Things You Must Know
Introduction to Accounting
how a cost will change as the level of activity/volume changes
Changes in total, in direct proportion to changes in the level of activity.
Variable cost per unit does not change
As volume changes the total cost changes in the same direction.
Total cost does not change regardless of the level of activity
The cost per unit will change as the number of units changes
Investment in facilities, equipment, and the basic organization of the company
1) long term in nature
2) can’t be significantly reduced, even over short periods of time without changing the long-term goals of the company
Arise from annual decisions made by management to spend in certain areas.
Can be cut for short periods of time with minimal damage to long term goals
Mixed Costs (also known as semi-variable costs):
Contains both variable and fixed costs elements.
Fixed part: minimum cost of having a service ready and available for use
Variable part: cost incurred for additional or actual consumption of the service
Fixed Cost $
+ (Variable Cost $ per X # activity)
= Total Mixed Costs
Example of mixed costs:
Cell phone charges: $39.99 per month plus 10 cents for every minute used above 400
Utilities: electricity and water: charges $56 per month plus $1.20 per kilowatt/gallon used
Driving a car: $400 per month for insurance and depreciation plus $0.05 per mile
When projecting profitability at different volumes it is important to separate out the fixed cost portion and the variable cost portion because these two types of costs change differently when volume changes. Fixed costs do not change and variable costs change proportionately with changes in volume.
Methods used to determine the fixed cost and variable cost portion of total cost:
Scatter graph Plotting:
$ Cost – is plotted on the verticle axis (up and down)
Activity – is plotted on the horizontal axis (across bottom), the “activity is what is done over and over again and you pay every time it occurs.
Plot the points, making a dot at the point where the dollar value is on the left up and down line and the activity is on the lower bottom line. Then draw a straight line through the most points that will fall closest to the line.
The fixed cost is the point that the line hits the vertical (up and down, $cost) line
Once you know the total fixed cost, pick one point and note the total dollar and the total activity and use the formula below to calculate variable cost per activity.
Total Cost $
– Fixed Cost $
= Total Variable Cost $
Total Variable Cost $ / Total Activity = Variable Cost $ per Unit of Activity
Now write the cost formula:
Total Cost $ = Total Fixed Cost $ + (variable cost $ per activity x # activity)
Use this formula for any level of activity to estimate the total cost at that level.
High – Low Method
1st – Identify the period with the lowest level of activity and the highest level of activity
2nd – Use the formula below to calculate the variable cost per activity
Variable Cost = Cost at high activity level – cost at the low activity level
High activity level – Low activity level
It is very important that you put the activity in the formula first and then use the cost that is associated with the high activity level and the cost that is associated with the low activity level. Do not just use the highest and the lowest cost.
3rd – Now that you have calculated the variable cost per unit using the formula above, use the formula below to determine the fixed portion of the cost.
You must select either the high activity and total dollars associated with the high activity or the low activity and total dollars associated with the low activity.
Either one will give the same answer for the fixed cost portion.
Fixed Cost $ = Total Cost $ – (Variable cost $ per X # of activity)
This is a topic that is mentioned in some managerial accounting textbooks, however, it is rarely covered by the professor. Please check you notes to see if you are required to know how to separate fixed and variable costs using regression analysis. Since it is rarely discussed, it is not discussed here.