Measurement of Cost Behavior

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İ2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e,

Horngren/Sundem/Stratton
3 -1
Measurement of
Cost Behaviour
Chapter 3
3 -2
Step- and Mixed-C

Cost
Behaviour Patterns
Step costs change abruptly at intervals
of activity because the resources and
their costs come in indivisible chunks.
3 -3
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Step- and Mixed-C

Cost
Behaviour Patterns
Lease cost example
Oil and gas exploration activity
Relevant
range
Actual cost
behavior
Fixed cost
approximation
Lease cost
3 -4
Step- and Mixed-C

Cost
Behaviour Patterns
Supermarket checker wage cost example
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Shoppers per hour

Relevant range
Variable
cost
approximation
Actual cost
behaviour
40
440
Wage cost
3 -5
Step- and Mixed-C

Cost
Behaviour Patterns
Mixed costs contain elements of both
fixed- and variable-cost behavior.
The fixed-cost element is unchanged
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over a range of cost-driver activity.

The variable-cost element varies
proportionately with cost-driver activity.
3 -6
Step- and Mixed-C

Cost
Behaviour Patterns
Facilities maintenance
department cost
Number of patient-days per month
$10,000
1,000
5,000
Total
variable
cost
Fixed
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cost
Relevant range
$5.00 per
patient day
3 -7
Product and Service Decisions

and the Value Chain
Distribution channels
Choice of process and product design
Quality levels
Product features
Management
influence on cost behaviour
3 -8
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2. Capacity Decisions
What are capacity costs?
They are the fixed costs of being able

to achieve a desired level of production or
to provide a desired level of service while
maintaining product or service attributes,
e.g. quality
3 -9
2. Capacity Decisions (Contd.)

Full capacity,
New plant
& assembly lines
Cannot recover
fixed costs
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Overtime, oursource
production
Good economic conditions
Can be eliminated
Adverse economic conditions
3 - 10
3. Committed Fixed Costs

Salaries of key personnel
Committed fixed costs usually arise
from the possession of facilities,
equipment, and a basic organization.
Lease payments
Property taxes
3 - 11
4. Discretionary Fixed Costs

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Discretionary fixed costs are costs fixed

at certain levels only because management
decided that these levels of cost should be
incurred to meet the organization’s goals.
These discretionary fixed costs have no
obvious relationship to levels of output
activity but are determined as part
of the periodic planning process.
3 - 12
4. Discretionary
Fixed Costs (Contd.)
Each planning period, management
will determine how much to
spend on discretionary items.
These costs then become fixed
until the next planning period.
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3 - 13
Examples of Discretionary
Fixed Costs
Advertising and promotion
Research and development
Management salaries
Employee training
3 - 14
5. Technology Decisions
Choice of technology (e-commerce vs.
in-store or mail-order sales) positions the
organization to meet its current goals and
to respond to changes in the environment.
3 - 15
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6. Cost-Control Incentives
Managers use their knowledge of cost
behaviour to set cost expectations.
Employees may receive rewards that
are tied to meeting these expectations.
3 - 16
Cost Functions
Planning and controlling the activities
of an organization require accurate
and useful estimates of future
fixed and variable costs.
3 - 17
Cost Functions (Contd.)

Understanding relationships between costs
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and their cost drivers allows managers to...

evaluate strategic plans and
operational improvement programs.
make short- and long-run decisions.
plan or budget the effects of future activities.
3 - 18
Cost Functions (Contd.)

st
The 1 step in estimating or predicting
costs is measuring cost behaviour as a
function of appropriate cost drivers.
nd
The 2 step is to use these cost
measures to estimate future costs at
expected levels of cost-driver activity.
3 - 19
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Cost Function Equation

Y = Total cost
F = Fixed cost
V = Variable cost per unit
X = Cost-driver activity in number of units
3 - 20
Cost Function Equation (Contd.)

Mixed-cost function:
Y = F + VX
The mixed-cost function is
called a linear-cost function.
Y = $10,000 + $5.00X
3 - 21
Developing Cost Functions

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Plausibility:
A cost function’s estimates of costs
at actual levels of activity must reliably
conform with actually observed costs.
The cost function must be believable.
Reliability:
3 - 22
Choice of Cost Drivers:

Activity Analysis
Choosing a cost function starts
with choosing cost drivers.
Managers use activity analysis to
identify appropriate cost drivers.
Activity analysis directs management
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accountants to the appropriate

cost drivers for each cost.
3 - 23

Activity Analysis
Northwestern Computers makes 2
products: Mozart-Plus and Powerdrive
In the past, most of the support costs
were twice as much as labour costs.
Northwest has upgraded the production
function, which has increased support
costs and reduced labour cost.
3 - 24
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Activity Analysis
Using the old cost driver, labour cost, the
prediction of support costs would be:
Labour cost $ 8.50 $130.00
Support cost:
2 × Direct labour cost $17.00 $260.00
Mozart-Plus
Powerdrive
3 - 25

Activity Analysis
Using the more appropriate cost driver,
the number of components added to
products, the predicted support costs are:
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3 - 26

Activity Analysis
Support cost
at $20/component
$20 × 5 components $100.00
$20 × 9 components $180.00
Difference in predicted
support cost $ 83.00 $ 80.00
higher lower
Mozart-Plus
Powerdrive
3 - 27
Methods of Measuring
Cost Functions
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1. Engineering analysis
2. Account analysis
3. High-low analysis
4. Visual-fit analysis
5. Least-squares regression analysis
3 - 28
1. Engineering Analysis
It measures cost behaviour according to what
costs should be, not by what costs have been.
Engineering analysis entails a systematic
review of materials, supplies, labor,
support services, and facilities
needed for products and services.
3 - 29
2. Account Analysis
The simplest method of account
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analysis selects a plausible

cost driver and classifies each
account as a variable or fixed cost.
3 - 30
Account Analysis Example

Supervisor’s salary and benefits $
3,800 $3,800
Hourly workers’ wages and benefits
14,674 $14,674
Equipment depreciation and rentals 5,873
5,873
Equipment repairs 5,604 5,604
Cleaning supplies 7,472 7,472
Total
maintenance costs $37,423 $9,673 $27,750
Monthly cost
Amount
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Fixed
Variable
3 - 31
Account Analysis Example

Fixed cost per month = $9,673
Variable cost per patient-day
= $27,750 ÷ 3,700
= $7.50 per patient-day
3,700 patient-days
Y = $9,673 + ($7.50 × patient-days)
3 - 32
3. High-Low Method
The focus of this method is normally on
the highest- and lowest-activity points.
The first step is to plot the historical
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data points on a graph.

3 - 33
High-Low Method Example

High month: April
Maintenance cost: $47,000
Number of patient-days: 4,900
Low month: September
Maintenance cost: $17,000
Number of patient-days: 1,200
What is the variable cost?
3 - 34

($47,000 – $17,000) ÷ (4,900 – 1,200)
= $30,000 ÷ 3,700 = $8.1081
What is the fixed cost?
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3 - 35

$47,000 = Fixed cost + ($8.1081× 4,900)
$47,000 – $39,730 = $7,270
$17,000 = Fixed cost + ($8.1081× 1,200)
$17,000 – $9,730 = $7,270
3 - 36
4. Visual-Fit Method
In the visual-fit method, the cost analyst
visually fits a straight line through a plot
of all of the available data, not just
between the high point and the
low point, making it more reliable
than the high-low method.
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3 - 37
5. Least-Squares
Regression Method
Regression analysis measures
a cost function more objectively
by using statistics to fit a cost
function to all the data.
Regression analysis measures
cost behavior more reliably than
other cost measurement methods.
3 - 38
Coefficient of Determination
One measure of reliability,
or goodness of fit, is the
coefficient of determination,
R² (or R-squared).
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The coefficient of determination

measures how much of the
fluctuation of a cost is explained
by changes in the cost driver.
3 - 39
Exercise 3-50 (Page 120)

Sandra, a cost
analyst at ABC Company, was asked to
predict overhead costs for the company’s
operations in 2005, when 510 units are
expected to be produced. She collected
the following quarterly data:
3 - 40
991
90
3/04
1050
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122
2/04
835
84
1/04
957
84
4/03
996
115
3/03
1066
129
2/03
997
124
1/03
1042
133
4/02
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1119
125
3/02
1111
128
2/02
1001
125
1/02
1131
136
4/01
655
72
3/01
715
79
2/01
721
76
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1/01
Overhead costs (RM)
Production (units)
Quarter
3 - 41
Exercise 3-50 (Page 120) (Contd.)

Using
the high-low method to estimate costs,
prepare a prediction of overhead costs
for 2005.
Variable cost/unit
= ($1,131 - $655) (136 - 72)
= $476 64 = $7.4375
Fixed cost
= $1,131 - (136 x 7.4375)
= $119.50
3 - 42
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Predicted cost for 510 units
= ($119.50 x 4) + (510 x $7.4375)
= $4,271.13
Notice that
the data are quarterly observations.
Thus, the annual fixed cost is 4
times the computed (quarterly) fixed cost.
3 - 43

2. Sandy ran
a regression analysis using the data she
had collected. The result was:
Y = RM337 + 5.75X
Using this cost function, predict costs for 2005.
Predicted cost for 510 units
= ($337 x 4) + (510 x $5.75)
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= $4,280.50
3 - 44

3. Which prediction do you prefer? Why?
The regression
analysis gives better cost estimates because
it uses all the data to form a cost function.
The 2 points
used by the high-low method may not
be representative of the general relation
between costs and volume.
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Measurement of Cost Behavior http://webcache.googleusercontent.com/search?q=cache:Rpw2...

This is the html version of the file http://www.freewebs.com/accountingforengineers/KT4982/Week5.ppt.

İ2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e,

Step- and Mixed-C

Step- and Mixed-C

Step- and Mixed-C

Shoppers per hour

Step- and Mixed-C

over a range of cost-driver activity.

Step- and Mixed-C

Product and Service Decisions

They are the fixed costs of being able

2. Capacity Decisions (Contd.)

3. Committed Fixed Costs

4. Discretionary Fixed Costs

Discretionary fixed costs are costs fixed

İ2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e,

Cost Functions (Contd.)

and their cost drivers allows managers to...

Cost Functions (Contd.)

Cost Function Equation

Cost Function Equation (Contd.)

Developing Cost Functions

Choice of Cost Drivers:

accountants to the appropriate

Choice of Cost Drivers:

Choice of Cost Drivers:

Choice of Cost Drivers:

Choice of Cost Drivers:

analysis selects a plausible

Account Analysis Example

Account Analysis Example

data points on a graph.

High-Low Method Example

High-Low Method Example

İ2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e,

High-Low Method Example

The coefficient of determination

Exercise 3-50 (Page 120)

Exercise 3-50 (Page 120) (Contd.)

Exercise 3-50 (Page 120) (Contd.)

Exercise 3-50 (Page 120) (Contd.)

Exercise 3-50 (Page 120) (Contd.)

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