Chapter Ten

Determining How Costs Behave

Learning Objectives
Define cost functions

Causality and cost functions

Linear functions Quantitative cost estimation techniques Non-linear functions Data problems

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Cost Function
A mathematical representation of the behavior of costs relative to activity level
Variable costscosts that change in relation to a chosen

activity or output
Fixed costscosts that do not change in relation to a

chosen activity or output

Mixed costscosts that have both fixed and variable

components; also called semi-variable costs

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Cost Estimation: Variable Costs

Variable Costs Directly based on resource usage Variable Step Costs - Total

cost is fixed within a narrow

range

Total Pay Per View Bill

Number of Pay Per View shows watched

Volume purchase buy 5 movies for $10

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Cost Estimation: Fixed Costs

Fixed Costs constant no Fixed Step Costs - constant

matter how much of a resource

is used

for a wide range of activity,

then jumps to a higher level

Monthly Basic Cable Bill

Number of hours watched

Rent an additional floor in

an office tower
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The Relevant Range

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Criteria for Classifying Variable and Fixed Costs

Choice of cost object
Different objects may result in different classifications

Time horizon
The longer the period, the more likely the cost will be

variable Relevant range

Behavior is predictable only within a band of activity
Extrapolation vs. interpolation
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Linear Cost Functions

y = a + bX
The dependent variable: the cost that is being predicted
The intercept: fixed costs

The independent variable: the cost driver The slope of the line: variable cost per unit
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Accounting and Mathematical Terminology

Accounting
Variable Cost
Fixed Cost Mixed Cost

Mathematical
Slope
Intercept Linear Cost Function

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Linear Cost Functions

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Cause and Effect

A cause-and-effect relationship might arise as a result of:
A physical relationship between the level of activity

and costs
A contractual agreement

Knowledge of operations

Correlation does not necessarily mean causality

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Cost Estimation Methods

1.

Industrial engineering method

2.
3. 4.

Conference method
Account analysis method Quantitative analysis methods
1. 2.

High-low method Regression analysis

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Industrial Engineering Method

Analyze the relationship between inputs and outputs in

physical terms
Time-and-motion studies Very thorough and detailed, but also costly and time-

consuming
Also called the work-measurement method

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Conference Method
Gather analyses and opinions about costs and their drivers

from various departments

Pool expert knowledge Subjective

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Account Analysis Method

Classify cost accounts as variable, fixed, or mixed with

respect to the identified level of activity

Is reasonably accurate, cost-effective, and easy to use Subjective

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Quantitative Analysis
Uses a formal mathematical method to fit cost functions to

data observations
Advantage: results are objective High-Low Method - uses algebra to determine a unique

equation between representative high and low cost points

Least-Squares Regression Method - Uses statistical

techniques to determine the relationship between

activity and cost
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Estimating a Cost Function Using Quantitative Analysis

1. 2. 3. 4. 5.

Choose the dependent variable (the cost to be predicted) Identify the independent variable or cost driver Collect data on the dependent variable and the cost driver

Plot the data

Estimate the cost function using the high-low method or regression analysis Evaluate the viability of the model

6.

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Sample CostActivity Plot

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Sample CostActivity Plot

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High-Low Method

1.

Calculate variable cost per unit of activity

Variable Cost per Unit of Activity

Cost associated with highest activity level Highest activity level

Cost associated with lowest activity level Lowest activity level

High-Low Method
2.

Calculate total fixed costs

Total Cost from either the highest or lowest activity level - (Variable Cost per unit of activity X Activity associated with above total cost) Fixed Costs

3.

Summarize by writing a linear equation.

Y = Fixed Costs + ( Variable cost per unit of Activity * Activity ) Y = FC + (VCu * X)

High-Low Method

Not resistant to unusual situations

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Using the High-Low Method

What are the variable and the fixed costs for this situation?
Y = a + (bX) Where Y = the value of the estimated cost X = the cost driver a = a fixed quantity that represents Y when X is zero b = the slope of the line (unit variable cost)

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The High-Low Method

Pros:
Requires less effort than regression analysis Provides a reasonable cost equation from which you can

estimate future costs

Cons:
Relies on only two subjectively determined points Regression analysis, based on statistical estimation, would

provide more accurate estimates

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Regression Analysis
A statistical method that;
Measures an average amount of change in the dependent

variable
Associated with a unit change in one or more independent

variables More accurate than the high-low method

Uses information from all observations

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Types of Regression
Simple estimates the relationship between the

dependent variable and one independent variable

Multiple estimates the relationship between the

dependent variable and two or more independent variables

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Regression Analysis
Minimize the sum of the squares of the estimation errors:
An error is the distance measured from the regression line

to the data point

Referred to as least-squares regression

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Criteria for Evaluating Alternative Cost Drivers

1. 2. 3.

Economic plausibility Goodness of fit Significance of the independent variable

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Sample Regression Model Plot

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Alternative Regression Model Plot

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Regression Analysis
Pros:
Objective, statistically precise Provides quantitative measures of its precision and

reliability
the statistical goodness of fit & validity of the

regression, measured by R2, t-values, and p-values)

Readily available software will do the calculations

Cons:
Can be influenced by outlier data points

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Nonlinear Cost Functions

Economies of scale Quantity discounts Step cost functions Resources increase in lot-sizes, not individual units

Learning curves
Labor hours decrease as workers learn their jobs Experience curve Broader application of learning curve that includes

downstream activities such as marketing and distribution

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Nonlinear Cost Functions

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Learning Curve
A cost that is influenced by learning
Repetitive labor that becomes more proficient over time

Learning curve analysis is a systematic method for estimating learning based costs
The learning rate is the percentage by which average time

falls from previous levels as output doubles

A learning rate ranges from 1.0 (no learning) to 0.5 (infinite

learning)

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Learning Curve
The general equation used in learning-curve analysis:

Y = aXb Where: Y = the average time per unit of output a = the time required for the first unit of output X = cumulative output b = the learning index
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Learning Curve

Learning effects are large initially Average Labor Time per Unit

Learning effects become smaller, eventually reaching steady state

Cumulative Production Output

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Types of Learning Curves

Cumulative average-time learning model

Cumulative average time per unit declines by a constant

percentage each time the cumulative quantity of units produced doubles

Incremental unit-time learning model

Incremental time to produce the last unit declines by a

constant percentage each time the cumulative quantity of units produced doubles

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Cumulative Average-Time Model

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Incremental Unit-Time Model

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The Ideal Database

Should contain numerous reliably measured observations of

the cost driver and the costs

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Data Problems
The time period for measuring the dependent variable

does not match the period for measuring the cost driver
Fixed costs are allocated as if they are variable Data are either not available for all observations or are

not uniformly reliable

Extreme values occur from errors in recording costs The relationship between the cost driver and the cost is

not static
Inflation has affected costs, the driver, or both
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