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CHAPTER FIVE
Cost Behavior
This chapter focuses on the behavior of costs. Specific costs behave in
predictable ways as volume changes. This concept of predictable cost
Key Concepts
• Within the relevant range, fixed costs are constant in total and vary
per unit, and variable costs vary in total and are constant per unit.
• Variable costing is consistent with CVP’s focus on differentiating fixed
and variable costs and provides useful decision-making information
that is often not apparent when using absorption costing.
Learning Objectives
LO1— Describe the nature and behavior of fixed and variable costs.
LO2— Use regression analysis and the high/low method to define and analyze
mixed costs.
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LO6— Recognize the benefits of using variable costing for decision making.
Lecture Outline
A. Introduction
1. As production volume changes, some costs may increase or
decrease and other costs may remain stable, but specific costs
B. Fixed and Variable Costs (LO1)
1. Fixed Costs: Fixed costs remain the same in total but vary per unit,
2. Variable Costs: Variable costs vary in direct proportion to changes
in production volume but are constant when expressed as per-unit
amounts (linear relationship). Examples include direct material,
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3. Relevant Costs and Cost Behavior
o Relevant costs (differential or incremental costs) are
avoidable or can be eliminated by choosing one alternative
over another.
4. The Cost Equation
o The linear relationship between total cost and production
volume, if expressed in an algebraic equation, takes the
Key Equation
y = a + bx
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C. Mixed Costs (LO2)
Mixed costs include both a fixed and a variable component. These costs
change in total and also changes per unit. It is difficult to predict the
behavior of a mixed cost as production volume changes unless the costs
are first separated into their fixed and variable components. A statistical
tool called regression analysis is often used to estimate the fixed and
variable components of a mixed cost.
1. Regression Analysis
Regression analysis is the procedure that uses statistical methods
(least squares regression) to fit a cost line (called a regression line)
Key Concept
Within the relevant range, fixed costs are constant in total and vary per
unit, and variable costs vary in total and are constant per unit.
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variable because it drives the cost of the dependent
variable) into a spreadsheet, using one column for each
variable.
b. Next, click on the Data tab and choose data analysis
d. After inputting the appropriate y and x ranges, click OK,
and the regression model summary output appears.
o Regression Statistics
The regression statistics section provides useful diagnostic
tools.
a. The multiple R (called the correlation coefficient) is a
measure of the proximity of the data points to the
• An R2 of 1 indicates a perfect correlation
between the independent and dependent
variables in the regression equation; in other
words, 100 percent of the data points are on
the regression line.
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• R2 can be interpreted as the proportion of
dependent-variable variation that is explained
by changes in the independent variable.
2. Estimating Regression Results Using the High/Low Method
We could estimate the regression equation by using a simpler
technique called the high/low method.
o The high/low method uses only two data points (related to
the high and low levels of activity) and mathematically
a. Step 1: Identify the highest and lowest volume and take
the costs numbers corresponding to those two
observations.
c. Step 3: Multiply the variable cost per unit (from Step 2)
with the volume (any one level of volumes identified in
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d. Step 4: Using the variable cost per unit (step 2) and
o Regression is a statistical tool that fits the “best” line
through all data points, whereas the high/low method
mathematically derives a straight line between just two of
D. The Impact of Income Taxes on Costs and Decision Making (LO3)
The first key to understanding the impact of taxes on costs and revenues is
the recognition that many costs of operating businesses are deductible for
income tax purposes and that most business revenues are taxable.
1. After-tax costs and Revenues
o The impact of income taxes on tax-deductible expenses is
Key Formula
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E. A Comparison of Absorption Costing and Variable Costing (LO4)
1. Absorption Costing (or full costing) is a method of costing in which
2. Variable costing (or direct costing) treats only variable product
costs as product costs and treats fixed manufacturing overhead as
3. The only difference between absorption and variable costing is the
treatment of fixed overhead.
Key Formula
Key Formula
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o Under absorption costing, fixed overhead is treated as a
product cost, added to the cost of the product and
o The impact of this difference on reported income becomes
F. The Impact of Absorption Costing and Variable Costing on the Income
Statement (LO 5)
To explain the impact of absorption costing and variable costing on the
income statement of a company, let’s consider the impact over three
consecutive years with the following conditions: Year 1 – units sold equals
units produced (no inventory built up); Year 2- units sold are less than units
produced (increase in inventory); Year 3- units sold are more than units
produced (decrease in inventory to zero).
1. Year 1 Income Comparison: When units sold equal units produced,
net operating income is the same under both absorption costing
2. Year 2 Income Comparison: When units sold are less than units
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3. Year 3 Income Comparison: When units sold are more than units
produced, variable costing reports higher net operating income than
absorption costing. This happens because the entire fixed
G. Variable Costing and Decision Making (LO6)
The use of absorption costing for internal decision making can result in less-
than-optimal decisions. However, this problem can be avoided if variable
costing method is used. Now the question is which method should be
chosen.
1. Choosing the Best Method for Performance Evaluation
o For external reporting and for filing annual income tax
o For internal decision making, variable costing is often the
best choice.
a. Using variable costing for internal decision making
removes the impact of changing production levels on
b. If a manager’s compensation package is based on net
income, using absorption costing may motivate that
manager to increase production simply to increase
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c. Variable costing is consistent with CVP’s focus on
2. Advantages of Variable Costing
Variable costing has the following advantages:
o Changes in production and inventory levels do not affect
the calculation of profits.
o Variable costing focuses attention on relevant product
costs.
Key Concept
Variable costing is consistent with CVP’s focus on differentiating fixed from
variable costs and provides useful decision-making information that is often not
apparent when using absorption costing.
Key Concept
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End-of-Chapter Material
Brief exercises, exercises, problems, and cases based on different learning