Chapter 3 Cost behaviour, cost drivers and cost estimation Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Outline What are cost behaviour, cost estimation and cost prediction? Cost drivers Cost behaviour patterns The relevant range Engineered, committed and discretionary costs Cost structures in modern business environments Cost estimation Practical issues in cost estimation Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

What are cost behaviour, cost estimation and 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 forecast the level of cost at a particular level of activity Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost drivers A cost driver An activity or factor that causes costs to be incurred Conventional approaches to understanding cost behaviour assume that production or sales are the only cost driver Variable costs are assumed to vary in proportion to the level of production volume Fixed costs remain unchanged as production costs increase or decrease Volume-based cost drivers include units produced, direct labour hours, direct labour cost and machine hours (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost drivers (cont.) Contemporary viewpoints recognise that there are a range of possible cost drivers other than production volume A non-volume cost driver is a cost driver not directly related to production volume Activity-based approaches classify activities and costs into four levels Unit Batch Product Facility (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost drivers (cont.) Unit level costs Batch level costs Relate to activities performed for each unit produced Use conventional volume-based cost drivers Batch level costs Relate to activities performed for a group of product units, such as a batch or a delivery load Product (or product-sustaining) level Relates to activities performed for specific products or product groups Facility level Costs incurred to run the business, not caused by any particular product (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost drivers (cont.) Selecting the best cost drivers Input or outputs? Example of an input cost driver is the weight of material Example of an output driver is the volume of production Cost–benefit principles will determine the choice How detailed should the analysis be? As the number of cost categories increases, the accuracy of the resulting information should increase Again, cost–benefit criteria are important Long or short term? Cost behaviour and cost drivers can change over time Choice depends on the intended purpose of the cost analysis (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost drivers (cont.) 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 factors that cause a cost to be incurred Search for the true causes of costs (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost drivers (cont.) When choosing cost drivers the costs and benefits of each driver must be assessed, taking into account Reasons for analysing cost behaviour, such as cost prediction, product costing, cost management, pricing Timeframe for analysing the cost behaviour (short term or long term) Availability of data on cost drivers Any other uses that the cost behaviour information might serve Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost behaviour patterns The relationship between a cost and the level of activity (or cost driver) Cost behaviour patterns Variable costs Fixed costs Step-fixed costs Semivariable costs Curvilinear costs (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost behaviour patterns (cont.) Variable costs Total variable costs increase in direct proportion to changes in the level of activity but the variable cost per unit remains constant The variable cost per unit 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 (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost behaviour patterns (cont.) Fixed costs As activity increases or decreases total fixed costs do not change but fixed cost per unit changes Fixed cost per unit is often calculated to use in product costs but is of limited use in management decision making as it does not reflect the way that fixed costs actually behave Contemporary approaches to cost analysis recognise that there are cost drivers for some of these fixed costs and very few costs remain fixed (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost behaviour patterns (cont.) Step-fixed costs Remain fixed over a wide range of activity levels but jump to a different amount for levels outside that range Semivariable (or mixed) cost Has both fixed and variable components Curvilinear cost Has a curved cost line but is often approximated as a semivariable cost function At lower levels of activity there is decreasing marginal cost At higher levels of activity there is increasing marginal cost (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost behaviour and the relevant range The relevant range is the range of activity over which a particular cost behaviour pattern is assumed to be valid. For example, The relevant range for the variable cost of electricity may hold for 200 to 800 batches of production per month, but outside of that range the variable cost per unit may differ The direct material cost per unit may only hold for production up to 1000 units per day, and for higher volumes the cost per unit may decrease due to cheaper cost of buying material in larger quantities The range of activity which is relevant for a particular cost estimate should be specified Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Engineered, committed and discretionary costs Distinction is useful when estimating costs for budgeting and planning purposes Engineered costs Bear a defined physical relationship to the level of output If we know the level of activity, we can predict total cost Committed costs Arise from an organisation’s basic structure and facilities, and are difficult to change in the short term Discretionary costs Are the result of a management decision to spend a particular amount of money for some purpose Can be changed easily Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Shifting cost structures in modern business environments A decreasing proportion of production costs no longer vary directly with production volume As production becomes more automated there is less reliance on labour and more reliance on equipment. Equipment costs do not vary with production volume Some employee wage agreements specify fixed salaries and a stabilised workforce Wages do not vary with production activity levels More difficult to change the number of staff employed as activity levels change Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost estimation Approaches to cost estimation Managerial judgment Engineering approach Quantitative analysis Using experience and knowledge rather than formal analysis to classify costs as variable, fixed or semivariable Future costs are estimated by examining past costs and identifying factors that might affect future costs Reliability of cost estimates is dependent upon the ability of the manager (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost estimation (cont.) The engineering approach Studying processes that result in the incurrence of a cost Focuses 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 tasks These techniques are expensive and time-consuming Useful when there is no reliable past data on which to base cost estimates Most effective when there is a direct relationship between inputs and outputs Activity-based approaches extend task analysis to the study of indirect activities and costs (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost estimation (cont.) Quantitative analysis Formal analysis of past data to identify the relationships between costs and activities A scatter diagram can be useful to plot the data points and 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 a range of observations to determine the cost function (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost estimation (cont.) Regression analysis A statistical technique used to estimate the relationship between a dependent variable (cost) and independent variables (cost driver) The line of best fit makes 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 More accurate than high–low method as it makes use of all data and has statistical properties that allows inferences to be drawn between cost and activity levels (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Cost estimation Regression analysis Multiple regression estimates a linear relationship between one dependent variable and two or more independent variables Y = a + b1X1 + b2X2 The regression line can be evaluated using several criteria: Economic plausibility—does the regression line make sense? Goodness of fit—how well does the line fit the data points? Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Practical issues in cost estimation Data collection problems Missing data Outliers—extreme observations of activity or costs Mismatched time periods for dependent and independent variables Trade-offs in choosing the time period—the number of observations compared to the reliability of past data points as predictors of future cost behaviour Allocated fixed costs may be misleading Inflation may cause past cost data to be less relevant (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Practical issues in cost estimation (cont.) Effect of learning on cost behaviour In estimating labour costs for relatively new products or processes, labour times per unit may decrease at varying rates Activity-based approaches allow more complex cost behaviour patterns to be considered Costs are assigned to activities Unit, batch and product level costs are assumed to vary in proportion to their cost drivers (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Practical issues in cost estimation (cont.) The accuracy of cost functions Sometimes budgets and cost estimates capture only approximations of cost behaviours Why? Limited time and knowledge to undertake appropriate 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 (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Practical issues in cost estimation (cont.) All cost functions are based on simplifying assumptions, such as: Cost behaviours depend on a single or only a few types of activity Cost behaviours are linear within a relevant range Costs of producing more accurate cost estimates need to be assessed against the likely benefits Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Summary Understanding cost behaviour allows cost prediction for planning and control Conventional cost drivers are volume-based, but more recently may be non-volume related Cost behaviours range from variable to fixed Costs can be estimated using managerial judgment, engineering approaches and quantitative techniques Cost estimation is fraught with a range of practical difficulties, and the choice of technique involves a cost-benefit trade-off Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith