Cost behaviour, cost drivers and cost estimation 3 Cost behaviour, cost drivers and cost estimation

Basic concepts Cost behaviour Cost estimation Cost prediction The relationship between a cost and the level of activity or cost driver Cost estimation The process of determining the cost behaviour of a particular cost item Cost prediction Using knowledge of cost behaviour to focus the level of cost at a particular level of activity

Cost drivers A cost driver An activity or factor that causes costs to be incurred The higher the correlation between the cost and cost driver, the more accurate is the description and understanding of cost behaviours Conventional understandings of cost behaviour regarded costs as variable or fixed, based on the level of production volume continued

Cost drivers Contemporary viewpoints recognise that there are a range of possible costs divers other than production volume (non-volume cost drivers) Activity-based approaches classify costs and cost drivers into four levels: Unit Batch Product, and Facility continued

Cost drivers Unit level costs Batch level costs Relate to activities that are performed for each unit produced Uses conventional volume-based cost drivers Batch level costs Relate to activities performed for a group of product units Product (or product-sustaining) level Relate to activities performed for specific products or product groups Facility level Costs incurred to run the business continued

Cost drivers Selecting the best cost drivers Input or outputs? An example of an input cost driver is the weight of material, and an output driver is the number of units of production Cost benefit principles will determine the choice How detailed should the analysis be? Long or short term? Cost behaviour and cost drivers can change over time Depends on the purpose of the cost prediction continued

Cost drivers Cost drivers for cost estimation or cost management? Cost drivers that are used to predict costs, may differ from those used to manage costs Effective cost management requires the identification of root cause cost drivers The basic costs that cause a cost to be incurred The true causes of costs continued

Cost drivers In choosing cost drivers the costs and benefits of each driver must be assessed: Reasons for analysing cost behaviour Timeframes for analysing the cost behaviour Availability of data on cost drivers, and Any other uses for the cost behaviour information

Cost behaviour patterns Variable costs Fixed costs Step-fixed costs Semi-variable costs Curvilinear costs continued

Cost behaviour patterns Variable costs Change in total in direct proportion to a change in activity The variable cost is the slope of the cost line in the following cost function: Y = a + bX Where Y = total cost a = fixed cost component (the intercept on the vertical axis) b = variable cost per unit of activity (the slope of the line) X = the level of activity continued

Cost behaviour patterns Fixed costs Remains unchanged in total as the level of activity varies As activity increases, total fixed costs do not change, but unit fixed cost declines Contemporary approaches to cost analysis recognise that there are cost drivers for some of these “fixed” costs, and very few costs remain fixed continued

Cost behaviour patterns Step-fixed costs Remain fixed over a wide range of activity levels but jump to a different amount for levels outside that range Semi-variable cost Has both fixed and variable components Curvilinear cost Has a curved cost line, but is often approximated as a semi-variable cost function continued

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Cost behaviour patterns Cost structures are shifting towards a decreasing proportion of costs that vary with production due to: Labour being replaced by equipment, which does not vary with production output Production wages moving towards fixed salaries that do not vary with production activity levels Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Cost estimation Approaches to cost estimation Managerial judgement Engineering approach, and Quantitative analysis Using managerial judgment to estimate costs The account classification method involves managers using their judgement to classify costs as exhibiting certain behaviours continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Cost estimation The engineering approach to estimating costs Studying processes that result in the incurrence of a cost Focus on the relationships that should exist between inputs and outputs Using time and motion studies (or task analysis) where employees are observed as they undertake work tasks Activity-based approaches extend task analysis to the study of indirect activities and costs continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Cost estimation Estimating costs using quantitative analysis A scatter plot can be useful in allowing us to plot the data points to visualise the relationship between cost and the level of activity The high-low method involves taking the two observations with the highest and lowest level of activity to calculate the cost function Regression analysis is a statistical technique that uses all observations to determine the cost function continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Cost estimation Regression analysis Allows us to estimate the line of best fit by making the deviations between the cost line and the data points as small as possible Simple regression involves estimating the relationship between the dependent variable (Y) and one independent variable (X) Y = a + bX continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Cost estimation Regression analysis Multiple regression allows us to include two or more independent variables, that is, cost drivers Y = a + b1X1 + b2X2 The regression line can be evaluated using several criteria: Economic plausibility Goodness of fit Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Practical issues in cost estimation Data collection problems Missing data Outliers Mismatched time periods for dependent and independent variables Trade-offs in choosing the number of observations and the reliability of past data points as predictors of future cost behaviour Allocated fixed costs Inflation continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Practical issues in cost estimation Effect of learning on cost behaviour In estimating labour costs for relatively new product or processes, labour times per unit may decrease at varying rates Activity-based approaches allows us to consider more complex cost behaviour patterns Costs are assigned to activities Unit, batch and product level costs are assumed to vary in proportion to their cost drivers continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Practical issues in cost estimation The accuracy of cost functions Sometimes approximate estimates are used to estimate cost functions within firms Why is the case? Limited time and knowledge to undertake quantitative techniques The data required to estimate reliable cost functions may not exist A low priority may be given to determining accurate cost behaviour and cost estimation Subjective cost estimates may be considered good enough for the firm’s needs continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Practical issues in cost estimation All cost functions are based on simplifying assumptions, such as: Cost behaviour depends on a single activity Cost behaviours are linear within a relevant range Costs and benefits of producing accurate cost information need to be assessed Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith