1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-1 Chapter 3 Cost behaviour, cost drivers and cost estimation

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-2 What are cost behaviour, cost estimation and cost prediction? Cost behaviour –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

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-3

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-4 Cost drivers A cost driver –An activity or factor that drives or causes costs –The higher the correlation between the cost and the cost driver, the more accurate is the description and understanding of cost behaviours –Cost allocation base is commonly used instead of cost driver, as the causal relationship may not always exist –Conventional understandings of cost behaviour regard costs as variable or fixed, based on the level of production volume –Volume-based cost drivers include units produced, direct labour hours, direct labour cost and machine hours continued

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-5 Cost drivers Contemporary viewpoints recognise that there are a range of possible cost drivers other than production volume (non-volume cost drivers) Activity-based approaches classify costs and cost drivers into four levels: –Unit –Batch –Product –Facility continued

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-6 Cost drivers Unit level costs –Relate to activities that are performed for each unit produced –Use conventional volume-based cost drivers Batch level costs –Relate to activities performed for a group of product units Product (or product-sustaining) level –Relate to activities performed for specific products or product groups Facility level –Costs incurred to run the business continued

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-7 Cost drivers Selecting the best cost drivers –Input or outputs?  One input cost driver is the weight of material  One output driver is the number of units 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  Depends on the purpose of the cost prediction continued

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-8 Cost drivers 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 costs that cause a cost to be incurred  The true causes of costs continued

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-9 Cost drivers In choosing cost drivers, the costs and benefits of each driver must be assessed –Reasons for analysing cost behaviour –Timeframes for analysing the cost behaviour –Availability of data on cost drivers –Any other uses for the cost behaviour information

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-10

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-11 Cost behaviour patterns Cost behaviour –The relationship between a cost and the level of activity Cost behaviour patterns –Variable costs –Fixed costs –Step-fixed costs –Semivariable costs –Curvilinear costs continued

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-12 Cost behaviour patterns Variable costs –A change, in total, that is in direct proportion to a change in the level of activity –The variable cost 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 continued

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-13

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-14 Cost behaviour patterns Fixed costs –Remain unchanged, in total, despite changes in the level of activity –As activity increases, total fixed costs do not change, but unit fixed cost declines –Contemporary approaches to cost analysis recognise that there are cost drivers for some of these ‘fixed’ costs, and very few costs remain fixed continued

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-15

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-16 Cost behaviour patterns Step-fixed costs –Remain fixed over a wide range of activity levels but jump to a different amount for levels outside that range Semivariable 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 continued

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-17

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-18

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-19

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-20 Cost behaviour patterns An engineered cost –Bears a defined physical relationship to the level of output –If we know the level of activity, we can predict the total cost A committed cost –Results from an organisation’s basic structure and facilities, and is difficult to change in the short term A discretionary cost –Results from a management decision to spend a particular amount of money for some purpose, and can be easily changed continued

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-21 Cost behaviour patterns Cost structures are shifting towards a decreasing proportion of costs that vary with production. This is due to the following: –As production becomes more automated, there is less reliance on labour and more reliance on equipment; this does not vary with production output –Some employee enterprise agreements lead to a more stable labour force with fixed salaries  Wages do not vary with production activity levels  More difficult to change the number of staff employed as activity levels change

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-22 Cost estimation Approaches to cost estimation –Managerial judgment –Engineering approach –Quantitative analysis Using managerial judgment to estimate costs –Using experience and knowledge rather than formal analysis to predict future costs –The account classification method involves managers using their judgment to classify costs as exhibiting certain behaviours –Reliability of cost estimates dependent on the ability of the manager continued

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-23 Cost estimation The engineering approach to estimating costs –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 work tasks –These techniques are expensive and time-consuming –Useful when there is no reliable past data on which to base cost estimates –Most cost 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 continued

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-24 Cost estimation Estimating costs using quantitative analysis –Formal analysis of past data to identify the relationship between cost and activities –A scatter diagram can be useful in allowing us to plot the data points 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 all observations to determine the cost function continued

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-25 Cost estimation Regression analysis –Allows us to estimate the line of best fit by making the 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 method than high–low method as it makes use of all data and has statistical properties that allows us to make predictions and draw inferences continued

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-26 Cost estimation Regression analysis –Multiple regression allows us to include two or more independent variables; that is, cost drivers Y = a + b 1 X 1 + b 2 X 2 –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?

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-27

28. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-28 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 continued

29. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-29 Practical issues in cost estimation 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 us to consider more complex cost behaviour patterns –Costs are assigned to activities –Unit, batch and product level costs are assumed to vary in proportion to their cost drivers continued

30. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-30 Practical issues in cost estimation The accuracy of cost functions –Sometimes approximate estimates are used to estimate cost functions within firms –Why is the case?  Limited time and knowledge to undertake 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 continued

31. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-31 Practical issues in cost estimation All cost functions are based on simplifying assumptions, such as: –Cost behaviour depends on a single activity –Cost behaviours are linear within a relevant range Costs and benefits of producing accurate cost information need to be assessed