Sem 1 2014 2015 (Page 1)

AMAB 333: ADVANCED MANAGEMENT ACCOUNTING

SEMESTER 1 2014 / 2015

TOPIC 2: COST ESTIMATION & COST BEHAVIOUR

Learning Outcomes
At the end of this lecture students should be able to:
1. Describe the different methods of estimating costs
2. Distinguish regression equations using the high-low method, scatter graph and least-squares
technique
3. Calculate the learning curve and compute the average and incremental labour hours for different
output levels.

GENERAL PRINCIPLES

1. A regression equation (or cost function) measures past relationships between a dependent variable
(total cost) and potential independent variables (i.e. cost drivers/activity measures).
2. Simple regression y = a + bx
where y = Total cost
a = Total fixed cost for the period
b = Average unit variable cost
x = Volume of activity or cost driver for the period
3. Multiple regression y = a + b1 x1 + b2 x2
4. Resulting cost functions must make sense and be economically plausible.

COST ESTIMATION METHODS

1. Engineering methods
2. Inspection of accounts method
3. Graphical or scatter graph method
4. High-low method
5. Least squares method.

1. Engineering methods
Analysis based on direct observations of physical quantities required for an activity and then
converted into cost estimates.
Useful for estimating the costs of repetitive processes where input-output relationships are clearly
defined.
Appropriate for estimating the costs associated with direct labour, materials and machine time.

2. Inspection of accounts
Departmental manager and accountant inspect each item of expenditure within the accounts for a
particular period and classify each item as fixed, variable or semi-variable.







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3. Graphical or scatter graph method
Past observations are plotted on a graph and a line of best fit is drawn.




Graph of maintenance cost at
different activity levels

Y = ________________










4. High low method
Involves selecting the periods of highest and lowest activity levels and comparing changes in costs
that result from the two levels.

Example
Quarter 1 9,000 units RM28,000
Quarter 2 5,000 units RM20,000
Quarter 3 10,000 units RM30,000
Quarter 4 8,000 units RM26,000

Cost per unit = ________________________
Fixed costs = __________________________

Major limitation = Reliance on two extreme observations


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5. The least squares regression formula



The simple regression equation y = a + bx can be found from the following two equations and solving
for a and b

Determine the regression equation using the above data by calculating value of b first and then value
of a:








The above equation can be used to predict costs at different output levels.

MULTIPLE REGRESSION ANALYSIS

1. With simple regression analysis it is assumed that total cost is determined by only one activity-based
variable.
2. With multiple regression several factors (rather than one) are assumed to determine total cost.
For example, y = a + b1 x1 + b2 x2; where x1 and x2 are different activity variables.
Assume x1 = Number of machine hours;
x2 = Number of days in period in which temperature < 15 degree

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Assuming that y = 20 + 4x1 + 12x2;

Estimate the total cost for 1000 machine hours and a period of 30 days with a temperature of less than
15 degrees.

Total cost (y) = ____________________________

3. Multicollinearity exists when the independent variables are highly correlated with each other,
resulting in it being impossible to separate the effect of each of these variables on the dependent
variable.
4. The existence of multicollinearity does not affect the validity of the prediction of total cost but it does
affect the validity of the individual coefficient estimates.

Factors to be considered when using past data to estimate cost functions
1. Identify the potential activity bases (i.e. cost drivers). The objective is to find the cost driver that has
the greatest effect on cost.
2. Ensure that the cost data and activity measures relate to the same period. Some costs lag behind the
associated activity measures (e.g. wages paid for the output of a previous period).
3. Ensure that a sufficient number of observations are obtained.
4. Ensure that accounting policies do not lead to distorted cost functions.
5. Adjust for past changes so that all data relates to the circumstances of the planning horizon.
6. Adjust for inflation, technological changes and observations based on abnormal situations.

TESTS OF RELIABILITY

1. Tests of reliability indicate how reliable potential cost drivers are in predicting the dependent
variable.
2. The most simplistic approach is to plot the data for each potential cost driver and examine the
distances from the straight line derived from the visual fit.
3. A more simplistic approach is to compute the coefficient of variation (known as r
2
)
4. See below for the calculation of r
2
from the data shown in Exhibit 23.1 on pg. 3.



.: r
2
= (_______)
2
=
r
2
indicates that ____% of the variation in total cost is explained by the variation in the activity base
and the remaining________% by other factors.
Therefore, the higher the coefficient of variation; the stronger the relationship between the
dependent and independent variable.







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THE LEARNING-CURVE EFFECT

1. Learning curve effect occurs in situation where workers become more efficient as they are more
familiar with the task that they perform.
2. Labour hours required for the production of each unit will become lesser.
3. Through studies & experiments undertaken on the learning-curve phenomena, regularity in the
pattern of a workers ability to learn new task has been observed.
4. The learning-curve effect can be determined through 3 methods:
Computation on sequence of production/orders.
Graphical method
Mathematical method (formula)

Computation on sequence of production/orders













Graphical Method




80% LEARNING CURVE
















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Mathematical method
1. Yx = ax
b

Yx = Average time per unit of cumulative production of x units
a = Time required to produce the first unit of output
b = Ratio of the log of the learning curve improvement rate divided by log of 2.

2. For an 80% learning curve
b = log 0.8 = -0.0969 = -0.322
log 2 0.3010

3. Assume the company received an order to complete 35 units of product. It is estimated that direct
labour is subjected to a learning curve effect of 80%. The learning effect is expected to reach its
optimum level when 35 units have been produced. Initial time taken to produce the first unit is 10
hours.

a) Calculate total time taken to complete 35 units






b) Assume that the company has completed 15 units cumulative production. Calculate incremental
hours for 20 more units.







c) Calculate total time taken to complete 50 units if the learning effect is expected to reach its
optimum level when 35 batches have been produced.








4. Note learning effect only applies to direct labour-related variable costs.

5. Learning curve applications:
Pricing decisions
Work scheduling
Standard setting

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SUMMARY
.
27
Engineering
Y = a + bx
Test of reliability:
R
2 =
Indicate
variation in y
explain by x
Methods:
Least squares :
Inspection of accounts
Graphical /scattergraph
High-low:
a = highest lowest cost
highest lowest
activities
b = fixed cost
Learning curve effect:
Computation on sequence of
production/orders.
Graphical method
Mathematical method
(formula)
Yx = ax
b
Yx = Average time per unit
of cumulative production of
x units
a = Time required to
produce the first unit of
output
b = log % of learning curve
log 2
Factors to be considered
when using past data to
estimate cost functions
Multiple regression:
y = a + b
1
x
1
+ b
2
x
2
several factors are
assumed to
determine total
cost.