What is cost?

The term cost does not have a definite meaning and its scope is extremely broad and general; However cost is defined as; “The amount of expenditure (actual or national) incurred or attributed to a given thing”

VARIABLE COST:A variable cost is a cost which tends to vary with the level of activity. Total variable cost is proportional to the activity level with the relevant range. Variable cost per unit remains the same over wide range of activity.

Example of total variable cost

Your total long distance telephone bill is based on how many minutes you talk.

TOTAL LONG DISTANCE TELEPHONE BILL

MINUTES TALKED

EXAMPLE OF VARIABLE COST PER UNIT

The cost per minute talked is constant For example RS.3 per minute.

Per minute telephone charge

minutes talked

Some variable cost behave in a true variable or proportionately variable pattern. Other variable cost behave in a step variable pattern. True variable cost True variable cost is defined as a type of cost which varies in direct proportion to the level of production activity.

Example:Direct material is a true proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover any amounts purchased but not used can be stored and carried forward to the next period of inventory.

Step variable cost

The cost of a resource that is obtainable only in large chunks and that increases or decreases only in response to fairly wide changes in activity is known as a step variable cost. Example:The wages of skilled repair technician are often considered to be a step variable cost. Why we put this example in step variable cost not in true variable cost? The answer is “such a technician’s time can only be obtained in large chunks it is difficult to hire a skilled technician on anything other than a full time basis. Another reason:Moreover any technician’s time not currently used can not be stored as inventory and carried forward to the next period.

Fixed cost

A fixed cost is a cost which is fixed for a particular period of time and which within certain activity levels is unaffected by changes in the level of activity.

Total fixed costs remain constant within the relevant range of activity but change with per unit. Since fixed cost remains constant in total the average fixed cost per unit becomes progressively smaller as the level of activity increases.

Example of total fixed cost

Your monthly unlimited wateen internet package bill is fixed and does not change when you open more websites.

Example of unit fixed cost Your monthly unlimited wateen internet package but as you open more links the per unit cost of each link decreases or as much you download more the cost of downloadable reduces.

Types of fixed costs

Committed fixed cost

Investments in facilities ,equipment , and the basic organization that can’t be significantly reduced even for short periods of time without making fundamental changes are referred to as committed fixed cost.

Example

1. Deprication of buildings and equipment 2. Real estate Taxes 3. Insurance expenses 4. Salaries of top management

Discretionary fixed cost / managed fixed cost

Discretionary fixed costs usually arise from annual decisions by management to spend on certain fixed cost items. The most important characteristic of discretionary fixed cost is that management is not locked into its decisions regarding such cost. Discretionary cost can be adjusted from year to year or even perhaps during the course of a year if necessary.

Examples

1. Advertising 2. Research 3. Public relations 4. Management programs and internships for students

Differences between discretionary fixed and committed fixed cost

Discretionary cost Planning horizon for discretionary fixed cost is short term. Usually a single year Cost can be cut for short period of Committed fixed cost Planning horizon that encompasses many years.

time with minimal damage to the long run goals of the organization. Example Due to poor economic condition company can reduced spending on management development.

It can not be for short period of time.

Mixed cost

Mixed cost has both fixed and variable components. Mixed cost is also named as semi variable cost. Since mixed cost is represented by a straight line, the following equation for straight line can be used to express the relationship between a mixed cost and the level of activity.

Y=a+bX

Y = total mixed cost x= the level of activity a = total fixed cost ( the vertical interpret of the line) b = the variable cost per unit or activity (the slope of the line)

Machine hours

The analysis of mixed cost: Accounting analysis Engineering approach High low method

Scatter graph method

Least-square regression line method Accounting analysis

Each accountant is classified as either fixed or variable cost base on the analyst’s knowledge of how the account behaves.

Engineering estimates

Cost estimates are based on an evaluation of production methods , the material , labour and overhead requirements.

High low method

In high low method using two level of activity high and low inventory compete The variable cost per unit Fixed cost and then Express the cost in equation form Y = a +bX Algebraic procedure used to separate a semivariable cost or Mixed Cost into the fixed and the variable components. The high-low method, as the name indicates, uses two extreme data points to determine the values of a (the fixed cost portion) and b (the variable rate) in the Cost- Volume. The extreme data points are the highest and lowest x - y pairs.

Example

Let us take the example of an air conditioner reparing shop using high low method, we must first identify the periods with the highest and lowest activity in this case we take the data for the month of june and april. We than use the

activity and cost data from these two periods to estimate the variable cost component as follows: No of air conditioners come for reparing (days) High activity level(june) Low activity level (april) Change 8,000 5,000 3,000 Maintenance cost incurred RS RS.9,800 RS.7,400 RS.2400

Variable cost = change in cost Change in activity

= Rs.2,400 3,000

= RS.0.80

Fixed cost element = total cost – variable cost element = RS 9,800 – (RS. 0.80 × 8,000 ) = RS. 3,400 Y = RS.3,400 + RS.0.80 X Y =Total maintenance cost one day x= total no of air conditioners come for repair in

Scattered graph method

the first step in analyzing the cost and activity data is to plot the data on scattergraph. This plot immediately reveals any nonlinearities or other problems with the data. Two things should be noted about this scattergraph. The Total maintenance cost ,Y is plotted on the vertical axis. Cost is known as the dependent variable. The activity , X is plotted on the horizontal axis. Activity is known as independent variable , since it causes variations in the cost.

Least-squares regression method

A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. The least squares regression method, unlike the high low method, uses all of the data to separate a mixed cost into its fixed and variable components.

The goal of this method is to fit a straight line to the data that

minimizes the sum of squared error.

Software can be used to fit a regression line through the data points.

The cost analysis objective is the same: Y = a + bX

Least-squares regression also provides a statistic, called the R2, which is a measure of the goodness of fit of the regression line to the data points. R2 is the percentage of the variation in the dependent variable (total cost) that is explained by variation in the independent variable (activity). Preparing an income statement using contribution formate

Total Sales revenue Less variable cost 100,000 (60,000) _______________ Contribution margin Less fixed cost 40,000 30,000 ______________ 10,000 Net operating income

unit 50 (30) __________ 20 ____________

The contribution margin formate emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

Uses of the contribution formate:The contribution income statement format is used as an internal planning and decision-making tool. We will use this approach for:

1. Cost-volume-profit analysis

2. Budgeting

3. Segmented reporting of profit data 4. Special decisions such as pricing and make-or-buy analysis

Comparing results from three method

The three methods just discussed provide slightly different estimates of the fixed and variable cost components of the mixed cost. This is to be expected because each method uses differing amounts of the data points to provide estimates.

Least-squares regression provides the most accurate estimate

because it uses all the data points.

The term cost does not have a definite meaning and its scope is extremely broad and general; However cost is defined as; “The amount of expenditure (actual or national) incurred or attributed to a given thing”

VARIABLE COST:A variable cost is a cost which tends to vary with the level of activity. Total variable cost is proportional to the activity level with the relevant range. Variable cost per unit remains the same over wide range of activity.

Example of total variable cost

Your total long distance telephone bill is based on how many minutes you talk.

TOTAL LONG DISTANCE TELEPHONE BILL

MINUTES TALKED

EXAMPLE OF VARIABLE COST PER UNIT

The cost per minute talked is constant For example RS.3 per minute.

Per minute telephone charge

minutes talked

Some variable cost behave in a true variable or proportionately variable pattern. Other variable cost behave in a step variable pattern. True variable cost True variable cost is defined as a type of cost which varies in direct proportion to the level of production activity.

Example:Direct material is a true proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover any amounts purchased but not used can be stored and carried forward to the next period of inventory.

Step variable cost

The cost of a resource that is obtainable only in large chunks and that increases or decreases only in response to fairly wide changes in activity is known as a step variable cost. Example:The wages of skilled repair technician are often considered to be a step variable cost. Why we put this example in step variable cost not in true variable cost? The answer is “such a technician’s time can only be obtained in large chunks it is difficult to hire a skilled technician on anything other than a full time basis. Another reason:Moreover any technician’s time not currently used can not be stored as inventory and carried forward to the next period.

Fixed cost

A fixed cost is a cost which is fixed for a particular period of time and which within certain activity levels is unaffected by changes in the level of activity.

Total fixed costs remain constant within the relevant range of activity but change with per unit. Since fixed cost remains constant in total the average fixed cost per unit becomes progressively smaller as the level of activity increases.

Example of total fixed cost

Your monthly unlimited wateen internet package bill is fixed and does not change when you open more websites.

Example of unit fixed cost Your monthly unlimited wateen internet package but as you open more links the per unit cost of each link decreases or as much you download more the cost of downloadable reduces.

Types of fixed costs

Committed fixed cost

Investments in facilities ,equipment , and the basic organization that can’t be significantly reduced even for short periods of time without making fundamental changes are referred to as committed fixed cost.

Example

1. Deprication of buildings and equipment 2. Real estate Taxes 3. Insurance expenses 4. Salaries of top management

Discretionary fixed cost / managed fixed cost

Discretionary fixed costs usually arise from annual decisions by management to spend on certain fixed cost items. The most important characteristic of discretionary fixed cost is that management is not locked into its decisions regarding such cost. Discretionary cost can be adjusted from year to year or even perhaps during the course of a year if necessary.

Examples

1. Advertising 2. Research 3. Public relations 4. Management programs and internships for students

Differences between discretionary fixed and committed fixed cost

Discretionary cost Planning horizon for discretionary fixed cost is short term. Usually a single year Cost can be cut for short period of Committed fixed cost Planning horizon that encompasses many years.

time with minimal damage to the long run goals of the organization. Example Due to poor economic condition company can reduced spending on management development.

It can not be for short period of time.

Mixed cost

Mixed cost has both fixed and variable components. Mixed cost is also named as semi variable cost. Since mixed cost is represented by a straight line, the following equation for straight line can be used to express the relationship between a mixed cost and the level of activity.

Y=a+bX

Y = total mixed cost x= the level of activity a = total fixed cost ( the vertical interpret of the line) b = the variable cost per unit or activity (the slope of the line)

Machine hours

The analysis of mixed cost: Accounting analysis Engineering approach High low method

Scatter graph method

Least-square regression line method Accounting analysis

Each accountant is classified as either fixed or variable cost base on the analyst’s knowledge of how the account behaves.

Engineering estimates

Cost estimates are based on an evaluation of production methods , the material , labour and overhead requirements.

High low method

In high low method using two level of activity high and low inventory compete The variable cost per unit Fixed cost and then Express the cost in equation form Y = a +bX Algebraic procedure used to separate a semivariable cost or Mixed Cost into the fixed and the variable components. The high-low method, as the name indicates, uses two extreme data points to determine the values of a (the fixed cost portion) and b (the variable rate) in the Cost- Volume. The extreme data points are the highest and lowest x - y pairs.

Example

Let us take the example of an air conditioner reparing shop using high low method, we must first identify the periods with the highest and lowest activity in this case we take the data for the month of june and april. We than use the

activity and cost data from these two periods to estimate the variable cost component as follows: No of air conditioners come for reparing (days) High activity level(june) Low activity level (april) Change 8,000 5,000 3,000 Maintenance cost incurred RS RS.9,800 RS.7,400 RS.2400

Variable cost = change in cost Change in activity

= Rs.2,400 3,000

= RS.0.80

Fixed cost element = total cost – variable cost element = RS 9,800 – (RS. 0.80 × 8,000 ) = RS. 3,400 Y = RS.3,400 + RS.0.80 X Y =Total maintenance cost one day x= total no of air conditioners come for repair in

Scattered graph method

the first step in analyzing the cost and activity data is to plot the data on scattergraph. This plot immediately reveals any nonlinearities or other problems with the data. Two things should be noted about this scattergraph. The Total maintenance cost ,Y is plotted on the vertical axis. Cost is known as the dependent variable. The activity , X is plotted on the horizontal axis. Activity is known as independent variable , since it causes variations in the cost.

Least-squares regression method

A method used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables. The least squares regression method, unlike the high low method, uses all of the data to separate a mixed cost into its fixed and variable components.

The goal of this method is to fit a straight line to the data that

minimizes the sum of squared error.

Software can be used to fit a regression line through the data points.

The cost analysis objective is the same: Y = a + bX

Least-squares regression also provides a statistic, called the R2, which is a measure of the goodness of fit of the regression line to the data points. R2 is the percentage of the variation in the dependent variable (total cost) that is explained by variation in the independent variable (activity). Preparing an income statement using contribution formate

Total Sales revenue Less variable cost 100,000 (60,000) _______________ Contribution margin Less fixed cost 40,000 30,000 ______________ 10,000 Net operating income

unit 50 (30) __________ 20 ____________

The contribution margin formate emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

Uses of the contribution formate:The contribution income statement format is used as an internal planning and decision-making tool. We will use this approach for:

1. Cost-volume-profit analysis

2. Budgeting

3. Segmented reporting of profit data 4. Special decisions such as pricing and make-or-buy analysis

Comparing results from three method

The three methods just discussed provide slightly different estimates of the fixed and variable cost components of the mixed cost. This is to be expected because each method uses differing amounts of the data points to provide estimates.

Least-squares regression provides the most accurate estimate

because it uses all the data points.