This chapter presents methods of estimating and predicting cost behavior. When managers are able to
predict cost behavior, managers can estimate the amount of costs that are expected to be incurred at
different levels of activity. Estimated costs is the heart of budgeting and forecasting which is one of the
primary functions of managerial accounting.
To predict/estimate cost behavior, you must assume the following:
The number of units produced is equal to the number of units sold. In other words, there is no
change in inventory levels.
The cost behavior is linear.
The level of activity (sales/production) occurs within the relevant range.
The Relevant Range
A relevant range is a range of activity within which cost behavior holds true. It is the normal range of
production or sales that can be expected for a particular product or company. For example, a particular
retail store may have normal monthly revenues of $500,000, with occasional lows of $400,000 or highs
of $600,000. The relevant range is the range of normal activity from $400,000 to $600,000. The costs
that are identified as fixed, such as manager salaries, are the same throughout the entire range. If sales
were to increase to $700,000, the company would likely acquire an additional manager thereby
increasing it salary costs. Conversely, if sales drop to $320,000, the company would likely eliminate a
manager to reduce total fixed costs. A relevant range ignores extreme levels of activity. Above or below
the relevant range, forecasts of cost behavior may be linear and likely be less accurate in predictions of
Variable Cost Behavior
Total variable costs
vary in direct proportion to volume. In other words, the more units produced the
higher the total variable cost. Total variable cost is zero if no units are produced. As weekly sales climb,
each dollar of additional sales generates 20 cents of variable costs. The total variable labor cost rises to
$5,000 when sales activity reaches $25,000. Note the rising variable cost line.
The math function that
names this line is shown as:
y = 0.20X, where y is the total cost and X represents the activity. In this case the activity is weekly