3-1

3
Cost
Analysis
Prepared
Preparedby
by
Douglas
DouglasCloud
Cloud
Pepperdine
PepperdineUniversity
University
 3-2

Objectives
Objectives
 Understand the importance of cost management.
After
After
 Describe the two reading
reading
aspects this
this
of managing costs.
chapter, you
you should
chapter,value-added
 Distinguish between shouldand non-value-
be
be able
adding activities and able to:
costs. to:
 Understanding the limitations of methods of cost
behavior and analysis.
 Classify costs along several dimensions including
whether managers can change them at short
notice.
 3-3

Cost
Cost Drivers
Drivers and
and Pools
Pools

Activities
Activities that
that cause
cause costs
costs
are
are cost
cost drivers
drivers and
and include
include
sales,
sales, production,
production, andand items
items
such
such as
as the
the number
number of of
products
products thethe company
company
AA group
group ofof costs
costs
makes
makes andand the
the number
number of
of by
driven
driven by the
the
customers
customers itit serves.
serves.
same
same activity
activity isis aa
cost
cost pool.
pool.
 3-4

Estimated
Estimated Cost
Cost Behavior
Behavior
Fixed Cost Behavior Variable Cost Behavior

$ $

Activity Activity

Unit Cost Varies with Volume Unit Cost Rate is Constant

 3-5

Estimated
Estimated Cost
Cost Behavior
Behavior
Mixed Cost

Total Costs
$ Cost

Variable Costs

Fixed amount

Number of Units Produced

Total Costs = Fixed Amount + (Variable Cost Per Unit x Number of Units)
Total Costs = Fixed Costs + Variable Costs
 3-6

Estimating
Estimating Cost
Cost Behavior
Behavior
 Account Analysis
 Engineering Approach
 Interviews
 The (High-Low) Two-Point Method
 Scatter-Diagram Method
 Regression
 3-7

Account
Account Analysis
Analysis
Manager decides how to classify a cost by
looking at its name and then checking this
judgment by scanning the account for that
cost for several periods.
Example: Rent, depreciation, salaries, and
advertising are generally fixed.
Weakness: It only shows what costs have
been, not what they should be.
 3-8

Engineering
Engineering Approach
Approach
Engineers study the material and labor
requirements of products and related
operations, then make per-unit estimates of
the costs that should vary with production.
Advantage: It indicates what costs should
be rather than what they
have been.
 3-9

Interviews
Interviews
This is a simple tool that has proven useful in
determining what drives many costs, and to
determine what is likely to happen to particular
costs, given specific actions.
Advantage: It does help to identify cost
drivers.
Weakness: Interviewing does not help
determine how much of a
particular cost is fixed or
variable.
 3-10

High-Low
High-Low (Two-Point)
(Two-Point) Method
Method

The high-low (two-point) method is a

relatively unsophisticated, yet widely used,
method of estimating the components of a
mixed cost.
Approach: This method uses two past levels
of activity and the amounts of the
cost incurred at those levels;
more specifically, the highest and
lowest levels of activity.
 3-11

High-Low
High-Low (Two-Point)
(Two-Point) Method
Method
Variable cost
change in cost
component of =
mixed cost change in activity
Variable cost
$40,800 – $14,800
component of =
mixed cost 18,000 – 5,000

Variable cost
component of = $26,000 $2 per
= machine hour
mixed cost 13,000
 3-12

High-Low
High-Low (Two-Point)
(Two-Point) Method
Method
Fixed cost variable
component of = total – volume x
cost cost
mixed cost components
At the high point: 18,000
Fixed cost
component of = $40,000 – (18,000 x $2)
mixed cost
Fixed cost
component of = $4,800
mixed cost
 3-13

High-Low
High-Low (Two-Point)
(Two-Point) Method
Method
Fixed cost variable
component of = total – volume x
cost cost
mixed cost components
At the low point: 5,000
Fixed cost
component of = $14,800 – (5,000 x $2)
mixed cost
Fixed cost
component of = $4,800
mixed cost
 3-14

High-Low
High-Low (Two-Point)
(Two-Point) Method
Method
An Example
Month Utility Costs Units Produced
January $4,000 400
February 5,000 800
March 9,000 1,200
April 10,000 1,600
May 15,000 2,000

High!
High!
 3-15

High-Low
High-Low (Two-Point)
(Two-Point) Method
Method
An Example
Month Utility Costs Units Produced
January $4,000 400
February 5,000 800
March 9,000 1,200
April 10,000 1,600
May 15,000 2,000

Low!
Low!
 3-16

High-Low
High-Low (Two-Point)
(Two-Point) Method
Method
Variable Cost = ($15,000 – $4,000) / (2,000 – 400)
= $11,000 /1,600
= $6.875 per unit

Fixed Costs = $15,000 – ($6.875 x 2,000)

= $1,250

The cost formula using the high-low method is:

Y = $1,250 + $6.875 (X)

 3-17

Scatter-Diagram
Scatter-Diagram Method
Method
The scatter-diagram (or graphical) method
requires cost and volume data from prior
periods, and drives an equation (cost
prediction formula) based on those data.
Weakness: The placement and slope of the
line are matters of
judgment; the manager “eyeballs” the
data and fits the line visually.
 3-18

Scatter-Diagram
Scatter-Diagram Method
Method
Utility Cost
$16,000
x

12,000

x
x
8,000 Analyst can fit line
based on his or her
x experience
4,000 x

0
400 800 1,200 1,600 2,000
Units Produced
 3-19

Regression
Regression Method
Method
Regression analysis (or just regression) is a
more sophisticated method for estimating the
fixed and variable components of a mixed
cost.
Regression uses cost and volume data from
prior periods to yield an equation of the form
y = a + bx.
The appendix covers regression in more
detail.
 3-20

Problems and Pitfalls in

Cost Behavior Analysis
Historical Data
 High-low, scatter-diagram, and regression
methods all use historical information.
 Formulas based on historical data can give
useful predictions only if past conditions prevail
in the future.
 Outliers should be ignore
 3-21

Problems and Pitfalls in

Cost Behavior Analysis
Correlation and Association

For
For an
an equation
equation to
to be
be
useful
useful for The
The visual
for planning,
planning, theaspect
the
visual aspect of
of the
the scatter-
scatter-
relationship diagram
relationship between themethod
the
diagram
between method allows
allows the the
cost
cost and
and the manager
the activity
activity mustto
must
manager to see
see whether
whether the the
be
be fairly activity
fairly close.activity chosen
close. chosen as as the
the
independent
independent variable
variable isis aa good
good
predictor
predictor ofof cost.
cost.
 3-22

Step
Step Variable
Variable Costs
Costs
Linearity Assumption

Narrow Width
$ Cost

Number of Units Produced

 3-23

Definitions
Definitions
Discretionary costs are fixed costs that can be
quickly altered by managerial action.
Example: Advertising, employee training,
and research and development
Committed costs are fixed costs that cannot
be changed so quickly.
Example: Depreciation
 3-24

Definitions
Definitions
Avoidable costs are costs that can be avoided
by adding, dropping, or curtailing some
activities.
Example: Advertising, sales salaries

A
A company
company that
that drops
drops aa product
product line
line might
might not
not
be
be able
able to
to reduce
reduce its
its sales
sales force
force or
or its
its rent.
rent.
Such
Such costs
costs are
are unavoidable.
unavoidable.
 3-25

Definitions
Definitions
A direct cost is incurred specifically because
of a particular activity of a firm, like a product
line, or geographical area.
Direct costs are sometimes called separable
or traceable costs.
An indirect cost does not relate to one
specific activity, but rather to several.
An indirect cost is sometimes called a common
or joint cost.
 3-26

Manufacturing
Manufacturing Costs
Costs

 Direct materials
 Direct labor
 Manufacturing overhead
 3-27

Regression
Regression Output
Output (Appendix)
(Appendix)
Regression Output:
Constant $7,731.78
Standard Error of Y Estimate $1,763.16 R
Squared .0954921 No. of
Observations 12
Degrees of Freedom 10 X
Coefficient(s) $1.76678
Standard Error of Coefficient $0.12139

Model: Y = $7,731.78 + $1.76678X

 3-28

Goodness
Goodness of
of Fit
Fit (Appendix)
(Appendix)
Goodness of fit tells us how well the
regression line fits the data, and therefore
suggests to managers how good their
predictions are likely to be. Two potential
measures are:
1. the coefficient of determination (R-
squared).
2. the standard error of the estimate
(Standard Error of Y Estimate).
 3-29

Multiple
Multiple Regression
Regression Equation
Equation
(Appendix)
(Appendix)
TC = FC + b1X1 + b2X2 + … + bnXn
 3-30

Chapter 3

The
The End
End
3-31