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1.1 Basic Cost Terminology

• Cost—sacrificed resource to achieve a specific objective
• Actual cost—a cost that has occurred
• Budgeted cost—a predicted cost
• Cost object—anything of interest for which a cost is desired

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 Basic Cost Terminology……
• Cost accumulation—a collection of cost data in an organized
manner
• Cost assignment—a general term that includes assigning
accumulated costs to a cost object.
• This includes:
• Tracing accumulated costs with a direct relationship to the
cost object and
• Allocating accumulated costs with an indirect relationship to
a cost object

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 Direct and Indirect Costs
• Direct costs can be conveniently and economically traced
(tracked) to a cost object.
• Indirect costs cannot be conveniently or economically traced
(tracked) to a cost object.
• Instead of being traced, these costs are allocated to a cost
object in a rational and systematic manner.

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BMW: Assigning Costs to a Cost
Object

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 1.2 Cost Behavior
• Variable costs—changes in total in
proportion to changes in the related level of
activity or volume.
• Fixed costs—remain unchanged in total
regardless of changes in the related level
of activity or volume.

• Costs are fixed or variable only with respect to a

specific activity or a given time period.
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 Cost Behavior . . .
• Variable costs are constant on a per-unit basis.
If a product takes 5 pounds of materials each, it
stays the same per unit regardless of one, ten,
or a thousand units are produced.
• Fixed costs change inversely with the level of
production. As more units are produced, the same
fixed cost is spread over more and more units,
reducing the cost per unit.
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 Other Cost Concepts

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 Cost Estimation Methods
1. Industrial engineering method
2. Conference method
3. Account analysis method
4. Quantitative analysis methods
1. High-low method
2. Regression analysis

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 Conference Method

 Estimates cost functions on the basis of

analysis and opinions about costs and their
drivers gathered from various departments of
a company
 Pools expert knowledge
 Reliance on opinions still makes this method
subjective
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 Account Analysis Method

 Estimates cost functions by classifying various

cost accounts as variable, fixed, or mixed with
respect to the identified level of activity
 Is reasonably accurate, cost-effective, and
easy to use, but is subjective

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 Quantitative Analysis

 Uses a formal mathematical method to fit

cost functions to past data observations
 Advantage: results are objective

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 Steps in Estimating a Cost Function Using
Quantitative Analysis
1. Choose the dependent variable (the cost to be predicted).
2. Identify the independent variable or cost driver.
3. Collect data on the dependent variable and the cost driver.
4. Plot the data.
5. Estimate the cost function using the high-low method or
regression analysis.
6. Evaluate the cost driver of the estimated cost function.

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 High High-Low Method
• Simplest method of quantitative analysis
• Uses only the highest and lowest observed values

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 Regression Analysis
• 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.
• 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.

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 Types of Regression
• Simple—estimates the relationship between the
dependent variable and one independent
variable
• Multiple—estimates the relationship between
the dependent variable and two or more
independent variables

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 Terminology
• Goodness of fit—indicates the strength of the relationship
between the cost driver and costs
• Residual term—measures the distance between actual cost
and estimated cost for each observation

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 End of Chapter One
Next
CH II Multi-Product CVP Analysis

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