Notes Chapter 3 Essay

CHAPTER 3 NOTES

Cost Structure: the proportion of variable costs and fixed costs in an organization.

Variable cost: these costs vary in total directly and proportionately with activity level, but are constant per unit.
Activity level or activity base: measure of what causes or drives variable cost.
Can be a measure of either inputs or outputs.
For many purposes we’ll use output units as the activity base – but not always as time goes on!

EXAMPLES: See Exhibit 3-2.

Although some variable costs are actually curvilinear, we assume that, within the relevant range, a straight line can approximate them.

Step-variable costs: instead of increasing or decreasing one-for-one with activity, these change in larger “chunks”
Can require very astute management to avoid over-investment in resources that are not needed over the intermediate term.
This is why a hospital, for example, might use a part-time (often caller “per diem”) nurse when they see an upsurge in patients in a particular area, rather than hiring another full-time nurse.

Fixed costs: In total, these costs remain constant within the relevant range of activity.
Average fixed cost per unit decreases, at a decreasing rate, as activity increases.
Committed fixed costs: investments in facility and equipment, and related costs.
Long-term planning horizon.
Reducing a committed cost may have significant consequences on the ability to do business – may be more costly to replace in the future.
Discretionary or managed fixed cost: these result from management decisions.
Short term planning horizon.
Can be reduced with minimal damage to strategic goals.
The difference between a step variable cost and a discretionary fixed cost is that
Step variable costs can be adjusted much more rapidly, and
The width of the “step” in a discretionary fixed cost is much wider.

Mixed cost: has both variable and fixed elements – also called semi variable.
Equation for a mixed cost: Y = a + bX, where
Y = total cost a = fixed cost b = variable cost per unit
X = volume or activity level
The fixed portion is the cost of the availability of the resource; the variable portion is the cost of the consumption of the resource.
For analysis purposes, the variable and fixed portions must be separated, and there are several ways to do this.
Account analysis: based on the analyst’s knowledge of how the components behave.
Engineering approach: based on industrial engineers’ knowledge of the business process involved and its costs.
Scatter graph: plot the recorded costs on the Y-axis against activity on the X-axis, and estimate the best line through the points. Assumption: the costs are linear.

High-low method:
The slope of the line is variable cost per unit.
The Y-intercept is total fixed cost.
Thus, VCu = (the difference in cost between the highest volume and the lowest volume), divided by (the difference between the highest and the lowest volume)
Using either the highest or the lowest volume, determine total variable cost, then subtract from total cost to determine fixed cost.
Formula:

(cost @ highest volume – cost @ lowest volume) (highest volume – lowest volume)

Total cost – (VCu * lowest volume) = total fixed cost

Uses only 2 data points to determine the line, not the entire distribution, so one or both could be outliers.

Least squares regression: uses all data points and fits a line to the distribution that minimizes the sum of the squared errors (differences) of data points from the line. You’ll study this extensively (if you have not already) in your Statistics course.

Contribution format Income Statement: this income statement clearly defines fixed and variable costs, showing the effect of changes in

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