how should mixed costs be classified in CVP analysis? What approach is used to effect the appropriate classification?
In CVP (Cost-Volume-Profit) analysis, mixed costs are classified into their fixed and variable components because understanding the behavior of costs is important to determine the breakeven point, target profit, and overall profitability.
To classify mixed costs, the high-low method or regression analysis can be used. These approaches help separate the fixed and variable components of a mixed cost.
1. High-low method: This method compares the highest and lowest activity levels and corresponding costs to determine the variable and fixed components. The steps involved are:
a. Identify the highest and lowest activity levels and their corresponding costs.
b. Calculate the change in cost and change in activity levels.
c. Divide the change in cost by the change in activity to find the variable cost per unit.
d. Multiply the variable cost per unit by the activity level to obtain the total variable cost.
e. Subtract the total variable cost from the total cost at any activity level to get the fixed cost.
2. Regression analysis: This statistical technique uses historical data to estimate the fixed and variable components of a mixed cost. It provides a more accurate estimation than the high-low method but requires statistical software or tools. The steps involved are:
a. Plot the historical data points on a graph.
b. Use regression analysis to find a line of best fit that represents the relationship between the activity level and the total cost.
c. The slope of the line represents the variable cost per unit, while the y-intercept represents the fixed cost.
By using either the high-low method or regression analysis, the appropriate classification of mixed costs can be determined, enabling better decision-making in CVP analysis.
Mixed costs should be classified in CVP (Cost-Volume-Profit) analysis based on their variable and fixed components. The appropriate approach used to classify mixed costs is called the High-Low method or the Scattergraph method.
Here are the steps to classify mixed costs using the High-Low method:
1. Gather data: Collect data on costs and corresponding activity levels for a range of time periods. For example, gather data on total costs and activity levels (such as units produced, machine hours, or labor hours) for 6-12 months.
2. Identify the high and low data points: Determine the time periods with the highest and lowest activity levels. Identify the total costs associated with these levels.
3. Calculate the variable cost per unit: Subtract the total fixed cost (associated with the low activity level) from the total cost (associated with the high activity level) to get the total variable cost. Divide the total variable cost by the difference in activity levels to calculate the variable cost per unit of activity.
4. Calculate the fixed cost: Take the total cost associated with the low activity level and subtract the total variable cost (calculated in step 3) multiplied by the corresponding low activity level.
5. Verify the cost prediction: Use the variable cost per unit and the fixed cost to predict the total cost at different activity levels. Compare these predictions with the actual costs for the respective periods to ensure accuracy.
By following these steps, mixed costs can be properly classified into their variable and fixed components for CVP analysis.