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.