. The traditional approach organizes costs in a

52 functional format. Costs relating to
production, administration, and sales are
grouped together without regard to their cost
behavior.
2. The traditional approach is used primarily
for external reporting purposes.

Helpful Hint: The income statement from the annual

report of a well-known local manufacturing firm can be
used to illustrate the functional income statement. Ask
if the various expense categories on the income
statement contain both fixed and variable costs. Also
ask how to estimate the increase in profit that would
result from a 4% increase in sales using the functional
statement. There is no way to do this with reasonable
accuracy, since there is no way to tell on a functional
income statement what costs would increase.

Learning Objective 5: Use variable costing to prepare

53 a contribution format income statement and contrast
absorption costing and variable costing.

IV. Appendix 5A: variable costing (Slide #54 is a title slide)

A. Absorption costing

55 i. This approach treats all manufacturing costs as

product costs, regardless of whether they are
variable or fixed.

173
 “In Business Insights”
“The Perverse Effects of Absorption Costing at
Nissan” (see page 226)

ii. The cost of a unit of product consists of direct

materials, direct labor, and both variable and
fixed overhead.

iii. Variable and fixed selling and administrative

expenses are treated as period costs and are
deducted from revenue as incurred.

“In Business Insights”

“The House of Cards at Gillette” (see page 229)

B. Variable costing

i. This approach treats only those costs of production

that vary with output as product costs.
55
ii. The cost of a unit of product consists of direct
materials, direct labor, and variable overhead.

Helpful Hint: For simplicity, nearly all examples,

exhibits, problems, and exercises in this chapter treat
direct labor as a variable cost. However, students
should be reminded that labor is essentially a fixed cost
in some companies. Under variable costing, direct
labor would not be included in product costs when it is
a fixed cost.

iii. Fixed manufacturing overhead, and both variable

and fixed selling and administrative expenses are
treated as period costs and deducted from revenue
as incurred.

174
 Helpful Hint: Emphasize that the only difference between
variable and absorption costing is in how the two methods
treat fixed manufacturing overhead costs. Also, emphasize
that under both methods, selling and administrative costs
are period costs and are not product costs.

56-57 Quick Check – absorption vs. variable costing

C. Unit cost computations

i. Assume Harvey Company produces a single

58 product with available information as shown.

ii. The unit product costs under absorption and

variable costing would be $16 and $10,
respectively.

1. Under absorption costing, all production

59
costs, variable and fixed, are included when
determining unit product cost.
2. Under variable costing, only the variable
production costs are included in product
costs.

Helpful Hint: Before beginning the forthcoming income

comparisons, remind students of the relationship
between ending inventory and net operating income.
Higher ending inventory results in higher net operating
income since costs of goods available for sale less
ending inventory equals cost of goods sold. Therefore,
a higher ending inventory results in a lower expense
(cost of goods sold) deducted to arrive at net operating
income.

175
 D. Income comparison of absorption and variable
costing

i. The Harvey Company example continued

(additional assumptions):

60 1. 20,000 units were sold during the year.

2. The selling price per unit is $30.
3. There is no beginning inventory.

ii. Absorption costing

1. The unit product cost is $16.

61 2. The fixed manufacturing overhead cost
deferred in inventory is $30,000 (5,000
units × $6 per unit).
3. The net operating income is $120,000.

Helpful Hint: Explain that under absorption costing,

the recognition of fixed costs as an expense is really a
timing issue. When the items are sold, the fixed costs
will be reflected on the income statement as part of cost
of goods sold.

iii. Variable costing.

1. The unit product cost is $10.

62 2. All $150,000 of fixed manufacturing cost is
expensed in the current period.
3. The net operating income is $90,000.

iv. Comparing the two methods.

63
1. Under absorption costing, $120,000 of fixed
manufacturing overhead is included in cost

176
 of goods sold and $30,000 is deferred in
ending inventory as an asset on the balance
sheet.
2. Under variable costing, the entire $150,000
of fixed manufacturing overhead is treated
63 as a period expense.
a. The variable costing ending
inventory is $30,000 less than
absorption costing, thus explaining
the difference in net operating
income between the two methods.
3. The difference in net operating income
between the two methods ($30,000) can also
be reconciled by multiplying the number of
64 units in ending inventory (5,000 units) by
the fixed manufacturing overhead per unit
($6) that is deferred in ending inventory
under absorption costing.

E. Extended comparisons of income data

i. The Harvey Company example continued

(additional assumptions/facts):

1. 30,000 units were sold in year 2.

65 2. The selling price per unit, variable costs per
unit, total fixed costs, and number of units
produced remain unchanged.
3. 5,000 units are in beginning inventory.

177
 ii. Unit cost computations

1. Since the variable costs per unit, total fixed

66 costs, and the number of units produced
remained unchanged, the unit cost
computations also remain unchanged.

iii. Absorption costing

1. The unit product cost is $16.

67 2. The fixed manufacturing overhead cost
released from inventory is $30,000.
3. The net operating income is $230,000.

iv. Variable costing

1. The unit product cost is $10.

2. All $150,000 of fixed manufacturing
68
overhead cost is expensed in the current
period.
3. The net operating income is $260,000.

v. Comparing the two methods

1. The difference in net operating income

between the two methods ($30,000) can be
reconciled by multiplying the number of
69 units in beginning inventory (5,000 units)
by the fixed manufacturing overhead per
unit ($6) that is released from beginning
inventory under absorption costing.
2. Across the two year time frame, both
methods reported the same total net
70
operating income ($350,000). This is
because over an extended period of time

178
 sales cannot exceed production, nor can
production much exceed sales. The shorter
70 the time period, the more the net operating
income figures will tend to differ.

F. Summary of key insights

i. When production is greater than sales, as in year

1 for Harvey, absorption income is greater than
variable costing income.

ii. When production is less than sales, as in year 2

71
for Harvey, absorption costing income is less
than variable costing income.

iii. When production equals sales, the two methods

report the same net operating income.

179
180
TM 5-1

AGENDA: COST BEHAVIOR

1. Variable cost behavior.

2. Types of fixed costs: committed and discretionary.
3. Behavior of fixed costs in total and on a unit basis.
4. Mixed costs (combination of fixed and variable).
5. Scattergraph plot of a mixed cost.
6. High-low method of mixed cost analysis.
7. Least-squares regression method of mixed cost analysis.
8. Contribution format income statement.
9. (Appendix 5A) Variable costing and absorption costing

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-2

VARIABLE COST BEHAVIOR

Many costs can be described as variable, fixed, or mixed.

A variable cost changes in total in proportion to changes in activity; a
variable cost is constant on a per-unit basis.

EXAMPLE: Each bicycle requires one bicycle chain costing $8.

Total Cost of Bicycle Chains

$800 • $8 per
bicycle
chain

0
0 100
Number of Bicycles Produced

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-3

EXAMPLES OF COSTS THAT ARE NORMALLY VARIABLE WITH

RESPECT TO OUTPUT VOLUME

Merchandising company
Costs of goods (merchandise) sold
Manufacturing company
Manufacturing costs:
Prime costs:
Direct materials
Direct labor*
Variable portion of manufacturing overhead:
Indirect materials
Lubricants
Supplies
Power
Both merchandising and manufacturing companies
Selling and administrative costs:
Commissions
Clerical costs, such as invoicing
Shipping costs
Service organizations
Supplies, travel, clerical
*Whether direct labor is fixed or variable will depend on the labor laws of
the country, custom, and the company’s employment contracts and
policies.

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-4

FIXED COST BEHAVIOR

A fixed cost remains constant in total amount throughout wide ranges of
activity.
EXAMPLE: Fashion photographer Lori Yang rents studio spaces in a
prestige location for $50,000 a year. She measures her firm’s activity in
terms of the number of photo sessions.

Cost

Cost of
Studio
Rental

$50,000

500 1,000
Number of Photo Sessions

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

 TM 5-5

FIXED COST BEHAVIOR (cont’d)

A fixed cost varies inversely with activity if expressed on a per unit
basis.

$200
Average Cost Per Photo Session

$160
for Studio Rental

$120

$80

$40

$0
0 500 1,000
Number of Photo Sessions

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-6

TYPES OF FIXED COSTS

• Committed fixed costs relate to investment in plant, equipment, and
basic administrative structure. It is difficult to reduce these fixed costs in
the short-term. Examples include:
• Depreciation of plant facilities.
• Taxes on real estate.
• Salaries of key operating personnel.
• Discretionary fixed costs arise from annual decisions by management to
spend in certain areas. These costs can often be reduced in the short-
term. Examples include:
• Advertising.
• Research.
• Public relations.
• Management development programs.

TREND TOWARD FIXED COSTS

The trend is toward greater fixed costs relative to variable costs. The
reasons for this trend are:
• Increase in automation of business processes.
• Shift from laborers paid by the hour to salaried knowledge workers.

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-7

MIXED COSTS

A mixed (or semi-variable) cost contains elements of both variable and

fixed costs.
Example: Lori Yang leases an automated photo developer for $2,500 per
year plus 2¢ per photo developed.

.
Y
Slope = b
$2,800
Variable
Cost
Lease Cost

Element
$2,500

Fixed
Cost
Intercept = a
Element

$0 X
0 5,000 10,000 15,000
Photos Developed

Equation of a straight line: Y = a + bX

Y = $2,500 + $0.02X

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-8

SCATTERGRAPH METHOD

As the first step in the analysis of a mixed cost, the cost and its activity
base should be plotted on a scattergraph. This permits the analyst to
quickly diagnose the nature of the relation between the cost and the
activity base.
Example: Piedmont Wholesale Florists has maintained records of the
number of orders and billing costs in each quarter over the past several
years.
Number Billing
Quarter of Orders Costs
Year 1—1st 1,500 $42,000
2nd 1,900 $46,000
3rd 1,000 $37,000
4th 1,300 $43,000
Year 2—1st 2,800 $54,000
2nd 1,700 $47,000
3rd 2,100 $51,000
4th 1,100 $42,000
Year 3—1st 2,000 $48,000
2nd 2,400 $53,000
3rd 2,300 $49,000

These data are plotted on the next page, with the activity (number of
orders) on the horizontal X axis and the cost (billing costs) on the vertical Y
axis.

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-9

A COMPLETED SCATTERGRAPH
Y

$60,000 Regression Line

$50,000
$48,000

$40,000
Billing Costs

$30,000

$20,000

$10,000

$0 X
0 500 1,000 1,500 2,000 2,500 3,000
Number of Orders

The relation between the number of orders and the billing cost is
approximately linear. (A straight line was drawn on the scattergraph with a
ruler that seems to reflect the basic relation between cost and activity.)

Since a straight line seems to be a reasonable fit to the data, we can

proceed to estimate the variable and fixed elements of the cost using one
of the following three methods.
1)Quick-and-dirty method based on the line in the scattergraph.
2)High-low method.
3)Least-squares regression method.

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-10

THE QUICK-AND-DIRTY METHOD

The straight line drawn on the scattergraph can be used to make a quick-
and-dirty estimate of the fixed and variable elements of billing costs.

Recall that we are trying to estimate the fixed cost, a, and the variable cost
per unit, b, in the linear equation Y= a + bX.
• The vertical intercept, approximately $30,000 in this case, is a rough
estimate of the fixed cost.
• The slope of the straight line is an estimate of the variable cost per
unit.

Select a point falling on the line (in this case 2,000 orders):
Total billing cost for 2,000 orders........ $48,000
Less fixed cost element (intercept)......  30,000
Variable cost element for 2,000 orders. $18,000
Variable cost per unit = $18,000 ÷ 2,000 orders = $9 per order.

Therefore, the cost formula for billing costs is $30,000 per quarter plus $9
per order or:
Y = $30,000 + $9X,
where X is the number of orders.

Because of the imprecision of this method of estimating the variable and

fixed cost components of a mixed cost, it is seldom used in practice.

Nevertheless, it is always a good idea to plot the data on a scattergraph

before using the more precise high-low or least-squares regression
methods.

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TM 5-11

ANALYSIS OF MIXED COSTS: HIGH-LOW METHOD

EXAMPLE: Kohlson Company has incurred the following shipping costs over
the past eight months:
Units Shipping
Sold Cost
January..... 6,000 $66,000
February. . . 5,000 $65,000
March........ 7,000 $70,000
April.......... 9,000 $80,000
May.......... 8,000 $76,000
June.......... 10,000 $85,000
July........... 12,000 $100,000
August...... 11,000 $87,000
With the high-low method, only the periods in which the lowest activity and
the highest activity occurred are used to estimate the variable and fixed
components of the mixed cost.

Units Shipping
Sold Cost
High activity level, July........ 12,000 $100,000
Low activity level, February.  5,000   65,000
Change..............................  7,000 $ 35,000
Change in cost $35,000
Variable cost= = =$5 per unit
Change in activity 7,000 units

Fixed cost = Total cost - Variable cost element

= $100,000 - (12,000 units × $5 per unit)

= $40,000
The cost formula for shipping cost is:
Y = $40,000 + $5X

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TM 5-12

EVALUATION OF THE HIGH-LOW METHOD

Y high
level of
activity
$100,000
Shipping Costs

$80,000 low level

of Variable
activity Cost
$60,000 $5/unit

$40,000

Fixed
$20,000 Cost
$40,000

$0 X
0 2,000 4,000 6,000 8,000 10,000 12,000
Units Sold

The high-low method suffers from two major defects:

1. It throws away all but two data points.
2. The high and low volume periods are often unusual.

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TM 5-13

LEAST-SQUARES REGRESSION METHOD

The least-squares regression method for analyzing mixed costs uses

mathematical formulas to determine the regression line that minimizes the
sum of the squared “errors.”

The least-squares regression method is more objective and precise than

the scattergraph method.

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.

TM 5-14

TRADITIONAL VERSUS CONTRIBUTION INCOME STATEMENT

Traditional Approach Contribution Approach

(costs organized by function) (costs organized by behavior)
Sales................................. $60,000 Sales............................. $60,000
Cost of goods sold*............  34,000 Less variable expenses:
Gross margin...................... 26,000 Variable production...... $12,000
Selling & admin. expenses: Variable selling............ 3,000
Selling*........................... $15,000 Variable administrative.   1,000  16,000
Administrative*................    6,000  21,000 Contribution margin....... 44,000
Net operating income......... $ 5,000 Less fixed expenses:
Fixed production.......... 22,000
Fixed selling................ 12,000
Fixed administrative.....   5,000  39,000
Net operating income..... $ 5,000
* Contains both variable and fixed elements since this is the income statement for a manufacturing
company. If this were a merchandising company, then the cost of goods sold would be entirely variable.

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TM 5-15

(APPENDIX 5A) VARIABLE AND ABSORPTION COSTING

Variable costing and absorption costing are alternative methods of

determining unit product costs. They affect:
• Inventory valuations.
• Net operating income.
KEY ELEMENTS

ABSORPTION COSTING
• Absorption costing was used in earlier chapters and is generally
considered to be required for external financial reports.
• Under absorption costing, product costs include all manufacturing costs:
• Direct materials.
• Direct labor.
• Variable manufacturing overhead.
• Fixed manufacturing overhead.
• Under absorption costing, selling and administrative costs are treated as
period expenses and are excluded from product costs:

VARIABLE COSTING
• Variable costing is an alternative for internal management reports.
• Under variable costing, product costs include only the variable
manufacturing costs:
• Direct materials.
• Direct labor (unless fixed).
• Variable manufacturing overhead.
• Under variable costing, the following costs are treated as period
expenses and are excluded from product costs:
• Fixed manufacturing overhead.
• Variable selling and administrative costs.
• Fixed selling and administrative costs.

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TM 5-16

CLASSIFICATION OF COSTS UNDER

VARIABLE AND ABSORPTION COSTING

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TM 5-17

UNIT PRODUCT COST COMPARISON

• Unit product costs differ between variable and absorption costing.

EXAMPLE: Harvey Company produces a single product.
Number of units produced annually............................ 25,000
Variable costs per unit:
Direct materials, direct labor, and variable
manufacturing overhead....................................... $10
Selling and administrative expense.......................... $3
Fixed costs per year:
Fixed manufacturing overhead................................ $150,000
Fixed selling & administrative expense..................... $100,000

Unit product costs are computed as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor, and
variable manufacturing overhead....... $10 $10
Fixed manufacturing overhead
($150,000 ÷ 25,000 units)................. 6      
Total unit product cost......................... $16 $10

• Selling and administrative expenses are always treated as period costs

and are expensed in the current period; they are not treated as product
costs under either costing method.

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TM 5-18

INCOME STATEMENT COMPARISON

Harvey Company had no beginning inventory, produced 25,000 units,

and sold 20,000 units last year.
Absorption Costing
Sales (20,000 units × $30 per unit)................ $600,000
Cost of goods sold
(20,000 units × $16 per unit)......................  320,000
Gross margin................................................ 280,000
Selling and administrative expense
(20,000 units × $3 per unit + $100,000)......  160,000
Net operating income.................................... $120,000

Variable Costing
Sales (20,000 units × $30 per unit)................ $600,000
Less variable expenses:
Variable cost of goods sold
(20,000 units × $10 per unit).................... $200,000
Variable selling and administrative expense
(20,000 units × $3 per unit).....................    60,000  260,000
Contribution margin....................................... 340,000
Less fixed expenses:
Fixed manufacturing overhead..................... 150,000
Fixed selling and administrative expense......  100,000  250,000
Net operating income.................................... $ 90,000

RECONCILIATION OF NET OPERATING INCOMES:

Variable costing net operating income.......... $ 90,000
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (5,000 units × $6 per unit)............    30,000
Absorption costing net operating income...... $120,000

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TM 5-19

COMPARATIVE INCOME EFFECTS —

VARIABLE AND ABSORPTION COSTING

Relation Between
Relation Between Variable and Absorption
Production and Sales Costing Net Operating Incomes
Production = Sales Absorption costing NI
(No change in inventory) = Variable costing NI
Production > Sales Absorption costing NI >
(Inventory increases) Variable costing NI *
Production < Sales Absorption costing NI <
(Inventory decreases) Variable costing NI #

* Net operating income will be higher under absorption costing since fixed
manufacturing overhead cost will be deferred in inventory under absorption
costing.
# Net operating income will be lower under absorption costing since fixed
manufacturing overhead cost will be released from inventory under
absorption costing.

© The McGraw-Hill Companies, Inc., 2007. All rights reserved.