1 Measurement of Cost Behavior

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 1 Explain step- and mixed-cost behavior.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Linear-Cost Behavior Linear-cost behavior can be graphed with a straight line when a cost changes proportionately with changes in a single cost driver.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Relevant Range The relevant range specifies the limits of cost-driver activity within which a specific relationship between a cost and its cost driver will be valid.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step- and Mixed-Cost Behavior Patterns A purely fixed cost is not affected by the cost-driver level. A purely variable cost varies in proportion to the selected cost driver.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step- and Mixed-Cost Behavior Patterns l In addition to these pure versions of cost, two additional types of costs combine characteristics of both fixed- and variable- cost behavior. 1 Step costs 2 Mixed costs

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step Costs l Step costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step Costs A. Lease Cost Oil and Gas Exploration Activity Relevant Range Fixed Cost Approximation Actual Cost Behavior

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step Costs B. Supermarket Checker Wage Cost Shoppers per Hour Relevant Range Variable Cost Approximation Actual Cost Behavior 40440

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Step Costs l The total step cost at a level of activity is the amount of fixed cost appropriate for the range containing that activity level. l When the steps are relatively small, the step cost behaves much like a variable cost and could be used as such for planning with little loss of accuracy.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Mixed Costs l Mixed costs contain elements of both fixed- and variable-cost behavior. l Unlike step costs, there is usually only one relevant range of activity and one level of fixed costs in a mixed cost.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Mixed Costs Facilities Maintenance Department Cost Number of Patient-Days per Month Rs.10,000 1,0005,000 Total Variable Cost Fixed Cost Relevant Range Rs.5.00 per Patient Day

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 2 Explain management influences on cost behavior.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Product and Service Decisions and the Value Chain Managers influence cost behavior. Choice of process and product design Quality levels Distribution

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Capacity Decisions l What are capacity costs? l Capacity costs are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Committed Fixed Costs l Committed fixed costs usually arise from the possession of facilities, equipment, and a basic organization. l These are large, indivisible chunks of cost that the organization is obliged to incur or usually would not consider avoiding.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Discretionary Fixed Costs l 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. l These discretionary fixed costs have no obvious relationship to levels of output activity but are determined as part of the periodic planning process.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Discretionary Fixed Costs Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next planning period.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Examples of Discretionary Fixed Costs What are some examples? Advertising and promotion Public relations Research and development Charitable donations Employee training programs

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost-Control Incentives Managers use their knowledge of cost behavior to set cost expectations. Employees may receive rewards that are tied to meeting these expectations.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 3 Measure and mathematically express cost functions and use them to predict costs.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost Functions l The first step in estimating or predicting costs is measuring cost behavior as a function of appropriate cost drivers. l The second step is to use these cost measures to estimate future costs at expected, future levels of cost-driver activity.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost Function Equation Y = Total cost F = Fixed cost V = Variable cost per unit X = Cost-driver activity in number of units

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Cost Function Equation Mixed Cost Function: Y = F + VX The mixed-cost function is called a linear-cost function.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Criteria for Choosing Functions Plausibility Reliability The cost function must be believable. A cost function’s estimates of costs at levels of activity must reliably conform to actually observed costs.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 4 Describe the importance of activity analysis for measuring cost functions.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis Choosing a cost function starts with choosing cost drivers.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis l Managers use activity analysis to identify appropriate cost drivers. l Activity analysis is especially important for measuring and predicting costs for which cost drivers are not obvious.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis What are some cost drivers? Direct labor hours Machine hours Units of sales Transactions Work cells Order size

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Methods of Measuring Cost Functions – Engineering analysis – Account analysis – High-low analysis – Visual-fit analysis – Least-squares regression analysis

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Engineering Analysis l Engineering analysis entails a systematic review of materials, supplies, labor, support services, and facilities needed for products and services. l It measures cost behavior according to what costs should be, not by what costs have been.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 5 Measure cost behavior using the account analysis, high-low, visual-fit, and least-squares regression methods.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Account Analysis The simplest method of account analysis selects a volume-related cost driver and classifies each account as a variable or fixed cost.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton High-Low Method l This method selects the lowest and the highest activity levels. l These levels should be within the relevant range. l The costs chosen should represent the normal cost incurred at these levels.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton High-Low Method Example High capacity January: 55,000 machine hours Cost of electricity Rs. 80,450 Low capacity September: 30,000 machine hours Cost of electricity: Rs. 64,200 What is the variable rate?

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton High-Low Method Example (Rs80,450 – Rs64,200)Rs16,250 (55,000 – 30,000) 25,000 What is the fixed cost = =.65

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton High-Low Method Example Rs.80,450 = Fixed cost + 55,000(Rs. 0.65) Rs.80,450 – Rs.35,750 = Rs.44,700 Rs.64,200 = Fixed cost + 30,000(Rs.0.65) Rs.64,200 – Rs.19,500 = Rs.44,700

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Visual-Fit Method l 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.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 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 usually measures cost behavior more reliably than other cost measurement methods.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Coefficient of Determination l One measure of reliability, or goodness of fit, is the coefficient of determination, R² (or R-squared). l The coefficient of determination measures how much of the fluctuation of a cost is explained by changes in the cost driver.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Learning Objective 6 Understand the relationship between management decision making and cost behavior.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Management Decision Making and Cost Behavior Understanding cost behavior provides managers with valuable insights about how cost will respond to managers’ decisions as well as to outside influences.