1. Chapter 3 Cost behaviour, cost drivers and cost estimation
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2. 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
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3. 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
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5. 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.)
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6. 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.)
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7. 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.)
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8. 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.)
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9. 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.)
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10. 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
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12. 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.)
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13. 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.)
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15. 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.)
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17. 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.)
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21. 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
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22. 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
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23. 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
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24. 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.)
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25. 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.)
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26. 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.)
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27. 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.)
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28. 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?
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30. 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.)
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31. 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.)
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32. 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.)
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33. 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
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34. 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
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