Ch03 PPT Hongren CostAccounting 2e

Chapter 3
Determining how
costs behave
PowerPoint to accompany:
LEARNING OBJECTIVES
Describe linear cost functions and three common

ways in which they behave
Explain the importance of causality in estimating

cost functions
Describe various methods of cost estimation
Outline six steps in estimating a cost function using

quantitative analysis
Copyright 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442563377/Horngren/Cost accounting/2e
LEARNING OBJECTIVES
Describe three criteria used to evaluate and choose

cost drivers
Explain non-linear cost functions, in particular those

arising from learning curve effects
Explain of data problems encountered in estimating

cost functions.
Basic assumptions and examples of cost

functions
A cost function is a mathematical representation of how a

cost changes with changes in the level of an activity relating
to that cost.

functions
Variations in the level of a single activity (the cost driver) explain

the variations in the related total costs.
Cost behaviour is approximated by a linear cost function within

the relevant range:
represented graphically, the total cost versus the level of

a single activity related to that cost is a straight line
within the relevant range.
Linear cost functions
y = a + bX
The dependent
variable:
the cost that is
being predicted
The independent
variable:
the cost driver
The intercept:
fixed costs
The slope of
the line:
variable cost
per unit

functions
Linear cost functions illustrated:

functions
Review of cost classification
Choice of cost object different objects may result in different

classifications of the same cost.
Time horizon the longer the period, the more likely the cost
will be variable.
Relevant range behaviour is predictable only within this band

of activity.

functions
The relevant range illustrated:
Identifying cost drivers
Cost estimation measures a relationship based on data from past

costs and the related level of an activity.
Cost predictions are forecasts of future costs.
Better cost predictions help managers make planning and control

decisions that are more informed.
10
The cause-and-effect criterion in choosing

cost drivers
11
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.

cost drivers
12
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.
Note a high correlation (connection) between activities and

costs does not necessarily mean causality.

cost drivers web links
The tutorial Accounting Cost Behavior can be found at:

http://simplestudies.com/accounting-cost-behavior.html
A cost analysis spreadsheet (see item 5) can be found at:

http://www.bized.co.uk/learn/sheets/acc_index.htm
13
Cost estimation methods
14
Industrial engineering method
Conference method
Account analysis method
Quantitative analysis methods:
highlow method
regression analysis.

Industrial engineering method:
15
estimates cost functions by analysing the relationship between

inputs and outputs, in physical terms
includes time-and-motion studies
very thorough and detailed, but also costly and time-consuming
also called the work-measurement method.

Conference method:
16
estimates cost functions on the basis of analysis and opinions

about costs and their drivers gathered from various departments
of a company
pools expert knowledge
reliance on opinions still make this method subjective.

Account analysis method:
17
estimates cost functions by classifying various cost accounts

as variable, fixed, or mixed with respect to the identified level
of activity
is reasonably accurate, cost-effective, and easy to use but

is subjective.

Quantitative analysis method:
18
uses a formal mathematical method to fit cost functions to past

data observations
advantage results are objective.
Steps in estimating a cost function using

19
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 highlow method or
regression analysis.
Evaluate the cost driver of the estimated cost function.

Sample cost activity plot:
20

Highlow method:
21
simplest method of quantitative analysis
uses only the highest and lowest observed values.

Highlow method plot:
22

Steps in the highlow method:
23
calculate variable cost per unit of activity

Steps in the highlow method:
24
calculate total fixed costs
summarise by writing a linear equation
or, in text book terms: y = a + bX

Regression analysis:
25
is a statistical method that measures the average amount of change

in the dependent variable associated with a unit change in one or
more independent variables
is more accurate than the highlow method, because the regression

equation estimates costs using information from all observations; the
high-low method uses only two observations.

Regression analysis:
goodness of fit indicates the strength of the relationship

between the cost driver and costs
residual term measures the distance between actual cost and

estimated cost for each observation.
26

Types of regression:
27
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.

Sample regression model plot:
28

Alternative regression model plot:
29
Evaluating cost drivers of the estimated cost

function
Choosing among cost drivers:
30
economic plausibility
goodness of fit
significance of the independent variable.
Evaluating cost drivers of the estimated cost

function web link
31
Notes on A Few (Partial) Thoughts On Cost Estimation can be

found at:
http://faculty.txwes.edu/ttolleson/course1/documents/Hilo_Regress
ion.pdf
Cost drivers and activity-based costing
Activity-based costing (ABC) systems focus on individual activities.
To implement ABC systems managers must identify a cost driver for

each activity.
ABC systems have a great number and variety of cost drivers and
cost pools.
32
Cost behaviour analysis web links
Activity Based Costing (with questions) explained at:

http://www.accountingcoach.com/online-accounting-course/35Xpg0
1.html
Lecture notes with worked explanations for all of the preceding can
be found at:
http://www.docstoc.com/docs/8128902/Lecture_03_Cost-Behaviou
r
33
Non-linear cost functions
34
Economies of scale
Quantity discounts
Step cost functions resources increase in lot-sizes, not
individual units
Learning curves labour hours consumed decrease as workers
learn their jobs and become better at them
Experience curve broader application of learning curve
that includes downstream activities, including marketing
and distribution.
Non-linear cost functions
35
Learning curves
36
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 needed to

produce the last unit declines by a constant percentage each time the
cumulative quantity of units produced doubles.
Incremental unit-time learning model
37
38
39
Incorporating learning-curve effects into prices and

standards
40
Data collection and adjustment issues
41
The database should contain numerous reliably measured

observations of the cost driver and the related costs.
The database should consider many values spanning a wide

range for the cost driver.

Problems:
42
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.

Problems, contd:
43
extreme values of observations occur from errors in recording

costs
there is no homogeneous relationship between the cost driver and

the individual cost items in the dependent variable-cost pool. A
homogeneous relationship exists when each activity, whose costs
are included in the dependent variable, has the same cost driver
the relationship between the cost driver and the cost is not
stationary
inflation has affected costs, the driver, or both.
Appendix 3-1: Regression analysis
Estimating the regression line
Goodness of fit
Significance of independent variables.
44
45
Specification analysis of estimation assumptions testing of the

assumptions of regression analysis:
linearity within the relevant range
constant variance of residuals
independence of residuals.
Using regression output to choose cost drivers of cost functions
Multiple regression and cost hierarchies
Multicollinearity.
46

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Chapter 3

Describe linear cost functions and three common

Explain the importance of causality in estimating

Describe various methods of cost estimation

Outline six steps in estimating a cost function using

Describe three criteria used to evaluate and choose

Explain non-linear cost functions, in particular those

Explain of data problems encountered in estimating

Basic assumptions and examples of cost

A cost function is a mathematical representation of how a

Basic assumptions and examples of cost

Variations in the level of a single activity (the cost driver) explain

Cost behaviour is approximated by a linear cost function within

represented graphically, the total cost versus the level of

Linear cost functions

Basic assumptions and examples of cost

Basic assumptions and examples of cost

Choice of cost object different objects may result in different

Relevant range behaviour is predictable only within this band

Basic assumptions and examples of cost

Identifying cost drivers

Cost estimation measures a relationship based on data from past

Cost predictions are forecasts of future costs.

Better cost predictions help managers make planning and control

The cause-and-effect criterion in choosing

The most important issue in estimating a cost function is

The cause-and-effect criterion in choosing

A cause-and-effect relationship might arise as a result of:

a physical relationship between the level of activity and

Note a high correlation (connection) between activities and

The cause-and-effect criterion in choosing

The tutorial Accounting Cost Behavior can be found at:

A cost analysis spreadsheet (see item 5) can be found at:

Cost estimation methods

Industrial engineering method

Account analysis method

Quantitative analysis methods:

Cost estimation methods

estimates cost functions by analysing the relationship between

includes time-and-motion studies

very thorough and detailed, but also costly and time-consuming

also called the work-measurement method.

Cost estimation methods

estimates cost functions on the basis of analysis and opinions

pools expert knowledge

reliance on opinions still make this method subjective.

Cost estimation methods

estimates cost functions by classifying various cost accounts

is reasonably accurate, cost-effective, and easy to use but

Cost estimation methods

uses a formal mathematical method to fit cost functions to past

advantage results are objective.

Steps in estimating a cost function using

Choose the dependent variable (the cost to be predicted).

Steps in estimating a cost function using

Steps in estimating a cost function using

simplest method of quantitative analysis

uses only the highest and lowest observed values.

Steps in estimating a cost function using

Steps in estimating a cost function using

calculate variable cost per unit of activity

Steps in estimating a cost function using

calculate total fixed costs

summarise by writing a linear equation