Determining How

Costs Behave
Chapter 10

1
 Learning objectives
1. Describe linear cost functions and three common ways in
which they behave
2. Explain the importance of causality in estimating cost
functions
3. Understand various methods of cost estimation
4. Outline six steps in estimating a cost function using
quantitative analysis
5. Describe three criteria used to evaluate and choose cost
drivers
6. Understand the pattern of non-linear cost functions
7. Be aware of data problems in estimating cost functions
2
1.Cost Function, Defined
A cost function is a mathematical description of how
a cost changes with changes in the level of an
activity relating to that cost.
Managers often estimate cost functions based on two
assumptions:
 Variations in the level of a single activity (the cost

driver) explain the variations in the related total

costs, and
 Cost behavior is approximated by a linear cost

function within the relevant range.

Cost Terminology
From prior chapters, we are familiar with the distinction
between variable and fixed costs and in this chapter, we
introduce mixed costs.
Variable costs—costs that change in total in relation
to some chosen activity or output.
Fixed costs—costs that do not change in total in
relation to some chosen activity or output.
Mixed costs—costs that have both fixed and variable
components; also called semivariable costs.
Linear Cost Function

y = a + bX
The dependent The independent
variable: variable:
the cost that is the cost driver
being predicted
The slope of
The intercept: the line:
fixed costs variable cost
per unit
Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
Bridging Accounting and Statistical
Terminology

ACCOUNTING STATISTICS

Variable Cost Slope or Slope Coefficient

Fixed Cost Intercept or Constant

Mixed Cost Linear Cost Function

Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
 Example
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 whose change
causes a change in total costs.
The cost is variable.
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
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Cost Function
y = cost
y

x = number of rooms
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Cost Function
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?
y = $8,000
$8,000 is called a constant or intercept.
The slope of the cost function is zero.

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Cost Function
y = cost y

$8,000

x = number of rooms
X
10
Cost Function
3 $3,000 per month plus $24 per room
This is an example of a mixed cost.
y = $3,000 + $24x
y = a + bx

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Cost Function
y = cost y

3,000

x = number
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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-behavior functions primarily
because these estimates can help them
make more accurate cost predictions.

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 Linear Cost Functions,
Illustrated
Exhibit 10.1 Examples of Linear Cost Functions
Review of Cost Classification
1. Choice of cost object—different objects may result
in different classification of the same cost.
2. Time horizon—the longer the period, the more
likely the cost will be variable.
3. Relevant range—behavior is predictable only within
this band of activity.
Better management decisions, cost predictions and
estimation of cost functions can be achieved only if
managers correctly identify the factors that affect costs.
2.The Cause-and-Effect
Criterion (1 of 3)
The most important issue in estimating a cost
function is determining whether a cause-and-effect
relationship exists between the level of an activity
and the costs related to it.
Without a cause-and-effect relationship, managers
will be less confident about their ability to estimate or
predict costs.
Recall from Chapter 2 that when a cause-and-effect
relationship exists between a change in the level of
an activity and a change in the level of total costs,
we refer to the activity measure as a cost driver.
The Cause-and-Effect Criterion
(2 of 3)

A cause-and-effect relationship might arise as a result

of:
 A physical relationship between the level of activity

and the costs (e.g.material cost)

 A contractual agreement (mobile charges based on

usage)
 Knowledge of operations (Implicitly established by

logic)
Only a cause-and-effect relationship—not merely
correlation—establishes an economically plausible
relationship between the level of an activity and its
costs.
The Cause-and-Effect Criterion
(3 of 3)

Economic plausibility is critical because it gives

analysts and managers confidence that the estimated
relationship will appear repeatedly in other sets of
data.
Identifying cost drivers also gives managers insights
into ways to reduce costs and the confidence that
reducing the quantity of the cost drivers will lead to a
decrease in costs.
Cost Drivers and the Decision-
Making Process
To correctly identify cost drivers in order to make
decisions, managers should always use a long time
horizon.
Costs may be fixed in the short run (during which
time they have no cost driver), but they are usually
variable and have a cost driver in the long run.
Managers should follow the five-step decision-making
process outlined in Chapter 1 to evaluate how
changes can affect costs and product decisions.
3.Different methods of Cost
Estimation Approaches
– Industrial engineering method
– Conference method
– Account analysis method
– Quantitative analysis methods

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Industrial Engineering Method
Estimates cost functions by analyzing the relationship
between inputs and outputs in physical terms.
Includes time-and-motion studies.
Very thorough and detailed when there is a physical
relationship between inputs and outputs, but also
costly and time-consuming.
Also called the work-measurement method.
Some government contracts mandate its use.
Conference Method
Estimates cost functions on the basis of analysis and
opinions about costs and their drivers gathered from
various departments of a company.
Pools expert knowledge, increasing credibility.
Because opinions are being used, the accuracy of the
cost estimates depends largely on the care and skill
of the people providing the inputs.
Account Analysis Method
Estimates cost functions by classifying various cost
accounts as variable, fixed, or mixed in respect to the
identified level of activity.
Typically, managers use qualitative rather than quantitative
analysis when making these cost-classification decisions.
Widely used because it is reasonably accurate, cost-
effective, and easy to use.
The accuracy of the account analysis method depends on
the accuracy of the qualitative judgments that managers
and management accountants make about which costs are
fixed and which are variable.
Account Analysis example
Quatisha & Co. sells software programs.
Total sales = $390,000
The company sold 1,000 programs.
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

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Account Analysis

What is the variable cost per unit sold?

Cost of goods sold: $130,000
Commissions: $390,000 × .12 = $46,800
($130,000 + $46,800) ÷ 1,000 = $176.80
The cost function is?

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4. Six Steps in Quantitative
Analysis
uses a formal mathematical method to
fit linear cost functions to past data
observations.

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Six 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.

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Steps In Estimating
A Cost Function
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.

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 Steps In Estimating
A Cost Function
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).
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.

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Steps In Estimating
A Cost Function
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

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Steps In Estimating
A Cost Function
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.

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Steps In Estimating
A Cost Function
5 Estimate the cost function.
– High-low method
– Regression analysis
6 Evaluate the estimated cost function.
A key aspect of estimating a cost
function is choosing the appropriate
cost driver.

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High-Low Method
Simplest method of quantitative analysis.
Uses only the highest and lowest observed values.
“Fits” a line to data points which can be used to
predict costs.
Three steps in the high-low method to obtain the
estimate of the cost function.
High-Low Method
Step 1: Calculate the slope coefficient (the variable cost
per unit of activity).
Slope coefficient = Difference between costs
associated with highest and lowest observations of the
cost driver / Difference between highest and lowest
observations of the cost driver.

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High-Low Method
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?

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 High-Low Method
($80,450 – $64,200) ÷ (55,000 – 30,000)
$16,250 ÷ 25,000 = $0.65

Step 2: is to calculate the constant (the total fixed

costs).
Total cost from either the highest or lowest
activity level – (Variable Cost per unit of activity X
Activity associated with above total cost) = Fixed
Costs

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High-Low Method
What is the fixed cost?
$80,450 = Fixed cost + 55,000 X $0.65
Fixed cost = $80,450 – $35,750 =
$44,700
$64,200 = Fixed cost + 30,000 x $0.65
Fixed cost = $64,200 – $19,500 =
$44,700

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High-Low Method
The third and final step in the high-low
method is to summarize by writing a
linear equation:

y = a + bx
y = $44,700 + ($0.65 × Machine-hours)

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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.
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Regression Analysis
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.

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Regression Analysis
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.

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Regression Analysis
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.

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 Sample Regression Model Plot
Exhibit 10.6 Regression Model for Weekly Indirect Manufacturing Labor Costs and
Machine-Hours for Elegant Rugs
5.Criteria to Evaluate and
Choose Cost Drivers
1 Economic plausibility
2 Goodness of fit
3 Significance of the independent variable

Determining the correct cost driver to estimate

costs is critical. Identifying the wrong drivers or
misestimating cost functions can lead
management to incorrect and costly decisions
along a variety of dimensions
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Goodness of Fit
indicates the strength of the relationship
between the cost driver and costs.

The coefficient of determination (r )

2

expresses the extent to which the changes in

(x) explain the variation in (y).

An (r ) of 0.80 indicates that more than 80

2

percent of the change in the dependent

variable can be explained by the change in
the independent variable. 45
6.Nonlinearity and Cost
Functions
A nonlinear 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

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Nonlinearity and Cost
Functions
Economies of scale in advertising may
enable an advertising agency to double
the number of advertisements for less
than double the cost.
Quantity discounts on direct materials
purchases produce a lower cost per unit
purchased with larger orders (panel A).

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Nonlinearity and Cost
Functions
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.
Step fixed cost and variable cost (Panel
B and C)
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Nonlinearity and Cost Functions

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7. Data Collection and
Adjustment Issues

The ideal database for estimating cost functions

quantitatively has two characteristics:
1. The database should contain numerous reliably
measured observations of the cost driver and the
related costs.
2. The database should consider many values
spanning a wide range for the cost driver.
Data Problems (1 of 3)

Managers should ask about these problems and assess

how they have been resolved before they rely on cost
estimates generated from the data.
1. The time period for measuring the dependent
variable does not properly match the period for
measuring the cost driver.
2. Fixed costs are allocated as if they are variable.
3. Data are either not available for all observations or
are not uniformly reliable.
Data Problems (2 of 3)

4. Extreme values of observations occur.

5. There is no homogeneous relationship between the
cost driver and the individual cost items in the
dependent variable-cost pool. (A homogeneous
relationship exists when each activity whose costs
are included in the dependent variable has the
same cost driver.)
Data Problems (3 of 3)

6. The relationship between the cost driver and the

cost is not stationary. This can occur when the
underlying process that generated the observations
has not remained stable over time.
7. Inflation has affected the costs, the cost driver, or
both.