COST BEHAVIOR

Cost behavior is the measure of how a cost responds to changes in the level of business activity.
Understanding of how costs behave in a particular situation is crucial for decision-making
process in an organization. Thus the production performance results reported on the income
statement.

Cost behavior information allows managers:

• To prepare budgets
• To predict cash flows
• To plan dividend payments
• To establish selling prices

Depending on the cost behaviors, there are four common cost types, which are variable, fixed,
mixed, and step-variable costs.

Method for analyzing cost behavior

For mixed cost to be planned and controlled, they must be divided into their variable and fixed
components. A number of techniques based on the equation y=a+bx can be used for the
separation of mixed cost. All three of these methods are based on the collection of historical data.

1. Visual fit scatter diagram method

2. High-low method

3. Linear regression analysis method

FUNCTIONAL AND CONTRIBUTION MARGIN INCOME STATEMENTS

Up until now, we have been using the functional, or traditional, or conventional income
statement format that you learned in financial accounting. But managers are better aided in their
decision making by a contribution margin or variable costing income statement.
A traditional, functional income statement is required for external financial statements. It
separates costs by their function: product costs or period costs. Product costs (COGS) are
subtracted from sales to show gross margin (gross profit). All period costs (selling, general, and
administrative) are then subtracted to show operating income.

Sales
Less Cost of goods sold (including DM, DL, VOH, and FOH)
Gross margin
Less operating expenses
Variable selling, general, and administrative expenses
Fixed selling, general, and administrative expenses
Net operating income
 The contribution margin income statement is preferable for management purposes. It separates
costs by their behavior: variable costs and fixed costs. It also works very well with CVP analysis.
All variable costs, both product and period, are subtracted from sales to show contribution
margin. All fixed costs, both fixed overhead (a product cost) and fixed period costs, are then
subtracted to show operating income. Fixed overhead is subtracted in total regardless of how
many are produced or sold.

Sales
Less variable cost
Variable cost of goods sold (including DM, DL, and VOH)
Variable selling, general, and administrative expenses
Contribution margin
Less fixed costs
Fixed overhead
Fixed selling, general, and administrative expenses
Net operating income

If all units produced are also sold, the operating income will be the same regardless of the type of
income statement produced.

On the contribution margin income statement, note that everything, including sales, direct
materials, direct labor, variable overhead, variable selling/general/administrative, and
contribution margin will vary in direct relationship to the number of units sold. The fixed costs,
both fixed overhead and fixed selling/general/administrative, remain the same whether we sell
any number of units or no units. We’ll find this concept very helpful when we analyze the
relationships among costs, volume, and profit.

Variable costing Absorption costing

Basic purpose
Net income comparison:
Production equals sales
Production more than sales
Production less than sales
Net income difference
Internal Reporting External Reporting
Net income same as absorption Net income same as variable
costing costing
Net income less than absorption Net income more than variable
costing costing
Net income more than absorption Net income less than variable
costing costing
Fixed cost in ending inventory
compared with those in
beginning inventory.
Example # 1 (Condition 1 since all the units produced were sold)

Production 60,000 units

Sales 60,000 units $12/unit
Costs:
Direct material $180,000 $3 per unit produced
Direct labor $120,000 $2 per unit produced
Variable overhead $ 60,000 $1 per unit produced
Fixed overhead $150,000
Variable selling/administrative $ 60,000 $1 per unit sold
Fixed selling/administrative $ 30,000

Required: Prepare income statement using the functional and contribution margin formats.

Example # 2 (Condition 1 since all the units produced were sold)

Actual Production 10,000 units

Unit sold 10,000 units $25/ unit

Variable manufacturing cost/unit $10/ unit

Variable selling exp/unit $2 / unit

Fixed MOH cost $40,000

Fixed selling/administrative exp $ 10,000

Selling price/ unit $25/ unit

Required: Prepare income statement using the functional and contribution margin formats.

Example # 3 (Condition 1 since all the units produced were sold)

Selling price/ unit $ 20

Variable manufacturing cost/unit 8
Annual Fixed MOH cost 48,000
Fixed selling/administrative cost 54,000
Variable selling cost/ unit 2
Units produced & sold $ 12,000

Required: Prepare income statement using the functional and contribution margin formats.
Example # 4 (Condition 2 since production more than sales)

Actual Production 10,000 units

Unit sold 9,000 units $25/ unit
Variable manufacturing cost/unit $10/ unit

Variable selling exp/unit $2 / unit

Fixed MOH cost $40,000

Fixed selling/administrative exp $ 10,000
Selling price/ unit $25/ unit

Required: Prepare income statement using the functional and contribution margin formats.

Example # 5 (Condition 2 since production more than sales)

Actual Production 25,000 units

Unit sold 20,000 units $30/ unit
Variable manufacturing cost/unit $16/ unit

Variable selling exp/unit $4 / unit

Fixed MOH cost $60,000

Fixed selling/administrative exp $ 30,000
Selling price/ unit $30/ unit

Required: Prepare income statement using the functional and contribution margin formats.

Example # 6 (Condition 2 since production more than sales)

Actual Production 120,000 units

Unit sold 100,000 units $20/ unit
Variable manufacturing cost/unit $10.5/ unit

Variable selling exp/unit $1.5 / unit

Fixed MOH cost $440,000

Fixed selling/administrative exp $ 120,000
Selling price/ unit $20/ unit

Required: Prepare income statement using the functional and contribution margin formats.
Example # 7 (Condition 2 since production more than sales & beg inv is given)

Units Variable costing Absorption costing

(unit cost) (unit cost)
Beginning Inventory 12,000 units $8 $11
Ending Inventory 14,000 $10 $12

42,000 units were sold during the period.

Required:
a) How many units were produced during period?
b) Determine the difference in Absorption & Variable costing net income.
c) Interpret the difference in net income.

Example # 8 (Condition 3 since production less than sales)

 Applied Overhead
Units Direct Labor Direct Materials Fixed Variable
Beg inventory 14,000 $ 10/ unit $ 8/ unit $ 8/ unit $ 4/ unit
Ending inventory 9,000 $ 11/ unit $ 10/ unit $ 7/ unit $ 5/ unit
Under applied
overhead = $ 22,000
Sales = 32,000 units
@ $ 42 each
Variable selling
expense = $ 54,000
Fixed selling & adm
exp = $ 88,000
Required:
1. The number of units produced
2. Cost of ending inventory using absorption costing
3. Cost of ending inventory using variable costing
4. Difference in net income between absorption & variable costing