Module 14Cost Behavior, Activity Analysis, and Cost Estimation

Basic Cost Behavior PatternsChange in total in direct proportion to changes in activity

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

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

Fixed CostsNo change as activity increases or decreasesNo response to short-run changes in activity cost drivers

Mixed CostsIncrease in a linear fashion when activity increasesPositive in amount when activity is zero

Step CostsIncrease in a step like fashion as activity increasesTotal cost shifts to a higher level when activity exceeds a range

Step cost: Y = ai

Shift in Cost StructureTotal cost function in recent yearsHas shifted to more fixed costs and lower variable costsImportant for organizations to manage their fixed costsExample: Vizio acquires television components rather than manufacturing them

Cost Behavior Pattern AssumptionsA unit of final output is the primary cost driverThe time period is too short to incorporate changes in strategic cost drivers such as the scale of operationsCauses some costs to be viewed as fixed in the short term, but appear variable in the long runThe four cost behavior patterns assume:

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

Relevant RangeA portion of a range of activity associated with the fixed cost of the current or expected capacityA normal range of activity in which a company expects to operate, where the fixed costs remain linear, i.e., total cost remains the sameExample: 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 RangeEconomists total cost function, referred to as curvilinear Accountants linear approximation of total cost function

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

Marginal Costs and Activity Levels

Predicting Total Costs With a Graph Total costs0 100 200 300 400 500$0$6,000 -

$5,000 -

$4,000 -

$3,000 -

$2,000 -

$1,000 -

Number of Customers served

Unit Variable Costs

Average Costs Number of Average CostCustomers Per customer 100 $35.00 300 $15.00 500 $11.00

Classifying Fixed CostsClassification depends on the immediate impact if the company attempts to change the fixed costs.Committed fixed costs, known also as capacity costs, are required to maintain the current service or production capacity or to fill previous legal commitments.Discretionary fixed costs , known also as managed fixed costs, are set at a fixed amount each period by management.

Cost Estimation

What is it?The determination of the relationship between activity and costAn important part of cost managementIdentifying variable or fixed costsAnalyzing available accounting recordsInterviewsPurpose of cost estimationCost predictioni.e., forecasting future costs

Estimating Mixed Cost ComponentsHigh-low methodScatter diagramsLeast-squares regression analysisMethods of estimating fixed and variable cost components

High-Low Cost Estimation Utilizes data from two time periods A high activity period, and a low activity periodSelect a representative high point and a representative low activity point.Determine variable costs per unit:Subtract total variable costs from total fixed costs using either the high or low point:Total costs [Variable cost per unit number of units]

High-Low Example: Variable Costs $31,600 $25,000 11,600 8,600 = $2.20The variable cost of each unit produced is $2.20.

High Low Example Fixed CostsVariable cost per unit (b) = $2.20 per unitJanuarya = Total costs Variable costs $25,000 = a + ($2.20 8,600 units) a = $6,080March $31,600 = a + ($2.20 11,600 units) a = $6,080The same total fixed costs result using either the high or low activity point.Calculate fixed costs:

High-Low Cost EstimationTotal costs [Variable cost per unit number of units] Y = $2.20X + 6,080Total Fixed Costs = Total Cost Equation:

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

Least-Squares RegressionAlso known as simple regression (one variable)A mathematical technique to fit a cost-estimating equation to observed dataMinimizes the vertical squared difference between the estimated and actual costs at each data pointAccomplished usingMicrosoft ExcelStatistical softwareSome calculatorsTime consuming math calculations

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

Least-Squares AdvantageSuperior to the high-low and scatter diagram methodsBecause it uses all data points, andDoes not rely on subjective judgmentStatistical measures are available to determine how well the equation fits the lineCoefficient of determination Measures the percent of variation in the dependent variable that the independent variable explainsAlso called R-squared (R2)

Simple and Multiple RegressionMultiple RegressionOften contains more than two variablesCan be used to determine the effect of individual product features on the market value of a product

Y = a + bXY = a + b1X1 + b2X2

Cautions in Developing Cost Estimate EquationsManagers are responsible for making decisionsMathematical models do not make decisions; they are tools to aid decision makingNot all data are based on normal operating conditionsNonlinear relationships may existResults should make sense

Cost Estimation Problems:Technology & PriceData used in developing cost estimates must be based on the same technology.

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

Cost Estimation Problems:Matching Activity & CostsActual costs are not known until a future time periodShorter time periods have higher probabilities of error in matching costs and activities

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

Cost Estimation Problems:Identifying Cost DriversCost 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 BehaviorAssumes 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 changesFrom labor-based to automated manufacturingFrom a limited number related products to multiple products, with variations in volume and complexityFrom a set of similar customers to a diverse set of customers

Manufacturing CostsDirect costs = easily or directly traceable to a finished product/service

Changing Composition of Total Manufacturing CostsThe problemPast tendency was to ignore overhead and focus on direct materials and laborUnits produced is no longer adequate in explaining manufacturing costsDealing with overhead causing activitiesInclude non-unit activity driversHierarchy scheme frameworks Manufacturing cost hierarchy, orCustomer cost hierarchy

Changing Composition of Total Manufacturing Costs

Changing Manufacturing Cost StructuresVariable CostsOnly one type of variable cost is considered: Variable CostsMany types of variable cost drivers are considered, including: Fixed CostsCosts that do not vary with the number of unitsFixed CostsCosts that do not respond to change in variable cost drivers are considered:Facility levelUnit levelUnit level, Batch level, &Product level

Manufacturing Cost HierarchyA separate cost driver is selected for each level of cost.

Unit Level ActivityCost of raw materialsCost of cutting a componentCost of a box to package cerealSales commissionCost of paint brushes used by a painting company to paint an office building

Examples:

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

Batch Level ActivityCost of processing sales ordersCost of tracking work ordersCost of equipment setupCost of moving a batch between work stationsCost of inspecting batches

Examples:

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

Product Level ActivityCost of product developmentCost of product marketing such as advertisingCost of specialized equipmentCost of maintaining specialized equipment

Examples:

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

Facility Level ActivityCost of maintaining factory building and groundsCost of real property taxesCost of non-specialized equipmentCost of general advertisingCost of factory supervisor

Examples:

This activity is performed to maintain general manufacturing capabilities.

Customer Cost Hierarchies for Merchandising and Sales DivisionsOften used byMerchandising organizationsSales divisions of manufacturersCustomer classification schemeUnit-level activitiesOrder-level activitiesCustomer-level activitiesFacility-level activities

Customer Cost Hierarchy for Distinct Market SegmentsOften used by companies that sell to distinct market segments, such asNot-for-profitFor profitGovernmentUnit-level activitiesOrder-level activitiesCustomer-level activitiesMarket-segment-level activitiesFacility-level activitiesCustomer classification scheme

Customer Cost Hierarchy for Unique ProjectsOften used byBuildersSpecial contracts with the governmentCustomer classification schemeProject-level activitiesMarket-segment-level activitiesFacility-level activities

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