Chapter 3

Cost behaviour, cost drivers

and cost estimation

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
Basic concepts
Cost behaviour
The relationship between a cost and the level of
activity or cost driver
Cost estimation
The process of determining the cost behaviour
of a particular cost item
Cost prediction
Using knowledge of cost behaviour to focus the
level of cost at a particular level of activity

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Cost drivers
A cost driver
An activity or factor that causes costs to be
incurred
The higher the correlation between the cost and
cost driver, the more accurate is the description
and understanding of cost behaviours
Conventional understandings of cost
behaviour regarded costs as variable or
fixed, based on the level of production
volume
continued
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Cost drivers
Contemporary viewpoints recognise that
there are a range of possible costs divers
other than production volume (non-volume
cost drivers)
Activity-based approaches classify costs and
cost drivers into four levels:
Unit
Batch
Product, and
Facility
continued
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Cost drivers
Unit level costs
Relate to activities that are performed for each unit
produced
Uses conventional volume-based cost drivers
Batch level costs
Relate to activities performed for a group of product
units
Product (or product-sustaining) level
Relate to activities performed for specific products or
product groups
Facility level
Costs incurred to run the business continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
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Cost drivers
Selecting the best cost drivers
Input or outputs?
An example of an input cost driver is the weight of
material, and an output driver is the number of units
of production
Cost benefit principles will determine the choice
How detailed should the analysis be?
Long or short term?
Cost behaviour and cost drivers can change over time
Depends on the purpose of the cost prediction

continued
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Cost drivers
Cost drivers for cost estimation or cost
management?
Cost drivers that are used to predict costs, may
differ from those used to manage costs
Effective cost management requires the
identification of root cause cost drivers
The basic costs that cause a cost to be incurred
The true causes of costs

continued
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Cost drivers
In choosing cost drivers the costs and
benefits of each driver must be assessed:
Reasons for analysing cost behaviour
Timeframes for analysing the cost behaviour
Availability of data on cost drivers, and
Any other uses for the cost behaviour
information

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Cost behaviour patterns
Cost behaviour patterns
Variable costs
Fixed costs
Step-fixed costs
Semi-variable costs
Curvilinear costs

continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
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Cost behaviour patterns
Variable costs
Change in total in direct proportion to a change
in activity
The variable cost is the slope of the cost line in
the following cost function:
Y = a + bX
Where Y = total cost
a = fixed cost component (the intercept on the vertical axis)
b = variable cost per unit of activity (the slope of the line)
X = the level of activity

continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Slides prepared by Kim Langfield-Smith
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Cost behaviour patterns
Fixed costs
Remains unchanged in total as the level of
activity varies
As activity increases, total fixed costs do not
change, but unit fixed cost declines
Contemporary approaches to cost analysis
recognise that there are cost drivers for some of
these fixed costs, and very few costs remain
fixed

continued
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Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Cost behaviour patterns
Step-fixed costs
Remain fixed over a wide range of activity levels
but jump to a different amount for levels
outside that range
Semi-variable cost
Has both fixed and variable components
Curvilinear cost
Has a curved cost line, but is often
approximated as a semi-variable cost function
continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Slides prepared by Kim Langfield-Smith
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Slides prepared by Kim Langfield-Smith
Cost behaviour patterns
Cost structures are shifting towards a
decreasing proportion of costs that vary
with production due to:
Labour being replaced by equipment, which
does not vary with production output
Production wages moving towards fixed salaries
that do not vary with production activity levels

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Cost estimation
Approaches to cost estimation
Managerial judgement
Engineering approach, and
Quantitative analysis
Using managerial judgment to estimate
costs
The account classification method involves
managers using their judgement to classify
costs as exhibiting certain behaviours
continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
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Cost estimation
The engineering approach to estimating
costs
Studying processes that result in the incurrence
of a cost
Focus on the relationships that should exist
between inputs and outputs
Using time and motion studies (or task analysis)
where employees are observed as they
undertake work tasks
Activity-based approaches extend task analysis
to the study of indirect activities and costs
continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Cost estimation
Estimating costs using quantitative analysis
A scatter plot can be useful in allowing us to
plot the data points to visualise the relationship
between cost and the level of activity
The high-low method involves taking the two
observations with the highest and lowest level
of activity to calculate the cost function
Regression analysis is a statistical technique
that uses all observations to determine the cost
function
continued
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Cost estimation
Regression analysis
Allows us to estimate the line of best fit by
making the deviations between the cost line and
the data points as small as possible
Simple regression involves estimating the
relationship between the dependent variable (Y)
and one independent variable (X)
Y = a + bX

continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
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Cost estimation
Regression analysis
Multiple regression allows us to include two or
more independent variables, that is, cost drivers
Y = a + b1X1 + b2X2

The regression line can be evaluated using

several criteria:
Economic plausibility
Goodness of fit

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Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Slides prepared by Kim Langfield-Smith
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Practical issues in cost
estimation
Data collection problems
1. Missing data
2. Outliers
3. Mismatched time periods for dependent and
independent variables
4. Trade-offs in choosing the number of
observations and the reliability of past data
points as predictors of future cost behaviour
5. Allocated fixed costs
6. Inflation
continued
Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Practical issues in cost
estimation
Effect of learning on cost behaviour
In estimating labour costs for relatively new
product or processes, labour times per unit may
decrease at varying rates
Activity-based approaches allows us to
consider more complex cost behaviour
patterns
Costs are assigned to activities
Unit, batch and product level costs are assumed
to vary in proportion to their cost drivers
continued
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Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Practical issues in cost
estimation
The accuracy of cost functions
Sometimes approximate estimates are used to
estimate cost functions within firms
Why is the case?
Limited time and knowledge to undertake quantitative
techniques
The data required to estimate reliable cost functions
may not exist
A low priority may be given to determining accurate
cost behaviour and cost estimation
Subjective cost estimates may be considered good
enough for the firms needs
continued
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Practical issues in cost
estimation
All cost functions are based on simplifying
assumptions, such as:
Cost behaviour depends on a single activity
Cost behaviours are linear within a relevant
range
Costs and benefits of producing accurate
cost information need to be assessed

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
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Slides prepared by Kim Langfield-Smith