Measurement of Cost Behaviour 3 Measurement of Cost Behaviour

Measurement of Cost Behavior Cost Driver an activity which influences a cost Relevant Range limit over which we can assume that the cost behavior is linear Variable Costs vary in proportion to changes in their cost driver Fixed Costs are not affected by changes in the cost driver $ Volume $ Volume $ Volume

Variations in Cost Behaviour Step Costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks supervisory salaries Mixed Costs contain both variable and fixed cost elements maintenance costs $ Volume $ Volume

Management’s Influence on Cost Functions Capacity Costs fixed costs related to being able to achieve a desired level of production or service setting capacity is very important if long-run demand fluctuates Committed Fixed Costs arise from the possession of facilities, equipment, and a basic organization large, indivisible chunks of cost that the organization is obligated to incur and usually would not consider avoiding mortgage, lease payments, property taxes, insurance, salaries of key personnel committed fixed costs can only be changed by changing the basic philosophy, scale or scope of the organization's operations

Management’s Influence on Costs Functions II Discretionary Fixed Costs each planning period, management will determine how much to spend advertising, promotion, research and development, employee training the amount of spending may vary, but only because management has decided to spend more or less management can influence spending on these costs in the short run

Measuring Cost Behaviour Cost Function algebraic equation of the cost and its cost driver linear cost function is as follows: Y = F + VX where F is the intercept of the vertical axis or the fixed cost V is the slope or the variable cost per unit of activity Total Maintenance Costs per month = fixed cost per month + variable cost per unit = $10,000 + $5.00 per unit Criteria for Choosing A Cost Function Use activity analysis to determine which cost driver best explains how the cost behaves Economic plausibility (it must make sense that X causes Y) Reliability (the estimates derived by the cost equation must conform with actually observed costs)

Methods of Measuring Cost Functions Engineering Analysis systematic review of costs based on past experience Account Analysis review of accounting records and the subjective determination of cost behavior patterns High-Low Analysis use of simple linear algebra to determine variable and fixed costs may yield unreliable results Visual Fit Analysis fit a representative line to the data as shown in a scatter diagram Regression Analysis using mathematical formula, determine the cost equation which best fits the data may be simple least squares regression with one X variable or multiple least squares regression with more than one X variable enables user to measure the "quality" of the predictive equation

High-Low Approach to Cost Analysis Equation: Y = F + VX Step 1: Plot/examine data to find lowest and highest point Step 2: Calculate variable unit cost = largest y value – smallest y value largest x value – smallest x value Step 3: Calculate fixed cost (use above # and one point (x,y) in equation to solve for F) Step 4: Write equation

Visual Fit Method Equation: Y = F + VX Step 1: Plot data Step 2: Draw “line of best fit” (trend line) Step 3: Read fixed cost from graph (y-intercept) Step 4: Calculate unit variable cost Use two points ON the trend line and calculate: = largest y value – smallest y value largest x value – smallest x value Step 5: Write equation

Regression Analysis Check for Economic Plausibility Does it make sense that X and Y are related? Plot the data to see if basic relationship is linear and identify "outliers" Generate Regression Output Constant $9,329 Std Error of Y Estimate $2,145 Observations 12 R-Squared 0.954 Degrees of Freedom 10 X Coefficient(s) $6.95 Std Error of Coefficient 0.479 Interpret Regression Output R-squared (R2) varies between 0 and 1 The closer to R2 is to 1 the more X explains the changes in Y Standard error of Y estimate and standard error of X coefficient(s) can be used to set confidence intervals for the cost function estimates and the predicted value of the variable cost per unit

Example P3-17 (page 122) On November 15, 2001, Sandra Cook, a newly hired cost analyst at Demgren Company, was asked to predict overhead costs for the company’s operations in 2002, when 500 units are expected to be produced. She collected the following quarterly results. Use the high-low method, visual fit method and regression to predict overhead costs in 2002. (Excel sheet will be available after class)

Example P3-15 (page 121) Violet Blossom Technology develops and markets computer software for the agriculture industry. Since support costs comprise a large portion of the cost of software development, the director of cost operations of Violet Blossom, Shirley Temple, is especially concerned with understanding the effects of support cost behavior. Temple has completed a preliminary activity analysis of one of its primary software products: Ferti Mix. This is a “template” software that is customized for specific customers, who are charged for the basic product plus customizing cots.

Example P3-15 (page 121) Cont’d … The activity analysis is based on the number of customized lines of Ferti Mix code. Currently, support cost estimates are based on a fixed rate of 50 percent of the basic cost. Data are shown below for two recent customers: Customer West Acres Plant Beautiful Bloom Basic Cost of Ferti Mix $ 12,000 $ 12,000 Lines of Customized Code 490 180 Estimated cost per line of customized code $ 23 $ 23

Example P3-15 (page 121) Cont’d … 1. Compute the support cost of customizing Ferti Mix for each customer using each cost estimating approach. 2. If the activity analysis is reliable, what are the pros and cons of adopting it for all of Violet Blossom’s software products?

Suggested Problems Summary Problems 1,2 (page 107) Questions (all even) (page 114) Problems 2,4,6,8,10,12 (page 116)

Assignment Questions 13 (page 114 ) Problems 1,3,9,21 (page 115 ) Case 1, 3 (page 125)