Activity Analysis, Cost Behavior, and Cost Estimation

1. 7 Chapter Seven Activity Analysis, Cost Behavior, and CostEstimation

2. 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.

3. Cost Behavior Patterns Recall the summary of our cost behavior discussion from Chapter 2.

4. Total Variable Cost Example Your total long distance telephone bill is based on how many minutes you talk. Total Long DistanceTelephone Bill Minutes Talked

5. Variable Cost Per Unit Example The cost per long distance minute talked is constant. For example, 5 cents per minute. Per MinuteTelephone Charge Minutes Talked

6. Total Fixed Cost Example Your monthly basic telephone bill probably does not change when you make more local calls. Monthly Basic Telephone Bill Number of Local Calls

7. Fixed Cost Per Unit Example The average cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call Number of Local Calls

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

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

10. 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

11. Step-Fixed Costs 90 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. 60 Rent Cost in Thousands of Dollars 30 0 0 1,000 2,000 3,000 Rented Area (Square Feet)

12. 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?

13. Semivariable Cost A semivariable cost is partly fixed and partly variable. Consider thefollowing electric utility example.

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

15. 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

16. 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.

17. Shifting Cost Structure in the New Manufacturing Environment A trend toward more fixed costs because of • Increased automation. • Stable workforce. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions.

18. 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

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

20. Cost Estimation Account-Classification Method Visual-Fit Method High-Low Method Least-Squares Regression Method Engineering Method of Cost Estimation

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

22. Account Classification MethodExample

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

24. 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).

25. 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.

26. 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

27. 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 Total variable cost = Total cost – Total fixed costTotal variable cost = $16,000 – $10,000 = $6,000

28. 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 Total variable cost = Total cost – Total fixed costTotal variable cost = $16,000 – $10,000 = $6,000Unit variable cost = $6,000 ÷ 3,000 units = $2

29. 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.

30. The High-Low Method

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

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

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

34. 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)

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. The High-Low Method Question 1 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit

38. The High-Low Method Question 1 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit $4,000 ÷ 40,000 units = $.10 per unit

39. The High-Low Method Question 2 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000

40. The High-Low Method Question 2 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000

41. 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 in cost terms TC = F + VX Total Cost Activity

42. Total Cost is thedependent variable. The activity (X) is theindependent variable. The intercept term (F) isthe estimate of fixed costs. The X term coefficient (V)is the estimate of variablecost per unit of activity,the slope of the cost line. Equation Form of Least-Squares Regression Line TC = F +VX

43. 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.

44. Goodness of fit is a measure of thevariation of the dependent variable thatis explained by the independent variable. Goodness of fit is high here as the datapoints are close to the regression line. Goodness of Fit 20 * * * * * * * * * * Total Cost 10 0 0 1 2 3 4 Activity

45. Multiple Regression Multiple regression includes two or more independent variables: Terms in the equation have the samemeaning as in simple regression withonly one independent variable. TC = FC + V1X1 + V2X2

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

47. I’ve noticed the same thing, but I’m not improving my times as much as I did earlier. I must be reaching what they call steady state. 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.

48. Effect of Learningon Cost Behavior A systematic relationship betweenthe amount of experience inperforming a task and the timerequired to carry out the task.

49. Effect of Learningon Cost Behavior A systematic relationship betweenthe amount of experience inperforming a task and the timerequired to carry out the task. The average time per task declines by a constant percentage each time the quantity of tasks doubles.

50. Effect of Learningon Cost Behavior BerryCo. makes products requiring labor that follows an 80 percent learning rate. If the first unit of such a product requires 10 hours, what is the average time for 16 units of this product?