Determining How Costs Behave

Slide 9.
Determining How
Costs Behave
Chapter 9
Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 9.2
Introduction
 How do managers know what price to charge,

whether to make or buy, or answer other
questions related to costs?
 They need to have an understanding of how
costs change in relation to various factors.
 This chapter will focus on how to determine
cost behaviour.
Slide 9.3
Learning Objectives
1 Explain the two assumptions frequently

used in cost-behaviour estimation
2 Describe linear cost functions and three
common ways in which they behave
3 Recognise various approaches to cost
estimation
Slide 9.4
Learning Objectives (Continued)
4 Outline six steps in estimating a cost function

on the basis of current or past cost
relationships
5 Describe three criteria to evaluate and choose
cost drivers
6 Explain and give examples of non-linear cost
functions
Slide 9.5
Learning Objectives (Continued)
7 Distinguish between the cumulative average-

time learning model and the incremental
unit-time learning model
Slide 9.6
Learning Objective 1
Explain the two assumptions

frequently used in cost-behaviour
estimation
Slide 9.7
Assumptions in Cost-behaviour
Estimation
1 Changes in total costs can be explained by

changes in the level of a single activity.
– Variation in machine-hours can explain
variations in total cost.
– Variation in labour-hours can explain variations
in total cost.
Slide 9.8
Assumptions in Cost-behaviour
Estimation (Continued)
2 Cost behaviour can adequately be

approximated by a linear function of the
activity level within the relevant range.
– A linear cost function is a cost function in
which the graph of total cost versus the level
of a single activity is a straight line.
Slide 9.9
Describe linear cost functions

and three common ways in
which they behave
Slide 9.10
Cost Function
Cost function is a mathematical expression

describing how costs change with changes
in the level of an activity.
 Output produced
 Direct manufacturing labour-hours
 Machine-hours
 Batches of production
Slide 9.11
Cost Function (Continued)
 La Bella Hotel offers Happy Airline three

alternative cost structures to accommodate
its crew overnight:
1 €60 per night per room usage
 Total room usage is the only factor where
change causes a change in total costs.
 The cost is variable.
Slide 9.12
 What is the cost function?

 y = €60x
 y measures the total costs of the rooms used.
 x refers to the actual number of rooms used.
 The slope of the cost function is €60.
Slide 9.13
y = cost y
x x = number of rooms
Slide 9.14
2 €8,000 per month

 The total cost will be €8,000 per month
regardless of room usage.
 The cost is fixed, not variable.
 What is the cost function?
Slide 9.15
 y = €8,000
 €8,000 is called a constant or intercept.
 The slope of the cost function is zero.
Slide 9.16
y = cost y
€8,000
x x = number of rooms
Slide 9.17
3 €3,000 per month plus €24 per room

 This is an example of a mixed cost
 y = €3,000 + €24x
 y = a + bx
Slide 9.18
y = cost y
€3,000
x x = number
of rooms
Slide 9.19
Cost Classification and Estimation
– Choice of cost object

– Time span
– Relevant range
Slide 9.20
Choice of Cost Object
 A cost item may be variable with respect to

one cost item and fixed with respect to
another.
 If the number of taxis owned by a taxi
company is the cost object, annual taxi
registration and licence costs would be a
variable cost.
Slide 9.21
Choice of Cost Object (Continued)
 If miles driven during a year on a particular

taxi is the cost object, registration and licence
costs for that taxi are fixed costs.
Slide 9.22
Time Span
 Whether a cost is variable or fixed with

respect to a particular activity depends on
the time span.
 More costs are variable with longer
time spans.
Slide 9.23
Relevant Range
 Variable and fixed cost behaviour patterns

are valid for linear cost functions only
within the given relevant range.
 Costs may be non-linear outside the range.
Slide 9.24
Cost Estimation
Cost estimation is the attempt to measure a

past cost relationship between costs and the
level of an activity.
 Managers are interested in estimating past
cost-behaviour functions primarily because
these estimates can help them make more
accurate cost predictions.
Slide 9.25
The Cause-and-Effect Criterion in

Choosing Cost Drivers
– Physical relationship (materials costs)

– Contractual agreements (phone charges
based on minutes)
– Implicitly established by logic (ordering
costs driven by number of parts)
Slide 9.26
Recognise various approaches

to cost estimation
Slide 9.27
Cost Estimation Approaches
– Industrial engineering method

– Conference method
– Account analysis method
– Quantitative analysis methods
Slide 9.28
Industrial Engineering Method
Industrial engineering method is also called

the work-measurement method.
 It estimates cost functions by analysing the
relationship between inputs and outputs in
physical terms.
Slide 9.29
Conference Method
Conference method estimates cost functions

on the basis of analysis and opinions about
costs and their drivers gathered from various
sources.
 This method involves the pooling of expert
knowledge.
Slide 9.30
Account Analysis
Account analysis estimates cost functions

by classifying cost accounts in the ledger as
variable, fixed or mixed with respect to the
identified activity.
 Typically, managers use qualitative rather
than quantitative analysis when making
these cost-classification decisions.
Slide 9.31
Account Analysis (Continued)
 The cost analyst uses experience and

judgement to separate total costs into fixed
and variable.
 Officework & Co sells software programs.
 Total sales = €390,000
 The company sold 1,000 programs.
Slide 9.32
 Cost of goods sold = €130,000

 Manager’s salary = €60,000
 Secretary’s salary = €29,000
 Commissions = 12% of sales
 What is the total fixed cost?
 €60,000 + €29,000 = €89,000
 What is the fixed cost per unit sold?
Slide 9.33
 €89,000 ÷ 1,000 = €89.00

 What is the variable cost per unit sold?
 Cost of goods sold: €130,000
 Commissions: €390,000 × 0.12 = €46,800
 (€130,000 + €46,800) ÷ 1,000 = €176.80
Slide 9.34
Quantitative Analysis Methods
Quantitative analysis uses a formal

mathematical method to fit linear cost
functions to past data observations.
Slide 9.35
Outline six steps in estimating a

cost function on the basis of
current or past cost relationships
Slide 9.36
Steps in Estimating a Cost Function
1 Choose the dependent variable

2 Identify the independent variable cost driver(s)
3 Collect data on the dependent variable
and the cost driver(s)
4 Plot the data
5 Estimate the cost function
6 Evaluate the estimated cost function
Slide 9.37
Steps in Estimating
a Cost Function (Continued)
1 Choose the dependent variable

 Choice of the dependent variable (the cost to
be predicted) will depend on the purpose for
estimating a cost function.
Slide 9.38
Steps in Estimating
2 Identify the independent variable cost driver(s)

 The independent variable (level of activity or
cost driver) is the factor used to predict the
dependent variable (costs).
Slide 9.39
Steps in Estimating
 Two important aspects when identifying a cost

driver:
A It should have an economically plausible
relationship with the dependent variable.
B It should be accurately measurable.
Slide 9.40
Steps in Estimating
3 Collect data on the dependent variable and

the cost driver(s)
 Cost analysts obtain data from company
documents, from interviews with managers
and through special studies.
– Time-series data
– Cross-sectional data
Slide 9.41
Steps in Estimating
4 Plot the data

 The general relationship between the cost
driver and the dependent variable can readily
be observed in a plot of the data.
 The plot highlights extreme observations that
analysts should check.
Slide 9.42
Steps in Estimating
5 Estimate the cost function

– High-low method
– Regression analysis
Slide 9.43
Steps in Estimating
6 Evaluate the estimated cost function

 A key aspect of estimating a cost function
is choosing the appropriate cost driver.
Slide 9.44
High–Low Method
 Choose the highest and lowest value of the

cost driver and their respective costs.
 Determine a and b using algebra.
Slide 9.45
High–Low Method (Continued)
 High capacity – December: 55,000

machine-hours
 Cost of electricity: €80,450
 Low capacity – September: 30,000
machine-hours
 Cost of electricity: €64,200
 What is the variable rate?
Slide 9.46
 (€80,450 – €64,200) ÷ (55,000 – 30,000)

 €16,250 ÷ 25,000 = €0.65
 What is the fixed cost?
Slide 9.47
 €80,450 = Fixed cost + 55,000 – €0.65

 Fixed cost = €80,450 – €35,750 = €44,700
 €64,200 = Fixed cost + 30,000 × €0.65
 Fixed cost = €64,200 – €19,500 = €44,700
 y = a + bx
 y = €44,700 + (€0.65 × Machine-hours)
Slide 9.48
Regression Analysis
Regression analysis is used to measure the

average amount of change in a dependent
variable, such as electricity, that is
associated with unit increases in the amounts
of one or more independent variables, such
as machine-hours.
 Regression analysis uses all available data to
estimate the cost function.
Slide 9.49
Regression Analysis (Continued)
 Simple regression analysis estimates the

relationship between the dependent variable
and one independent variable.
 Multiple regression analysis estimates the
relationship between the dependent variable
and multiple independent variables.
Slide 9.50
 The regression equation and regression line are

derived using the least-squares technique.
 The objective of least-squares is to develop
estimates of the parameters a and b.
Slide 9.51
 The vertical difference (residual term)

measures the distance between the actual cost
and the estimated cost for each observation.
 The regression method is more accurate than
the high-low method.
Slide 9.52
Describe three criteria to evaluate

and choose cost drivers
Slide 9.53
Criteria to Evaluate and

Choose Cost Drivers
1 Economic plausibility
2 Goodness of fit
3 Slope of the regression line
Slide 9.54
Goodness of Fit
 The coefficient of determination (r ) expresses 2
the extent to which the changes in (x) explain

the variation in (y).
 An (r ) of 0.80 indicates that more than 80%
2
of the change in the dependent variable can be

explained by the change in the independent
variable.
Slide 9.55
Slope of Regression Line
 A relatively steep slope indicates a strong

relationship between the cost driver and costs.
 A relatively flat regression line indicates a
weak relationship between the cost driver
and costs.
Slide 9.56
Slope of Regression Line (Continued)
 The closer the value of the correlation

coefficient (r) to ±1, the stronger the statistical
relation between the variables.
 As (r) approaches +1, a positive relationship
is implied, meaning the dependent variable (y)
increases as the independent variable (x)
increases.
Slide 9.57
Slope of Regression Line (Continued)
 As (r) approaches –1, a negative, or inverse,

relationship is implied, meaning the dependent
variable (y) decreases as the independent
variable (x) increases.
Slide 9.58
Explain and give examples of

non-linear cost functions
Slide 9.59
Non-linearity and Cost Functions
 A non-linear cost function is a cost function

in which the graph of total costs versus the
level of a single activity is not a straight line
within the relevant range.
– Economies of scale
– Quantity discounts
– Step cost functions
Slide 9.60
Non-linearity and Cost

Functions (Continued)
 Economies of scale in advertising may

enable an advertising agency to double the
number of advertisements for less than
double the cost.
Slide 9.61

 Quantity discounts on direct materials

purchases produce a lower cost per unit
purchased with larger orders.
Slide 9.62

 A step function is a cost function in which

the cost is constant over various ranges of
the level of activity, but the cost increases
by discrete amounts as the level of activity
changes from one range to the next.
Slide 9.63
Distinguish between the cumulative

average-time learning model
and the incremental unit-time
learning model
Slide 9.64
Learning Curves
A learning curve is a function that shows

how labour-hours per unit decline as units
of output increase.
Slide 9.65
Experience Curve
Experience curve is a function that shows

how the costs per unit in various value chain
areas decline as units produced and sold
increase.
Slide 9.66
Cumulative Average-Time
Learning Model
Cumulative average time per unit is reduced

by a constant percentage each time the
cumulative quantity of units produced is
doubled.
Slide 9.67
Cumulative Average-Time
Learning Model (Continued)
The time needed to produce the last unit is

reduced by a constant percentage each time
the cumulative quantity of units produced is
doubled.
Slide 9.68
End of Chapter 9

Determining How Costs Behave

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Determining How Costs Behave

Uploaded by

Copyright:

Available Formats

Slide 9.

 How do managers know what price to charge,

1 Explain the two assumptions frequently

Learning Objectives (Continued)

4 Outline six steps in estimating a cost function

Learning Objectives (Continued)

7 Distinguish between the cumulative average-

Explain the two assumptions

1 Changes in total costs can be explained by

2 Cost behaviour can adequately be

Describe linear cost functions

Cost function is a mathematical expression

Cost Function (Continued)

 La Bella Hotel offers Happy Airline three

Cost Function (Continued)

 What is the cost function?

Cost Function (Continued)

Cost Function (Continued)

2 €8,000 per month

Cost Function (Continued)

Cost Function (Continued)

Cost Function (Continued)

3 €3,000 per month plus €24 per room

Cost Function (Continued)

Cost Classification and Estimation

– Choice of cost object

Choice of Cost Object

 A cost item may be variable with respect to

Choice of Cost Object (Continued)

 If miles driven during a year on a particular

 Whether a cost is variable or fixed with

 Variable and fixed cost behaviour patterns

Cost estimation is the attempt to measure a

The Cause-and-Effect Criterion in

– Physical relationship (materials costs)

Recognise various approaches

Cost Estimation Approaches

– Industrial engineering method

Industrial Engineering Method

Industrial engineering method is also called

Conference method estimates cost functions

Account analysis estimates cost functions

Account Analysis (Continued)

 The cost analyst uses experience and

Account Analysis (Continued)

 Cost of goods sold = €130,000

Account Analysis (Continued)

 €89,000 ÷ 1,000 = €89.00

Quantitative Analysis Methods

Quantitative analysis uses a formal

Outline six steps in estimating a

Steps in Estimating a Cost Function

1 Choose the dependent variable

1 Choose the dependent variable

2 Identify the independent variable cost driver(s)

 Two important aspects when identifying a cost

3 Collect data on the dependent variable and

4 Plot the data

5 Estimate the cost function

6 Evaluate the estimated cost function

 Choose the highest and lowest value of the

High–Low Method (Continued)

 High capacity – December: 55,000