Chapter 7 Cost Drivers and Cost Behavior IDIS 364 – Spring 2007

Nature of Fixed & Variable Costs Variable costs - change in total as the level of activity changes Also known as an engineered cost There is a definitive physical relationship to the activity measure Fixed costs - do not change in total with changes in activity levels

Nature of Fixed & Variable Costs Accounting concepts of variable and fixed costs are short run concepts Apply to a particular period of time Relate to a particular level of production Relevant range is the range of activity over which the firm expects cost behavior to be consistent Outside the relevant range, estimates of fixed and variable costs may not be valid

Types of Fixed Costs Capacity costs- fixed costs that provide a firm with the capacity to produce and/or sell its goods and services Also know as committed costs and typically relate to a firm’s ownership of facilities and its basic organizational structure Capacity costs may cease if operations shut down, but continue in fixed amounts at any level of operations Examples: property taxes, executive salaries

Types of Fixed Costs Discretionary costs - need not be incurred in the short run to operate the business, however, usually they are essential for achieving long-run goals Also referred to as programmed or managed costs Examples: research and development costs, advertising

Other Cost Behavior Patterns Curvilinear variable costs - costs may vary with the volume of activity, but not in constant proportion For example, as volume increases, the cost of materials may decrease per unit (perhaps due to quantity discounts), exhibiting decreasing marginal costs Marginal cost - the cost of producing the next unit

Other Cost Behavior Patterns Learning curves - shows how the time required to perform a task goes down, per unit, as the number of units increases Some companies experience learning effects on costs Compete by learning quickly so they become low-cost leaders and capture market share

Semivariable Costs Refers to costs that have both variable and fixed components Examples: repair and maintenance costs, utility costs

Semifixed Costs Refers to costs that increase in steps Example: A quality-control inspector can examine 1,000 units per day. Inspection costs are semifixed with a step up for every 1,000 units per day Distinction between fixed and semifixed is subtle Change in fixed costs usually involves a change in long-term assets: a change in semifixed costs often does not

Cost Estimation Methods Cost estimates are used in various business decisions, planning exercises, and performance evaluations Three methods discussed Statistical regression analysis Account analysis Engineering estimation

Estimating Costs Using Historical Data Trying to estimate fixed and variable costs using the following formula TC=F + VX Where: TC = Total Costs F = Fixed Costs V = Variable Costs X = Activity Variable

Estimating Costs Using Historical Data The following steps should be taken in analyzing cost data: Review alternative cost drivers Plot the data Examine the data and method of accumulation

Statistical Regression Analysis Used to estimate the relationship between costs and the activity that caused, or is closely associated with, those costs Costs are the dependent variable(s) Activity level is the independent variable Fits the data points to a line using least- squares criterion

Statistical Regression Analysis Results of this analysis yield an estimate of both the fixed component and the cost driver rates (variable component)

Account Analysis Analysts review each cost account and classifies it according to its relation to a cost driver The sum of costs for each activity are divided by the sum of the cost driver volumes to determine the cost driver rates These cost driver rates correspond to the coefficients calculated using regression analysis

Engineering Method of Estimating Costs The engineering method indicates what costs should be Analysts study the physical relation between the quantity of inputs and outputs Determine the steps required to perform the task, the time needed to complete each step, the number and type of employees required, and the materials and other inputs needed The accountant assigns costs to each of the inputs to estimate the cost of the outputs

Data Problems Missing Data Outliers Allocated and discretionary costs Inflation Mismatched time periods Trade-offs in choosing the time period

Interpreting Regression Analysis Output Standard errors of the coefficients indicate the degree of confidence we can have in the fixed and variable cost coefficients The smaller the standard error, the more precise the estimate The t-statistic is the ratio between an estimated coefficient and its standard error If about  2 or larger, we can be relatively confident that the actual coefficient differs from 0

Interpreting Regression Analysis Output If a variable cost coefficient has a small t- statistic, it may indicate that little relation exists between the activity and changes in costs If a fixed cost coefficient has a small t- statistic, it may indicate that these costs have little, if any, fixed cost component

R2R2 R 2 measures how well the line fits the data An R 2 of 1 means that the regression explains all of the variance An R 2 of 0 means that the regression explains none of the variance Many believe that a low R 2 indicates a weak relationship between total costs and the activity base

Cautions When Using Regression Users of regression analysis should be cautious in drawing inferences from regression results unless they are familiar with statistical estimation problems such as: Multicollinearity Autocorrelation, and Heteroscedasticity

End of Chapter 7