Cost Behavior & Cost Estimation

1. Cost Behavior & Cost Estimation

2. Costs behave in three ways • 1. Fixed costs • 2. Variable costs • 3. Semi-variable costs • Cost estimation is finding a relationship between cost behavior and the cost driver.

3. Cost behavior • Costs can be variable, fixed or semi variable. Variable costs are costs that vary in direct proportion to change in the cost drive. Direct labor is a good example only if workers are paid by piece. Fixedcosts are costs that that remain the same despite change in the cost drive e.g. Depreciation, rent and insurance.

4. Fixed costs are committed, i.e. they result from previous actions (depreciation). Or they can be discretionary because mgt uses its professional judgment to decide on the amount of cost. • Semi-variablecosts are costs that behave partly as fixed and partly as variable. e.g. indirect labor costs and indirect material.

5. Any cost can be defined in terms of this function • Y= a + bx • Where y is the total cost, a is constant that does not change with the activity level, b is a variable cost and x is the activity volume. • Cost estimation methods • The low- high method: this method requires that we know the highest and lowest activity level. This is the most common.

6. Example : • Bobs Company has budgeted factory costs for four values of operation. Machine hours • 5000 6000 7000 8000 • In-labor 2100 2400 2700 3000 • Insurance 600 600 600 600 • Depreciat1000 1200 1400 1600 • Utilities 2000 2300 2600 2900

7. Required: • 1. Indicate the behavior of the four costs • 2. using the low-high method determine the cost estimating formula for each of the four costs. • In order to check whether the cost is variable or not you will need to check if it varies directly with the number of units of production

8. Indirect labor is a semi-variable cost as the rate changes but not proportionally 2100/ 5000, 2400/6000, 2700/ 7000 and 3000/ 8000. • Insurance is a fixed cost because it does not change with production. • Depreciation is a variable cost and that changes directly with production. (0.2) is the rate. • Utilities are semi-variable as the rate changes but not proportionally with production.

9. Indirect labor • Highest no of hrs= 8000 highest cost =3000 • Lowest no of hrs= 5000 lowest cost = 2100 • Difference 3000 900 • Variable cost rate = 900/ 3000 = $0.3 • Fixed cost = 3000 – 0.3(8000) = $600 • The function is • TC (indirect labor) = 600+ 0.3(x)

10. Insurance • Highest no of hrs= 8000 highest cost = 600 • Lowest no of hrs= 5000 lowest cost = 600 • Difference 3000 0 • Variable cost rate = 0/ 3000 = $0 • Fixed cost = $600 – 0(8000) = $600 • The function is • TC (Insurance) = $600

11. Depreciation • Highest no of hrs= 8000 highest cost = 1600 • Lowest no of hrs= 5000 lowest cost = 1000 • Difference 3000 600 • Variable cost rate = 600/ 3000 = $0.2 • Fixed cost = 1600– 0.2(8000) = 0 • The function is • TC (Deprecation) = 0.2(x)

12. Utilities • Highest no of hours= 8000 highest cost = 2900 • Lowest no of hours= 5000 lowest cost = 2000 • Difference 3000 900 • Variable cost rate = 900/ 3000 = $0.3 • Fixed cost = 2900 – 0.3(8000) = $500 • The function is TC (utilities) = 500+ 0.3(x)

13. Faisal Company has budgeted factory costs for three values of operation. • Machine hours 1000 2000 3000 4000 • In.mat 1100 2100 3100 4100 • Rent 700 700 700 700 • Deprec 500 1000 1500 2000

14. Required: • Indicate the behavior of the costs • Use the low-high method to determine the cost estimating formula for each of the three costs.