Management Accounting

CNAcF 303 Advanced Management

Accounting

Week 1 一 Cost Behaviour and Estimation

Linlin ZHANG
Department of Accounting
Beijing Jiaotong University
 Cost Behaviour and Estimation

• Objectives
·Discuss why organizations need to estimate costs
·Identify different cost patterns
·Illustrate simple and multiple regression analysis
·Discuss account analysis and the engineering method
·Identify and discuss the effects of learming curves on cost
behavior
Cost Behaviour and Estimation
Cost Behaviour and Estimation
Cost Behaviour and Estimation
 Cost Behaviour and Estimation
 Cost
• direct and indirect costs ； period and product costs; relevant and irrelevant costs;
avoidable and unavoidable costs; sunk costs; opportunity costs; incremental and marginal
costs.
 Cost pools
 Cost object
 Cost assignment Cause and effect
 Cost driver
 Cost patterns
 Cost function
 Relevant range
 Cost Behaviour and Estimation

• We shall see that the cost collection system typically accounts for
costs in two broad stages:

• It accumulates costs by classifying them into certain categories such as by type

of expense (e.g. direct labour, direct materials and indirect costs) or by cost
behaviour (such as fixed and variable costs).
• It then assigns these costs to cost objects
Cost Behaviour and Estimation

Cost Cost Cost

behaviour estimation prediction
Process of
Existing Using results of
estimating
relationship cost estimation
relationship
Between to forecast a
between costs
cost and level of cost at
and cost driver
activity. a particular
activities that
activity.
cause
those costs.
 Cost Behaviour and Estimation

Summary of variable and fixed cost behaviour

Cost In Total Per Unit
Variable Total variable cost Variable cost per unit remains
changes as activity level the same over the relevant
changes range
Fixed Total fixed cost remains Fixed cost per unit reduces as
the same regardless of the level of activity increases
the activity level

Total Costs = Fixed costs + Variable costs

TC = F + VX
V is the variable cost per cost driver unit (cost driver rate).
X is the number of cost driver units
 Cost Behaviour and Estimation

 Step costs
A cost that increases in steps as the amount of the cost driver volume increases

Total cost remains unchanged over a narrow range of activity

As activity increases to the next range, total cost steps up to the next level

 Mixed costs
A mixed cost is a cost that has fixed and variable elements, such as a
contract mobile phone bill
Cost Behaviour and Estimation

semi-fixed or step-fixed costs

semi-variable costs (also known as mixed costs ）

Cost Behaviour and Estimation
Curvilinear
Cost Function

A nonlinear cost pattern

(e.g.
changes in unit variable
cost)
may often approximate a
straight line (when the unit
Relevant Range variable cost is constant)
within the relevant range

Activity
Cost Behaviour and Estimation

Scatter graph and high-low estimates

Statistical methods (regression analysis)

Account analysis

Engineering method
 Cost Behaviour and Estimation
Month Total Co sts Units
Examples January $ 6,720 1,280
February 7,260 1,810
March 7,270 1,620
April 11,060 2,830
May 12,580 3,630
June 8,660 2,610
July 8,580 2,460
August 9,550 2,640
September 13,050 3,620
October 11,060 2,840
Nove mbe r 7,320 1,820
December 7,370 1,650
January 6,790 1,260
February 7,480 1,850
March 6,990 1,710
April 11,400 2,940
Cost Behaviour and Estimation

Scatter graph
Cost Behaviour and Estimation

High-low estimates
Cost Behaviour and Estimation
Regression Analysis
A statistical method used to create an equation relating
dependent (or Y) variables to independent (or X)
variables
Data from the past are used to estimate relationships
between costs and activities

Independent variables are Before doing the analysis,

the cost drivers that drive take time to determine if a
the variation in dependent logical relationship between
variables the variables exists
 Cost Behaviour and Estimation
Regression Analysis
The objective of the regression method is still a
linear equation to estimate costs TC = F + VX
TC = value of the dependent variable
(estimated total cost)
F = a fixed quantity, the intercept, that
represents the value of TC when X = 0
V = the unit variable cost, the coefficient of
the independent variable measuring the
increase in TC for each unit increase in X

X = value of the independent variable, the cost driver

Cost Behaviour and Estimation
A statistical procedure that finds the unique line through data
400
points that minimizes the sum of squared distances from the
data points to the line
350

300

250

200

50 100 150 200

Independent Variable
Cost Behaviour and Estimation
V =the slope of the regression line or the
400 coefficient of the independent variable

350

300

250

200 F = a fixed quantity, the intercept

50 100 150 200

Independent Variable
Cost Behaviour and Estimation
400 proper line, excluding the outlier
improper line, influenced by outlier
350

300

250

200 Outlier

50 100 150 200

Independent Variable
Cost Behaviour and Estimation
R2, the coefficient of determination, is a measure
of the goodness of fit
400

350

300

250

200 Regression with

high R2 (close to 1.0)

50 100 150 200

Independent Variable
Cost Behaviour and Estimation

400

350

300

250
Regression with
200 low R2 (close to 0)

50 100 150 200

Independent Variable
 Cost Behaviour and Estimation
Economic plausibility
R² does not indicate whether:
• the independent variables are a cause of the changes in the
dependent variable;
• omitted-variable bias or collinearity exists;
• an appropriate regression model was used (linear, multiple
linear or nonlinear);
• the most appropriate set of independent variables has been
chosen; or
• the model might be improved by using transformed versions
of the existing set of independent variables.
 Cost Behaviour and Estimation
Month Total Co sts Units
Simple Linear Regression Analysis January $ 6,720 1,280
February 7,260 1,810
March 7,270 1,620
Eagle Enterprises wants to April 11,060 2,830
analyze the relationship May 12,580 3,630
between units produced June 8,660 2,610
July 8,580 2,460
and total costs
August 9,550 2,640
September 13,050 3,620
October 11,060 2,840
Using the data to the right, Nove mbe r 7,320 1,820
let’s see how to do a December 7,370 1,650
regression using Excel January 6,790 1,260
February 7,480 1,850
March 6,990 1,710
April 11,400 2,940
 Cost Behaviour and Estimation
Simple Regression Analysis
We will obtain three pieces Month Total Co sts Units
January $ 6,720 1,280
of information from our
February 7,260 1,810
regression analysis: March 7,270 1,620
1. Estimated Variable Cost per April 11,060 2,830
Unit (line slope) May 12,580 3,630
2. Estimated Fixed Costs (line June 8,660 2,610
intercept) July 8,580 2,460
August 9,550 2,640
3. Goodness of fit, or R2 September 13,050 3,620
October 11,060 2,840
We will need to Nove mbe r 7,320 1,820
find the following Excel De ce mbe r 7,370 1,650
January 6,790 1,260
functions: LINEST,
February 7,480 1,850
INTERCEPT and RSQ March 6,990 1,710
April 11,400 2,940
Cost Behaviour and Estimation
Cost Behaviour and Estimation
Simple Regression Analysis
The objective of the regression method is a
linear equation to estimate costs TC = F + VX

We found the following linear equation for Eagle:

TC = $2,618.72 + $2.768 per unit

The high value for R2 tells us that there is a very close match between the
calculated line and the actual data.
It also means that we have explained 93% of the variability of total costs.
We have a residual variability of 7% - whether this is significant will depend
on the circumstances and the costs associated with finding the other 7%.
Cost Behaviour and Estimation

Regression analysis – Key considerations

• A logical relationship must be established between the variables
• Entering data into the analysis that have no logical relationship will result
in meaningless estimates
• Outliers??
• The least squares procedure minimizes the sum of squares of the distances
from the data points to the line

• The intercept term should be used with caution to estimate fixed cost
 Technologies
Cost Behaviour and Estimation
Regression analysis – Key considerations continued
• The intercept is likely to be outside the relevant range of observations as it
occurs at an activity level of zero

• A regression equation may be a poor predictor of future costs if

− Cost-activity relationships have changed
− Costs themselves have changed independently of changes in activity
• Regression results may be questionable when
− Attempting to fit a linear equation to nonlinear data
− Failing to exclude outliers
− Including variables that have apparent but spurious relationships
Cost Behaviour and Estimation
Regression analysis – Caveats
• This technique does not provide exact measurements

• There is seldom 100% confidence about a relationship between dependent

and independent variables

• It cannot be always assumed that the cost estimation errors are normally
distributed, independent and with constant variation.

• So-called independent variables may be in fact closely correlated

Cost Behaviour and Estimation
Account analysis

• Cost estimates are based on a review of each activity account making up

the total cost being analyzed

• Objective: Relate costs and activity in the form of the general cost
equation: TC = F + VX

• How is Account analysis implemented in practice?

Cost Behaviour and Estimation
Account analysis
 Identify cost drivers and the costs associated with each driver

 Sum the fixed costs (facility costs)

 Sum the variable costs for each cost driver activity

 Divide the total variable costs for each cost driver activity by the total
number of cost driver units to obtain variable cost per unit

 Divide the fixed costs by the number of time periods in the data

 Identify the aggregate equation TC = F + VX

Cost Behaviour and Estimation

Account (to produce Total Variable Fixed

1,000 units) cost
Indirect labour 450 450
Electricity 850 550 300
Depreciation 1,200 1,200
Insurance 250 250
Telephone 150 100 50
Maintenance 900 700 200
TOTALS 3,800 1,800 2,000

Variable cost = £1,800 ÷ 1,000 units = £1.80 per unit

Total cost is estimated at £2,000 + £1.80 per unit
Cost Behaviour and Estimation
Account analysis and data problems
• Missing data can lead to inaccuracies of results

• Outliers may drive the results

• Allocated and discretionary costs should be included in regression and

account analysis with caution

• Historical costs may give misleading results in highly inflationary periods

• Mismatched time period costs

 Cost Behaviour and Estimation
Engineering Method
• Engineering estimates of cost are made, based on how products are manufactured.

• Direct labour
− Analyze the kind of work performed
− Estimate the time required for each labour skill for each unit
− Use local wage rates to obtain labour cost per unit

• Direct material
− Material required for each unit is obtained from engineering drawings and
specification sheets
− Material prices are determined from vendor bids

• Overhead costs
− Obtained in a similar manner using a step-by-step analysis of the work
involved
Cost Behaviour and Estimation
Engineering Method
Advantages of the engineering approach
• Detailed analysis results in better knowledge of the entire process
• The method is used to estimate costs of new activities

Disadvantages of the engineering approach

• High cost of detailed analysis
• High dependence on knowledge base of people making the cost
estimation
• Will tend to encourage the reinforcement of existing inefficiencies
Cost Behaviour and Estimation
Which method should firms use?

• The three cost estimation methods all have benefits and drawbacks
• Regression and account analysis rely on past data
• The engineering method relies on present data
• No single method is best for all situations
• Better results are often obtained by use of several of the methods.
For example….
− Engineering estimates and account analysis may lead to the
establishment of logical, causal relationships between variables
− Regression provides a cost equation for the data points with statistical
measures of fit
− Relevance of the causal (not casual!) relationships is critical to the
success of the chosen method.
Cost Behaviour and Estimation
Effect of learning on cost behaviour

• Learning curve: as an individual or team repeat an activity they learn how to

do it more efficiently. The labour time declines and the labour cost declines
as well.
• This can be shown visually in the Experience curve (Boston Consulting
Group, 1964).
Cost Behaviour and Estimation

Calculating learning rates

• Wright’s Cumulative Average Model Y=aXb

• Y = cumulative average time per unit
• X = cumulative number of units produced
• a = time required to produce the first unit
• b = the ratio of the logarithm of the learning curve improvement rate
(e.g. 0.8 for an 80 per cent learning curve) divided by the logarithm of 2.
ln (learning rate %)/ ln 2

We will use an example of producing up to 8 units with learning rates of

80% and 60%
Cost Behaviour and Estimation

The example assumes that the first unit takes 100 hours to produce....
Cumulative Cumulative Total Cumulative Total
number of average time time average time per time
units per unit at unit at 60%
produced 80% learning learning

1 100 100 100 100

2 80 160 60 120
3 70.21 210.63
4
5
6 b = ln (0.8) / ln 2 = -0.3219
7 y = 100 x 3 -0.3219
8
Cost Behaviour and Estimation

The example assumes that the first unit takes 100 hours to produce....
Cumulative Cumulative Total Cumulative Total
number of average time time average time per time
units per unit at unit at 60%
produced 80% learning learning

1 100 100 100 100

2 80 160 60 120
3 70.21 210.63 44.51 133.53
4
5
6 b = ln (0.6) / ln 2 = -0.7369
7 y = 100 x 3 -0.7369
8
Cost Behaviour and Estimation

The example assumes that the first unit takes 100 hours to produce....
Cumulative Cumulative Total Cumulative Total
number of average time time average time per time
units per unit at unit at 60%
produced 80% learning learning

1 100 100 100 100

2 80 160 60 120
3 70.21 210.63 44.51 133.53
4 64 256 36 144
5 59.57 297.85 30.54 152.7
6 56.17 337.02 26.7 160.2
7 53.45 374.15 23.84 166.88
8 51.2 409.6 21.6 172.8
Cost Behaviour and Estimation

Calculating learning rates

• The existence of two methods can make identifying the ‘learning rate’
complicated
• And so can the fact that lower learning rates actually represent higher
productivity
• The existence of learning curves can make cost behaviour models non-
linear
• It can also have implications for pricing (for example do we price ‘extra’
production lower because it is cheaper to produce?) Think about low
volume or customised production when considering this.
• A 100% learning rate indicates no learning has taken place
• A 50% learning rate suggests that each additional unit would take no
additional time because the incremental time incurred would have each
time production doubled.
Cost Behaviour and Estimation
Empirical evidence on learning rates
• For commercial reasons many studies on learning curve effects are
reluctant to publish specific rates.
• Macher and Mowery (2003) calculate a learning rate of 85% in the
semi-conductor industry.
• Harmsen and van Sambeek (2003) indicate a learning rate of 87-90%
in windfarm turbine proliferation.
• Pendharkar and Subramanian (2007) in software development found
the learning rate to be around 87%, which is perhaps surprisingly
efficient.
• Tomaszewski and Lundberg (2005) show that the choice of software
used by a company can increase productivity by up to 41% because
of learning curve effects.
 Cost Behaviour and Estimation
Empirical evidence on learning rates (cont)
• Ramdas and Randall (2008) in the automotive industry find that
component-sharing increases the speed of learning and efficiency but
led to increased failure rates.
• Field, Xue and Hitt (2012) take an original perspective and look at
learning by ‘customers as co-producers’ in the financial services sector
and showed significant learning curve effects in moving customers
from cashier-based banking to online and ATM processing.
Effect of learning on cost behaviour
• There are limits to the experience curve where labour cost is not a major
component of profitability.
• It may be difficult to distinguish experience curve effects from economies of scale
• Experience curve effects may be overstated due to the ‘Well-travelled road effect’.
 Extended Example - Wright-U-R plc

Calculating learning rates

• Wright’s Cumulative Average Model (Y=aXb)
• Y = cumulative average time per unit
• X = cumulative number of units produced
• a = time required to produce the first unit
• b = rate of learning, calculated as ln (learning rate %)/ ln 2

In this case b = ln (0.9) / ln (2) = -0.152

The question states that the first unit takes 3000 hours to produce....Cumulative

Total
number of average time time materials manufacturing overhead cost
units per unit at cost labour costs costs (at (£’000s)
produced 90% learning (at £25 per £15 per
hour) hour)
1 3,000 3,000 80,000 75,000 45,000 200
2 2,700 5,400 160,000 135,000 81,000 376
4
8

y = 3000 x 2 -0.152
 The question states that the first unit takes 3000 hours to produce....
Cumulative Cumulative Total Direct Direct Variable
Total
number of average time materials manufacturing overhead cost
units time per cost labour costs costs (at (£’000s)
produced unit at 90% (at £25 per £15 per
learning hour) hour)
1 3,000 3,000 80,000 75,000 45,000 200
2 2,700 5,400 160,000 135,000 81,000 376
4 2,430 9,720 320,000 243,000 145,800 708.8
8 2,187 17,496 640,000 437,400 262,440 1,339.84

Note the difference in the per-unit average cost £200 for the first and £167.5 when
there are 8 units produced.
 Cost Behaviour and
Estimation
Summary

• Organisations need to estimate costs for decision-making and for

determining the future viability of existing product lines
• Simple and multiple linear regression methods can be used to do so
• Two alternative estimation methods are account analysis and the
engineering method
• Experience curves will impact cost behaviours as will other social/
psychological effects and these may distort cost estimation
• Over-riding concerns must always be relevance and causality