Determining How Costs Behave Dr Hisham Madi 1

Determining How Costs Behave Dr. Hisham Madi 1 -1

Basic Cost Behavior Patterns Ø When managers make decisions, they need to compare the costs (and benefits) among alternative actions Ø Therefore, managers need to estimate the costs associated with each alternative. Ø Good decisions require good information about costs; the better these estimates, the better the decision managers will make. 1 -2

Basic Cost Behavior Patterns Ø The most important characteristic of costs for decision making is how they behave— how they vary with activity is the key distinction for decision making. Ø Therefore, the basic idea in cost estimation is to estimate the relation between costs and the variables affecting costs, the cost drivers Ø It is focused on the relation between costs and one important variable that affects them: activity level. Ø Activities can be measured by volume (for example, units of output, machine-hours, pages typed, miles driven), by complexity (for example, number of different products, number of components in a product), or by any other cost driver. 1 -3

How to determine cost behaviour Ø understanding how costs change with changes in activity levels, units of products produced, and so on. Ø Knowing how costs vary by identifying the drivers of costs and by distinguishing fixed from variable costs is frequently the key to making considered management decisions. Ø Many managerial functions such as planning and control rely on knowing how costs will behave Ø Should a component part be made or purchased? 1 -4

How to determine cost behaviour Ø Should we make the item or buy it? Ø What effect will a 20% increase in units sold have on operating profit? 1 -5

Basic assumptions and examples of cost functions Ø A cost function is a mathematical function describing cost behaviour patterns – how costs change with changes in the cost driver Ø Cost functions can be plotted on graph paper by measuring the cost driver on the x-axis and the corresponding amount of total costs on the y-axis 1 -6

Basic assumptions and examples of cost functions Two assumptions are frequently made when estimating cost functions: 1. Variations in the total costs of a cost-object are explained by variations in a single cost driver. 2. Cost behavior is approximated by a linear cost function within the relevant range. Ø a relevant range is the range of the activity in which there is a relationship between total cost and the level of activity. 1 -7

Cost Terminology Variable costs Ø Costs that change in total in relation to some chosen activity or output Fixed costs Ø Costs that do not change in total in relation to some chosen activity or output Mixed costs Ø Costs that have both fixed and variable components; also called semivariable costs. 1 -8

Linear Cost Function y = a + b. X The independent variable: the cost driver The dependent variable: the cost that is being predicted The intercept: fixed costs 1 -9 The slope of the line: variable cost per unit

Bridging Accounting and Statistical Terminology 1 -10 Accounting Statistics Variable Cost Slope Fixed Cost Intercept Mixed Cost Linear Cost Function

Linear Cost Functions Illustrated 1 -11

Criteria for Classifying Variable and Fixed Components of a Cost Choice of cost object— Ø A particular cost item could be variable with respect to one cost object and fixed with respect to another. Ø For example, annual van registration and licence costs would be a variable cost with respect to the number of vans owned and operated by PLUS Company. Ø But registration and licence costs for a particular van are a fixed cost with respect to the number of kilo/meters that the van covered during the year. 1 -12

Criteria for Classifying Variable and Fixed Components of a Cost Time span 1 -13 Ø The longer the period, the more likely the cost will be variable Ø For example, inspection costs at Boeing Company are typically fixed in the short run with respect to inspection-hours used because inspectors earn a fixed salary in a given year regardless of the number of inspection-hours of work done Ø But, in the long run, Boeing’s total inspection costs will vary with the inspection-hours required: More inspectors will be hired if more inspection-hours are needed, and some inspectors will be reassigned to other tasks

Criteria for Classifying Variable and Fixed Components of a Cost Relevant range Ø Behavior is predictable only within this band of activity. Ø Outside the relevant range, variable and fixed cost-behavior patterns change, causing costs to become nonlinear 1 -14

Cause and Effect as It Relates to Cost Drivers Ø The most important issue in estimating a cost function is determining whether a cause-and-effect relationship exists between the level of an activity and the costs related to that level of activity. Ø Without a cause-and-effect relationship, managers will be less confident about their ability to estimate or predict costs. 1 -15

The Cause-and-Effect Criterion The cause-and-effect relationship may arise as a result of: Ø A physical relationship between the level of activity and costs. There is a physical relationship between direct materials and the number of units produced Ø A contractual arrangement. For example, in a car rental contract that charges by the mile, miles driven is specified in the contract as the activity that affects the rental cost Ø Knowledge of operations. A product with many parts will incur higher ordering costs than a product with few parts. If the company is measuring ordering costs, the activity driver could be number of parts 1 -16

The Cause-and-Effect Criterion Ø Managers must be careful not to interpret a high correlation, or connection, in the relationship between two variables to mean that either variable causes the other Ø Be careful not to interpret a high correlation, or connection, between two variables to mean that either variable causes the other Ø A high correlation between two variables, u and v, indicates merely that the two variables move together Ø It is possible that u may cause v; v may cause u; u and v may interact; both may be affected by a third variable z; or the correlation may be due to chance 1 -17

The Cause-and-Effect Criterion Ø No conclusions about cause and effect are warranted by high correlations. Ø For example, higher production generally results in higher materials costs and higher labour costs. Materials costs and labour costs are highly correlated, but neither causes the other. 1 -18

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