McGraw-Hill/Irwin

7-1
Activity Analysis, Cost
Behavior, and Cost
Estimation
Chapter Seven
McGraw-Hill/Irwin
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Cost
prediction
Using knowledge
of cost behavior
to forecast
level of cost at
a particular
activity. Focus
is on the future.
Introduction
Cost
behavior
Relationship
between
cost and
activity.
Process of
determining
cost behavior,
often focusing
on historical
data.
Cost
estimation
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Cost Behavior Patterns
Recall the summary of our cost behavior
discussion from Chapter 2.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Total variable cost changes Variable cost per unit
Variable as activity level changes. remains the same over
wide ranges of activity.
Total fixed cost remains Fixed cost per unit
Fixed the same even when the goes down as activity
activity level changes. level goes up.
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Total Variable Cost Example
Your total long distance telephone bill is
based on how many minutes you talk.
Minutes Talked
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Variable Cost Per Unit Example
Minutes Talked
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The cost per long distance minute talked is
constant. For example, 5 cents per minute.
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Total Fixed Cost Example
Your monthly basic telephone bill probably
does not change when you make more local
calls.
Number of Local Calls
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Fixed Cost Per Unit Example
Number of Local Calls
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The average cost per local call decreases as
more local calls are made.
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Step-Variable Costs
Activity
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Total cost remains
constant within a
narrow range of
activity.
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Step-Variable Costs
Activity
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Total cost increases to a
new higher cost for the
next higher range of
activity.
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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.
Step-Fixed Costs
Continue
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0 1,000 2,000 3,000
Rented Area (Square Feet)
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30
60
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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.
Step-Fixed Costs
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Step-variable costs
can be adjusted more
quickly and . . .
The width of the
activity steps is much
wider for the
step-fixed cost.
How does this type
of fixed cost differ
from a step-variable
cost?
Step-Fixed Costs
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A semivariable
cost is partly
fixed and partly
variable.
Semivariable Cost
Consider the
following electric
utility example.
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Fixed Monthly
Utility Charge
Variable
Utility Charge
Activity (Kilowatt Hours)
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Semivariable Cost
Slope is
variable cost
per unit
of activity.
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Curvilinear Cost
Curvilinear
Cost Function
Relevant Range
Activity
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Curvilinear
Cost Function
A straight-Line
(constant unit variable
cost) closely
approximates a
curvilinear line within
the relevant range.
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Engineered, Committed and
Discretionary Costs
Discretionary
May be altered in the
short term by current
managerial decisions.
Committed
Long-term, cannot be
reduced in the short
term.
Engineered
Physical relationship
with activity measure.
Depreciation on
Buildings and
equipment
Advertising and
Research and
Development
Direct
Materials
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Shifting Cost Structure in the New
Manufacturing Environment
A trend toward more fixed costs because of
Increased automation.
gStable workforce.
Implications
Managers are more locked-in with fewer decision
alternatives.
Planning becomes more crucial because fixed costs are
difficult to change with current operating decisions.
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Cost Behavior in Other Industries
Merchandisers
Cost of Goods Sold
Manufacturers
Direct Material, Direct
Labor, and Variable
Manufacturing Overhead
Merchandisers and
Manufacturers
Sales commissions and
shipping costs
Service Organizations
Supplies and travel
Examples of variable costs
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Examples of fixed costs
Merchandisers, manufacturers, and
service organizations
Real estate taxes
Insurance
Sales salaries
Depreciation
Advertising
Cost Behavior in Other Industries
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Account-Classification Method
Visual-Fit Method
High-Low Method
Least-Squares Regression Method
Cost Estimation
Engineering Method of Cost Estimation
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Account Classification Method
Cost estimates are based on a
review of each account making up
the total cost being analyzed.
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Overhead Costs for 1,000 Units
Total Variable Fixed
Account Cost Cost Cost
Indirect Labor 450 $ 450 $
Indirect Material 700 700
Depreciation 1,000 1,000
Property Taxes 200 200
Insurance 300 300
Utilities 400 350 50
Maintenance 600 500 100
Totals 3,650 $ 2,000 $ 1,650 $
Account Classification Method
Example
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A scatter diagram of past cost behavior
may be helpful in analyzing mixed costs.
Visual-Fit Method
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Plot the data points on a
graph (total cost vs. activity).
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Activity, 1,000s of Units Produced
Visual-Fit Method
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Draw a line through the plotted data points so that about
equal numbers of points fall above and below the line.
Visual-Fit Method
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Activity, 1,000s of Units Produced
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Visual-Fit Method
Vertical distance
is total cost,
approximately
$16,000.
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Activity, 1,000s of Units Produced
Estimated fixed cost = $10,000
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Visual-Fit Method
Vertical distance
is total cost,
approximately
$16,000.
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Activity, 1,000s of Units Produced
Estimated fixed cost = $10,000
Total variable cost = Total cost Total fixed cost
Total variable cost = $16,000 $10,000 = $6,000
McGraw-Hill/Irwin
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Visual-Fit Method
Total variable cost = Total cost Total fixed cost
Total variable cost = $16,000 $10,000 = $6,000
Unit variable cost = $6,000 3,000 units = $2
Vertical distance
is total cost,
approximately
$16,000.
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Activity, 1,000s of Units Produced
Estimated fixed cost = $10,000
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OwlCo recorded the following production activity
and maintenance costs for two months:






Using these two levels of activity, compute:
the variable cost per unit.
g the total fixed cost.
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 $
McGraw-Hill/Irwin
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Units Cost
High activity level 9,000 9,700 $
Low activity level 5,000 6,100
Change 4,000 3,600 $
The High-Low Method
McGraw-Hill/Irwin
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Units Cost
High activity level 9,000 9,700 $
Low activity level 5,000 6,100
Change 4,000 3,600 $
Unit variable cost =
in cost
in units
The High-Low Method
McGraw-Hill/Irwin
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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
The High-Low Method
McGraw-Hill/Irwin
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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
g Fixed cost = Total cost Total variable cost
The High-Low Method
McGraw-Hill/Irwin
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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
g Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($0.90 per unit 9,000 units)
The High-Low Method
McGraw-Hill/Irwin
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Unit variable cost = $3,600 4,000 units = $0.90 per unit
g Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($0.90 per unit 9,000 units)
Units Cost
High activity level 9,000 9,700 $
Low activity level 5,000 6,100
Change 4,000 3,600 $
The High-Low Method
McGraw-Hill/Irwin
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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 = $.90 per unit
g 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
The High-Low Method
McGraw-Hill/Irwin
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The High-Low Method Question 1
If sales commissions are $10,000 when 80,000 units
are sold and $14,000 when 120,000 units are sold,
what is the variable portion of sales commission per
unit sold?

a. $.08 per unit
b. $.10 per unit
c. $.12 per unit
d. $.125 per unit
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The High-Low Method Question 1
$4,000 40,000 units
= $.10 per unit
If sales commissions are $10,000 when 80,000 units
are sold and $14,000 when 120,000 units are sold,
what is the variable portion of sales commission per
unit sold?

a. $.08 per unit
b. $.10 per unit
c. $.12 per unit
d. $.125 per unit
Units Cost
High level 120,000 14,000 $
Low level 80,000 10,000
Change 40,000 4,000 $
McGraw-Hill/Irwin
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The High-Low Method Question 2
If sales commissions are $10,000 when 80,000 units
are sold and $14,000 when 120,000 units are sold,
what is the fixed portion of the sales commission?

a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
McGraw-Hill/Irwin
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If sales commissions are $10,000 when 80,000 units
are sold and $14,000 when 120,000 units are sold,
what is the fixed portion of the sales commission?

a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
The High-Low Method Question 2
Total cost = Total fixed cost +
Total variable cost
$14,000 = Total fixed cost +
($.10 120,000 units)
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000
McGraw-Hill/Irwin
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Regression is a statistical procedure used
to determine the relationship between
variables such as activity and cost.
Least-Squares Regression Method
Activity
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The objective of
the regression
method is the
general cost equation:
Y = a + bX
in cost terms
TC = F + VX
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TC = F + VX
Total Cost is the
dependent variable.
The activity (X) is the
independent variable.
The X term coefficient (V)
is the estimate of variable
cost per unit of activity,
the slope of the cost line.
The intercept term (F) is
the estimate of fixed costs.
Equation Form of Least-Squares
Regression Line
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wStatistics courses and
computer courses deal
with detailed regression
computations using
computer spreadsheet
software.
wAccountants and
managers must be able
to interpret and use
regression estimates.
Least-Squares Regression Method
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Goodness of Fit
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Goodness of fit is a measure of the
variation of the dependent variable that
is explained by the independent variable.
Goodness of fit is high here as the data
points are close to the regression line.
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Multiple Regression
Multiple regression includes two or more
independent variables:



Terms in the equation have the same
meaning as in simple regression with
only one independent variable.
TC = FC + V
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Data Collection Problems
Missing data.
gOutlier data points.
@Mismatched time periods costs.
jTrade-offs in choosing the time period.
)Allocated and discretionary costs.
gInflation.
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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, but Im not
improving my times as
much as I did earlier. I
must be reaching what
they call steady state.
McGraw-Hill/Irwin
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A systematic relationship between
the amount of experience in
performing a task and the time
required to carry out the task.
Effect of Learning
on Cost Behavior
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A systematic relationship between
the amount of experience in
performing a task and the time
required to carry out the task.
The average time per task declines
by a constant percentage each time
the quantity of tasks doubles.
Effect of Learning
on Cost Behavior
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Effect of Learning
on Cost Behavior
BerryCo. makes products requiring labor
that follows an 80 percent learning rate.
If the first unit of such a product requires
10 hours, what is the average time for 16
units of this product?
McGraw-Hill/Irwin
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BerryCo. makes products requiring labor
that follows an 80 percent learning rate.
If the first unit of such a product requires
10 hours, what is the average time for 16
units of this product?
An 80 percent learning rate means that the average
time required to make two units is 80 percent of the
time for one unit, and that the average time for four
units is 80 percent of the time for two units, etc.
Effect of Learning
on Cost Behavior
McGraw-Hill/Irwin
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Average
Number Labor Time Total
of Units per Unit Labor time
1 1 10 = 10 1 10 = 10
2
4
8
16
Effect of Learning
on Cost Behavior
McGraw-Hill/Irwin
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Average
Number Labor Time Total
of Units per Unit Labor time
1 1 10 = 10 1 10 = 10
2 .80 10 = 8 2 8 = 16
4
8
16
Effect of Learning
on Cost Behavior
McGraw-Hill/Irwin
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Average
Number Labor Time Total
of Units per Unit Labor time
1 1 10 = 10 1 10 = 10
2 .80 10 = 8 2 8 = 16
4 .80 8 = 6.4 4 6.4 = 25.6
8 .80 6.4 = 5.12 8 5.12 = 40.96
16 .80 5.12 = 4.096 16 4.096 = 65.536
The graphic presentation of the learning
phenomenon is called the learning curve.
Effect of Learning
on Cost Behavior
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Learning Curve
Cumulative Production Output
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Learning effects
are large initially.
Learning effects
become smaller, eventually
reaching steady state.
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End of Chapter 7