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Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -1

Chapter 3 Measurement of Cost Behavior Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -2

Chapter 3 Learning Objectives When you have finished studying this chapter, you should be able to: 1. Explain management influences on cost behavior. 2. Measure and mathematically express cost functions and use them to predict costs. 3. Describe the importance of activity analysis for measuring cost functions. 4. Measure cost behavior using the engineering analysis, high-low, visual-fit, and least-squares regression methods. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -3

Cost Drivers and Cost Behavior Accountants and managers often assume that cost behavior is linear over some relevant range of activity or cost-driver levels. We can graph linear-cost behavior with a straight line because we assume each cost to be either fixed or variable. Recall that the relevant range specifies the interval of cost-driver activity within which a specific relationship between a cost and its driver will be valid. Managers usually define the relevant range based on their previous experience operating the organization at different levels of activity. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -4

Linear-Cost Behavior Costs are assumed to be fixed or variable within the relevant range of activity Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -5

Learning Objective 1 Management’s Influence on Cost Behavior Product and service decisions and the value chain Capacity Technology Policies to create incentives to control costs Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -6

The Value Chain Managers influence cost behavior throughout the value chain through their choices of: • process and product design, • quality levels, • product features, • distribution channels, etc. . Each decision contributes to the organization’s performance. Managers must consider the costs and benefits of each decision. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -7

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. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -8

Committed Fixed Costs Committed fixed costs arise from the possession of facilities, equipment, and a basic organization. Lease payments Property taxes Salaries of key personnel Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 -9

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 organization’s goals. These discretionary fixed costs have no obvious relationship to levels of output activity but are determined as part of the periodic planning process. Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next planning period. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 10

Examples of Committed and Discretionary Fixed Costs Amounts Advertising and promotion Depreciation Employee training Management salaries Mortgage payment Property taxes Research and development Total Planned $ 50, 000 400, 000 100, 000 800, 000 250, 000 600, 000 1, 500, 000 $3, 700, 000 Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 11

Examples of Committed and Discretionary Fixed Costs Committed Depreciation Mortgage payment Property taxes Total committed Planned Amounts $ 400, 000 250, 000 600, 000 $1, 250, 000 Discretionary (potential savings) Advertising and promotion $ 50, 000 Employee training 100, 000 Management salaries 800, 000 Research and development 1, 500, 000 Total discretionary $2, 450, 000 Total committed and discretionary $3, 700, 000 Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 12

Technology Decisions Choosing the type of technology an organization will use to produce products or deliver services is a critical decision for management. Choice of technology (e-commerce versus in-store or mail-order sales) positions the organization to meet its current goals and to respond to changes in the environment. The use of high-technology methods rather than labor usually means a much greater fixed-cost component to the total cost. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 13

Cost-Control Incentives Managers use their knowledge of cost behavior to set cost expectations. Employees may receive rewards that are tied to meeting these expectations. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 14

Learning Objective 2 Cost Functions Managers will use cost functions often as a planning and control tool. Planning and controlling the activities of an organization require useful and accurate estimates of future fixed and variable costs. Cost measurement involves estimating or predicting costs as a function of appropriate cost drivers. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 15

Cost Functions Understanding relationships between costs and their cost drivers allows managers to. . . Make better operating, marketing, and production decisions Plan and evaluate actions Determine appropriate costs for short-run and long-run decisions. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 16

Cost Functions The first step in estimating or predicting costs is measuring cost behavior as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of cost-driver activity. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 17

Cost Function Equation Let: Y = Total cost F = Fixed cost V = Variable cost per unit X = Cost-driver activity in number of units The mixed-cost function is called a linear-cost function. Mixed-cost function: Y = F + VX Y = $10, 000 + $5. 00 X Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 18

Developing Cost Functions The cost function must be believable. A cost function’s estimates of costs at actual levels of activity must reliably conform with actually observed costs. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 19

Learning Objective 3 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. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 20

Choice of Cost Drivers: Activity Analysis Northwestern Computers makes two products: Mozart-Plus and Powerdrive In the past, most of the support costs were twice as much as labor costs. Northwest has upgraded the production function, which has increased support costs and reduced labor cost. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 21

Choice of Cost Drivers: Activity Analysis Using the old cost driver, labor cost, the prediction of support costs would be: Mozart-Plus $ 8. 50 Labor cost Support cost: 2 × Direct labor cost $17. 00 Powerdrive $130. 00 $260. 00 Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 22

Choice of Cost Drivers: Activity Analysis Using the more appropriate cost driver, the number of components added to products, companies can predict support costs more accurately. Support cost at $20 per component $20 × 5 components $20 × 9 components Difference in predicted support cost Mozart-Plus $100. 00 $ 83. 00 higher Powerdrive $180. 00 $ 80. 00 lower Managers will make better decisions with this more accurate information. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 23

Learning Objective 4 Methods of Measuring Cost Functions 1. 2. 3. 4. 5. Engineering analysis Account analysis High-low analysis Visual-fit analysis Least-squares regression analysis Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 24

Engineering Analysis Engineering analysis measures cost behavior 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. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 25

Account Analysis The simplest method of account analysis selects a plausible cost driver and classifies each account as a variable or fixed cost. Parkview Medical Center Monthly cost Amount Fixed Variable Supervisor’s salary and benefits $ 3, 800 $3, 800 Hourly workers’ wages and benefits 14, 674 $14, 674 Equipment depreciation and rentals 5, 873 Equipment repairs 5, 604 Cleaning supplies 7, 472 Total maintenance costs $37, 423 $9, 673 $27, 750 Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 26

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) Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 27

High-Low Method Plot historical data points on a graph. Focus on the highest- and lowest-activity points. 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 Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 28

High-Low Method Example The point at which the line intersects the Y axis is the intercept, F, or estimate of Fixed Costs, and the slope of the line measures the variable cost. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 29

High-Low Method Example What is the variable cost (V)? Using algebra to solve for variable and fixed costs. Variable costs = Change in costs change in activity V = ($47, 000 – $17, 000) ÷ (4, 900 – 1, 200) = $30, 000 ÷ 3, 700 = $8. 1081 Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 30

High-Low Method Example What is the fixed cost (F)? F = Total mixed cost – total variable cost At X (high): F = $47, 000 - ($8. 1081× 4, 900 patient-days) = $47, 000 – $39, 730 = $7, 270 a month At X (low): F = $17, 000 = ($8. 1081× 1, 200 patient-days) = $17, 000 – $9, 730 = $7, 270 a month Cost function measured by high-low method: Y = $7, 270 per month + ($8. 1081 × patient-days) Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 31

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. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 32

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. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 33

Least-Squares Regression Method Y = $9, 329 + ($6. 951 × patient-days) Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 34

Coefficient of Determination One measure of reliability, or goodness of fit, is the coefficient of determination, R² (or R-squared). The coefficient of determination measures how much of the fluctuation of a cost is explained by changes in the cost driver. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 35

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2014 Pearsonto Education, Inc. publishing Prentice Hall © 2005 Prentice Hall Business Publishing, Introduction Management Accountingas 13/e, Horngren/Sundem/Stratton 3 - 36