Cost Behavior and Cost Estimation

1. Chapter 6 Activity Analysis, Cost Behavior, and CostEstimation

2. Learning Objective1

3. Costbehavior Costprediction Relationshipbetweencost andactivity. Using knowledgeof cost behaviorto forecastlevel of cost ata particularactivity. Focusis on the future. Introduction Costestimation Process ofdeterminingcost behavior,often focusingon historicaldata.

4. Learning Objective2

5. Total Variable Cost Example Your total Pay Per View bill is based on how many Pay Per View shows that you watch. Total Pay Per View Bill Number of Pay Per View shows watched

6. Variable Cost Per Unit Example The cost per Pay Per View show is constant. For example, $4.95 per show. Cost per Pay Per Viewshow Number of Pay Per View shows watched

7. Step-Variable Costs Total cost remainsconstant within anarrow range ofactivity. Cost Activity

8. Step-Variable Costs Total cost increases to a new higher cost for the next higher range of activity. Cost Activity

9. Total Fixed Cost Example Your monthly basic cable TV bill probably does not change no matter how many hours you watch. Monthly Basic Cable Bill Number of hours watched

10. Fixed Cost Per Unit Example The average cost per hour decreases as more hours are spent watching cable television. Monthly Basic cable Bill per hour watched Number of hours watched

11. Step-Fixed Costs Example: Officespace is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost. Continue

12. Step-Fixed Costs Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. 90 60 Rent Cost inThousands of Dollars 30 0 1,000 2,000 3,000 Rented Area (Square Feet)

13. Step-variable costs can be adjusted more quickly and . . . • The width of the activity steps is much wider for thestep-fixed cost. Step-Fixed Costs How does this type of fixed cost differ from a step-variable cost?

14. Semivariable Cost A semivariable cost is partly fixed and partly variable. Consider thefollowing example.

15. Slope isvariable costper unitof activity. Semivariable Cost Total semivariable cost Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

16. CurvilinearCost Function A straight-line(constant unit variable cost) closely approximates a curvilinear line withinthe relevant range. Total Cost Relevant Range Curvilinear Cost CurvilinearCost Function Activity

17. Learning Objective3

18. CurvilinearCost Function A straight-Line(constant unit variable cost) closely approximates a curvilinear line withinthe relevant range. Total Cost Curvilinear Cost CurvilinearCost Function Relevant Range Activity

19. Learning Objective4

20. Depreciation on Buildings and equipment Advertising and Research and Development Direct Materials Engineered, Committed and Discretionary Costs Committed Long-term, cannot be reduced in the short term. Discretionary May be altered in the short term by current managerial decisions. Engineered Physical relationship with activity measure.

21. Merchandisers Cost of Goods Sold Service Organizations Supplies and travel Merchandisers and Manufacturers Sales commissions and shipping costs Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Cost Behavior in Other Industries Examples of variable costs

22. Merchandisers, manufacturers, and service organizations Real estate taxesInsuranceSales salariesDepreciation Cost Behavior in Other Industries Examples of fixed costs

23. Learning Objective5

24. Cost Estimation Account-Classification Method Visual-Fit Method High-Low Method Least-Squares Regression Method

25. Account Classification Method Cost estimates are based on areview of each account making up the total cost being analyzed.

26. Visual-Fit Method A scatter diagram of past cost behavior may be helpful in analyzing mixed costs.

27. 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Visual-Fit Method Plot the data points on a graph (total cost vs. activity).

28. 20 * * * * * * * * Total Cost in1,000’s of Dollars * * 10 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Visual-Fit Method Draw a line through the plotted data points so that about equal numbers of points fall above and below the line.

29. Estimated fixed cost = $10,000 20 * * * * * * * Vertical distance is total cost, approximately $16,000. * Total Cost in1,000’s of Dollars * * 10 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Visual-Fit Method

30. The High-Low Method OwlCo recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute: • the variable cost per unit. • the total fixed cost.

31. The High-Low Method

32. The High-Low Method in costin units • Unit variable cost =

33. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

34. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit • Fixed cost = Total cost – Total variable cost

35. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit • Fixed cost = Total cost – Total variable cost • Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)

36. The High-Low Method • Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit • Fixed cost = Total cost – Total variable cost • Fixed cost = $9,700 – ($.90 per unit × 9,000 units) • Fixed cost = $9,700 – $8,100 = $1,600

37. Least-Squares Regression Method Regression is a statistical procedure usedto determine the relationship between variables such as activity and cost. The objective ofthe regressionmethod is thegeneral cost equation: Y = a + bX Total Cost Activity

38. Total Cost is thedependent variable. The activity (X) is theindependent variable. The intercept term (a) isthe estimate of fixed costs. The X term coefficient (b)is the estimate of variablecost per unit of activity,the slope of the cost line. Equation Form of Least-Squares Regression Line Y = a +bX

39. Least-Squares Regression Method • Statistics courses and computer courses deal with detailed regression computations using computer spreadsheet software. • Accountants and managers must be able to interpret and use regression estimates.

40. Learning Objective6

41. Multiple Regression Multiple regression includes two or more independent variables: Y = a + b1X1 + b2X2 Terms in the equation have the samemeaning as in simple regression withonly one independent variable.

42. Engineering Methodof Cost Estimation Cost estimates are based on measurement and pricing of the work involved.

43. Analyze the kindof work performed. • Estimate the time required for each labor skill for each unit. • Use local wage rates to obtain labor costper unit. • Material requiredfor each unit isobtained from engineering drawings and specification sheets. • Material prices are determined fromvendor bids. Engineering Methodof Cost Estimation Direct Labor Direct Material

44. I’ve noticed the same thing. And if you include all the variable overhead costs that are also declining, that must be the experience curve. Effect of Learningon Cost Behavior As I make more of thesethings it takes me lesstime for each one. It mustbe the learning curve effectthat the boss wastalking about.

45. Learning Curve Learning effectsare large initially. Learning effectsbecome smaller, eventually reaching steady state. Average LaborTime per Unit Cumulative Production Output

46. Learning Objective7

47. Data Collection Problems • Missing data. • Outlier data points. • Mismatched time periods costs. • Trade-offs in choosing the time period. • Allocated and discretionary costs. • Inflation.

48. End of Chapter 6