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

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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.

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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.

18. 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

19. 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

20. 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

21. 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

22. 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”

23. 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

24. Exhibit 3.2

25. Exhibit 3.3

26. Exhibit 3.5

27. Exhibit 3.9