Chapter 3

Cost behaviour, cost drivers

and cost estimation

Copyright

2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An

Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

Basic concepts
Cost behaviour
The relationship between a cost and the
level of activity or cost driver

Cost estimation
The process of determining the cost
behaviour of a particular cost item

Cost prediction
Using knowledge of cost behaviour to
focus the level of cost at a particular level
of activity

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Cost drivers
A cost driver
An activity or factor that causes costs to be
incurred
The higher the correlation between the cost
and cost driver, the more accurate is the
description and understanding of cost
behaviours

Conventional understandings of cost

behaviour regarded costs as variable or
fixed, based on the level of production
volume

continued

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Cost drivers
Contemporary viewpoints recognise
that there are a range of possible
costs divers other than production
volume (non-volume cost drivers)
Activity-based approaches classify
costs and cost drivers into four levels:
Unit
Batch
Product, and
Facility
continued

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Cost drivers
Unit level costs

Relate to activities that are performed for each

unit produced
Uses conventional volume-based cost drivers

Batch level costs

Relate to activities performed for a group of
product units

Product (or product-sustaining) level

Relate to activities performed for specific
products or product groups

Facility level
Costs incurred to run the business
continued

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Cost drivers
Selecting the best cost drivers
Input or outputs?
An example of an input cost driver is the weight
of material, and an output driver is the number
of units of production
Cost benefit principles will determine the choice

How detailed should the analysis be?

Long or short term?
Cost behaviour and cost drivers can change
over time
Depends on the purpose of the cost prediction
continued

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Cost drivers
Cost drivers for cost estimation or cost
management?
Cost drivers that are used to predict costs,
may differ from those used to manage
costs
Effective cost management requires the
identification of root cause cost drivers
The basic costs that cause a cost to be incurred
The true causes of costs
continued

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Cost drivers
In choosing cost drivers the costs and
benefits of each driver must be
assessed:
Reasons for analysing cost behaviour
Timeframes for analysing the cost
behaviour
Availability of data on cost drivers, and
Any other uses for the cost behaviour
information

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Cost behaviour patterns

Cost behaviour patterns
Variable costs
Fixed costs
Step-fixed costs
Semi-variable costs
Curvilinear costs

continued

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Cost behaviour patterns

Variable costs
Change in total in direct proportion to a
change in activity
The variable cost is the slope of the cost
line in the following cost function:
Y = a + bX
Where Y = total cost
a = fixed cost component (the intercept on the vertical
axis)
b = variable cost per unit of activity (the slope of the line)
X = the level of activity

continued

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Cost behaviour patterns

Fixed costs
Remains unchanged in total as the level of
activity varies
As activity increases, total fixed costs do
not change, but unit fixed cost declines
Contemporary approaches to cost analysis
recognise that there are cost drivers for
some of these fixed costs, and very few
costs remain fixed
continued

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Cost behaviour patterns

Step-fixed costs
Remain fixed over a wide range of activity
levels but jump to a different amount for
levels outside that range

Semi-variable cost
Has both fixed and variable components

Curvilinear cost
Has a curved cost line, but is often
approximated as a semi-variable cost
function

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continued

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Cost behaviour patterns

Cost structures are shifting towards a
decreasing proportion of costs that
vary with production due to:
Labour being replaced by equipment,
which does not vary with production
output
Production wages moving towards fixed
salaries that do not vary with production
activity levels

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Cost estimation
Approaches to cost estimation
Managerial judgement
Engineering approach, and
Quantitative analysis

Using managerial judgment to

estimate costs
The account classification method
involves managers using their judgement
to classify costs as exhibiting certain
behaviours

continued

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Cost estimation
The engineering approach to estimating
costs
Studying processes that result in the
incurrence of a cost
Focus on the relationships that should exist
between inputs and outputs
Using time and motion studies (or task
analysis) where employees are observed as
they undertake work tasks
Activity-based approaches extend task
analysis to the study of indirect activities
and costs

continued

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Cost estimation
Estimating costs using quantitative
analysis
A scatter plot can be useful in allowing us to
plot the data points to visualise the relationship
between cost and the level of activity
The high-low method involves taking the two
observations with the highest and lowest level
of activity to calculate the cost function
Regression analysis is a statistical technique
that uses all observations to determine the
cost function
continued

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Cost estimation
Regression analysis
Allows us to estimate the line of best fit by
making the deviations between the cost
line and the data points as small as
possible
Simple regression involves estimating the
relationship between the dependent
variable (Y) and one independent variable
(X)
Y = a + bX
continued

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Cost estimation
Regression analysis
Multiple regression allows us to include
two or more independent variables, that
is, cost drivers
Y = a + b1X1 + b2X2
The regression line can be evaluated
using several criteria:
Economic plausibility
Goodness of fit

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Practical issues in cost

estimation
Data collection problems
1. Missing data
2. Outliers
3. Mismatched time periods for dependent and
independent variables
4. Trade-offs in choosing the number of
observations and the reliability of past data
points as predictors of future cost behaviour
5. Allocated fixed costs
6. Inflation
continued

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Practical issues in cost

estimation
Effect of learning on cost behaviour
In estimating labour costs for relatively new
product or processes, labour times per unit
may decrease at varying rates

Activity-based approaches allows us to

consider more complex cost behaviour
patterns
Costs are assigned to activities
Unit, batch and product level costs are
assumed to vary in proportion to their cost
drivers

continued

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Practical issues in cost

estimation
The accuracy of cost functions
Sometimes approximate estimates are
used to estimate cost functions within firms
Why is the case?
Limited time and knowledge to undertake
quantitative techniques
The data required to estimate reliable cost
functions may not exist
A low priority may be given to determining
accurate cost behaviour and cost estimation
Subjective cost estimates may be considered
good enough for the firms needs

continued

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Practical issues in cost

estimation
All cost functions are based on
simplifying assumptions, such as:
Cost behaviour depends on a single
activity
Cost behaviours are linear within a
relevant range

Costs and benefits of producing

accurate cost information need to be
assessed
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