©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 3 - 1

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 3

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall When you have finished studying this chapter, you should be able to: 1. Explain management influences on cost behavior. 2. Measure and mathematically express cost functions and use them to predict costs. 3. Describe the importance of activity analysis for measuring cost functions. 4. Measure cost behavior using the engineering analysis, high-low, visual-fit, and least-squares regression methods. Chapter 3 Learning Objectives

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Accountants and managers often assume that cost behavior is linear over some relevant range of activity or cost-driver levels. We can graph linear-cost behavior with a straight line because we assume each cost to be either fixed or variable. Recall that the relevant range specifies the interval of cost-driver activity within which a specific relationship between a cost and its driver will be valid. Managers usually define the relevant range based on their previous experience operating the organization at different levels of activity. Cost Drivers and Cost Behavior

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Linear-Cost Behavior Costs are assumed to be fixed or variable within the relevant range of activity

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Policies to create incentives to control costs Product and service decisions and the value chain Capacity Technology Learning Objective 1 Management’s Influence on Cost Behavior

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall The Value Chain Managers influence cost behavior throughout the value chain through their choices of: process and product design, quality levels, product features, distribution channels, etc.. Each decision contributes to the organization’s performance. Managers must consider the costs and benefits of each decision.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Capacity Decisions 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Committed Fixed Costs Salaries of key personnel Committed fixed costs arise from the possession of facilities, equipment, and a basic organization. Lease payments Property taxes

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Discretionary Fixed Costs 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. Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next planning period.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Examples of Committed and Discretionary Fixed Costs Fixed Costs Planned Amounts Advertising and promotion $ 50,000 Depreciation 400,000 Employee training 100,000 Management salaries 800,000 Mortgage payment 250,000 Property taxes 600,000 Research and development 1,500,000 Total $3,700,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Examples of Committed and Discretionary Fixed Costs Fixed Costs Planned Amounts Committed Depreciation $ 400,000 Mortgage payment 250,000 Property taxes 600,000 Total committed $1,250,000 Discretionary (potential savings) Advertising and promotion $ 50,000 Employee training 100,000 Management salaries 800,000 Research and development 1,500,000 Total discretionary $2,450,000 Total committed and discretionary $3,700,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Technology Decisions Choosing the type of technology an organization will use to produce products or deliver services is a critical decision for management. Choice of technology (e-commerce versus in-store or mail-order sales) positions the organization to meet its current goals and to respond to changes in the environment. The use of high-technology methods rather than labor usually means a much greater fixed-cost component to the total cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Functions Learning Objective 2 Managers will use cost functions often as a planning and control tool. Planning and controlling the activities of an organization require useful and accurate estimates of future fixed and variable costs. Cost measurement involves estimating or predicting costs as a function of appropriate cost drivers.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Functions Understanding relationships between costs and their cost drivers allows managers to... Make better operating, marketing, and production decisions Plan and evaluate actions Determine appropriate costs for short-run and long-run decisions.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Functions The first step in estimating or predicting costs is measuring cost behavior as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of cost-driver activity.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Function Equation Let: Y = Total cost F = Fixed cost V = Variable cost per unit X = Cost-driver activity in number of units Mixed-cost function: Y = F + VX Y = $10,000 + $5.00X The mixed-cost function is called a linear-cost function.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Developing Cost Functions 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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 accountants to the appropriate cost drivers for each cost. Learning Objective 3

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Choice of Cost Drivers: Activity Analysis Northwestern Computers makes two products: Mozart-Plus and Powerdrive In the past, most of the support costs were twice as much as labor costs. Northwest has upgraded the production function, which has increased support costs and reduced labor cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Choice of Cost Drivers: Activity Analysis Using the old cost driver, labor cost, the prediction of support costs would be: Mozart-Plus Powerdrive Labor cost $ 8.50 $ Support cost: 2 × Direct labor cost $17.00 $260.00

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Choice of Cost Drivers: Activity Analysis Using the more appropriate cost driver, the number of components added to products, companies can predict support costs more accurately. Mozart-Plus Powerdrive Support cost at $20 per component $20 × 5 components $ $20 × 9 components $ Difference in predicted support cost$ $ higher lower Managers will make better decisions with this more accurate information.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Methods of Measuring Cost Functions 1. Engineering analysis 2. Account analysis 3. High-low analysis 4. Visual-fit analysis 5. Least-squares regression analysis Learning Objective 4

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Engineering Analysis Engineering analysis measures cost behavior 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Account Analysis The simplest method of account analysis selects a plausible cost driver and classifies each account as a variable or fixed cost. 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 Fixed Variable Parkview Medical Center

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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)

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall High-Low Method Focus on the highest- and lowest-activity points. Plot historical data points on a graph. 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

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall High-Low Method Example The point at which the line intersects the Y axis is the intercept, F, or estimate of Fixed Costs, and the slope of the line measures the variable cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall High-Low Method Example Variable costs = Change in costs change in activity V = ($47,000 – $17,000) ÷ (4,900 – 1,200) = $30,000 ÷ 3,700 = $ What is the variable cost (V)? Using algebra to solve for variable and fixed costs.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall High-Low Method Example F = Total mixed cost – total variable cost At X (high): F = $47,000 - ($8.1081× 4,900 patient-days) = $47,000 – $39,730 = $7,270 a month At X (low): F = $17,000 = ($8.1081× 1,200 patient-days) = $17,000 – $9,730 = $7,270 a month Cost function measured by high-low method: Y = $7,270 per month + ($ × patient-days) What is the fixed cost (F)?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Least-Squares Regression Method Y = $9,329 + ($6.951 × patient-days)

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Coefficient of Determination One measure of reliability, or goodness of fit, is the coefficient of determination, R² (or R-squared). The coefficient of determination measures how much of the fluctuation of a cost is explained by changes in the cost driver.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.