7 Chapter

Seven
Activity Analysis, Cost
Behavior, and Cost
Estimation

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning
Objective
1

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Introduction

Cost Cost Cost

estimation behavior prediction

Process of Relationship Using knowledge

determining between of cost behavior
cost behavior, cost and to forecast
often focusing activity. level of cost at
on historical a particular
data. activity. Focus
is on the future.

1-3
 Learning
Objective
2

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Total Variable Cost Example
Your total Pay Per View bill is based on how many
Pay Per View shows that you watch.
Total Pay Per View
Bill

Number of Pay Per

View shows watched
1-5
Variable Cost Per Unit Example
The cost per Pay Per View show is constant. For
example, $4.95 per show.

Cost per Pay Per View

show

Number of Pay Per

View shows watched
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 Step-Variable Costs

Total cost remains

constant within a
narrow range of
activity.

Cost
Activity

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 Step-Variable Costs
Total cost increases to a
new higher cost for the
next higher range of
activity.

Cost
Activity

1-8
 Total Fixed Cost Example
Your monthly basic cable TV bill probably does not
change no matter how many hours you watch.
Monthly Basic
Cable Bill

Number of hours
watched
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 Fixed Cost Per Unit Example
The average cost per hour decreases as more hours
are spent watching cable television.

Bill per hour watched

Monthly Basic cable

Number of hours
watched
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 Step-Fixed Costs

Example: Office space

is available at a rental
rate of $30,000 per year
in increments of 1,000
square feet. As the
business grows more
space is rented,
increasing the total cost.
Continue

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 Step-Fixed Costs
Total cost doesn’t change for a wide range of
activity, and then jumps to a new higher cost for the
next higher range of activity.

90
Thousands of Dollars
Rent Cost in

60

30

0 1,000 2,000 3,000

Rented Area (Square Feet)
1-12
 Step-Fixed Costs

Step-variable costs
can be adjusted more
How does this type quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is much
cost? wider for the
step-fixed cost.

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 Semivariable Cost

A semivariable
cost is partly
fixed and partly
variable.
Consider the
following
example.

1-14
 Semivariable Cost
Slope is
variable cost
per unit
of activity.
Total Utility Cost

s t
o
bl ec
a
i v ari
m Variable
l se
o ta Utility Charge
T

Fixed Monthly
Utility Charge
Activity (Kilowatt Hours)

1-15
 Curvilinear Cost
Curvilinear
Cost Function
Total Cost

A straight-line
(constant unit variable
cost) closely
approximates a
curvilinear line within
Relevant Range the relevant range.

Activity
1-16
 Learning
Objective
3

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Curvilinear Cost
Curvilinear
Cost Function
Total Cost

A straight-Line
(constant unit
variable cost) closely
approximates a
curvilinear line within
Relevant Range the relevant range.

Activity
1-18
 Learning
Objective
4

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Engineered, Committed and
Discretionary Costs
Committed
Long-term, cannot be
reduced in the short
term.
Discretionary
May be altered in the
short term by current
managerial decisions.

Engineered
Physical relationship
with activity measure.

Depreciation on Advertising and

Buildings and Direct Research and
equipment Materials Development
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 Shifting Cost Structure in the
New Manufacturing Environment
A trend toward more fixed costs because of
Increased automation.
Stable workforce.

Implications
Managers are more “locked-in” with fewer decision
alternatives.
Planning becomes more crucial because fixed costs are
difficult to change with current operating decisions.
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Cost Behavior in Other Industries
Merchandisers Service Organizations
Cost of Goods Sold Supplies and travel

Examples of variable costs

Manufacturers Merchandisers and

Manufacturers
Direct Material, Direct
Labor, and Variable Sales commissions and
Manufacturing Overhead shipping costs

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Cost Behavior in Other Industries
Examples of fixed costs

Merchandisers, manufacturers, and

service organizations
Real estate taxes
Insurance
Sales salaries
Depreciation

1-23
 Learning
Objective
5

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Cost Estimation

Account-Classification Method

Visual-Fit Method

High-Low Method

Least-Squares Regression Method

Engineering Method of Cost Estimation

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Account Classification Method

Cost estimates are based on a

review of each account making up
the total cost being analyzed.
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 Visual-Fit Method

A scatter diagram of past cost behavior

may be helpful in analyzing mixed costs.

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 Visual-Fit Method
Plot the data points on a
graph (total cost vs. activity).

20
1,000’s of Dollars

* ** *
Total Cost in

* *
**
10 * *

0
0 1 2 3 4
Activity, 1,000’s of Units Produced
1-28
 Visual-Fit Method
Draw a line through the plotted data points so that about
equal numbers of points fall above and below the line.

20
1,000’s of Dollars

* ** *
Total Cost in

* *
**
10 * *

0
0 1 2 3 4
Activity, 1,000’s of Units Produced
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 Visual-Fit Method

Estimated fixed cost = $10,000

20
1,000’s of Dollars

* ** *
Total Cost in

* *
** Vertical distance
10 * * is total cost,
approximately
$16,000.
0
0 1 2 3 4
Activity, 1,000’s of Units Produced
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 The High-Low Method
OwlCo recorded the following production activity and
maintenance costs for two months:

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100

Using these two levels of activity, compute:

 the variable cost per unit.
 the total fixed cost.

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

in cost
 Unit variable cost = in units

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

1-34
 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

 Fixed cost = Total cost – Total variable cost

1-35
 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)

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 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600

1-37
 Learning
Objective
6

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Least-Squares Regression
Method
Regression is a statistical procedure used
to determine the relationship between variables
such as activity and cost.
Total Cost

The objective of
the regression
method is the
general cost equation:
Y = a + bX

Activity
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 Equation Form of Least-Squares
Regression Line
Y = a + bX

Total Cost is the The activity (X) is the

dependent variable. independent variable.

The intercept term (a) is The X term coefficient (b)

the estimate of fixed costs. is the estimate of variable
cost per unit of activity,
the slope of the cost line.

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 Least-Squares Regression
Method
• Statistics courses and
computer courses deal
with detailed regression
computations using
computer spreadsheet
software.
• Accountants and
managers must be able to
interpret and use
regression estimates.

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 Multiple Regression
Multiple regression includes two or more
independent variables:

Y = a + b1X1 + b2X2

Terms in the equation have the same

meaning as in simple regression with
only one independent variable.

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 Engineering Method
of Cost Estimation

Cost estimates are based on measurement

and pricing of the work involved.

1-43
 Engineering Method
of Cost Estimation
Direct Labor Direct Material

•Analyze the kind •Material required

of work performed. for each unit is
•Estimate the time obtained from
required for each labor engineering drawings
skill for each unit. and specification sheets.

•Use local wage rates to •Material prices are

obtain labor cost determined from
per unit. vendor bids.

1-44
 Effect of Learning
on Cost Behavior
As I make more of these I’ve noticed the same
things it takes me less thing. And if you
time for each one. It must include all the variable
be the learning curve effect overhead costs that are
that the boss was also declining, that must
talking about. be the experience curve.

1-45
 Learning Curve

Learning effects
are large initially.
Average Labor
Time per Unit

Learning effects
become smaller, eventually
reaching steady state.

Cumulative Production Output

1-46
 Learning
Objective
7

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Data Collection Problems
Missing data.
Outlier data points.
Mismatched time periods costs.
Trade-offs in choosing the time period.
Allocated and discretionary costs.
Inflation.

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End of Chapter 7

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