Week 5

Measurement of Cost Behaviour
Chapter 3
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3-1
Step- and Mixed-Cost Behaviour Patterns

Step costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks.
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
3-2

Lease cost example
Relevant range Actual cost behavior
Lease cost
Fixed cost approximation
Oil and gas exploration activity


Supermarket checker wage cost example
Relevant range Actual cost behaviour
Wage cost
Variable cost approximation

40
Shoppers per hour
440
3-4

Mixed costs contain elements of both fixed- and variable-cost behavior. The fixed-cost element is unchanged over a range of cost-driver activity. The variable-cost element varies proportionately with cost-driver activity.

Facilities maintenance department cost
Relevant range $5.00 per patient day Total variable cost $10,000 Fixed cost 1,000 5,000
Number of patient-days per month

1.
Management influence on cost behaviour Product and Service Decisions and the Value Chain
Quality levels Product features Distribution channels
Choice of process and product design
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2. Capacity Decisions
They are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, e.g. quality
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2. Capacity Decisions (Contd.)

Good economic conditions Full capacity, New plant & assembly lines Overtime, oursource production
Adverse economic conditions Cannot recover fixed costs Can be eliminated

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3. Committed Fixed Costs

Committed fixed costs usually arise from the possession of facilities, equipment, and a basic organization. Lease payments Property taxes Salaries of key personnel
2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 3 - 10
4. Discretionary Fixed Costs

Discretionary fixed costs are costs fixed at certain levels only because management decided that these levels of cost should be incurred to meet the organizations goals. These discretionary fixed costs have no obvious relationship to levels of output activity but are determined as part of the periodic planning process.
4. Discretionary Fixed Costs (Contd.)

Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next planning period.
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Examples of Discretionary Fixed Costs

Advertising and promotion Employee training Management salaries Research and development
5. Technology Decisions
Choice of technology (e-commerce vs. in-store or mail-order sales) positions the organization to meet its current goals and to respond to changes in the environment.
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6. Cost-Control Incentives
Managers use their knowledge of cost behaviour to set cost expectations. Employees may receive rewards that are tied to meeting these expectations.
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Cost Functions
Planning and controlling the activities of an organization require accurate and useful estimates of future fixed and variable costs.
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Cost Functions (Contd.)

Understanding relationships between costs and their cost drivers allows managers to... evaluate strategic plans and operational improvement programs. make short- and long-run decisions. plan or budget the effects of future activities.
Cost Functions (Contd.)

The 1st step in estimating or predicting costs is measuring cost behaviour as a function of appropriate cost drivers. The 2nd step is to use these cost measures to estimate future costs at expected levels of cost-driver activity.
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Cost Function Equation

Y = Total cost F = Fixed cost V = Variable cost per unit X = Cost-driver activity in number of units
Cost Function Equation (Contd.)

Mixed-cost function: Y = F + VX Y = $10,000 + $5.00X The mixed-cost function is called a linear-cost function.
Developing Cost Functions
The cost function must be believable.
A cost functions estimates of costs at actual levels of activity must reliably conform with actually observed costs.
Choice of Cost Drivers: Activity Analysis

Choosing a cost function starts with choosing cost drivers. Managers use activity analysis to identify appropriate cost drivers. Activity analysis directs management accountants to the appropriate cost drivers for each cost.

Northwestern Computers makes 2 products: Mozart-Plus and Powerdrive In the past, most of the support costs were twice as much as labour costs. Northwest has upgraded the production function, which has increased support costs and reduced labour cost.

Using the old cost driver, labour cost, the prediction of support costs would be: Mozart-Plus Powerdrive $ 8.50 $130.00 $260.00
Labour cost Support cost: 2 Direct labour cost $17.00
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Using the more appropriate cost driver, the number of components added to products, the predicted support costs are:
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Mozart-Plus Powerdrive Support cost at $20/component $20 5 components $100.00 $20 9 components Difference in predicted support cost $ 83.00 higher
$180.00 $ 80.00 lower

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Methods of Measuring Cost Functions

1. Engineering analysis 2. Account analysis 3. High-low analysis 4. Visual-fit analysis 5. Least-squares regression analysis
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1. Engineering Analysis
It measures cost behaviour according to what costs should be, not by what costs have been. Engineering analysis entails a systematic review of materials, supplies, labor, support services, and facilities needed for products and services.
2. Account Analysis
The simplest method of account analysis selects a plausible cost driver and classifies each account as a variable or fixed cost.
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Account Analysis Example

Monthly cost
Supervisors salary and benefits Hourly workers wages and benefits Equipment depreciation and rentals Equipment repairs Cleaning supplies Total maintenance costs
Amount
$ 3,800 14,674 5,873 5,604 7,472 $37,423
Fixed
$3,800
Variable
$14,674
5,873 5,604 7,472 $27,750
$9,673
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Account Analysis Example

3,700 patient-days Fixed cost per month = $9,673 Variable cost per patient-day = $27,750 3,700 = $7.50 per patient-day Y = $9,673 + ($7.50 patient-days)
3. High-Low Method
The first step is to plot the historical data points on a graph.
The focus of this method is normally on the highest- and lowest-activity points.
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High-Low Method Example

High month: April Maintenance cost: $47,000 Number of patient-days: 4,900 Low month: September Maintenance cost: $17,000 Number of patient-days: 1,200 What is the variable cost?

($47,000 $17,000) (4,900 1,200) = $30,000 3,700 = $8.1081
What is the fixed cost?
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$47,000 = Fixed cost + ($8.1081 4,900) $47,000 $39,730 = $7,270
$17,000 = Fixed cost + ($8.1081 1,200) $17,000 $9,730 = $7,270
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4. Visual-Fit Method
In the visual-fit method, the cost analyst visually fits a straight line through a plot of all of the available data, not just between the high point and the low point, making it more reliable than the high-low method.
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5. Least-Squares Regression Method

Regression analysis measures a cost function more objectively by using statistics to fit a cost function to all the data. Regression analysis measures cost behavior more reliably than other cost measurement methods.
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Coefficient of Determination
One measure of reliability, or goodness of fit, is the coefficient of determination, R (or R-squared). The coefficient of determination measures how much of the fluctuation of a cost is explained by changes in the cost driver.
Exercise 3-50 (Page 120)

Sandra, a cost analyst at ABC Company, was asked to predict overhead costs for the companys operations in 2005, when 510 units are expected to be produced. She collected the following quarterly data:
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Quarter 1/01 2/01 3/01 4/01 1/02 2/02 3/02 4/02 1/03 2/03 3/03 4/03 1/04 2/04 3/04
Production (units) 76 79 72 136 125 128 125 133 124 129 115 84 84 122 90
Overhead costs (RM) 721 715 655 1131 1001 1111 1119 1042 997 1066 996 957 835 1050 991
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Exercise 3-50 (Page 120) (Contd.)

1. Using the high-low method to estimate costs, prepare a prediction of overhead costs for 2005. Variable cost/unit = ($1,131 - $655) (136 - 72) = $476 64 = $7.4375 Fixed cost = $1,131 - (136 x 7.4375) = $119.50

Predicted cost for 510 units = ($119.50 x 4) + (510 x $7.4375) = $4,271.13 Notice that the data are quarterly observations. Thus, the annual fixed cost is 4 times the computed (quarterly) fixed cost.
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2. Sandy ran a regression analysis using the data she had collected. The result was: Y = RM337 + 5.75X Using this cost function, predict costs for 2005. Predicted cost for 510 units = ($337 x 4) + (510 x $5.75) = $4,280.50

3. Which prediction do you prefer? Why? The regression analysis gives better cost estimates because it uses all the data to form a cost function. The 2 points used by the high-low method may not be representative of the general relation between costs and volume.
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Measurement of Cost Behaviour

Step- and Mixed-Cost Behaviour Patterns

Step- and Mixed-Cost Behaviour Patterns

Fixed cost approximation

Oil and gas exploration activity

Step- and Mixed-Cost Behaviour Patterns

Variable cost approximation

Shoppers per hour

Step- and Mixed-Cost Behaviour Patterns

Step- and Mixed-Cost Behaviour Patterns

Number of patient-days per month

Choice of process and product design

2. Capacity Decisions (Contd.)

Adverse economic conditions Cannot recover fixed costs Can be eliminated

3. Committed Fixed Costs

4. Discretionary Fixed Costs

4. Discretionary Fixed Costs (Contd.)

Examples of Discretionary Fixed Costs

Cost Functions (Contd.)

Cost Functions (Contd.)

Cost Function Equation

Cost Function Equation (Contd.)

Developing Cost Functions

The cost function must be believable.

Choice of Cost Drivers: Activity Analysis

Choice of Cost Drivers: Activity Analysis

Choice of Cost Drivers: Activity Analysis

Labour cost Support cost: 2 Direct labour cost $17.00

Choice of Cost Drivers: Activity Analysis

Choice of Cost Drivers: Activity Analysis

$180.00 $ 80.00 lower

Methods of Measuring Cost Functions

Account Analysis Example

5,873 5,604 7,472 $27,750

Account Analysis Example

High-Low Method Example

High-Low Method Example

What is the fixed cost?

High-Low Method Example

$17,000 = Fixed cost + ($8.1081 1,200) $17,000 $9,730 = $7,270

5. Least-Squares Regression Method

Exercise 3-50 (Page 120)

Exercise 3-50 (Page 120) (Contd.)

Exercise 3-50 (Page 120) (Contd.)

Exercise 3-50 (Page 120) (Contd.)

Exercise 3-50 (Page 120) (Contd.)

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