Module 14

Cost Behavior, Activity Analysis, and Cost Estimation

Basic Cost Behavior Patterns

Change in total in direct proportion to Variable Costs changes in activity
Step Costs

Do not change in response to a change in activity volume Contain a fixed and variable cost element; sometimes called semi-variable costs Constant within a narrow range of activity, but shift to a higher level when activity exceeds the range

Mixed Costs

Fixed Costs

Variable Costs
Increases as activity increases Equals zero dollars when activity is zero

Variable cost: Y = bX
Higher variable costs per unit create a steeper line slope.

Total variable costs (Y)

0 Total activity (X)

b = Variable cost per unit

Fixed Costs
Fixed cost: Y = a
Slope is zero, represented by a flat line.

Total fixed costs (Y)

0 Total activity (X)

a = Total fixed costs

No change as activity increases or decreases No response to short-run changes in activity cost drivers

Mixed Costs

Increase in a linear fashion when activity increases Positive in amount when activity is zero
Mixed cost: Y = a + bX
Contains both fixed and variable cost elements. Variable portion Fixed portion
0

Total mixed costs (Y)

Total activity (X)

b = Variable cost per unit

Step Costs

Increase in a step like fashion as activity increases Total cost shifts to a higher level when activity exceeds a range
Step cost: Y = ai

Total step costs (Y)

0
Total activity (X)

Shift in Cost Structure

Total cost function in recent years

Has shifted to more fixed costs and lower variable costs Important for organizations to manage their fixed costs

Example: Vizio acquires television components rather than manufacturing them

The importance of managers understanding cost behavior continues to increase efforts to monitor and minimize total cost.

Cost Behavior Pattern Assumptions

The four cost behavior patterns assume:

A unit of final output is the primary cost driver The time period is too short to incorporate changes in strategic cost drivers such as the scale of operations

Causes some costs to be viewed as fixed in the short term, but appear variable in the long run

Total Cost Behavior

Total Cost Equation = Total Fixed Costs + (Variable Costs per Unit Number of Units)

Relevant Range

A portion of a range of activity associated with the fixed cost of the current or expected capacity A normal range of activity in which a company expects to operate, where the fixed costs remain linear, i.e., total cost remains the same
Example:

During normal operations, factory space is adequate for Mattel. However, during the three months preceding the holiday season, Mattels operations are out of the relevant range and storage trailers must be rented for the additional merchandise.

Relevant Range
Economists total cost function, referred to as curvilinear Accountants linear approximation of total cost function

Marginal Cost
Marginal cost is the varying increment in total cost of making one more unit.

Economist

Marginal Costs and Activity Levels

Excess capacity resulting in high marginal costs

Optimal circumstances with marginal costs relatively low

Capacity constraints resulting in high marginal costs

Predicting Total Costs With a Graph

Total costs $6,000 $5,000 $4,000 -

$3,000 $2,000 $1,000 $0 0

Total cost graph is useful in predicting total costs for the coming period.

100

200

300

400

500

Number of Customers served

Unit Variable Costs

Costs per Unit

$$$$$-

Unit variable costs stay the same at all activity levels.

100

200

300

400

500

Activity

Average Costs
Average costs

$35 -$30 -$25 -$20 -$15 --

Average cost graph is useful if a manager wants to know the cost of serving a customer
Number of Customers 100 300 500 Average Cost Per customer $35.00 $15.00 $11.00

$10 -$5 -$0 | 100 | 200 | 300 | 400 | 500

Number of customers served

Classifying Fixed Costs

Classification depends on the immediate impact if the company attempts to change the fixed costs.
Discretionary fixed costs , known also as managed fixed costs, are set at a fixed amount each period by management.

Committed fixed costs, known also as capacity costs, are required to maintain the current service or production capacity or to fill previous legal commitments.

Cost Estimation

What is it?
The determination of the relationship between activity and cost An important part of cost management

Identifying variable or fixed costs

Analyzing available accounting records Interviews

Purpose of cost estimation

Cost prediction

i.e., forecasting future costs

Estimating Mixed Cost Components

Methods of estimating fixed and variable cost components

High-low method Scatter diagrams Least-squares regression analysis

Variable Costs
Mixed Costs Fixed Costs

High-Low Cost Estimation

Utilizes data from two time periods

A high activity period, and a low activity period representative low activity point.

Step 1: Select a representative high point and a

Step 2: Determine variable costs per unit:

Variable Costs = Per Unit Difference in total costs Difference in activity

Step 3: Subtract total variable costs from total fixed

costs using either the high or low point:

Total Fixed Costs =

Total costs [Variable cost per unit number of units]

High-Low Example: Variable Costs

Number of Shipments Packaging Costs

Low activity period

High activity period

January February March April

8,600 9,800 11,600 11,200

$25,000 26,000 31,600 33,000 = $2.20

Variable cost $31,600 $25,000 per unit (b) = 11,600 8,600

The variable cost of each unit produced is $2.20.

High Low Example Fixed Costs

Calculate fixed costs:
Variable cost per unit (b) = $2.20 per unit a January March = Total costs Variable costs

$25,000 = a + ($2.20 8,600 units) a = $6,080 $31,600 = a + ($2.20 11,600 units) a = $6,080

The same total fixed costs result using either the high or low activity point.

High-Low Cost Estimation

Variable Costs = per Unit
Difference in total costs Difference in activity
$30,000

$25,000 $10,000 0
8600 11,600

Total Fixed Costs =

Total costs [Variable cost per unit number of units]

Total Cost Equation:

Y = $2.20X + 6,080

Scatter Diagrams
A graph of past activity and cost data, with individual observations represented by dots

When used alone to estimate costs, professional judgment is required.

Least-Squares Regression

Also known as simple regression (one variable) A mathematical technique to fit a costestimating equation to observed data Minimizes the vertical squared difference between the estimated and actual costs at each data point Accomplished using
Microsoft Excel Statistical software Some calculators Time consuming math calculations

Least-Squares Criterion

The least-squares method minimizes the sum of all squared vertical deviations between individual observations and the cost-estimating line.

Least-Squares Advantage

Superior to the high-low and scatter diagram methods

Because it uses all data points, and Does not rely on subjective judgment

Statistical measures are available to determine how well the equation fits the line

Coefficient of determination

Measures the percent of variation in the dependent variable that the independent variable explains Also called R-squared (R2)

Simple and Multiple Regression

Simple Regression equation (one variable) Multiple Regression equation with two variables

Y = a + bX

Y = a + b1X1 + b2X2

Multiple Regression
Often contains more than two variables Can be used to determine the effect of individual product features on the market value of a product

Cautions in Developing Cost Estimate Equations

Managers are responsible for making decisions

Mathematical models do not make decisions; they are tools to aid decision making

Not all data are based on normal operating conditions Nonlinear relationships may exist Results should make sense

Cost Estimation Problems: Technology & Price

Changes in Technology

Data used in developing cost estimates must be based on the same technology.

Changes in Prices

Data used must reflect the same price level, or be restated to a single price level.

Cost Estimation Problems: Matching Activity & Costs

Time Lags

Actual costs are not known until a future time period Shorter time periods have higher probabilities of error in matching costs and activities

Examples: Vehicle mileage is used consistently but maintenance costs occur every few months Cell phone bills arrive at the end of the month, but usage occurs throughout the month

Cost Estimation Problems: Identifying Cost Drivers

Which cost driver should be used?

Cost driver should have a logical, causal relationship with costs Scatter diagrams and statistical measures are helpful Selection of a driver requires judgment and professional experience

Unit-Level Cost Behavior

Assumes changes in costs are best explained by changes in the number of units of product (or service provided) Inaccurate for analyzing cost behavior when a company changes
From labor-based to automated manufacturing From a limited number related products to multiple products, with variations in volume and complexity From a set of similar customers to a diverse set of customers

Manufacturing Costs
Direct Materials
Cost of primary raw materials converted into finished goods
Direct costs = easily or directly traceable to a finished product/service

Direct Labor
Wages earned by production employees for the time they spend converting raw materials into finished products

Manufacturing Overhead
All manufacturing costs other than direct materials and direct labor

Changing Composition of Total Manufacturing Costs

The problem
Past tendency was to ignore overhead and focus on direct materials and labor Units produced is no longer adequate in explaining manufacturing costs

Dealing with overhead causing activities

Include non-unit activity drivers

Hierarchy scheme frameworks Manufacturing cost hierarchy, or Customer cost hierarchy

Changing Composition of Total Manufacturing Costs

Changing Manufacturing Cost Structures

Volume-Based Unit Level Analysis Variable Costs Only one type of variable cost is considered: Unit level Activity-Based Multiple-Level Analysis Variable Costs Many types of variable cost drivers are considered, including:
Unit level, Batch level, & Product level

Fixed Costs Costs that do not vary with the number of units

Fixed Costs Costs that do not respond to change in variable cost drivers are considered:
Facility level

Manufacturing Cost Hierarchy

Unit level activities

Batch level activities

Product level activities Facility level activities

A separate cost driver is selected for each level of cost.

Unit Level Activity

This activity is performed for each unit of product produced or sold.

Examples: Cost of raw materials Cost of cutting a component Cost of a box to package cereal Sales commission Cost of paint brushes used by a painting company to paint an office building

Batch Level Activity

This activity is performed for each batch of product produced or sold.

Examples: Cost of processing sales orders Cost of tracking work orders Cost of equipment setup Cost of moving a batch between work stations Cost of inspecting batches

Product Level Activity

This activity is performed to support the production of each different type of product.

Examples: Cost of product development Cost of product marketing such as advertising Cost of specialized equipment Cost of maintaining specialized equipment

Facility Level Activity

This activity is performed to maintain general manufacturing capabilities.

Examples: Cost of maintaining factory building and grounds Cost of real property taxes Cost of non-specialized equipment Cost of general advertising Cost of factory supervisor

Customer Cost Hierarchies for Merchandising and Sales Divisions

Often used by
Merchandising organizations Sales divisions of manufacturers Customer classification scheme

Unit-level activities Order-level activities Customer-level activities Facility-level activities

Answers questions about the cost of individual orders or costs of individual customers

Customer Cost Hierarchy for Distinct Market Segments

Often used by companies that sell to distinct market segments, such as

Not-for-profit For profit Government

Answers questions about the profitability of a segment

Unit-level activities Order-level activities Customer classification Customer-level activities Market-segment-level activities scheme Facility-level activities

Customer Cost Hierarchy for Unique Projects

Often used by
Builders Special contracts with the government

Customer classification scheme

Project-level activities Market-segment-level activities Facility-level activities

Answers questions about the cost of individual projects