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

Costs and costing systems Cost estimation - process of determining cost behaviour of a particular cost item Cost behaviour - relationship between cost and activity (often cost driver) Cost prediction - using cost behaviour knowledge to forecast future costs at a particular level of activity

Cost drivers Any activity or factor that causes costs to be incurred Volume-based cost drivers - assumes all costs are driven, or caused, by the volume of production (or sales) Non-volume-based cost drivers - costs are not directly related to production volume Cont.

Cost drivers Activity-based costing classifies costs into four categories unit level - activities performed for each unit batch level - activities performed for a group of product units, such as batch or a delivery load product level- activities performed for specific products or product families facility level - costs incurred to support the whole business

Selecting the best cost drivers Input or output measure? strong correlation between cost and cost driver cost driver must be easy to measure Level of detail? accuracy increases with increased cost categories, but so does cost Long-term or short-term perspective? Consider costs and benefits

Cost estimation vs cost management Managing costs by managing cost drivers Effective cost management involves the identification of root-cause drivers the underlying factor that causes a cost to be incurred

Cost behaviour patterns Cost function - an equation used to describe cost behaviour: Y = a + bX Variable cost (bX) - total changes in direct proportion to a change in level of activity Fixed cost (a) - total remains unchanged as the level of activity varies Relevant range - range of activity over which cost behaviour patterns are valid Cont.

Cost behaviour patterns Step-fixed costs - fixed over a range of activity, but jumps to a different amount for levels outside that range Semivariable costs - fixed and variable components Curvilinear costs - approximated as a curved line Marginal cost - cost of producing the next unit of production

Using cost behaviour to predict costs Engineered costs - defined relationship to the cost driver Committed costs - results from an organisation’s ownership or use of premises and its basic organisation structure Discretionary costs - arise from management decisions

Cost structures in modern manufacturing Fewer costs vary with production volume automation - replacement of labour with machinery relatively stable workforce which cannot be varied in the short run It is important to understand the nature of the industry when analysing cost behaviour

Cost estimation Cost estimation Three approaches to cost estimation the process of determining the cost behaviour of a cost item Three approaches to cost estimation managerial judgement engineering approach quantitative analysis

Managerial judgement Use of experience rather than formal analysis to estimate cost behaviours Account classification method where managers use their judgement to classify the accounts in the general ledger as fixed, variable or semivariable costs adjusted by factors which may affect future costs

The engineering approach Study of processes that result in the incurrence of a cost engineering studies - focus on the relationships that should exist between inputs and outputs time and motion studies (task analysis or work measurement) - observation of the steps required and time taken by employees to perform particular activities

Quantitative analysis The analysis of past data to identify relationships between costs and activities Past data may be a poor guide to future cost behaviour Three approaches include visual fit method high-low method regression analysis

Visual fit method Visually fitting a line to data on a scatter diagram to estimate the cost function Lacks objectivity different lines can be drawn from the same data can be a first step to more in-depth analysis

High–low method Estimate a cost function by considering data at the highest and lowest levels of activity More objective than visual fit Uses only two data points, and ignores the rest

Regression analysis Statistical technique for estimating cost behaviour by minimising the difference between the cost line and data points Least squares regression: Y= a + bX independent variable (X) dependent variable (Y) Cont.

Regression analysis Uses all available data in defining the line of best fit Evaluation of regression line economic plausibility goodness of fit Multiple regression - estimates a linear relationship between one dependent variable and two or more independent variables

Data collection problems Cost estimates are only as good as the data upon which they are based Data problems missing data outliers mismatched time periods trade-offs in choosing time periods allocated fixed costs

Effect of learning on cost behaviour Learning curve effect reduction in labour time per unit which occurs in the early stages of producing a new product As the number of units produced increases, the total labour cost will increase but at a decreasing rate Labour costs are unlikely to have a linear relationship with cost

Cost behaviour, cost estimation and activity-based costing Activity-based costing (ABC) cost are assigned to activities costs driven by volume are unit level costs cost drivers are identified for batch-level and product-level costs, but not for facility-level costs assumed that unit, batch and product-level costs vary proportionally with their cost driver understanding cost behaviour and estimating cost functions is still important

Accuracy of cost functions in business Objective techniques are not widely used to estimate cost behaviours insufficient time or knowledge to use appropriate quantitative methods data required to estimate reliable cost functions not available low priority given to analysing cost behaviour and cost estimation approximations considered “accurate enough”

Costs and benefits of accurate cost information Difficult to assess the benefits flowing from more accurate cost estimation Common simplifying assumptions underlying cost estimation include cost behaviour depends on one activity cost behaviours are linear within the relevant range

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