CIA2009: Management Accounting

Lecture 3: 27 September 2017

CHAPTER 6

Activity Analysis, Cost

Behavior, and Cost
Estimation

Dr. Elaine Y.N. Oon

 Learning Objective 1

Explain the relationships between cost

estimation, cost behavior, and cost prediction.

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Introduction

Cost Cost Cost

estimation behavior prediction

Process of Relationship Using knowledge

determining between of cost behavior
cost behavior, cost and to forecast
often focuses activity. level of cost at
on historical a particular
data. activity. Focus
is on the future.

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 Learning Objective 2

Define and describe the behavior of the different

types of costs.

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Total Variable Cost Example
Your total Pay Per View bill is based on how many Pay Per View
shows that you watch.
Total Pay Per View Bill

Number of Pay Per View shows

watched 6-5
Variable Cost Per Unit Example
The cost per Pay Per View show is constant. For example, $4.95
per show.

Cost per Pay Per View

show

Number of Pay Per View

shows watched 6-6
 Extent of Variable Costs
The proportion of variable costs differs across organizations. For example . . .

A public utility with

large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A service company A merchandising company

will normally have a high usually will have a high
proportion of variable costs. proportion of variable costs,
like cost of sales.
Step-Variable Costs

Total cost remains

constant within a
narrow range of
activity.

Cost
Activity

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Step-Variable Costs
Total cost increases to a
new higher cost for the
next higher range of
activity.

Cost
Activity

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 Total Fixed Cost Example
Your monthly basic cable TV bill probably does not change no matter
how many hours you watch.
Monthly Basic
Cable Bill

Number of hours watched

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Fixed Cost Per Unit Example
The average cost per hour decreases as more hours are spent
watching cable television.

Monthly Basic cable Bill

per hour watched

Number of hours watched

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 The Trend Toward Fixed Costs
The trend in many industries is toward greater fixed costs relative to
variable costs.

As machines take over Knowledge workers

many mundane tasks
previously performed
by humans,
knowledge workers
are demanded for
their minds rather
than their muscles.
tend to be salaried,
highly-trained and
difficult to replace. The
cost to compensate
these valued employees
is relatively fixed
rather than variable.
Is Labor a Variable or a Fixed Cost?
The behavior of wage and salary costs can differ across countries,
depending on labor regulations, labor contracts, and custom.

In France, Germany, China, and Japan, management has

little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.

In the United States and the United Kingdom, management

has greater latitude. Labor costs are more variable in nature.
Step-Fixed Costs
Example: Office space is
available at a rental rate of
$30,000 per year in increments
of 1,000 square feet. As the
business grows more space is
rented, increasing the total
cost.

Continue

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Step-Fixed Costs
Total cost doesnt change for a wide range of activity,
and then jumps to a new higher cost for the next
higher range of activity.

90
Thousands of Dollars
Rent Cost in

60

30

0 1,000 2,000 3,000

Rented Area (Square Feet) 6-15
Step-Fixed Costs

Step-variable costs
can be adjusted more
How does this type quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is much
cost? wider for the
step-fixed cost.

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 Types of Cost Behavior Patterns
Recall the summary of our cost behavior discussion from last week.

More output = more cost

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity
level within the relevant range.
Total fixed cost remains the
same even when the activity
Fixed level changes within the
relevant range.
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
More output = lower cost per unit
 Quick Check
Which of the following statements about cost behavior are true?

1. Fixed costs per unit vary with the level of activity.

2. Variable costs per unit are constant within the relevant
range.
3. Total fixed costs are constant within the relevant range.
4. Total variable costs are constant within the relevant range.
 Quick Check
Which of the following statements about cost behavior are true?

1. Fixed costs per unit vary with the level of activity.

2. Variable costs per unit are constant within the relevant
range.
3. Total fixed costs are constant within the relevant range.
4. Total variable costs are constant within the relevant range.
Semivariable (Mixed) Cost

A semivariable or
mixed cost is partly
fixed and partly
variable.
Consider the
following
example:.
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Semivariable (Mixed) Cost
The slope is
the variable
cost per unit
of activity.
Total Lease Cost

Variable Lease
Charge Per Hour

Fixed Monthly
Rental Charge
Rental Charge Per Hour
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Semivariable (Mixed) Cost
Semivariable (Mixed) Cost
Semivariable (Mixed) Cost
Semivariable (Mixed) Cost
Semivariable (Mixed) Cost: Example

If your fixed monthly utility charge is $40, your variable cost is

$0.03 per kilowatt hour, and your monthly activity level is
2,000 kilowatt hours, what is the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 2,000)
Y = $100
Curvilinear Cost Curvilinear
Cost Function
Total Cost

A straight-line
(constant unit
variable cost) closely
approximates a
curvilinear line within
Relevant Range the relevant range.

Activity
6-27
To summarize..

COST FUNCTION
A cost function is a mathematical representation of how a
cost changes with changes in the level of an activity relating
to that cost
Bridging Accounting and Statistical
Terminology

Accounting Statistics
Variable Cost Slope
Fixed Cost Intercept
Mixed Cost Linear Cost Function

Y = a + bx
The Linear Cost Function
(Mixed Cost)

y = a + bX
The Dependent The Independent
Variable: Variable:
The cost that is The cost driver
being predicted

The Slope of
The Intercept: the Line:
Fixed costs Variable cost
per unit
Fixed Cost Function, Graphically
Total Cost Function: Y = $10,000

$60,000

$50,000

$40,000

$30,000

$20,000

$10,000

$-
0 2000 4000 6000 8000 10000 12000
Variable Cost Function, Graphically
Total Cost Function: Y = $5X

$60,000

$50,000

$40,000

$30,000

$20,000

$10,000

$-
0 2000 4000 6000 8000 10000 12000
Total Cost Function, Graphically
Total Cost Function: Y = $10,000 + $5X

$70,000

$60,000

$50,000

$40,000

$30,000

$20,000

$10,000

$-
0 2000 4000 6000 8000 10000 12000
Cost Functions Combined
$70,000

$60,000

$50,000

$40,000
Variable Cost Y = $5X
Fixed Cost Y = $10,000
Total Cost Y = $10,000 + $5X
$30,000

$20,000

$10,000

$-
0 2000 4000 6000 8000 10000 12000
 Learning Objective 3

Explain the importance of the relevant range in

using a cost behavior pattern for cost prediction.

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Curvilinear Cost Curvilinear
Cost Function
Total Cost

A straight-Line
(constant unit
variable cost) closely
approximates a
curvilinear line within
Relevant Range the relevant range.

Activity
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 Learning Objective 4

Define and give examples of engineered costs,

committed costs, and discretionary costs.

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Engineered, Committed, and Discretionary
Costs
Committed Discretionary
Long-term, cannot be May be altered in the
reduced in the short short term by current
term. managerial decisions.

Engineered
Physical relationship
with activity measure.

Depreciation on Advertising and

Buildings and Direct Research and
equipment Materials Development
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Cost Behavior in Other Industries
Merchandisers Service Organizations
Cost of Goods Sold Supplies and travel

Examples of variable costs

Manufacturers Merchandisers and

Manufacturers
Direct Material, Direct
Labor, and Variable Sales commissions and
Manufacturing Overhead shipping costs
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Cost Behavior in Other Industries
Examples of fixed costs

Merchandisers, manufacturers, and

service organizations
Real estate taxes
Insurance
Sales salaries
Depreciation

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Criteria for Classifying Variable and
Fixed Components of a Cost
1. Choice of Cost Object different objects may result in
different classification of the same cost

2. Time Horizon the longer the period, the more likely

the cost will be variable

3. Relevant Range cost behavior is predictable only

within this band of activity (the given relevant range)
 Learning Objective 5

Describe and use the following cost estimation

methods: account classification, visual fit, high-
low, and least-squares regression

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Cost Estimation
Account-Classification Method

Visual-Fit Method

High-Low Method

Least-Squares Regression Method

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Account Classification Method

Each costs is classified as variable, fixed

or mixed based on the analysts
knowledge of the firms activities and
experience with the firms costs.
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Visual-Fit Method
A scatter diagram of past cost behavior
may be helpful in analyzing mixed costs.

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 Visual-Fit Method
Plot the data points on a
graph (total cost vs. activity).
1,000s of Dollars

20
* ** *
Total Cost in

* *
**
10 * *

0
0 1 2 3 4
Activity, 1,000s of Units Produced
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 Visual-Fit Method
Draw a line through the plotted data points so that about
equal numbers of points fall above and below the line.
1,000s of Dollars

20
* ** *
Total Cost in

* *
**
10 * *

0
0 1 2 3 4
Activity, 1,000s of Units Produced
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 Visual-Fit Method

Estimated fixed cost = $10,000

(the intercept)
20
1,000s of Dollars ($)

* ** *
Total Cost in

16
* *
** Vertical distance
10 * * is total cost,
approximately
$16,000
0
0 1 2 3 4
Activity, 1,000s of Units Produced
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 An Example: Visual Fit Method
(The Scattergraph Method)
Use one data point to estimate the total level of
activity and the total cost
Y
Total maintenance cost = $11,000
20
Maintenance Cost
1,000s of Dollars

* * * ** *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000s
Patient days = 800
 An Example: Visual Fit Method
(The Scattergraph Method)
Make a quick estimate of variable cost per unit and
determine the cost equation.
Total maintenance at 800 patients $ 11,000
Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

Fixed cost
Analyze a mixed cost
using the high-low
method.
The High-Low Method
Owl Co recorded the following production activity &
maintenance costs for two months:

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100

Using these two levels of activity, compute:

1) the variable cost per unit.
2) the total fixed cost.
3) express the cost in equation form:Y = a + bX
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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Change in cost
Unit variable cost = Change in units

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit

Fixed cost = Total cost Total variable cost

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit

Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($0.90 per unit 9,000 units)

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit

Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($.90 per unit 9,000 units)
Fixed cost = $9,700 $8,100 = $1,600

Total cost = Fixed cost + (Variable cost per unit of activity x Activity)
Y = a + bX
Y = $1600 + $0.90 X
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Quick Check
Sales salaries and commissions are $10,000 when 80,000 units are
sold, and $14,000 when 120,000 units are sold. Using the high-
low method, what is the variable portion of sales salaries and
commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
 Quick Check
Sales salaries and commissions are $10,000 when 80,000 units are
sold, and $14,000 when 120,000 units are sold. Using the high-
low method, what is the variable portion of sales salaries and
commission?
a. $0.08 per unit
Units Cost
b. $0.10 per unit High level 120,000 $ 14,000
c. $0.12 per unit Low level 80,000 10,000
d. $0.125 per unit Change 40,000 $ 4,000

$4,000 40,000 units

= $0.10 per unit
Quick Check
Sales salaries and commissions are $10,000 when 80,000 units
are sold, and $14,000 when 120,000 units are sold. Using the
high-low method, what is the fixed portion of sales salaries and
commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
Quick Check
Sales salaries and commissions are $10,000 when 80,000 units
are sold, and $14,000 when 120,000 units are sold. Using the
high-low method, what is the fixed portion of sales salaries and
commissions?
a. $ 2,000 Total cost = Total fixed cost +
Total variable cost
b. $ 4,000
$14,000 = Total fixed cost +
c. $10,000 ($0.10 120,000 units)
d. $12,000 Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000
Least-Squares Regression Method
Regression is a statistical procedure used
to determine the relationship between variables such as
activity and cost.
Total Cost

The objective of
the regression
method is the
general cost equation:
Y = a + bX

Activity
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Equation Form of Least-Squares
Regression Line

Y = a + bX

Total Cost is the The activity (X) is the

dependent variable. independent variable.

The intercept term (a) is The X term coefficient (b)

the estimate of fixed costs. is the estimate of variable
cost per unit of activity,
the slope of the cost line.
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Least-Squares Regression Method
Statistics courses and computer
courses deal with detailed
regression computations using
Microsoft Excel.
Accountants and managers must
be able to interpret and use
regression estimates.

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 Learning Objective 6

Describe the multiple regression, engineering, and

learning-curve approaches to cost estimation.

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Multiple Regression
Multiple regression includes two or more independent variables:

Y = a + b1X1 + b2X2

Terms in the equation have the same

meaning as in simple regression with
only one independent variable.

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Engineering Method
of Cost Estimation

Cost estimates are based on measurement

and pricing of the work involved.
Very thorough and detailed, but also costly
and time consuming
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Engineering Method
of Cost Estimation

Direct Labor Direct Material

Analyze the kind Material required

of work performed. for each unit is
Estimate the time obtained from
required for each labor engineering drawings
skill for each unit. and specification sheets.

Use local wage rates to Material prices are

obtain labor cost determined from
per unit. vendor bids.

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Effect of Learning
on Cost Behavior
As I make more of these
things it takes me less
time for each one. It must
be the learning curve effect
that the boss was
talking about.
Ive noticed the same
thing. And if you include
all the variable overhead
costs that are also
declining, that must be
the experience curve.
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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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 Learning Objective 7
Describe some problems often encountered in
collecting data for cost estimation.

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Data Collection Problems
1. Missing data.
2. Outlier data points: errors
3. Mismatched time periods costs.
4. Trade-offs in choosing the time period.
5. Allocated and discretionary costs.
6. Inflation affecting the cost or cost driver or
both.
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End of Chapter 6

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