Chapter 12 Module 3. AMIS 310 Foundations of Accounting

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1 Chapter 12, Module 3 AMIS 310: Foundations of Accounting Slide 1 CHAPTER 1 MODULE 1 AMIS 310 Foundations of Accounting Professor Marc Smith Hi everyone, welcome back. Let s continue our discussion on cost behaviors and let s get started. Go ahead to the next slide with me. AMIS 310 Professor Marc Smith

2 Slide 2 AMIS 310: Foundations of Accounting : Cost Behaviors The ideas behind cost behavior analysis are very useful in management decisionmaking. Why? Cost behavior analysis allows managers to develop expectations of costs at any level of activity. The ideas behind cost behavior analysis are really very useful in management decision making. What about them makes it so useful? The reason is having this cost behavior analysis, having how costs are going to change given some kind of activity level change really will allow our managers to develop some type of expectation of costs at any level of activity. It facilitates budgeting. It allows managers to plan for the future in terms of what is going to happen if this change in activity level occurs. So these cost behavior patterns really are very useful in decision making. Now go ahead to the next slide with me. AMIS 310 Professor Marc Smith

3 Slide 3 AMIS 310: Foundations of Accounting : Cost Behaviors In utilizing cost behavior analysis, managers should use (work with) variable costs expressed on a per unit basis and fixed costs in total. The reason? Both variable costs per unit and total fixed costs are considered constant at all activity levels. This assumption of being constant allows managers to make predictions about future costs. In utilizing the cost behaviors that we ve talked about, managers want to work with or make use of variable costs expressed on a per unit basis and fixed costs expressed as a total dollar cost. So what we are really going to be interested in working with would be the variable costs per unit and fixed costs in total. And there is something very important about those two things. Can you tell me why is it that we (managers actually using this stuff) why is it that we and they want to work with variable costs per unit and fixed costs in total? Well, the reason is and we learned this is the last module. Those are the constants. Both variable costs per unit and total fixed costs are assumed constant at all levels of activity within our relevant range. AMIS 310 Professor Marc Smith

4 So we can basically play the what if games at any level of activity using these constant costs. It allows us to make predictions about what the costs that we incur will be if the activity changes to any particular level. Very useful in budgeting and trying to decide what sorts of things the company should do in the future. Now, go to the next slide with me. Slide 4 : Mixed Costs PROBLEM: What do we do with mixed costs as they do NOT have a constant component SOLUTION: We need a means of separating the mixed cost into its fixed and variable components so that we can isolate these constant components But that does present a real problem. The problem is what do we do with our mixed costs? Remember the mixed costs are the costs that have a little bit of variable and a little bit of fixed in them. But because they have both a variable and a fixed component there is no constant element. AMIS 310 Professor Marc Smith

5 And we just got through saying how critical that constant element was. We were so after variable costs per unit and fixed costs in total because those are the constants. The solution to this is we need to find a way to take our mixed costs and split them. We need to be able to separate the mixed costs into the variable component and the fixed component. And once we separate them into the variable and fixed components, we re able to isolate those constants that we are so desirous of. So we are able to take the mixed costs and split it to the constant variable costs per unit and the total fixed cost. Now, go ahead to the next slide. Slide 5 : Mixed Costs Method used to separate a mixed cost into its fixed and variable components: HIGH-LOW METHOD AMIS 310 Professor Marc Smith

6 The method that we use, the method that is used to separate a mixed cost into its variable and fixed components is referred to as the high-low method. So we are going to make use of what is called the high-low method to separate a mixed cost into its variable and fixed pieces. Go ahead to the next slide. Slide 6 : High-Low Method HIGH-LOW METHOD STEPS 1. From a set of data, choose 2 data points - the high and the low ACTIVITY LEVEL (Note: do not choose your 2 data points based on the high and low cost) 2. Calculate the variable cost per unit = change in cost for 2 data points change in activity level for 2 data points 3. Calculate the total fixed cost And let s list out the steps and there s 3 fairly straightforward steps to applying the high-low method. The most important is the first step. From a set of data, from a set of data choose 2 data points. So we are only going to work with 2 data points and in the high-low method it is fairly obvious as to which data points to choose the high and the low. But we need to be a little bit more precise. AMIS 310 Professor Marc Smith

7 The two data points we are going to work with should be the data points that contain the high activity point and the low activity point. Don t base your choice on the data points that have the high and low costs. In most example, the data point with the high cost would also correlate to the high activity. And the data point with the low cost would correlate to the low activity. But not always. So you want to choose your data points (two points to work with) based on the points that have the high activity and the low activity. Once we have identified our two data points and again that is the critical thing here, once we have identified our two data points, separate into the constants. We calculate the variable cost per unit. And it is actually a fairly easy thing to do. Take the cost at the high point minus the cost at the low point (change in the costs). Divide that by the activity at the high point minus the activity at the low point the change in activity. So take the change in the cost of the two data points divided by the change in activity at those two data points that we chose. That isolates or separates into the constant variable cost per unit. The other piece is the fixed cost and that is step 3. We have to calculate the total fixed cost. And once we get into our example, I ll show you how to do that. AMIS 310 Professor Marc Smith

8 Now go ahead to the next slide with me. AMIS 310: Foundations of Accounting Slide 7 : Example #1 Month Material Handling Costs Units Produced January $2, February 3, March 2, April 1, May 7, June 5, July 4, August 6, September 5, October 6, Step 1: Choose the two data points Please take a look at Example 1 from the problems posted on our course website, our lecture problem. And here is what it says. An analysis of the material handling costs of XYZ Company disclosed the following information for the first 10 months of the year. So you can see the material handling costs and the number of units produced in months January through October. There is our set of data. Using the high-low method, they want us to first develop a cost formula for the material handling cost. Develop a cost formula that will allow us to make predictions as to what future material handling costs will be. AMIS 310 Professor Marc Smith

9 Remember how the high-low method works. From a set of data, we have to choose two data points. AMIS 310: Foundations of Accounting And the first data point we should always choose is the point that has the highest activity. If you look at the problem, the activity is the units that were produced. And the month where we produced more units than any other was May. In the month of May, we made 500 units. We also have to pick the low activity point, the month where we produced the fewest number of units. And as you look down your problem that month is January. In January only 100 units were produced. So we are going to work with the months of May and January. All other data will not be used in doing the high-low method. Before we move forward one thing I just want to point out to you take a look at the month of April. In the month of April, the cost is $1990 which is lower than the cost in January. But we don t base our data points on the high and low costs. We base our data points on the high and the low activity points. So we want to work with May, the high activity point and January, the low activity point. Now go to the next slide with me. AMIS 310 Professor Marc Smith

10 Slide 8 AMIS 310: Foundations of Accounting : Example #1 Month Material Handling Costs Units Produced January $2, February 3, March 2, April 1, May 7, June 5, July 4, August 6, September 5, October 6, Step 2: Calculate the variable cost per unit $7,500 $2, = $13.75 Now that we have identified our two data points, step 2 is to calculate the constant variable cost per unit. And the way in which we do that is we take the change in cost associated with the two data points. The cost at the high data point (the month of May, $7500). The cost at the low data point (the month of January, $2000). Change in cost $5500. Divide that by the change in activity at those two points. The high point, the month of May, 500 units were produced. The low point, the month of January, 100 units were produced. The change 400 units. AMIS 310 Professor Marc Smith

11 When we do that, we get a constant variable cost per unit produced $ Now that we have that go ahead to the next slide. Slide 9 : Example #1 Step 3: Using either the high cost or low activity point, solve for the total fixed cost. Total Cost = Fixed Cost + Variable Cost $7,500 = F + $13.75(500) $625 = F $2,000 = F + $13.75(100) $625 = F High End Low End In step 3 in the high-low method was come up with the total fixed cost, the other constant component. And when we listed out the steps we said when we got to our example we d go through how to do that. So let s go ahead through that. And the way in which you are going to do this, the way in which you are going to determine the constant total fixed cost is you choose one of the two data points that we worked with either the month of May or the month of January. Let s go ahead and let s assume that we are going to work with the month of May, the high data point. AMIS 310 Professor Marc Smith

12 Now, the way in which we are going to set up this cost formula is remember that the total cost is equal to the fixed component plus the variable component. The total cost equals our fixed costs plus variable costs. And we know in the month of May the high data point. The total cost was $7500. That was given. That was the total material handling cost. But it was mixed. It contained some variable and some fixed. We know that in the month of May the number of units we made were 500 and we just calculated on the previous slide the variable cost per unit $ So take $13.75 times the number of units. That gives you your total variable cost. We re able then to do some basic algebra to determine the total fixed costs associated with material handling $625. There s a check and you should always do the check because it only takes a second. Do the same set of calculations but do it with the low data point. In our example, the month of January. In that month, the total material handling cost was $2000. We made 100 units that month and we know the variable cost per unit $ AMIS 310 Professor Marc Smith

13 Solve for the total fixed cost, the F. When you do that, we verify total fixed costs associated with material handling $625. Now go ahead to the next slide with me. Slide 10 : Example #1 The cost formula using the high-low method is: Total cost = $625 + $13.75X Where X = activity (in this problem, units produced) If 150 units are expected to be produced in November, the expected material handling cost would be: Total cost = (150) Total cost = ,063 Total cost = $2,688 Now that we ve done our work, we can answer requirement 1. Develop a cot formula for material handling. The cost formula using our high-low method total cost equals the fixed component $625. Not a function of activity. It s going to be $625 no matter how many units are produced plus $13.75, the variable component times x where x is the number of units produced. Because for every unit we produce, we incur a variable cost of $ AMIS 310 Professor Marc Smith

14 Now that we have that, we can answer question or requirement 2. What would be the total budgeted material handling cost for next month the month of November if we expect to make 150 units? Once we develop our cot formula that is easy. Just plug in the 150 for x, the total material handling cost for the month of November would be estimated or budgeted as $2688. High-low method just like to say a couple of things in wrapping the discussion up. It s actually a fairly straightforward method to apply. And you can always guarantee on your quiz and on your exam you are always going to have a question where you ve got to do the high-low method. So you really just want to know how to work it. It is one of those things that it is not that difficult to deal with. And it is always going to be there. So, get one of those questions right. Just know how to deal with the high-low method. The other thing or point that I did want to make about high-low and some folks might try this and wonder why it doesn t work one of the drawbacks to the high-low method is it only makes use of those 2 data points. In our example, we only used the month of January and the month of May. It discarded all the other months data. So when we go to do our equation, come up with our cost formula, it would work using the information in those two data points, January and May. AMIS 310 Professor Marc Smith

15 However, if you go and try to plug these numbers in to the other months, you won t come out to exactly what that total cost is. It is an estimate; it is a way of trying to isolate variable and fixed costs so managers can make decisions. And remember how we started the very first module of this chapter. Managerial accounting is not meant to be 100% precise. It is meant to be pretty precise, pretty accurate but we also need the information to be provided timely so managers can make meaningful decisions. And I think high-low is a real good example of that. AMIS 310 Professor Marc Smith