Determining How Costs Behave Chapter 10 2003 Prentice

Learning Objective 1 Explain the two assumptions frequently used in cost-behavior estimation. © 2003

Assumptions in Cost-Behavior Estimation Changes in total costs can be explained by changes in the level of a single activity. Cost behavior can adequately be approximated by a linear function of the activity level within the relevant range. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 3

Learning Objective 2 Describe linear cost functions and three common ways in which they

Cost Function What is a cost function? It is a mathematical expression describing how costs change with changes in the level of an activity. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 5

Cost Function La Playa Hotel offers an airline three alternative cost structures to accommodate its crew overnight: 1. $60 per night per room usage y = $60 x The slope of the cost function is $60. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 6

Cost Function © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 -

Cost Function 2. $8, 000 per month y = $8, 000 is called a constant or intercept. The slope of the cost function is zero. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 8

Cost Function 3. $3, 000 per month plus $24 per room This is an example of a mixed cost. y = $3, 000 + $24 x y = a + bx © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 10

Cost Classification and Estimation Function Choice of cost object Time span Relevant range ©

Choice of Cost Object Example If the number of taxis owned by a taxi company is the cost object, annual taxi registration and license fees would be variable costs. If miles driven during a year on a particular taxi is the cost object, registration and license fees for that taxi are fixed costs. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 13

Time Span Whether a cost is variable or fixed with respect to a particular activity depends on the time span. More costs are variable with longer time spans. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 14

Relevant Range Variable and fixed cost behavior patterns are valid for linear cost functions only within the given relevant range. Costs may behave nonlinear outside the range. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 15

Cost Estimation What is cost estimation? It is the attempt to measure a past cost relationship between costs and the level of an activity. Past cost-behavior functions can help managers make more accurate cost predictions. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 16

The Cause-and-Effect Criterion In Choosing Cost Drivers Physical relationship Contractual agreements Implicitly established by logic © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 17

Learning Objective 3 Understand various approaches to cost estimation. © 2003 Prentice Hall Business

Cost Estimation Approaches Industrial engineering method Conference method Account analysis method Quantitative analysis methods © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 19

Account Analysis Example The cost analyst uses experience and judgment to separate total costs into fixed and variable. Avisha & Co. sells software programs. Total sales = $390, 000 The company sold 1, 000 programs. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 20

Account Analysis Example Cost of goods sold = $130, 000 Manager’s salary = $60, 000 Secretary’s salary = $29, 000 Commissions = 12% of sales What is the total fixed cost? $60, 000 + $29, 000 = $89, 000 What is the fixed cost per unit sold? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 21

Account Analysis Example $89, 000 ÷ 1, 000 = $89. 00 What is the variable cost per unit sold? Cost of goods sold: $130, 000 Commissions: $390, 000 ×. 12 = $46, 800 ($130, 000 + $46, 800) ÷ 1, 000 = $176. 80 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 22

Learning Objective 4 Outline six steps in estimating a cost function on the basis of past cost relationships. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 23

Steps In Estimating A Cost Function Step 1: Choose the dependent variable. Step 2: Identify the independent variable cost driver(s). Step 3: Collect data on the dependent variable and the cost driver(s). © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 24

Steps In Estimating A Cost Function Step 4: Plot the data. Step 5: Estimate the cost function. Step 6: Evaluate the estimated cost function. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 25

High-Low Method Example High capacity December: 55, 000 machine-hours Cost of electricity: $80, 450 Low capacity September: 30, 000 machine-hours Cost of electricity: $64, 200 What is the variable rate? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 26

High-Low Method Example ($80, 450 – $64, 200) ÷ (55, 000 – 30, 000) $16, 250 ÷ 25, 000 = $0. 65 What is the fixed cost? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 27

High-Low Method Example $80, 450 = Fixed cost + (55, 000 × $0. 65) Fixed cost = $80, 450 – $35, 750 = $44, 700 $64, 200 = Fixed cost + (30, 000 × $0. 65) Fixed cost = $64, 200 – $19, 500 = $44, 700 y = a + bx y = $44, 700 + ($0. 65 × Machine-hours) © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 28

Regression Analysis It is used to measure the average amount of change in a dependent variable, such as electricity, that is associated with unit increases in the amounts of one or more independent variables, such as machine-hours. Regression analysis uses all available data to estimate the cost function. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 29

Regression Analysis Simple regression analysis estimates the relationship between the dependent variable and one independent variable. Multiple regression analysis estimates the relationship between the dependent variable and multiple independent variables. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 30

Regression Analysis The regression equation and regression line are derived using the least-squares technique. The objective of least-squares is to develop estimates of the parameters a and b. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 31

Regression Analysis The vertical difference (residual term) measures the distance between the actual cost and the estimated cost for each observation. The regression method is more accurate than the high-low method. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 32

Learning Objective 5 Describe three criteria used to evaluate and choose cost drivers. ©

Criteria to Evaluate and Choose Cost Drivers Economic plausibility Goodness of fit Slope of the regression line © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 34

Goodness of Fit The coefficient of determination (r ) expresses the extent to which the changes in (x) explain the variation in (y). An (r ) of 0. 80 indicates that more than 80% of the change in the dependent variable can be explained by the change in the independent variable. 2 2 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 35

Slope of Regression Line A relatively steep slope indicates a strong relationship between the cost driver and costs. A relatively flat regression line indicates a weak relationship between the cost driver and costs. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 36

Slope of Regression Line The closer the value of the correlation coefficient (r) to ± 1, the stronger the statistical relation between the variables. As (r) approaches +1, a positive relationship is implied, meaning the dependent variable (y) increases as the independent variable (x) increases. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 37

Slope of Regression Line As (r) approaches – 1, a negative, or inverse, relationship is implied, meaning the dependent variable (y) decreases as the independent variable (x) increases. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 38

Learning Objective 6 Explain and give examples of nonlinear cost functions. © 2003 Prentice

Nonlinearity and Cost Functions A nonlinear cost function is a cost function in which the graph of total costs versus the level of a single activity is not a straight line within the relevant range. Economies of scale Quantity discounts Step cost functions © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 40

Nonlinearity and Cost Functions Economies of scale in advertising may enable an advertising agency to double the number of advertisements for less than double the cost. Quantity discounts on direct materials purchases produce a lower cost per unit purchased with larger orders. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 41

Nonlinearity and Cost Functions A step function is a cost function in which the cost is constant over various ranges of the level of activity, but the cost increases by discrete amounts as the level of activity changes from one range to the next. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 42

Learning Objective 7 Distinguish the cumulative average-time learning model from the incremental unit-time learning model. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 43

Learning Curves A learning curve is a function that shows how labor-hours per unit decline as units of output increase. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 44

Experience Curve This is a function that shows how the costs per unit in various value chain areas decline as units produced and sold increase. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 45

Cumulative Average-Time Learning Model Cumulative average time per unit is reduced by a constant percentage each time the cumulative quantity of units produced is doubled. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 46

Incremental Unit-Time Learning Model The time needed to produce the last unit is reduced by a constant percentage each time the cumulative quantity of units produced is doubled. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 47

Learning Objective 8 Be aware of data problems encountered in estimating cost functions. ©

Data Collection and Adjustment Issues The ideal database for cost estimation has two characteristics: 1. It contains numerous reliably measured observations of the cost driver(s) and the cost that is the dependent variable. 2. It considers many values for the cost driver that span a wide range. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 49

Data Collection and Adjustment Issues Time periods do not match. Fixed costs are allocated as if they were variable. Data are either not available or not reliable. Inflation may play a role. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 50

Data Collection and Adjustment Issues Extreme values of observations occur from errors in recording costs. Analysts should adjust or eliminate unusual observations before estimating a cost relationship. There is no homogeneous relationship. The relationship between the cost driver and the cost is not stationary. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 51

Data Collection and Adjustment Issues The most difficult task in cost estimation is collecting high-quality, reliably measured data on the dependent variable and the cost driver(s). © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 10 - 52