Cost Behavior & Cost Estimation

Costs behave in three ways Costs behave in three ways 1. Fixed costs 1. Fixed costs 2. Variable costs 2. Variable costs 3. Semi-variable costs 3. Semi-variable costs Cost estimation is finding a relationship between cost behavior and the cost driver. Cost estimation is finding a relationship between cost behavior and the cost driver.

Cost behavior Cost behavior Costs can be variable, fixed or semi variable. Variable costs are costs that vary in direct proportion to change in the cost drive. Direct labor is a good example only if workers are paid by piece. Fixed costs are costs that that remain the same despite change in the cost drive e.g. Depreciation, rent and insurance. Costs can be variable, fixed or semi variable. Variable costs are costs that vary in direct proportion to change in the cost drive. Direct labor is a good example only if workers are paid by piece. Fixed costs are costs that that remain the same despite change in the cost drive e.g. Depreciation, rent and insurance.

Fixed costs are committed, i.e. they result from previous actions (depreciation). Or they can be discretionary because mgt uses its professional judgment to decide on the amount of cost. Fixed costs are committed, i.e. they result from previous actions (depreciation). Or they can be discretionary because mgt uses its professional judgment to decide on the amount of cost. Semi-variable costs are costs that behave partly as fixed and partly as variable. e.g. indirect labor costs and indirect material. Semi-variable costs are costs that behave partly as fixed and partly as variable. e.g. indirect labor costs and indirect material.

Any cost can be defined in terms of this function Any cost can be defined in terms of this function Y= a + bx Y= a + bx Where y is the total cost, a is constant that does not change with the activity level, b is a variable cost and x is the activity volume. Where y is the total cost, a is constant that does not change with the activity level, b is a variable cost and x is the activity volume. Cost estimation methods Cost estimation methods The low- high method: this method requires that we know the highest and lowest activity level. This is the most common. The low- high method: this method requires that we know the highest and lowest activity level. This is the most common.

Example : Example : Bobs Company has budgeted factory costs for four values of operation. Machine hours Bobs Company has budgeted factory costs for four values of operation. Machine hours In-labor In-labor Insurance Insurance Depreciat Depreciat Utilities Utilities

Required: Required: 1. Indicate the behavior of the four costs 1. Indicate the behavior of the four costs 2. using the low-high method determine the cost estimating formula for each of the four costs. 2. using the low-high method determine the cost estimating formula for each of the four costs. In order to check whether the cost is variable or not you will need to check if it varies directly with the number of units of production In order to check whether the cost is variable or not you will need to check if it varies directly with the number of units of production

Indirect labor is a semi-variable cost as the rate changes but not proportionally 2100/ 5000, 2400/6000, 2700/ 7000 and 3000/ Indirect labor is a semi-variable cost as the rate changes but not proportionally 2100/ 5000, 2400/6000, 2700/ 7000 and 3000/ Insurance is a fixed cost because it does not change with production. Insurance is a fixed cost because it does not change with production. Depreciation is a variable cost and that changes directly with production. (0.2) is the rate. Depreciation is a variable cost and that changes directly with production. (0.2) is the rate. Utilities are semi-variable as the rate changes but not proportionally with production. Utilities are semi-variable as the rate changes but not proportionally with production.

Indirect labor Highest no of hrs= 8000 highest cost =3000 Highest no of hrs= 8000 highest cost =3000 Lowest no of hrs= 5000 lowest cost = 2100 Lowest no of hrs= 5000 lowest cost = 2100 Difference Difference Variable cost rate = 900/ 3000 = $0.3 Variable cost rate = 900/ 3000 = $0.3 Fixed cost = 3000 – 0.3(8000) = $600 Fixed cost = 3000 – 0.3(8000) = $600 The function is The function is TC (indirect labor) = (x) TC (indirect labor) = (x)

Insurance Insurance Highest no of hrs= 8000 highest cost = 600 Highest no of hrs= 8000 highest cost = 600 Lowest no of hrs= 5000lowest cost = 600 Lowest no of hrs= 5000lowest cost = 600 Difference Difference Variable cost rate = 0/ 3000 = $0 Variable cost rate = 0/ 3000 = $0 Fixed cost = $600 – 0(8000) = $600 Fixed cost = $600 – 0(8000) = $600 The function is The function is TC (Insurance) = $600 TC (Insurance) = $600

Depreciation Depreciation Highest no of hrs= 8000 highest cost = 1600 Highest no of hrs= 8000 highest cost = 1600 Lowest no of hrs= 5000 lowest cost = 1000 Lowest no of hrs= 5000 lowest cost = 1000 Difference Difference Variable cost rate = 600/ 3000 = $0.2 Variable cost rate = 600/ 3000 = $0.2 Fixed cost = 1600 – 0.2(8000) = 0 Fixed cost = 1600 – 0.2(8000) = 0 The function is The function is TC (Deprecation) = 0.2(x) TC (Deprecation) = 0.2(x)

Utilities Utilities Highest no of hours= 8000 highest cost = 2900 Highest no of hours= 8000 highest cost = 2900 Lowest no of hours= 5000 lowest cost = 2000 Lowest no of hours= 5000 lowest cost = 2000 Difference Difference Variable cost rate = 900/ 3000 = $0.3 Variable cost rate = 900/ 3000 = $0.3 Fixed cost = 2900 – 0.3(8000) = $500 Fixed cost = 2900 – 0.3(8000) = $500 The function is TC (utilities) = (x) The function is TC (utilities) = (x)

Faisal Company has budgeted factory costs for three values of operation. Faisal Company has budgeted factory costs for three values of operation. Machine hours Machine hours In.mat In.mat Rent Rent Deprec Deprec

Required: Required: Indicate the behavior of the costs Indicate the behavior of the costs Use the low-high method to determine the cost estimating formula for each of the three costs. Use the low-high method to determine the cost estimating formula for each of the three costs.