A manager must use reliable information generated through techniques called cost-volume-profit analysis in determining which business prospects to pursue. One must have a clear understanding of cost behaviors before being able to effectively utilize these techniques, otherwise the information provided may be erroneous, and consequently not a good basis for decision making. A common mistake most managers make is treating mixed costs as fixed costs.
Mixed costs are composed of both variable and fixed cost components and should be broken down to such. The techniques commonly used sort these components are the high-low method, the scatter diagram and the least-squares regression analysis (cliffsnotes. com). The high-low method uses the data from the highest and lowest levels activity for the given period and computes for the difference.
The difference in cost divided by the difference in activity units is the variable cost per unit. After obtaining this rate, one can now compute for the fixed cost component by subtracting the total variable cost from the total cost, using either the lowest or highest activity level data. This method is simple to use but may yield an inaccurate answer if there are “a number of rogue data points” (Walther, 2009) since it only utilizes two data points.
The second method is the scatter diagram which consists of plotting all data on a graph, the horizontal and vertical axis representing the activity units and total costs, respectively. A line, called the regression line is then drawn through the points in such a way that equal number of points fall above and below it (Garrison & Noreen, 2000). The point in which the line touches the vertical axis is the fixed cost, while the variable cost rate can be computed by selecting a point in the line and dividing its total cost by its total activity units.
Since this method uses all data available, discrepancies arising out of fortuitous events can be easily identified by the experienced analyst who then makes the adjustment to the regression line (Garrison & Noreen, 2000). However, this method is highly subjective, in that no two analysts are likely to draw the same exact regression line; this method also does not provide for a very accurate amount of fixed costs since it is difficult to ascertain the exact amount where the line touches the vertical axis (Garrison & Noreen).
Least squares regression analysis is the last method. This involves the use of complex manual computations or that of a spreadsheet or statistical program. Either way, the goal of this method is “to define a line so that it fits through a set of points on a graph, where the cumulative sum of the squared distances between the points and the line is minimized,” hence the name (Walther, 2009). Regression analysis provides the intercept (the fixed cost component), the slope (the variable cost rate) and the adjusted R2.
The R2 provides the percentage of the variation in the dependent variable (cost) that is explained by variation in the independent variable activity (activity units); it is a measure of the “goodness of fit” (Garrison & Noreen, 2000) hence the higher this percentage, the better. Of the three methods, it provides the most accurate cost formula but is also the most cumbersome if performed manually. As with any business decision, the choice of which cost estimation technique to employ requires a cost-benefit analysis.
If the cost estimation is to be performed manually, it is suggested that the analyst start with the scatter diagram to get a grasp of the entire behavior of the particular cost and supplement this with the high-low method to get a more accurate amount of the fixed costs. If there are spreadsheet or statistical programs available at a reasonable costs, then the least squares regression analysis should be used since it provides for the most accurate cost formula. These suggestions aim to provide the maximum benefit for the company at the minimum cost.
References: Accounting Principles II: Cost Behavior – CliffsNotes. (n. d. ). Retrieved May 1, 2009, from http://www. cliffsnotes. com/WileyCDA/CliffsReviewTopic/Cost-Behavior. topicArticleId-21248,articleId-21228. html Garrison, R. H. , & Noreen, E. W. (2000). Managerial Accounting Ninth Edition. United States of America: Irwin McGraw-Hill. Walther, L. M. (n. d. ). Cost-volume-profit and business scalability. Retrieved May 1, 2009, from http://www. principlesofaccounting. com/chapter%2018. htm