PPT 3 -1 Don R. Hansen Maryanne M. Mowen COST MANAGEMENT

PPT 3 -2 Activity Cost Behavior Chapter Three

PPT 3 -3 Learning Objectives l Define and describe fixed, variable, and mixed costs. l Explain the use of resources and activities and their relationship to cost behavior. l Separate mixed costs into their fixed and variable components using the high-low method, the scatterplot method, and the method of least squares.

PPT 3 -4 Learning Objectives (continued) l Evaluate the reliability of the cost formula. l Explain how multiple regression can be used to assess cost behavior l Discuss the use of managerial judgment in determining cost behavior.

PPT 3 -5 Fixed Cost BehaviorVariable Cost Behavior $ $ Relevant Range Activity Activity Cost Behavior

PPT 3 -6 Total Costs $Cost Number of Units Produced Fixed Costs Variable Costs Linearity Assumption Y = F + VX The Behavior of a Mixed Cost

PPT 3 -7 Basic Terms Activity capacity is the ability to perform activities. Practical capacity is the efficient level of activity performance. Resources are economic inputs that are consumed in performing activities.

PPT 3 -8 Types of Fixed Resources l Flexible Resources l Committed Resources l Discretionary Fixed Costs

PPT 3 -9 Flexible Resources Flexible resources are supplied as used and needed. They are acquired from outside sources, where the terms of acquisition do not require any long-term commitment for any given amount of the resource. Example: Materials and energy

PPT Committed Resources Committed resources are supplied in advance of usage. They are acquired by the use of either an explicit or implicit contract to obtain a given quantity of resource, regardless of whether the amount of the resource available is fully used or not. Committed resources may have unused capacity. Example: Buying or leasing a building or equipment

PPT Committed Resources (continued) Committed fixed expenses are costs incurred for the acquisition of long-term capacity. Example: Plant, equipment, warehouses, vehicles, and salaries of top employees Discretionary fixed expenses are shorter-term committed resources. Example: The hiring of new receiving clerks

PPT Resource Relationships The relationship between resources supplied and resources used is expressed by the following equation: Resources available = Resources used + Unused capacity

PPT Available orders = Orders used + Orders unused 7,500 orders = 6,000 orders + 1,500 orders Fixed engineering rate = $150,000/7,500 = $20 per change order Variable engineering rate = $90,000/6,000 = $15 per change order Example

PPT Cost of orders supplied= Cost of orders used + Cost of unused orders = [($20 + $15) x 6,000] + ($20 x 1,500) = $240,000 Of course, the $240,000 is precisely equal to the $150,000 spent on engineers and the $90,000 spent on supplies. The $30,000 of excess engineering capacity means that a new product could be introduced without increasing current spending on engineering. Example (continued)

PPT $Cost Number of Units Produced Linearity Assumption Narrow Width Step-Variable Costs

PPT $Cost Number of Units Produced Linearity Assumption Wider Width Step-Fixed Costs

PPT Methods for Measuring the Fixed and Variable Components of a Mixed Cost l The High-Low Method l Scatterplot Method l The Method of Least Squares

PPT Month Utility Costs Units Produced January $2, February 2, March 4, April 5, May 7,5001,000 High-Low Method: An Example

PPT Y= F + VX Variable Cost Rate (V)= (Y 2 - Y 1 )/(X 2 - X 1 ) V= ($7,500-$2,000)/(1, ) V= $5,500/800 V= $6.875 per unit The High-Low Method (continued)

PPT Y=F + VX $7,500= F + $6.875 (1,000) F=$7,500 - $6,875 F= $625 The cost formula using the high-low method is: Y = $625 + $6.875 (X) The High-Low Method (continued)

PPT Units Produced Utility Cost $8,000 6,000 4,000 2, , Analyst can fit line based on his or her experience Important: Cost function is only relevant within relevant range Scatterplot Method

PPT Nonlinear Relationship Activity Cost 0 Activity Output * * * * *

PPT Upward Shift in Cost Relationship Activity Cost 0 Activity Output * * * * * *

PPT Presence of Outliers Activity Cost 0 Activity Output * * * * * *

PPT Least Squares Constant250 Std Err of Y Est R squared No. of Observations5 Degrees of Freedom3 X Coefficient(s) 6.75 Std Err of Coef

PPT Least Squares (continued) The results gives rise to the following equation: Utility Costs = $250 + ($6.75 x # of units produced) R 2 =.944, or 94.4 percent of the variation in setup costs is explained by the number of setup hours variable.

PPT Using Confidence Intervals: Given: *T-value for sample size of 5 at 95% confidence level is (two-tale test and 3 degrees of freedom) *Standard error of estimate for this sample at the 95% confidence level is The confidence interval for 300 units is: TC = $ (300) + (3.192 x $598.6) = $ $1911 Least Squares (continued)

PPT TC = b 0 + b 1 X 1 + b 2 X b 0 = the fixed cost or intercept b i = the variable rate for the ith independent variable X i = the ith independent variable Multiple Regression

PPT Utility MonthMHrsSummerCost January1,3400$1,688 February1,29801,636 March1,37601,734 April1,40501,770 May1,50012,390 June1,43212,304 July1,32212,166 August1,41612,284 September1,37011,730 October1,58001,991 November1,46001,840 December1,45501,833 Multiple Regression (continued)

PPT Constant Std Err of Y Est R squared No. of Observations12 Degrees of Freedom9 X Coefficient(s) Std Err of Coef Multiple Regression (continued)

PPT Multiple Regression (continued) The results gives rise to the following equation: Utilities cost = $ $1.097(MH) + $510.49(Summer) R2 = 0.967, or 96.7 percent of the variation in utilities cost is explained by the machine hours and summer variables.

PPT l Use past experience l Try to confirm results with operating personal l Use common sense to confirm statistical studies Some Tips Cost Behavior and Managerial Judgment

PPT End of Chapter 3