Chapter 2

Costs Analysis and

Forecasting

Course: Management Accounting

 Objectives
1. Explain step and mixed cost behavior
2. Explain management influences on cost behavior
3. Measure and mathematically express cost
functions and use them to predict costs
4. Describe the importance of activity analysis for
measuring cost functions.
5. Measure cost behavior using the account analysis,
high-low, visual-fit, and regression methods.
6. Costs forecasting
7. Understand the relationship between
management decision making and cost behavior.

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 Linear cost behavior

Linear-cost behavior can be graphed with a

straight line when a cost changes
proportionately with changes in a single cost
driver.

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 Relevant range

The relevant range specifies the limits of

cost-driver activity within which a specific
relationship between a cost and its cost
driver will be valid.

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Step and mixed cost behavior patterns

A purely variable cost varies in

percentage to the selected cost driver.

A purely fixed cost is not affected

by the cost-driver level.

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Step and mixed cost behavior patterns

In addition to these pure versions of cost, two

additional types of costs combine
characteristics of both fixed and variable cost
behavior.
1. Step costs
2. Mixed costs

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Step costs

 Step costs change abruptly at intervals of

activity because the resources and their
costs come in indivisible chunks.
 The total step cost at a level of activity is
the amount of fixed cost appropriate for
the range containing that activity level.
 When the steps are relatively small, the
step cost behaves much like a variable
cost and could be used as such for
planning with little loss of accuracy.

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 Mixed costs

 Mixed costs contain elements of both

fixed and variable cost behavior.
 Unlike step costs, there is usually only
one relevant range of activity and one
level of fixed costs in a mixed cost.

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 Mixed costs

Relevant Range
Facilities Maintenance
Department Cost

$5.00 per
Patient-Day
Total
Variable
Cost
$10,000
Fixed
Cost

1,000 5,000
Number of Patient-Days per Month
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 Product and service decisions and the
value chain

Managers influence cost behavior.

 Choice of process and product design
 Quality levels
 Distribution

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 Capacity decisions

 What are capacity costs?

 Capacity costs are the fixed costs of being
able to achieve a desired level of
production or to provide a desired level of
service.

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 Committed fixed costs

 Committed fixed costs usually arise from

the occupancy of facilities, equipment, and
a basic organization.
 These are large, indivisible blocks of cost
that the organization is obliged to incur or
usually would not consider avoiding.

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 Optional fixed costs

 Optional fixed costs are costs fixed at

certain levels only because management
decided that these levels of cost should
be incurred to meet the organization’s
goals.
 These optional fixed costs have no
obvious relationship to levels of output
activity but are determined as part of the
periodic planning process.

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 Optional fixed costs (cont.)

Each planning period, management will

determine how much to spend on
optional items.

These costs then become fixed until the next

planning period.

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 Optional fixed costs (cont.)

What are some examples

 Employee training programs
 Advertising and promotion
 Research and development
 Charitable donations
 Public relations

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 Example of commited and optional
fixed costs

Fixed costs Planned

Advertising and promotion 50
Depreciation 400
Employee training 100
Management salaries 800
Mortgage payment 250
Property taxes 600
Research and development 1,500
Total 3,700

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 Example of commited and optional
fixed costs (cont.)
Fixed costs Planned
Commited:
Depreciation 400
Mortgage payment 250
Property taxes 600
Total commited 1,250
Optional (potential savings):
Advertising and promotion 50
Employee training 100
Management salaries 800
Research and development 1,500
Total optional 2,450
Total commited & optional 3,700
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 Cost control premium

 Managers use their knowledge of cost

behavior to set cost expectations.
 Employees may receive rewards that
are tied to meeting these expectations.

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 Cost functions

 The first step in estimating or predicting

costs is measuring cost behavior as a
function of appropriate cost drivers.
 The second step is to use these cost
measures to estimate future costs at
expected, future levels of cost-driver
activity.

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 Cost function equation

Y = a + bX

Where,
Y: Total cost
a: Fixed cost
b: Variable cost per unit
X: Cost-driver activity in number of units

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 Cost function equation

Mixed cost function:

Y = a + bX

The mixed cost function is called

a linear cost function.

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 Criteria for choosing functions

Reality
The cost function must be believable.

Reliability
A cost function’s estimates of costs at levels
of activity must reliably conform to actually
observed costs.

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 Choice of cost drivers:
Activity analysis

 Choosing a cost function starts with

choosing cost drivers.
 Managers use activity analysis to identify
appropriate cost drivers.
 Activity analysis is especially important for
measuring and predicting costs for which
cost drivers are not obvious.

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Choice of cost drivers:
Activity analysis

What are some cost drivers

 Direct labor hours
 Machine hours
 Units of sales
 Sales in dollars
 Work cells
 Order size

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 Methods of measuring
cost functions

 Engineering analysis
 Account analysis
 High-low analysis
 Visual-fit analysis
 Regression analysis

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 Engineering analysis

 Engineering analysis requires a systematic

review of materials, supplies, labor,
support services, and facilities needed for
products and services.
 It measures cost behavior according to
what costs should be, not by what costs
have been.

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 Account analysis

The simplest method of account analysis

selects a volume related cost driver
and classifies each account as a
variable or fixed cost.

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 High-Low method

 This method selects the lowest and the

highest activity levels.
 These levels should be within the
relevant range.
 The costs chosen should represent the
normal cost incurred at these levels.

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 High-Low method example

There a set of data following:

Quarter Sales Selling costs

1 2,000 200
2 2,100 205
3 1,900 197
4 2,500 215

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 High-Low method example (cont.)

High capacity Q4: $2,500 in sales; and cost

of selling: $215
Low capacity Q3: $1,900 in sales; and cost of
selling: $197
What is the variable rate?

215 – 197
b= = 0.03
2,500 – 1,900

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 High-Low method example (cont.)

At high point:
$215 = Fixed cost + $2,500 × 0.03
 Fixed cost (a) = $215 – $75 = $140
or,
At low point:
$197 = Fixed cost + $1,900 × 0.03
 Fixed cost (a) = $197 – $57 = $140

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 Visual-fit method

In the visual-fit method, the cost analyst

visually fits a straight line through a plot of
all of the available data, not just between
the high point and the low point, making it
more reliable than the high-low method.

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 Regression method

 Regression analysis measures a cost

function more objectively by using
statistics to fit a cost function to all the
data.
 Regression analysis usually measures
cost behavior more reliably than other
cost measurement methods.

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 Coefficient of determination

 One measure of reliability, or goodness

of fit, is the coefficient of determination,
R² (or R-squared).
 The coefficient of determination measures
how much of the change of a cost is
explained by changes in the cost driver.

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Regression method example
Quarter Sales Selling costs
1 2,000 200
2 2,100 205
3 1,900 197
4 2,500 215

Excel: fx/statistical
 Slope: (y, x) = 0.03 (variable cost b)
 Intercept: (y, x) = 140 (fixed cost a)
 RSQ: (y, x) = 0.984 (R-squared)

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Regression method example (cont.)

Excel: fx/statistical
 Slope: (y, x) = 0.03 (variable cost b)
 Intercept: (y, x) = 140 (fixed cost a)
 RSQ: (y, x) = 0.984 (R-squared)

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 Graph of costs behavior

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 Forecasting costs

We had a cost function:

Y = a + bX = 140 + 0.03X

At the level of sales is $4,000, the

selling cost will be forecasted as follows:
Y = 140 + 0.03 × 4,000 = $260

Excel: fx/statistical/forecast

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 Forecasting costs for NPC-EVN

NPC-EVN (bil.)
Year Sales COGS Selling Admin Total cost
2014 57,553 53,606 1,540 1,511 56,656
2015 70,537 65,147 1,726 1,957 68,830
2016 82,135 76,695 2,131 2,265 81,090
2017 91,670 85,399 2,419 2,481 90,299
2018 106,815 99,246 2,315 2,785 104,346
2019 124,284 116,696 2,309 2,903 121,908
Forecast for 2019
Slope 0.932 0.018 0.026 0.976
Forecasting costs 115,652 2,804 3,291 121,747
Diff. forecast & actual -1% 21% 13% -0.1%

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 Forecasting costs for NPC-EVN (cont.)

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 Forecasting costs for NPC-EVN (cont.)

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 Forecasting costs for Petrolimex
Quarter (bil. VND) Sales COGS Selling Admin. Total cost
I/2017 35,801 32,619 1,800 239 34,658
II/2017 38,449 35,277 2,077 270 37,624
III/2017 38,293 35,106 2,010 198 37,314
IV/2017 43,224 40,161 1,613 303 42,076
I/2018 45,430 42,220 1,957 150 44,326
II/2018 51,327 47,178 2,304 181 49,664
III/2018 46,175 42,849 2,057 107 45,013
IV/2018 49,090 45,791 2,296 153 48,240
I/2019 41,961 38,183 2,254 135 40,571
II/2019 49,735 46,191 2,007 149 48,347
III/2019 48,640 45,263 2,150 151 47,564
IV/2019 49,340 45,782 2,276 198 48,256
I/2020 38,478 38,028 2,016 149 40,193
II/2020 26,709 23,957 2,082 186 26,225
III/2020 27,462 24,326 2,011 217 26,554
IV/2020 31,277 27,560 2,507 265 30,332
Forecast QIV/2020
Slope 0.960 0.008 (0.002) 0.966
Forecast 28,563 1,971 211 30,745
Diff. Actual & forecast 4% -21% -20% 1%

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 Forecasting costs for Petrolimex (cont.)

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 Forecasting costs for Kho van Tan cang/TCW

Quarter (bil. VND) Sales COGS Selling Admin. Total cost

II/2017 168 135 1.3 9.4 146
III/2017 160 127 1.1 10.5 138
IV/2017 186 149 2.5 15.1 166
I/2018 156 125 1.9 8.9 136
II/2018 163 134 1.4 10.0 145
III/2018 167 132 0.5 10.0 143
IV/2018 157 124 1.3 12.6 138
I/2019 156 124 1.5 11.5 137
II/2019 182 147 1.0 13.2 161
III/2019 175 138 1.0 8.6 148
IV/2019 190 140 5.4 21.2 167
I/2020 185 146 2.3 9.1 157
II/2020 186 148 2.2 11.9 162
III/2020 193 151 2 12 165
IV/2020 204 157 4 25 185
Forecast QVI/2020
Slope 0.69 0.05 0.11 0.85
Forecast 158.2 3.4 15.1 176.6
Diff. actual & forecast 1.0% -9.8% -39.4% -4.7%

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Forecasting costs for Kho van Tan cang/TCW (cont.)

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Forecasting costs for Kho van Tan cang/TCW (cont.)

Correlation: 0.96
R-square: 0.93

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 Forecasting costs for Kho van Tan cang/TCW (cont.)
Quarter Sales COGS
II/2017 168 135
III/2017 160 127
IV/2017 186 149
I/2018 156 125
II/2018 163 134
III/2018 167 132
IV/2018 157 124
I/2019 156 124
II/2019 182 147
III/2019 175 138
IV/2019 190 140
I/2020 185 146
II/2020 186 148
III/2020 193 151
IV/2020 204 157
Forecast QVI/2020
Slope 0.69
Forecast 158
Diff. of actual & forecast 1.0%

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Forecasting costs for Kho van Tan cang/TCW (cont.)
Quarter Sales COGS
II/2017 168 135
III/2017 160 127
IV/2017 186 149
I/2018 156 125
II/2018 163 134
III/2018 167 132
IV/2018 157 124
I/2019 156 124
II/2019 182 147
III/2019 175 138

I/2020 185 146

II/2020 186 148
III/2020 193 151
IV/2020 204 157

Removed the outlier, QIV/2019 [Sales: 190;

COGS: 140]; We had the trend lines is more
smooth; R-square is larger [0.9722>0.9281].

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 Management decision making
and cost behavior

Understanding cost behavior provides

managers with valuable insights about
how cost will respond to managers’
decisions as well as to outside affects.

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