Cost Behavior, Activity Analysis, and Cost Estimation Module 15 Cost Behavior, Activity Analysis, and Cost Estimation © Cambridge Business Publishers, 2018

1 Identify basic patterns of how costs respond to changes in activity cost drivers. © Cambridge Business Publishers, 2018

Basic Cost Behavior Patterns Variable Costs Change in total in direct proportion to changes in activity Fixed Costs Do not change in response to a change in activity volume Mixed Costs Contain a fixed and variable cost element; sometimes called semi-variable costs Step Costs Constant within a narrow range of activity, but shift to a higher level when activity exceeds the range © Cambridge Business Publishers, 2018

Variable Costs Increases as activity increases Equals zero dollars when activity is zero Total variable costs (Y) Total activity (X) Higher variable cost per unit creates a steeper line slope. Total variable cost: Y = bX b = Variable cost per unit © Cambridge Business Publishers, 2018

Slope is zero, represented by a flat line. Fixed Costs No change as activity increases or decreases No response to short-run changes in activity cost drivers Total fixed costs (Y) Total activity (X) Slope is zero, represented by a flat line. Total fixed cost: Y = a a = Total fixed costs © Cambridge Business Publishers, 2018

Contains both fixed and variable cost elements. Mixed Costs Increase in a linear fashion when activity increases Positive in amount when activity is zero Contains both fixed and variable cost elements. Total mixed costs (Y) Total activity (X) Fixed portion Variable portion Total mixed cost: Y = a + bX © Cambridge Business Publishers, 2018

Step Costs Increase in a step-like fashion as activity increases Total cost shifts to a higher level when activity exceeds a range Total step costs (Y) Total activity (X) Total step cost: Y = ai © Cambridge Business Publishers, 2018

Shift in Cost Structure The importance of managers understanding cost behavior continues to increase efforts to monitor and minimize total cost. Total cost function in recent years Has shifted to more fixed costs and lower variable costs Important for organizations to manage their fixed costs Example: Vizio acquires television components rather than manufacturing them © Cambridge Business Publishers, 2018

Cost Behavior Pattern Assumptions The four cost behavior patterns assume… A unit of final output is the primary cost driver The time period is too short to incorporate changes in strategic cost drivers such as the scale of operations Causes some costs to be viewed as fixed in the short term, but appear variable in the long run © Cambridge Business Publishers, 2018

Determine a linear total cost estimating equation. 2 Determine a linear total cost estimating equation. © Cambridge Business Publishers, 2018

Total Fixed Costs + (Variable Costs per Unit x Number of Units) Total Cost Behavior Total Cost Equation = Total Fixed Costs + (Variable Costs per Unit x Number of Units) Y = a + bX © Cambridge Business Publishers, 2018

Relevant Range A portion of a range of activity associated with the fixed cost of the current or expected capacity A normal range of activity in which a company expects to operate, where the fixed costs remain linear, i.e., total cost remains the same Example During normal operations, factory space is adequate for Mattel. However, during the three months preceding the holiday season, Mattel’s operations are out of the relevant range and storage trailers must be rented for the additional merchandise. © Cambridge Business Publishers, 2018

Relevant Range Accountant’s linear approximation of total cost function Economist’s total cost function, referred to as curvilinear © Cambridge Business Publishers, 2018

Marginal Cost Marginal cost is the varying increment in total cost of making one more unit. © Cambridge Business Publishers, 2018

Marginal Costs and Activity Levels Excess capacity resulting in high marginal costs Optimal circumstances with marginal costs relatively low Capacity constraints resulting in high marginal costs © Cambridge Business Publishers, 2018

Predicting Total Costs with a Graph 100 200 300 400 500 $0 $6,000 - $5,000 - $4,000 - $3,000 - $2,000 - $1,000 - | | | | | Customer repairs Total cost graph is useful in predicting total costs for the coming period. © Cambridge Business Publishers, 2018

Unit variable costs stay the same at all activity levels. $ - 0 - Costs Per unit 100 200 300 400 500 Customer repairs Unit variable costs stay the same at all activity levels. © Cambridge Business Publishers, 2018

Customers Per customer Average Costs Average cost graph is useful if a manager wants to know the cost of serving a customer. Number of Average Cost Customers Per customer 100 $35.00 300 $15.00 500 $11.00 Notice: Average costs decrease as the number of units produced increases. © Cambridge Business Publishers, 2018

Classifying Fixed Costs Classification depends on the immediate impact if the company attempts to change the fixed costs. Committed fixed costs, known also as capacity costs, are required to maintain the current service or production capacity or to fill previous legal commitments. Discretionary fixed costs, known also as managed fixed costs, are set at a fixed amount each period by management. © Cambridge Business Publishers, 2018

Calculate and compare three different approaches to cost estimation. 3 Calculate and compare three different approaches to cost estimation. © Cambridge Business Publishers, 2018

Cost Estimation What is it? Identifying variable or fixed costs The determination of the relationship between activity and cost An important part of cost management Identifying variable or fixed costs Analyzing available accounting records Interviews Purpose of cost estimation Cost prediction i.e., forecasting future costs © Cambridge Business Publishers, 2018

Estimating Mixed Cost Components Variable Costs Fixed Costs Mixed Costs Methods of estimating fixed and variable cost components High-low method Scatter diagrams Least-squares regression analysis © Cambridge Business Publishers, 2018

High-Low Cost Estimation Uses data from two time periods A high activity period, and a low activity period Select a representative high point and a representative low activity point. Step 1: Difference in total costs Difference in activity Variable costs per unit = Determine variable costs per unit: Step 2: Subtract total variable costs from total fixed costs using either the high or low point: Step 3: Total costs – [Variable cost per unit × Number of units] Total Fixed Costs = © Cambridge Business Publishers, 2018

High-Low Example: Variable Costs Number of Shipments Packaging Costs January 8,600 $25,000 February 9,800 26,000 March 11,600 31,600 April 11,200 33,000 Low activity period Variable cost per unit (b) $31,600 – $25,000 11,600 – 8,600 = $2.20 = High activity period The variable cost of each unit produced is $2.20. © Cambridge Business Publishers, 2018

High-Low Example: Fixed Costs Calculate fixed costs: Variable cost per unit (b) = $2.20 per unit a = Total costs – Variable costs $25,000 = a + ($2.20 x 8,600 units) a = $6,080 January The same total fixed costs result using either the high or low activity point. $31,600 = a + ($2.20 x 11,600 units) a = $6,080 March © Cambridge Business Publishers, 2015

High-Low Cost Estimation Total Cost Equation: Y = $2.20X + $6,080 © Cambridge Business Publishers, 2018

When used alone to estimate costs, professional judgment is required. Scatter Diagrams A graph of past activity and cost data, with individual observations represented by dots. When used alone to estimate costs, professional judgment is required. © Cambridge Business Publishers, 2018

Least-Squares Regression Also known as simple regression (one variable) A mathematical technique to fit a cost-estimating equation to observed data Minimizes the vertical squared difference between the estimated and actual costs at each data point Accomplished using Microsoft Excel® Statistical software Some calculators Time consuming math calculations © Cambridge Business Publishers, 2018

Least-Squares Criterion The least-squares method minimizes the sum of all squared vertical deviations between individual observations and the cost-estimating line. © Cambridge Business Publishers, 2018

Least-Squares Advantage Superior to the high-low and scatter diagram methods Because it uses all data points, and Does not rely on subjective judgment Statistical measures are available to determine how well the equation fits the line Coefficient of determination Measures the percent of variation in the dependent variable that the independent variable explains Also called R-squared (R2) © Cambridge Business Publishers, 2018

Simple and Multiple Regression Simple Regression Equation (one variable) Multiple Regression Equation (two variables) Y = a + bX Y = a + b1X1 + b2X2 Multiple regression Often contains more than two variables Can be used to determine the effect of individual product features on the market value of a product © Cambridge Business Publishers, 2018

Cautions in Developing Cost Estimate Equations Managers are responsible for making decisions Mathematical models do not make decisions; they are tools to aid decision making Not all data are based on normal operating conditions Nonlinear relationships may exist Results should make sense © Cambridge Business Publishers, 2018

Identify and discuss problems encountered in cost estimation. 4 Identify and discuss problems encountered in cost estimation. © Cambridge Business Publishers, 2018

Cost Estimation Problems: Technology & Price Data used in developing cost estimates must be based on the same technology. Changes in Technology Data used must reflect the same price level, or be restated to a single price level. Changes in Prices © Cambridge Business Publishers, 2018

Cost Estimation Problems: Matching Activity & Costs Actual costs are not known until a future time period. Time Lags Examples Cell phone bills arrive at the end of the month, but usage occurs throughout the month. Vehicle mileage is used consistently but maintenance costs occur every few months. Shorter time periods have higher probabilities of error in matching costs and activities. © Cambridge Business Publishers, 2018

Cost Estimation Problems: Identifying Activity Cost Drivers Which cost driver should be used? Selection of a driver requires judgment and professional experience Cost driver should have a logical, casual relationship with costs Scatter diagrams and statistical measures are helpful © Cambridge Business Publishers, 2018

5 Describe and develop alternative classifications for activity cost drivers. © Cambridge Business Publishers, 2018

Unit-Level Cost Behavior Assumes changes in costs are best explained by changes in the number of units of product (or service provided) Inaccurate for analyzing cost behavior when a company changes… From labor-based to automated manufacturing From a limited number related products to multiple products, with variations in volume and complexity From a set of similar customers to a diverse set of customers © Cambridge Business Publishers, 2018

Cost of primary raw materials converted to finished goods Manufacturing Costs Direct Materials Cost of primary raw materials converted to finished goods Direct Labor Wages earned by production employees for the time they spend converting raw materials into finished products “Direct costs: easily or directly traceable to a finished product or service Manufacturing Overhead All manufacturing costs other than direct materials and direct labor © Cambridge Business Publishers, 2018

Changing Composition of Total Manufacturing Costs © Cambridge Business Publishers, 2018

Changing Composition of Total Manufacturing Costs The problem Past tendency was to ignore overhead and focus on direct materials and labor Units produced is no longer adequate in explaining manufacturing costs Dealing with overhead causing activities Include non-unit activity drivers Hierarchy scheme frameworks Manufacturing cost hierarchy, or Customer cost hierarchy © Cambridge Business Publishers, 2018

Manufacturing Cost Hierarchy Performed for each unit of product produced Unit level activities Batch level activities Performed to support the production of each different type of product Product level activities Performed to maintain general manufacturing capabilities Facility level activities A separate cost driver is selected for each level of cost. © Cambridge Business Publishers, 2018

This activity is performed for each UNIT of product produced or sold. Unit Level Activity Examples Cost of raw materials Cost of cutting a component Cost of a box to package cereal Sales commission Cost of paint brushes used by a painting company to paint an office building This activity is performed for each UNIT of product produced or sold. © Cambridge Business Publishers, 2018

This activity is performed for each BATCH of product produced or sold. Batch Level Activity Examples Cost of processing sales orders Cost of tracking work orders Cost of equipment setup Cost of moving a batch between workstations Cost of inspecting batches This activity is performed for each BATCH of product produced or sold. © Cambridge Business Publishers, 2018

Product Level Activity Examples Cost of product development Cost of specialized equipment Cost of maintaining specialized equipment This activity is performed to support the production of each different type of product. © Cambridge Business Publishers, 2018

Facility Level Activity Examples Cost of maintaining factory building and grounds Cost of real property taxes Cost of non-specialized equipment Cost of general advertising Cost of factory supervisor This activity is performed to maintain general manufacturing capabilities. © Cambridge Business Publishers, 2018

Customer Cost Hierarchies for Merchandising and Sales Divisions Often used by Merchandising organizations Sales divisions of manufacturers Customer classification scheme Unit-level activities Order-level activities Customer-level activities Facility-level activities Answers questions about the cost of individual orders or costs of individual customers. © Cambridge Business Publishers, 2018

Customer Cost Hierarchy for Distinct Market Segments Often used by companies that sell to distinct market segments such as: Not-for-profit For-profit Government Customer classification scheme Unit-level activities Order-level activities Customer-level activities Market-segment-level activities Facility-level activities Answers questions about the profitability of a segment. © Cambridge Business Publishers, 2018

Customer Cost Hierarchy for Unique Projects Often used by Builders Special contracts with the government Customer classification scheme Project-level activities Market-segment-level activities Facility-level activities Answers questions about the cost of individual projects. © Cambridge Business Publishers, 2018