University of London (LSE)

(UOL AC2097) Management Accounting

(2020 Academic Year)

Joanna Chia

Session 2 Lecture Notes

Cost Behaviour and Cost Estimation

For SIM Students’ Use Only

Do not distribute or upload to websites or reproduce in any form.
Not to be reproduced for sale.

DEFECTS ARE INHERENT IN THE ORIGINAL COPY

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 Session 2

Cost Behaviour and Cost Estimation

2.0 Cost and Cost Terminology

A cost may be defined as a sacrifice or giving up of resources for a particular purpose. It

is the amount of expenditure incurred on, or attributable to, a specified thing or activity
Costs are frequently measured by the monetary unit, e.g. dollars, that must be paid for
goods and services, for example: direct materials, advertising, etc. (Horngren et al 2015)

An actual cost is a cost that is incurred, which means it is the historical or past cost.

A budgeted cost is a future cost which is ‘predicted or forecasted’. (Horngren et al 2015,

p. 51)

At the simplest level, costs include two components, quantity used and the price.

Formula: Cost = Quantity Used x Price

2.1 Cost Object

Costs are always related to some object or function or service, e.g. the cost of a car.
Such units are known as cost objects and can be defined as: ‘anything for which a
measurement of costs is desired.’ (Horngren et al 2015, p. 51)

It is a quantitative unit of product or service in relation to which costs are ascertained.

The cost object in any given situation is that which is most relevant to the purpose of the
cost ascertainment exercise. This means that in any organization, numerous cost objects
may be used for particular parts of the organization or for differing purposes.

Cost objects may be products, services, activities, processes and customers, etc. They
may be identical units or they may be dissimilar as in a jobbing engineering factory
where the cost unit will be the job or batch, each of which will be costed individually.

2.2 Uses of the Cost Information

Managers would like to know the costs of various products, projects, services and
departments so that they can use their knowledge of the costs to guide decisions such
as product pricing, profitability, innovation, quality, and customer service.

They may also want to know the actual costs and budgeted costs of a cost object. By
comparing these actual costs with the budgeted costs, managers know if they have
managed to keep to the costs or are there cost overruns or cost savings. This will help in
the cost evaluation and enable them to know how well they did and how they can
improve in the future.

2.3 Cost Accumulation & Cost Assignment

In the determination of the costs of the various cost objects, there are two basic stages:
(1) Cost Accumulation
Cost accumulation is the way costs are collected and organised for eg the
various materials, different classifications of labour, and other costs such as

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 machine maintenance, supervision. It is ‘the collection of cost data in some
organized way by means of an accounting system.’ (Horngren et al 2015, p. 51)

(2) Cost Assignment

Cost assignment is the way the accumulated costs are assigned to the different
cost objects eg the table, chair or cabinet produced. It encompasses both cost
tracing, which is the assignment of direct costs to a cost object and cost
allocation which is the assignment of indirect costs to a cost object.

2.4 Classification of Cost

Costs, although referring to the same object or function or service, may be classified in
the following ways:

2.4.1 By Function

Functional costs are classified as production cost, administration cost, selling or

marketing cost and distribution cost.

2.4.2 By Elements

The elements of cost are described as material cost, labour cost and expenses. These
are further subdivided into:
(i) direct costs and
(ii) indirect costs.

2.5 Direct Cost

Direct costs are those that can be directly related to a cost object and can be traced to it
in an economically feasible or cost-effective way. (Horngren et al 2015, p. 52).

Direct costs include the cost of materials specifically used in manufacturing a product or
providing a service, specific labour costs that can be identified with the work involved in
manufacturing a product or providing a service, and other expenses that can be
specifically identified with a product or service.

2.6 Prime Costs

All direct manufacturing costs, that is, the total of ‘all direct manufacturing
costs’(Horngren et al 2015, p. 67) are referred to as prime costs, that is the direct
materials cost, direct labour cost and any direct expenses(if any).

Prime Costs = Direct material cost + Direct labour cost + (Direct expenses, if any)

2.7 Cost Tracing

‘The assignment of direct costs to a particular cost object’(Horngren et al 2015, p. 52) is

known as cost tracing.

2.8 Indirect Costs

Indirect costs of a cost object are those that cannot be traced to the cost object in an
economically feasible or cost effective way(Horngren et al 2015, p. 52). That is, the costs
cannot be specifically attributed to a good or service eg factory supervision costs.

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The total of indirect costs are referred to as overheads.

In a manufacturing firm, all indirect material costs, indirect labour costs and indirect
expenses incurred in the factory from receipt of an order for goods to be produced until
completion of production will make up the indirect manufacturing or production
overheads.

Indirect Manufacturing or Production Overheads = Indirect material cost + Indirect

labour cost + Indirect manufacturing expenses

2.9 Conversion Costs

Conversion costs are all manufacturing costs other than direct materials. It is the direct
labour costs and manufacturing overheads costs or the cost of transforming direct
materials into finished products, exclusive of direct material cost.

The formula is:

Conversion costs= Direct manufacturing labour costs + manufacturing overheads

costs

Note:

• Direct manufacturing labour costs form part of both the prime costs and conversion
costs.
• Some manufacturing operations, such as Computer-integrated manufacturing(CIM)
plants have very few workers so in costing systems, CIM plants do not have direct
manufacturing labour costs as it too small and difficult to trace to the products, so CIM
plants has only prime costs – direct material costs and, conversion costs which consist
only manufacturing overhead costs (Horngren et al 2015, p. 68).

2.10 Cost Allocation

‘The assignment of indirect costs to a particular cost object’ (Horngren et al 2015, p. 52)
is known as cost allocation.

2.11 Importance of Cost Assignment

Costs should be accurately assigned to cost objects. The consequence of inaccurate

costs is that it causes managers to be misled by the information on the profitability of the
different products. As a result, products that are undercosted were thought to be
profitable so, managers may promote and sell of these products, while those that were
overcosted may be de-emphasized and may even be dropped, as they were misled into
thinking that they were unprofitable as the costs appeared high.

2.12 Factors Affecting Direct / Indirect Cost Classification

• The materiality of the cost in question

• Available information-gathering technology
• Design of operations
• ‘Direct/indirect classification depends on the choice of the cost object.’
(Horngren et al 2015, p. 53)

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2.13 Inventoriable costs

Horngren et al (2015, p. 61) defined inventoriable costs as ‘all costs of a product that are
considered as assets in the balance sheet when the costs are incurred and that are
expenses as cost of goods sold only when the product is sold.’ It is used in the valuation
of inventory.

The inventoriable costs of goods in the merchandising sector companies(eg retail or

trading businesses) where they buy and resell goods in their same form (trading), will be
the costs of the goods plus any incoming freight, insurance, and handling costs for those
goods sold.

Service sector companies provide services or intangible products so the absence of

inventories of tangible products for sale will mean no inventoriable costs.

2.14 Period Costs

All costs other than the cost of goods sold in the income statement are period costs
(Horngren et al 2015). They are treated as expenses in the accounting period as
revenues match expenses incurred to generate those revenues. They are not included in
the inventoriable costs.

In the manufacturing sector companies, all non-manufacturing costs are period costs eg
design, administration, marketing and distribution costs

In merchandising sector companies, the period costs are all costs that are not related to
the cost of goods sold.

As for the service sector companies, all costs in the income statement are period costs
because there is no inventoriable costs as only services or intangible products are
provided, so there are no inventories of tangible products for sale. (Horngren et al 2015,
p. 61)

2.14.1 Administration Costs

All indirect material, indirect labour and indirect expenses incurred in the direction,
control and administration of the organization.

2.14.2 Selling Costs

All indirect materials, labour and expenses involved in promoting sales including
marketing and customer service costs.

2.14.3 Distribution Costs

All direct/indirect materials, labour and expenses incurred in preparing the finished
product for despatch and in distributing the product to its destination.

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2.15 Manufacturing, Retail (Merchandising) and Services Sector Companies

The three sectors are:

2.15.1 Manufacturing sector companies

Manufacturing sector companies purchase materials and components and convert them
into finished goods. Eg electronic components manufacturing companies, furniture
manufacturers, chemical processing companies, pharmaceutical companies, etc. All
manufacturing costs are inventoriable costs and all non-manufacturing costs are period
costs eg: design, administration, marketing and distribution costs

2.15.2 Retail (Merchandising) sector companies

Retail or Merchandising sector companies purchase and then sell tangible products
without changing them. Eg, trading companies, retailers such as supermarkets,
departmental stores, distributors, wholesalers – inventoriable costs are the cost of
purchases for resale, that is the cost of goods sold, and all costs not related to cost of
goods purchases for resale are period costs.

2.15.3 Service sector companies

Service sector companies provide service to customers. There are no inventoriable costs
as only services or intangible products are provided, so there are no inventories of
tangible products for sale. (Horngren et al 2015, p. 61)
Eg. Accounting firms, cleaning companies, law firms, banks, transport companies, etc
All costs are period costs (no inventoriable costs).

2.16 Example : Cost of a Cost Object

Example 1: Cost Statement

$
Direct Material Costs 6,000
Direct Labour Costs 3,000
Direct Expenses 1,000
Prime Cost 10,000
Manufacturing (Production or Factory) Overheads 8,000
Manufacturing (Production or Factory) Cost 18,000

Example 2:

The following are the cost information :

(i) Timber costs per table: 2 metres at $10 per metre
(ii) Machine operator’s wages per table: 3 hours at $12 per hour
(iii) Glue, nails, varnish: $1,000 for all furniture produced.
(iv) Factory supervision costs : $3,000 for all furniture produced
(v) Factory expenses: $800 for all furniture produced
(vi) Total machine hours in the factory : 600 machine hours
(vii) Machine time per table: 3 machine hours

Required

Compute the cost of producing a table.

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Solution to Example 2:

Cost of Producing a Table:

Direct Costs $
Direct Material: Timber (2m x $10) 20
Direct Labour: Machine operator’s wages (3 hr x $12) 36
Total Direct costs 56
Total Indirect costs: Manufacturing 3 machine hours X $8
overheads per machine hr 24

Total Production/Manufacturing cost of a table 80

Workings:
Indirect cost or Overhead rate = ($3,000 +1,000 +800 )/ 600
= $ 8 per machine hour
2.17 Typical Cost Statement
$ $
Direct Material Cost 6,000
Direct Labour Cost 3,000
Direct Expenses 1,000
Prime Cost 10,000
Production (or manufacturing or factory) Overhead 8,000
Production (or manufacturing or factory) Cost 18,000
Period Cost
Administration Overhead 700
Selling and Distribution Overhead 300
1,000
Total Costs 19,000

2.18 Cost Behavior Patterns

Cost behaviour is the response of an item of cost to changes in the level of activity.

‘Costs are defined as variable or fixed for a specific activity and for a given period of
time.’ (Horngren et al 2015, p 54)

2.18.1 Variable Cost

A variable cost is a cost changes in total proportion to changes in the related level of
activity or volume of output produced.’ (Horngren et al 2015, p 54)

The variable cost per unit is constant and as activity increases the total variable cost will
also increase proportionately, and as activity decreases, total variable costs will
decrease.
Eg direct material, direct labour (unless otherwise stated as fixed costs), direct expenses
(royalties, etc), sales commission.
Costs ($)
Variable cost

0 Units (Volume or Level of Activity)

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2.18.2 Fixed Cost

A fixed cost is a cost that ‘remains unchanged in total for a given time period, despite
wide changes in the related level of total activity or volume of output produced.’
(Horngren et al 2015, p 54)

The total fixed cost will remain constant within the relevant range, however, the fixed
cost per unit will decrease as activity increases, or increase as activity decreases.

It is important to remember that costs are, strictly speaking, only fixed in relation to a
particular time horizon, in the very long run, no costs are truly fixed. It is also important to
note that costs may be fixed over a particular range of output levels but start to vary
outside that range.
Eg rent, rates, insurance, executive/management salaries, depreciation.

Costs
Fixed cost

Units (Volume)

2.18.2.1 Stepped Fixed Costs

Stepped-fixed costs are costs that remain ‘fixed over a wide range of activity levels, but
jumps to a different amount for levels outside that range’ (Langfield-Smith et al 2007, p.
86). They are simply costs that ‘varies with the cost driver but in steps’ (Blocher et al
2010, p. 70). For example: Supervision costs – the cost would increase in steps as an
additional supervisor to supervise an increase in production volume as more workers are
added, would cause a jump in costs.

Stepped Fixed Costs Graph

Costs
Stepped Fixed cost

Units (Volume)

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2.18.3 Mixed Costs : Semi-Variable or Semi-Fixed Cost

Mixed costs are also called semi-variable or semi-fixed costs and are costs that
consists of ‘both variable and fixed elements.’ (Horngren et al 2015, p. 56)

An example of a semi-variable cost would be electricity costs which are based on a fixed
monthly charge (paid whatever quantity is consumed) and a charge per unit of electricity
actually consumed (which will therefore vary with the level of activity).
Other eg. mobile phone charges, inspection, machine repairs and maintenance costs.

Costs Semi-variable costs

($)

0
Units (volume)
2.18.4 Relationships of Types of Costs

There are two major classifications of costs :

(i) Direct and indirect
(ii) Variable and fixed
However, costs may simultaneously be :
• Direct and variable
• Direct and fixed
• Indirect and variable
• Indirect and fixed

2.18.5 Committed Fixed Cost & Discretionary Fixed Costs

Fixed costs can further be divided into

(i) Committed fixed costs and
(ii) Discretionary fixed costs.

2.18.5.1 Committed Fixed Costs consists largely of those fixed costs that arise from the
possession of the plant, equipment and basic organizational structure. Fixed costs
arising from ‘investments in facilities, equipment, and the basic organization often cannot
be significantly reduced even for short period of time without making fundamental
changes.’(Garrison et al 2012, p. 109). For example, once a building is constructed and
plant installed nothing much can be done to reduce the costs such as depreciation,
property taxes, insurance and salaries of the key personnel etc., without impairing the
organization’s long-term goals.

2.18.5.2 Discretionary Fixed Costs are those which are set as fixed amount for specific
time periods by the management in the budgeting process. These costs directly reflect
top management’s policies and have no particular relationship with volume of output.
These costs can therefore be reduced or eliminated entirely, if the circumstances so
require. Examples of such costs are: research and development costs, donations, sales
promotion and advertising costs, management consulting fees etc. These are also
termed as managed or programmed costs.

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2.19 Cost Driver

A cost driver or activity base is defined as ' any factor which causes a change in the cost
of an activity' CIMA.
‘A cost driver is a variable, such as the level of activity or volume, that causally affects
costs over a given span of time.’ (Horngren et al 2015, p. 56). A change in the cost driver
results in a change in the variable costs of the cost object, however, costs that are fixed
in the short run have no cost driver in the short run but may have a cost driver in the long
run. For eg, equipment and staff costs are fixed in the short run although there are
changes to the production volume, however in the long run, the equipment and staff
costs will increase or decrease in the future, to levels that support future production
volumes. (Horngren et al 2015)

Overheads are allocated to products or services based on an objective measure.

Examples of some of the cost drivers are:
• Units of output
• Direct labour hours
• Machine hours
• Direct material costs
• Direct labour costs
• Number of materials requisition
• Number of kilometres
• Number of calls
• Number of production runs

2.20 Relevant range

Costs are fixed or variable only with respect to a specific activity or a given time period
Relevant range – ‘the band of normal activity level (or volume)’ in which there is a
specific relationship between the level of activity (or volume) and a given cost(Horngren
et al 2015, p. 57).

For example, fixed costs are fixed only within a relevant range.

2.21 Total Costs and Unit Costs

The Unit Cost is computed by taking Total Costs divided by the number of units. Also
called average cost.

Unit costs = Total Manufacturing Costs

No. of Units Manufactured

Unit Costs to be used cautiously:

Unit costs should be used cautiously as unit costs change with a different level of output
or volume. Not all costs vary with the output or volume, as there are fixed costs, so it
may be more prudent to base decisions on a total costs rather than unit cost. ‘As a
general rule, first calculate total costs, then compute the unit costs’. (Horngren et al
2015, p. 59)

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2.22 Controllability of Costs

Controllability is the ‘degree of influence a specific manager has over the costs’
(Horngren et al 2015, p. 239). Costs may be classified as controllable and
noncontrollable costs. There are certain costs that are within the control of
management e.g. handling costs, ordering costs, etc. but there are other costs that are
beyond the control of management e.g. prices of materials, rent and rates, etc.

2.23 Some other Concepts of Costs

2.23.1 Shut down costs:

These represent the fixed costs which have to incurred even during the period when a
factory is shut down on account of some temporary difficulties, due to a lack of business
in the short term eg temporary shut down of a hotel during the off-peak - winter season,
shortage of raw materials, non-availability of requisite labour force, etc. During this
period, though no work is done, the fixed costs such as rent, insurance, depreciation,
maintenance, etc. for the entire plant have still to be incurred. Such costs are known as
shut down costs.

2.23.2 Sunk Costs:

Sunk costs are past costs that are ‘unavoidable and cannot be changed no matter what
action is taken.’ (Horngren et al 2015, p. 449) These are historical or past costs, i.e.
costs which have been incurred as a result of a decision made in the past. Such costs
cannot be reversed or revised by subsequent decisions. Investments in plant and
machinery, building etc. are some prominent examples of such costs. Sunk costs are
considered not relevant for decisions concerning the increase in the present profit levels.

2.23.3 Imputed or Hypothetical Costs:

These are costs, which do not involve cash outlay. They are not included in financial
accounts but are costs recognised in particular situations such as evaluating
investments, as they are important for making management decisions. For example,
imputed rent cost, interest on capital is ignored in financial accounting as there are
sufficient surplus cash but not considered in financial accounting but need to be
considered in the investment appraisal. If two projects require unequal outlays of cash,
the management must take into consideration interest on capital to judge the relative
profitability of the projects.

2.23.4 Differential or Incremental Costs:

The difference in total costs between two alternatives is termed as differential or

incremental cost. In case the choice of alternative results in increase in the total cost,
such increased cost is known as incremental costs. It is the ‘additional total cost incurred
for an activity.’ (Horngren et al 2015, p. 455). The choice may in some instances, result
in decrease in total costs. In the assessment of the profitability of a proposed change,
the incremental cost is matched with incremental benefits.

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Example:

A company is presently selling 1,000 units @$10 per unit. The variable cost per unit is
$5 and the total fixed costs are $4,000. The company receives an order for supply of 200
units @$8 per unit. The execution of this export order will increase fixed cost by $200.
Should the company accept this new export order?

The cost and sales data under the existing and proposed situation can be put as under:

Existing situation Proposed situation Incremental

Cost / Revenue
$ $ $
Sales 10,000 11,600 1,600
Less: Variable costs 5,000 6,000 1,000
Contribution 5,000 5,600 600
Less: Fixed costs 4,000 4,200 200
Profit 1,000 1,400 400

Under the existing situation, there is a profit of $1,000. If the alternative proposal is
considered, it would result in incremental revenue of $1,600 against the incremental cost
of $1,200. Hence the incremental profit will be $400.

2.23.5 Joint Costs:

Whenever two or more products are produced out of one and the same raw material or
process, the cost of material purchased and the processing are called joint costs. Take
the example of an oil refinery where a range of products such as bitumen, petrol,
kerosene, diesel, etc. are derived in the process of refining crude oil. All these products
have joint costs comprising the cost of crude and the cost incurred in the course of
refining. These joint costs are then apportioned to various products on some basis.

2.24 Cost Estimation and Cost Prediction

Accountants and statisticians often distinguish between Cost Estimation and Cost
Prediction. The former denotes the attempt to measure historical cost relationships; the
latter deals with forecasting or prediction of costs. The distinction is not universal; many
managers often use estimated cost and cost estimation to describe forecasts or
predictions.

Two assumptions are frequently used in the estimation of cost behaviour:

(with some exceptions)

(1) Cost Behaviour can be adequately approximated by a linear function.

(2) Variations in the total cost level can be explained by variations in a single variable
(such as direct-labour hours or machine-hours)

The question of which set of assumptions adequately approximates the underlying

relationship is one that can be answered only in actual situations, on a case-by-case
basis.

Given the assumptions of linearity and single explanatory variable, each cost has some
underlying cost behaviour pattern, more technically described as a cost function. Its
expected value, E (y), has the form

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E (y) = a + bx

where a and b are the underlying (but unknown) parameters.

Working with historical data, the analyst can develop a linear formula to estimate the
underlying relationship:

y’ = a + bx

where y’ is the estimated value, as distinguished from the observed value y, and
a is the intercept or estimated component of total costs that, in the relevant range, ‘a’
does not vary with the activity level of the explanatory variable.
The b is the slope coefficient; the amount of change in y for each unit of change in x.
The relevant range is the span of activity or volume over which the cost function is
expected to be valid.

Examples: variable cost, semi-variable cost, fixed cost.

2.25 Steps in Estimating Cost Function - Using Quantitative Analysis:

1. Choose the estimation approach : eg High-Low Method or Regression Analysis

2. Choose the dependent variable (the cost to be predicted),
3. Choose the independent variable(s): (or cost driver),
4. Collect data on dependent and independent variables,
5. Plot the data, and
6. Estimate the cost function
7. Evaluate the cost driver of the estimated cost function

Frequently the analyst will proceed through these steps several times before concluding
that an acceptable cost function has been identified.

2.25.1 Choose the Estimation Approach:

The approach normally considered include the choice of the estimation approach:

Methods of Cost Estimation:

(i) Industrial engineering
(ii) Conference method
(iii) Accounts analysis method
(iv) Quantitative analysis method
(v) Visual fit
(vi) Regression analysis
(vii)Two-point (high-low method)

2.25.2. Choose the dependent variable:

Choice of the dependent variable usually called y will be guided by the decision for which
the cost information is to be used. For example if the aim is to predict overhead costs on
a production line, then all those costs that are classified as being overhead with respect
to the production line should be incorporated into y.

2.25.3 Choose the independent variable(s):

The independent variable, often denoted by x, is sometimes termed the controllable or
explanatory variable. In cost accounting contexts, it is usually a measure of volume

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subject to the influence of a decision-maker. The possibilities include: units of
production, units of sales etc. Ideally, the independent variable(s) chosen should have
economic plausibility and should be accurately measurable.

Output level is the independent variable although the total cost of a unit may depend on
many factors such as output level, machine hours, labour hours, volume, quality of
materials and workers’ skills, etc Cost estimates may be more accurate if multivariate
cost function are used, it is likely that the various variables selected will themselves
depend to a great extent on the level of output.

If the independent variables are not truly independent, there is little extra benefit from
multivariate function in comparison with a univariate one, where the independent
variable is the level of output.

2.25.4 Collect data on the dependent and independent variables.

2.25.5 Plot the data

The general relationship between the independent variable and the dependent variable
can readily be observed in a plot of data. Moreover extreme observations can be
highlighted. These observations can then be checked to determine whether they arise
from an error in recording the data, from an unusual event such as strike, or from any
other event that would prevent them from being representative of the normal relationship
between the two variable. Plotting the data can also provide insight into relevant range of
the cost function.

2.25.6 Evaluate the estimated cost function.

In evaluating a cost function, the analyst should understand the perspective of economic
plausibility and data having goodness of fit characteristic.

2.26 Cost Estimation Methods

2.26.1 Industrial Engineering Method

• ‘Estimates cost functions by analyzing the relationship between inputs and
outputs in physical terms’ (Horngren et al 2015, p. 399).
• Includes time-and-motion studies
• Very thorough and detailed, but also costly and time consuming
• Also called the Work-Measurement Method
• Cost function is derived based on estimates determined by engineers to produce
a product or a service.
• Materials needed will be estimated from the specification of the product;
• Labour time from the time and motion studies;
• Overheads from capital equipment (depreciation & maintenance) needed and
other costs to be incurred.

Advantage
Particularly relevant and useful when there is no past data available.

2.26.2 Conference Method

• ‘Estimates cost functions on the basis of analysis and opinions about costs and
their drivers gathered from various departments of a company’ (Horngren et al
2015, p. 399). ie costs are estimated on the basis of a consensus of expert
knowledge from various relevant people in an organization

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 • Quick & economical, estimates are based on opinions (qualitative), rather than
quantitative basis
• Reliance on opinions still makes this method subjective

2.26.3 Account Analysis Method

• ‘Estimates cost functions by classifying various cost accounts as variable, fixed, or

mixed in regard to the identified level of activity’(Horngren et al 2015, p. 399).
• Is reasonably accurate, cost-effective, and easy to use, but is subjective

2.26.4 Quantitative Analysis Methods

• ‘Uses a formal mathematical method to fit cost functions to past data observations’
(Horngren et al 2015, p. 400).

Advantage:
• Results are objective

2.26.5 Past Data

Cost function is derived based on the cost relationship between costs and output in the
past.
E.g. Cost of making one unit of conference table during the previous year.
Important to be satisfied that cost relationships in the past will give us reliable information
about the relationship at present and in the future.

Advantage of using Past Data:

Less costly and fast.

Disadvantages of using Past Data:

3 factors must be noted:
(i) Choice of independent variable e.g. cost of labour can be affected by direct
labour hours although there are other factors such as availability of labour, skill
and experience of labour which can also affect it.
(ii) Selection of time period e.g. direct labour cost can only be reliably measured if
past observations allowed for sufficiently long period of time. This is to allow for
learning curve effects to be adjusted. But workforce would get used to it
thereafter.
(iii)Examination of accounting data. Where data cover a long period of time,
allowance must be made for inflation so that cost function reflects current
prices.

2.26.6 Cost Prediction:

Useful when relationship between costs and output shown in the past will give reliable
information about the relationship at present and in the future.
Before proceeding with the descriptions of approaches we have to ensure that
independent variable selected is relevant as sometimes cost may depend on more than
one factor.. Sometimes the independent variable may not be truly independent, time
period in question must be sufficiently long, yet circumstances between the past period
under review and the future environment must be comparable and accounting data
should be free from any bias e.g. inflation (adjustment may be needed).

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2.26.7 High-Low Method (Two point approach) :

• Based on a two point High - Low approach:

• This method entails using only the highest and the lowest values of the
independent variable within the relevant range.
• The line connecting these two points becomes the estimated cost function.

This entails using only the highest and the lowest values of the independent variable
within the relevant range. The line connecting these two points becomes the estimated
cost function.

Use the following data & use the High Low method to find the variable & fixed costs:

Week Number Direct-Labour Costs (y) Units Produced (x)

1 340 34
2 346 44
3 287 31
4 262 36
5 220 30
6 416 49
7 337 39
8 180 21
9 376 41
10 295 47
11 215 34
12 275 24

Using the data we see that:

Units Produced (x) Direct-labour costs (y)

High (H) 49 416
Low (L) 21 180
Difference 28 236

If y = a + bx,
where a = fixed costs, b = variable cost per unit,
x = cost driver or independent variable (eg units of output, machine hours, labour hours)
y = Total costs of the dependent variable eg direct labour cost.

Variable rate (b) = yH - yL / xH - xL = (416-180) / (49-21) = 236 / 28 = $8.43 per unit

Total fixed costs (a) = Total Costs – Total Variable Costs

= $416 – (8.43*49)
= $416 - $413
= $3
Then a = y - bx
Total fixed costs = Total costs minus variable costs
At xH: Total fixed costs = $416 - $8.43(49) = $3
At xL: Total fixed costs = $180 - $8.43(21) = $3

Therefore the high low estimate of the cost function is:

y = $3 total fixed costs + $8.43 per unit variable cost
Therefore : y = 3 + 8.43x

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2.26.8 Visual Inspection Method / Scattergraph / Line of Best Fit

It based on the data collected, a scatter diagram is drawn to decide whether a

relationship can be estimated by a linear approximation.
This procedure may provide more accurate estimates than using a casual summary or
only two observations.

However, a visual fit has no objective measure to ensure that the line is the most
accurate representation of the underlying data.
Furthermore, a visual fit ignores information that may be valuable about the quality to fit.

Visual Inspection Method: The following scattergraph demonstrates the use of this
method:

Costs

* * *
*
* * *
* * * * *
* *
* * * * *
* * *
* * *

Volume (units)

Inspection of the scatter of points will indicate the degree of relationship (often called
Correlation) between cost and volume. The scatter diagram is a key to deciding whether
the relationship can be estimated by a linear approximation. In this illustration the answer
is yes. A straight line could be fitted through the points.

In some cases, the cost analyst will use the scatter diagram to identify the cost function.
An advantage of visual fit is that all sample points are used in determining the cost
function. This procedure may provide more accurate estimates than using a casual
summary or only two observations. Nevertheless, a visual fit has no objective measure to
ensure that the line (or curve, if nonlinear) is the most accurate representation of the
underlying data. Furthermore, a visual fit ignores information that may be valuable about
the quality of the fit.

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2.26.9 Regression Analysis Approach

Linear Regression is the using a statistical approach to draw the line of best fit to
estimate cost function.

Regression analysis 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’ (Horngren et al 2015, p. 405).

Advantages :Least Square Method

It is more accurate than the High-Low method because the regression equation
estimates costs using information from all observations; the High-Low method uses only
two observations

It uses a statistical model to measure the average amount of change in the dependent
variable (direct-cost in our example) that is associated with a unit change in the amounts
of one or more independent variables (units produced in our example). When specific
assumptions hold, it provides reliable measures of probable error.

The most widely used regression model is ordinary least squares. In this method we use
following sets of formulas:

(1)  y = na + b  x
(2) x y = a  x + b  x2

The Linear Regression formulae can also be expressed as follows:

b= n xy -  x y
n x2 – ( x) 2

a=  y - b x
n n

Using the least-squares regression, the second graph shows the line of best fit. Placing
the amounts of a and b in the equation, we have

y’ = $77.08 + $6.10x

where y’ is the estimated direct-labour cost for any volume of output level (x). The
constant or intercept term of the regression is $77.08 while the slope coefficient is $6.10.
This method has following advantages:

• Considers all data.

• Can estimate how good is the line of best fit, using correlation coefficient.
r = n ( x y )- ( x)(  y) /[(n  x2 ) - ( x)2] [ n ( y2)-( y)2]
in this case it is equal to 0.755.

• Can be extended to cope with several independent variables, using multiple

regression analysis.

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• Can identify situations of multicollinarity, where the independent variables are in fact
interdependent.

2.26.9.1 Multiple Regression

Multiple regression occurs when there is more than one independent variable
eg machine hours and production batches for the estimation of the indirect
manufacturing labour costs.

Multicollinearity means when two or more independent variables are highly correlated to
each other.

Problems of Linear Regression

• Observations far from the line of best fit

• Difference between observed values and estimated values may not be independent,
e.g. due to seasonality factors
• Size of error term increases as output increases, e.g. due to growth of inflation factor.

2.27 Learning Curve

The learning curve is a function that measures how labour hours per unit decrease as
workers learn their jobs and become better at them (Horngren et al 2015, p. 411). This
has an effect on the labour costs as it reduces over time due to the learning curve effect,
affecting the estimation of labour costs as ‘it renders past information unsuitable for
predicting future costs’ due to ‘changes in the efficiency of the labour force’ (Drury 205,
p. 640).

When new products or processes are begun, learning also begins. Efficiency gradually
improves in a nonlinear manner. The sources of learning include increased dexterity by
workers doing repetitive tasks, improvements in the scheduling of workers, and more
efficient utilization of the operating facility.

The rate at which their efficiency increases is called the learning rate and is usually
estimated by a learning curve. Let us consider a simple example to explain the meaning
of the learning rate. Suppose that a company has received an order to produce eight oil
rigs. It estimates that the first rig will take 200 days to manufacture and the learning rate
is, on the basis of past experience, will be 90%. What this means is that when the
cumulative number of units produced doubles, the average per unit taken to produce all
units will be 90% of the average per unit taken to produce the previous cumulative units.
The cumulative average time for the first two rigs (180 days) is the 90% of the time to
produce the first rig (200 days). So the total time taken to produce two rigs is 360 days
(180x2 rigs) and the marginal time taken to produce the second rig is 160 days (360
days - 200 days). Similar calculations are undertaken for each successive doubling of
output.

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 Learning Curve Effect (90% learning rate)

(1) (2) (3) (4) ‘(5) [(3) X (4)] (6)

Units Cumula Cumulative Total time of Marginal time per unit for
Order Per -tive average time per cumulative units additional units (days)
No. Order units unit (days) (days)
1 1 1 200 200 200
2 1 2 90% * 200 =180 180 * 2 = 360 (360-200) / 1 = 160
3 2 4 90% * 180 = 162 162 * 4 = 648 (648-360) / 2 = 144
4 4 8 90% * 162 = 145.8 145.8 * 8 = 1,166.4 (1,166.4-648)/4= 129.6

The learning curve equation can be applied to compute the average time per unit taking
into consideration the learning effect.
The formula is Y = aXb
Y is the average time per unit of cumulative production to produce x units
a is the time to produce the first unit of output
X is the total number of units of output
b is the ratio factor used to calculate the cumulative average time to produce the units
and the formula is:
b = log (learning curve % in decimal form)
log 2].

It is the logarithm of the learning curve improvement rate, for example 80% learning
curve will be : b = log 0.8 / log 2 = -0.322

At 90% learning curve b = log 0.9 / log 2 = -0.152

Note that when the learning rate changes from 80% to 90%, it means that the labour
time taken will reduce at a slower rate and it results in higher total labour costs.

2.27.1 Estimating Incremental Hours with the Learning Curve Effect

After completing the production of 4 units of oil rigs, another order of 4 oil rigs were
manufactured, what is the average time per unit and the total time to produce the
additional 4 units of oil rigs?
Total cumulative number of oil rigs is now (4 +4) = 8 oil rigs
From the table the calculation shows:
Average time per unit for the incremental 4 oil rigs =145.8 days per unit
The total time to build the additional 4 oil rigs :
Total time for the 8 (cumulative 4+4 rigs) after the additional 4 units are to be produced:
= 145.8 days x 8 (cumulative 4+4 rigs) = 1,166.4 days
Less: Total hours to build the first 4 units = (4 x 162 days) = 648 days

Therefore, the time required for the 4 additional units after the completion of the first four
units is (1,166.4 – 648) days = 518.4 days after considering the learning-curve effect of
90%.

Note that the learning effect will come to a point when no further improvement is
expected and this is referred to as the steady-state of production level. (It is not logical to
assume the learning effect will continue to a point when it takes zero hours to produce a
product!)

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In the example above, if the question states that after the 4th order with a total
(cumulative) of 8 units of oil rigs were produced, it reached a steady state of time for
production. If the company then takes on another new order, 5th Order for another 10
units of oil rigs, then the average time to be taken per oil rig will remain at 145.8 days
from the 5th order onwards.
And so the total time taken will be 145.8 days x 10 units = 1,458 days.

For information only:

If the scientific calculator is used, the manual calculations of the table will not be
required. It is as follows:
The first four units:
X=4, a =200, b=- 0.152
The average time per unit of cumulative production to produce the cumulative 4 units
are:
Y = aXb
Y = 200 x 4-0.152
Y = 200 x 0.81
Y = 162 days

The average time per unit of cumulative 8 oil rigs produced:

Y = 200 x 8-0.152 = 200 x 0.729 = 145.8 days

Therefore, the time required for the 4 additional units after the completion of the first four
units is =(8 units x 145.8) – (4 units x 162)
=1,166.4 – 648) days
= 518.4 days after considering the learning-curve effect of 90%.

After the steady state of production is reached, the 5th order with an additional 10 units to
be produced will be 10 units x 145.8 days = 1,458 days.

Note that the scientific calculator is not allowed to be used in the UOL MA exams, so if it
is examined, it is likely that the exam question will probably require you to do the manual
calculations as in the earlier example.

2.28 Experience Curve

The experience curve ‘measures the decline in cost per unit of the various business
functions’ of the value chain includes downstream activities such marketing and
distribution ‘as the amount of these activities increases.’ (Horngren et al 2015, p. 411)

2.29 Uses of Learning curves and Experience curves

The learning curve is used to estimate labour hours and labour costs. The other related
costs that vary directly with labour hours or labour costs such as variable overheads
need to consider the learning effect.

Learning curves and experience curves are used to reduce costs and increase customer
satisfaction, market share, and profitability.

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 SESSION 2: TUTORIAL QUESTIONS

Question 1:

From the following data, calculate the variable cost per unit and the total fixed costs.

Activity Level Costs

units $
2,000 2,500
2,100 2,580
2,400 2,800
5,600 4,400
5,900 4,480
6,000 4,500

Question 2

The budgeted information of Yang Ltd is as follows:

Sales volume 150,000 units
Selling price $15 per unit
Direct Material $2 per unit
Direct Labour $5 per unit
Production Overheads $4 per unit (25% variable)
Selling and Administration costs $250,000 per annum

(a) Calculate the budgeted profit for the year based on the above budgeted
information.
(b) If the sales volume is increased by 20% and there is spare capacity to
accommodate the increase in production, what would be the estimated profits?

Question 3

Cheryl Ltd produces and sells a single product.

The company currently operates at 70% capacity with sales volume of 70,000 units and
selling price at £20 per unit.

You are given the following financial information for Cheryl Ltd:

Total Per Unit

£ £
Direct materials costs 245,000 3.50
Direct Labour costs 280,000 4.00
Variable production overheads 70,000 1.00

Fixed production overheads 224,000 3.20

Fixed selling & administration expenses 280,000 4.00

During the year, a prospective customer from a country in which Cheryl Ltd does not
have a distribution channel, expresses an interest to make an order for the supply of
14,000 units at a selling price of £14 per unit.

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Required:

(a) Assuming that being an export order, the regular market price of $14 a unit will
not be affected, analyse the effects on Cheryl Ltd’s profitability showing the
following:
(i) the existing order of 70,000 units
(ii) the new special order of 14,000 units
(iii) the total order of 84,000 units(including the new special order)
(b) Should Cheryl Ltd accept the new special order? State your reasons.

(c) Explain any important factors that must be considered by Cheryl Ltd before taking
up such an offer?

(d) If Cheryl Ltd is currently operating at 100% capacity, what are the factors that
must be the considered before taking up the special order?

Question 4

Secondline Ltd, a company which makes one type of product is aware of the uncertain
nature of their market for the coming year. They plan to sell 50,000 units per month but
have prepared monthly budgeted profit forecasts based on two different expected activity
levels as follows:
Units 45,000 50,000
% estimated activity 90% 100%
£ £
Sales revenue 1,350,000 1,500,000
Costs
Material AB 3kg x £1.20 per unit 162,000 180,000
Material CD 1 kg x £3.90per unit 175,500 195,000
Labour costs Skilled –fixed 125,000 125,000
Unskilled variable (1 hour x £7 per unit) 315,000 350,000
Production overhead 217,500 235,000
Administration costs 120,000 130,000
Selling & distribution costs 70,000 75,000
Total costs 1,185,000 1,290,000
Budgeted profit 165,000 210,000
In fact, actual activity for the month of January has turned out to be far worse than
expected and only 37,500 units were sold.

Required:

Use the estimates in the original budgets to calculate the fixed and variable elements of
the costs (you should assume that the same linearity applies across the range of 20,000
to 70,000 units). Calculate the fixed and variable costs per unit for each item of revenue
and cost and then prepare the revised budgeted income statement at the same level as
the actual activity (flexible budget).
(UOL 2011 / Zone B/Q 1(a) modified)

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Question 5

The following is a list of costs from Furniture Makers Company, a furniture manufacturer:
1. Wood used in manufacturing tables
2. Salaries of factory supervisors
3. Repairs of machinery
4. Factory rent
5. Wages of factory operators
6. Factory building insurance
7. Varnish and adhesive
8. Iron bars used for production of the tables
9. Depreciation on machinery
Required

Classify each cost as direct or indirect and also indicate whether each cost is a variable
or fixed cost.

Bhimani et al (2019) Textbook Questions:

Chapter 2, questions 2.1–2.10 and 2.12 and Chapter 9, questions 9.2, 9.3, 9.5, 9.7, 9.10,
9.11, 9.13, 9.17 and 9.18.

Readings:

UOL AC2097 Management Accounting Subject Guide: Chapter 6, pages 74-78 &
Chapter 7, pages 85-89.

Bhimani et al (2019) Textbook, Chapter 2, pages 30-46 & Chapter 9, pages 244-275.

References:

Garrison, R.H., Noreen, E.W., Brewer C. P., Cheng, N.S. & Yuen, K.C.K. 2011.
Managerial Accounting: An Asian Perspective, McGraw-Hill/Irwin, New York.

Horngren, C. T., Datar S. M. & Rajan M. V. 2015, Cost Accounting: A Managerial

Emphasis 15th Edn. Pearson Education Ltd. England.

Langfield-Smith, K., Thorne, H. & Hilton, R.W. 2017, Management Accounting:

Information for Managing and Creating Value, 7th Edn, McGraw-Hill, NSW, Australia.

Nayak, A and Mongiello M. 2019, AC2097 Management Accounting, UOL Subject

Guide, University of London International Programmes, Publications Office, UK.

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