Chapter 5:

COST BEHAVIOUR
Group 4
Leader:
Camano, Ma. Reina Nina
Members:
Arce, Hadjia Venice
Ilagan, Kimberley
Recto, Jean Pauline
Gregorio, Cherry Mae
Liwag, Kissette Joy
Cataquiz,Jhonalyn
Rosales, Karen Gail
Profitability is just around the corner.
 COST BEHAVIOR
The way a specific cost reacts to
changes in activity levels is called cost
behavior. Costs may stay the same or
may change proportionately in
response to a change in activity.
Knowing how a cost reacts to a change
in the level of activity makes it easier to
create a budget, prepare a forecast,
determine how much profit a new
product will generate, and determine
which of two alternatives should be
selected.
Cost Behavior, Cost Estimation, and
Cost Prediction
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
Relationship between Cost estimation,
Cost behavior, and Cost Prediction
 COST ESTIMATION
Cost estimation is the art of assigning
value. It is also a science making use of
a wide range of techniques to predict
the costs of activities and assets.
The accuracy of the estimate depends
heavily on the level of project scope
definition: as the design and conditions
of the project become better defined,
so do the estimated values.
Cost estimation is needed to provide
decision makers with the means to
make investment decisions, choose
between alternatives and to set up the
budget during the front end of
projects.
What Is a Cost Driver?
Let's imagine that you have just opened a new business.
At your place of business, you sell various electronics
ranging from computers to televisions to car stereos. Since
electronics always seem to be in demand, you hope to
have had great success with your new business. However,
after about three months in business, you realize that the
costs that you incurred are significantly higher than
anticipated. These costs have begun to cut into your
profits, and it's time to figure out what' happening.
You soon realize that a particular brand of car stereos
have had an abundance of returns, because the volume
button does not work well. It was at that time that you
also realized that those returns have become a cost
driver.
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.
COST DRIVERS
Conventional understandings of cost behaviour
regarded costs as variable or fixed, based on
the level of production volume.
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
COST DRIVERS
1. Unit level costs
Relate to activities that are performed for each unit
produced
Uses conventional volume-based cost drivers
2. Batch level costs
Relate to activities performed for a group of product units
3. Product (or product-sustaining) level
Relate to activities performed for specific products or
product groups
4. Facility level
Costs incurred to run the business
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
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
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
COST DRIVER
A cost driver triggers a change in the cost of an activity. The concept is
most commonly used to assign overhead costs to the number of
produced units. It can also be used in activity-based costing analysis to
determine the causes of overhead, which can be used to minimize
overhead costs.
Examples of cost drivers are as follows:
Direct labor hours worked
Number of customer contacts
Number of engineering change orders issued
Number of machine hours used
Number of product returns from customers
If a business is only concerned with following the minimum accounting
requirements to allocate overhead to produced goods, then just a single
cost driver will be used.
COST DRIVER
Examples of Cost Drivers:

Let's take a minute to look at some common costs

drivers that affect businesses:
Direct labor: this is exactly what the name indicates -
the employees needed to work for a business
Setting up equipment: Many businesses need
machines in order to conduct business, often required
to manufacture a product
Special instructions: Sometimes customers have
specific demands about products. When this happens,
a company incurs costs.
COST DRIVER
Examples of Cost Drivers:
Handling and storage: if a company needs to store its products,
it may have to pay for that storage. If a company has to pay
employees or companies to handle products, like getting them
ready to ship, there are also costs.
Components: A company may be incurring costs based on the
components in the products it produces. Obviously, the more
components in a product, the higher the costs. From our
example earlier, stereos have a lot of components, which means
they cost more money to produce than, say, a rubber ball.
Machine hours: Like mentioned earlier, machines are often used
to produce goods. The amount of hours that a machine runs to
make those products is often a cost driver for companies.
Returns: When customers return products, businesses have to
endure costs, such as restocking the item.
Nature of Cost
Managerial accounting methods provide
techniques for evaluating the viability and ability
to grow or scale a business. These techniques
are called cost-volume-profit analysis (CVP).
CVP fundamentally depends upon developing
an understanding of the nature and behavior of
an entitys costs. To understand how a business is
going to perform over time and with shifts in
volume, it is imperative to first consider the cost
structure of the business. This requires drilling
down into the specific types of costs that are to
be incurred and trying to understand their
unique attributes.
Two Basic Types of Cost
Variable costs will vary in direct proportion to
changes in the level of an activity. For example,
direct material, direct labor, sales commissions,
and so on, may be expected to increase with
each additional unit of output.
The opposite of variable costs are fixed costs.
Fixed costs do not fluctuate with changes in the
level of activity. Examples include administrative
salaries, rents, and property taxes.
Cost behaviour patterns
1. Variable costs
2. Fixed costs
3. Step-fixed costs
4. Semi-variable costs
5. Curvilinear costs
Cost behaviour patterns
1. 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
Cost behaviour patterns
The ACTIVITY BASE is a measure of whatever causes the
incurrence of variable cost.
It is sometimes referred to as cost driver
1. Direct Labor-hours
2. Machine-hours
3. Units produced
4. Units sold

You can assume that the activity base under

consideration is the total volume of goods and
services provided by the organization
Cost behaviour patterns
TWO KINDS OF VARIABLE COST

1. True Variable/Proportionately Variable Cost

Direct Materials is a true variable cost because the amount used
during a period will vary in direct proportion to the level of
production activity.

2. Step-Variable Cost
It is a resource that is obtainable only in large chunks and whose
costs increase or decrease only in response to fairly wide
changes in activity.
Cost behaviour patterns
Cost behaviour patterns

2. 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
Cost behaviour patterns
Fixed costs are those which do not change with the level of activity
within the relevant range. These costs will incur even if no units are
produced. For example rent expense, straight-line depreciation
expense, etc.
Fixed cost per unit decreases with increase in production. Following
example explains this fact:
Cost behaviour patterns
Cost behaviour patterns
Cost behaviour patterns
Cost behaviour patterns
Cost behaviour patterns
Cost behaviour patterns

3. Step-fixed costs

Remain fixed over a wide range of

activity levels but jump to a different
amount for levels outside that range.
Cost behaviour patterns

A step fixed cost is a cost that does not change

within certain high and low thresholds of activity,
but which will change when these thresholds
are breached. When the cost changes as a
result of a threshold breach, a new set of high
and low activity thresholds will then apply, within
which the fixed cost will not change
appreciably. The concept is useful when
deciding whether to invest in capital projects.
Cost behaviour patterns
A threshold breach can result in one of two conditions in
regard to a step fixed cost:
Activity declines. When the activity level declines below
the lower threshold level, management has the option
of terminating or reducing the associated step fixed
cost.
Activity increases. When the activity level increases
above the upper threshold level, management has the
choice of either accepting no additional activity and
not incurring an additional step fixed cost, or of
accepting the increase in activity and incurring the
additional cost
Cost behaviour patterns
Cost behaviour patterns
4. Semi-variable cost
Has both fixed and variable
components.
Cost behaviour patterns
Cost behaviour patterns
5. Curvilinear cost
Has a curved cost line, but is often
approximated as a semi-variable cost
function.
-A curvilinear cost, also called a nonlinear
cost, is an expense that increases at an
inconsistent rate as production volume
increases. In other words, this is an irregular
cost that increases at different rates as total
output increases.
Cost behaviour patterns
Cost Behavior 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
Product Cost Behavior

Direct Material Variable

Direct Labor Variable

Overhead Variable, fixed, or mixed