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COST BEHAVIOR

COST BEHAVIOR. Chapter 3. CHAPTER 3 Objectives. Define and describe fixed, variable, and mixed costs Explain the use of resources and activities and their relationship to cost behavior Explain how several methods of cost estimation can be used

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COST BEHAVIOR

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  1. COST BEHAVIOR Chapter 3

  2. CHAPTER 3 Objectives • Define and describe fixed, variable, and mixed costs • Explain the use of resources and activities and their relationship to cost behavior • Explain how several methods of cost estimation can be used • Separate mixed costs into their fixed and variable components using the high-low method, the scatterplot method, and the method of least squares

  3. CHAPTER 3 Objectives • Evaluate the reliability of the cost formula • Explain how multiple regression can be used to assess cost behavior • Define the learning curve, and discuss its impact on cost behavior • Discuss the use of managerial judgment in determining cost behavior

  4. BASICS OF Cost Behavior Cost Behavior • The term used to describe whether a cost changes when the level of output changes • Fixed costs do not change as output changes • Variable costs increase in total with an increase in output and decrease in total with a decrease in output LO-1

  5. BASICS OF Cost Behavior Cost Objects • An item for which managers want cost information • For manufacturing or merchandising firms, it is usually the tangible product • For service firms, it is usually the service provided LO-1

  6. BASICS OF Cost Behavior Measures of Output • Activity drivers explain changes in activity costs by measuring changes in activity output (usage) • The two general categories of activity drivers • Unit-level drivers • Non-unit-level drivers LO-1

  7. Basics of Cost Behavior LO-1 Fixed costs are costs that in total are constant within the relevant range as the level of the activity driver varies Fixed Costs

  8. Basics of Cost Behavior LO-1 JCM Audio Systems, Inc. produces speakers for home audio systems. One department produces voice coils. There are two production lines that can each make up to 100,000 voice coils per year. The production-line manager is paid $60,000 per year. For production up to 100,000 units only one manager is needed; above that (to 200,000 units) two managers are needed. Fixed Costs

  9. Basics of Cost Behavior JCM Audio Systems, Inc. The total cost of supervision remains the same within the relevant range, but the unit cost decreases as production increases. LO-1 Fixed Costs

  10. Basics of Cost Behavior JCM Audio Systems, Inc. The total cost of supervision remains the same within the relevant range, but the unit cost decreases as production increases LO-1 Fixed Costs

  11. EXHIBIT 3.1—FIXED Cost Behavior LO-1

  12. Basics of Cost Behavior LO-1 Variable costs are costs that in total vary in direct proportion to changes in an activity driver The total cost of direct materials for each level of production varies, but the unit cost stays the same Variable Costs

  13. Basics of Cost Behavior JCM Audio Systems, Inc. The total cost of supervision remains the same within the relevant range, but the unit cost decreases as production increases. LO-1 Variable Costs

  14. EXHIBIT 3.2—Variable Cost Behavior LO-1

  15. EXHIBIT 3.3—NONLINEARITY OF VARIABLE COSTS LO-1

  16. EXHIBIT 3.4—RELEVANT RANGE FOR VARIABLE COSTS LO-1

  17. BASICS OF COST BEHAVIOR Y = Fixed cost + Total variable cost Y = F + VX where Y = Total cost (Usually a mixed cost) LO-1 Mixed costs are costs that has both a fixed and a variable component Mixed Costs

  18. BASICS OF COST BEHAVIOR Y = $300,000 + $5X Fixed - salaries Variable - commission LO-1 JCM’s sales costs are mixed. There are 10 sales representatives who each earn $30,000 plus receive a commission of $5 per speaker sold. This function can be represented by the following equation Mixed Costs

  19. BASICS OF COST BEHAVIOR JCM Audio Systems, Inc. Selling Cost Per Unit Fixed Cost of Selling Speakers Sold Variable Cost of Selling Total Cost $300,000 $200,000 $ 500,000 40,000 $12.50 300,000 400,000 700,000 80,000 8.75 300,000 600,000 900,000 120,000 7.50 300,000 800,000 1,100,000 160,000 6.88 300,000 1,000,000 1,300,000 200,000 6.50 LO-1 Mixed Cost

  20. EXHIBIT 3.5—mixed COST BEHAVIOR LO-1

  21. Resources, Activities, and Cost Behavior Resources Economic elements that enable one to perform activities When a firm acquires the resources needed to perform an activity, it obtains activity capacity Practical capacity is the activity level where the activity is performed efficiently LO-2

  22. Resources, Activities, and Cost Behavior Flexible Resources Supplied as needed and used Quantity of resource supplied equals quantity demanded No unused capacity LO-2

  23. Resources, Activities, and Cost Behavior Committed Resources Supplied in advance of usage A given quantity is obtained, whether or not that full amount is used • Unused capacity is possible LO-2

  24. Resources, Activities, and Cost Behavior LO-2 A step cost function displays a constant level of cost for a range of output and then jumps to a higher level of cost at some point Step-Cost Behavior

  25. Resources, Activities, and Cost Behavior LO-2 Step-variable Costs Follow a step-cost behavior with narrow steps Step-fixed Costs Follow a step-cost function Exceed the relevant range, and the costs increase “one step” Step-Cost Behavior

  26. EXHIBIT 3.6— sTEP COST FUNCTION LO-2

  27. EXHIBIT 3.7—sTEP-FIXED COSTS LO-2

  28. Resources, Activities, and Cost Behavior Activities and Mixed Cost Behavior Many activities have characteristics of both flexible and committed resources • For example, a power department acquires long-term capacity for supplying power by investing in a building and equipment • It also acquires fuel to produce power on an as-needed basis LO-2

  29. Resources, Activities, and Cost Behavior Need for Cost Separation Sometimes it is easy to spot the variable and fixed portion of a cost • Other times it is not; thus there is a need for a method to separate costs into their fixed and variable components LO-2

  30. Methods of Determining Cost Behavior The Industrial Engineering Method A forward-looking method of determining, through physical observation and analysis, just what activities, in what amounts, are needed to complete a process The Account Analysis Method Used to estimate costs by classifying accounts in the general ledger as fixed, variable, or mixed LO-3

  31. Quantitative Methods for Separating MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS LO-4 Y = F + VX where Y = Total cost (the dependent variable) F = Fixed cost (the intercept parameter) V = Variable cost per unit (the slope parameter) X = Measure of output (the independent variable)

  32. Quantitative Methods for Separating MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS LO-4 Take two points (the high and the low by volume of activity) and determine the slope and intercept • Slope is variable rate • Intercept is fixed cost The High-Low Method

  33. Quantitative Methods for Separating MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS LO-4 Advantages • It is objective • It is simple to calculate Disadvantages • The high and low points may be “outliers” • Other pairs of points may clearly be more representative The High-Low Method

  34. Quantitative Methods for Separating MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS LO-4 Uses a scattergraph to visually assess the relationship between cost and output • Intercept is fixed cost • Slope is variable rate Scatterplot Method

  35. Quantitative Methods for Separating MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS LO-4 Advantages Allows for visual inspection of the data Identifies nonlinearity, outliers, and shifts in the cost relationship Disadvantages It is subjective Scatterplot Method

  36. EXHIBIT 3.8—Scattergraph for Anderson Company’s Materials Handling Costs LO-4

  37. EXHIBIT 3.8—Scattergraph for Anderson Company’s Materials Handling Costs (CONTINUED) LO-4

  38. EXHIBIT 3.8—Scattergraph for Anderson Company’s Materials Handling Costs (CONTINUED) LO-4

  39. EXHIBIT 3.9—Scattergraph for VARIOUS COST BEHAVIOR PATTERNS LO-4

  40. EXHIBIT 3.9—Scattergraph for VARIOUS COST BEHAVIOR PATTERNS (CONTINUED) LO-4

  41. EXHIBIT 3.9—Scattergraph for VARIOUS COST BEHAVIOR PATTERNS (CONTINUED) LO-4

  42. EXHIBIT 3.10—Deviations of Data from a Line LO-4

  43. EXHIBIT 3.11—Spreadsheet Data for Anderson Company’s Materials Handling Cost LO-4

  44. Quantitative Methods for Separating MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS Using Regression Programs • Enter the data • Choose the “Tools” menu • Choose the “Data Analysis” option • If this is not available, you may have to manage add-ins • Scroll down to “Regression” • Click on “Input Y Range” and highlight the cost cells • Click on “Input X Range” and highlight the driver cells • Choose your preferred location for output • Click ok LO-4

  45. EXHIBIT-3.12— Regression Results for Anderson Company’s Materials Handling Cost LO-4

  46. Quantitative Methods for Separating MIXED COSTS INTO FIXED AND VARIABLE COMPONENTS Using Regression Programs Interpreting the results • Under “coefficients” in the bottom left of the output find the intercept and the slope • Write the equation • Y = $12.39X + $854.50 • Use the equation to make a point estimate • At a point of 350 moves, total cost is predicted • Y = $12.39(350) + $854.50 • Y = $4,336.50 LO-4

  47. Reliability of Cost Formulas Three statistical assessments concerning the cost formula’s reliability • Hypothesis test of cost parameters • Goodness of fit • Confidence intervals LO-5

  48. Reliability of Cost Formulas Hypothesis Test of Cost Parameters • The “t Stat” tests the hypothesis that the parameters are different from zero • The “P-value” is the level of significance achieved • Generally, a P-value of 0.05 or less is needed for significance LO-5

  49. Reliability of Cost Formulas Goodness of Fit Measures The coefficient of determination, or R2, shows the percentage of variability in the dependent variable explained by the independent variable Since R2 is the percentage of variability explained, it always has a value between 0 and 1.00 Typically, the Adjusted R Square is used because this value has been adjusted for the number of variables included in the equation LO-5

  50. Reliability of Cost Formulas Coefficient of Correlation It is the square root of the coefficient of determination when there is one independent variable Range between −1 and +1 The higher the magnitude, the greater the correlation A coefficient of correlation value close to zero indicates no correlation LO-5

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