Cost Behavior Analysis & Use PDF

COST BEHAVIOR : ANALYSIS & USE COST BEHAVIOR & ITS IMPORTANCE IT MEANS HOW A COST WILL REACT WHEN THERE IS A CHANGE IN THE LEVEL OF BUSINESS ACTIVITY. THIS IS ESSENTIAL IN DECISION MAKING IN THE PLANNING AND CONTROL OF THE FIRM’S ACTIVITY. PLANNING REQUIRES THAT THE MANAGEMENT MAKE DECISIO...

COST BEHAVIOR : ANALYSIS & USE COST BEHAVIOR & ITS IMPORTANCE IT MEANS HOW A COST WILL REACT WHEN THERE IS A CHANGE IN THE LEVEL OF BUSINESS ACTIVITY. THIS IS ESSENTIAL IN DECISION MAKING IN THE PLANNING AND CONTROL OF THE FIRM’S ACTIVITY. PLANNING REQUIRES THAT THE MANAGEMENT MAKE DECISIONS BASED IN PART ON EXPECTATIONS AS TO THE FUTURE. THE EXPECTATIONS SHOULD BE BASED ON DATA RELEVANT TO THE DECISION OBJECTIVES.  CONTROL ON THE OTHER HAND IS THE PROCESS OF USING FEEDBACK INFORMATION FOR COMPARISON WITH EXPECTATIONS AND THE IMPLEMENTATION OF ACTION ON THE BASIS OF THAT COMPARISON. COST ANALYSIS IS AN INTEGRAL PART OF THE PLANNING AND CONTROL FUNCTIONS. THE KEY TO AN EFFECTIVE COST PREDICTION LIES IN THE UNDERSTANDING OF COST BEHAVIOR PATTERNS. EXAMPLE OF COST BEHAVIOR ABC COMPANY MANUFACTURES COMPUTERS. THE RENT OF THE FACTORY IS P150,000.00 PER MONTH. THE COST OF RAW MATERIALS FOR ONE COMPUTER IS P1,000.00. EVERY MONTH THE COMPANY MANUFACTURES 500 UNITS OF COMPUTERS. THE COST OF PRODUCTION IN ONE MONTH IS P150,000.00 + P 500,000.00 (500*1000) OR P650,000.00  IF IN THE FOLLOWING MONTH, THE COMPANY EXPANDS ITS PRODUCTION TO 600 UNITS THEN THE COST OF PRODUCTION CHANGES TO P150,000 + P600,000 (600*1,000) OR P750,000. THIS IS A COST BEHAVIOR ANALYSIS EXAMPLE. TYPES OF COST BEHAVIOR PATTERNS 1. VARIABLE COSTS - COSTS THAT CHANGE IN TOTAL AS THE LEVEL OF ACTIVITY CHANGES IN THE SHORT RUN AND WITHIN THE RELEVANT RANGE. SHORT RUN IS THE TIME PERIOD LONG ENOUGH TO ALLOW MANAGEMENT TO CHANGE THE LEVEL OF PRODUCTION. RELEVANT RANGE IS THE RANGE ACTIVITY WITHIN WHICH ASSUMPTIONS RELATIVE TO VARIABLE COST AND FIXED COST BEHAVIOR ARE VALID.  ESTIMATES OF VARIABLE AND OTHER COSTS ARE APPLICABLE ONLY IF THE LEVEL OF ACTIVITY IS WITHIN THE RELEVANT RANGE. VARIABLE COST PER UNIT IS ASSUMED TO BE CONSTANT WITHIN THIS RANGE. FOR A COST TO BE VARIABLE, IT MUST BE VARIABLE WITH RESPECT TO ITS ACTIVITY BASE WHICH IS A MEASURE OF WHATEVER CAUSES THE INCURRENCE OF VARIABLE COST. THIS IS ALSO REFERRED TO AS A COST DRIVER.  EXAMPLES OF VARIABLE COSTS IN A MANUFACTURING COMPANY- DIRECT MATERIALS, DIRECT LABOR, MANUFACTURING OVERHEAD SUCH AS INDIRECT MATERIALS, HANDLING COSTS, ENERGY COSTS, SUPPLIES IN A MERCHANDISING COMPANY – COST OF SALES, SALES COMMISSIONS IN A SERVICE ORGANIZATION – DIRECT LABOR AND MATERIALS USED TO PERFORM THE SERVICES 2. FIXED COSTS – COSTS THAT REMAIN CONSTANT IN TOTAL REGARDLESS OF CHANGES IN THE LEVEL OF ACTIVITY WITHIN THE RELEVANT RANGE. FIXED COST MAY CHANGE DUE TO SOME OUTSIDE FORCE SUCH AS PRICE CHANGES. FIXED COST PER UNIT WILL REACT INVERSELY WITH CHANGE IN ACTIVITY. IT DECREASES AS THE LEVEL OF ACTIVITY RISES AND INCREASES AS THE ACTIVITY LEVEL FALL.  TYPES OF FIXED COSTS (FOR PLANNING PURPOSES) 1. COMMITTED FIXED COSTS – RELATE TO THE INVESTMENT, EQUIPMENT AND THE BASIC ORGANIZATIONAL STRUCTURE OF THE FIRM. (E.G. DEPRECIATION , TAXES ON REAL ESTATE, INSURANCE AND SALARIES OF TOP MANAGEMENT & OPERATING PERSONNEL) TWO CHARACTERISTICS OF COMMITTED FIXED COSTS (1) LONG TERM IN NATURE (2) THEY CAN’T BE SIGNIFICANTLY REDUCED EVEN FOR SHORT PERIODS OF TIME WITHOUT IMPAIRING THE PROFITABILITY OF THE FIRM. EVEN IF OPERATIONS ARE INTERRUPTED THE COMMITTED FIXED COSTS SHALL CONTINUE UNCHANGED. 2. DISCRETIONARY FIXED COSTS – ALSO KNOWN AS MANAGED FIXED COSTS. ARISE FROM ANNUAL DECISIONS BY MANAGEMENT TO SPEND IN CERTAIN FIXED COST AREAS LIKE ADVERTISING, RESEARCH, PUBLIC RELATIONS,ETC. ITS MOST IMPORTANT CHARACTERISTICS IS THAT THE MANAGEMENT IS NOT LOCKED INTO A DECISION REGARDING SUCH COSTS MEANING THEY CAN BE ADJUSTED FROM YEAR TO YEAR OR EVEN DURING THE COURSE OF A YEAR IF CIRCUMSTANCES DEMAND SUCH A MODIFICATION. FOR EXAMPLE IF THE COMPANY HOPES TO ONCREASE SALES BY 10%, IT WOULD PLAN FOR LARGER ADVERTISING COSTS THAN IF NO SALES INCREASE WERE PLANNED. ONCE THE TOTAL DISCRETIONARY COSTS HAVEE BEEN BUDGETED THEY ARE UNAFFECTED BY THE ACTUAL LEVEL OF ACTIVITY.  EXAMPLES OF COSTS THAT ARE GENERALLY FIXED: RENT, INSSURANCE, PROPERTY TAXES, DEPRECIATION, ADMINISTRATIVE SALARIES, ADVERTISING, SUPERVISORY SALARIES 3. MIXED COSTS (SEMI-VARIABLE COSTS) - CONTAIN BOTH VARIABLE AND FIXED COST ELEMENTS. EXAMPLES – MAINTENANCE COSS, UTILITY COSTS COST ESTIMATION  THEBASIC IDEA IS TO ESTIMATE THE RELATION BETWEEN COSTS AND THE VARIABLES AFFECTING THE COSTS. THE FIXED PORTION OF THE MIXED COST REPRESENTS THE MINIMUM COST OF HAVING A SERVICE READY WHILE THE VARIABLE PORTION REPRESENTS THE COST INCURRED FOR THE ACTUAL CONSUMPTION OF THE SERVICE. METHODS OF ESTIMATING THE RELATION BETWEEN COST BEHAVIOR AND ACTIVITY LEVELS 1. ACCOUNT ANALYSIS METHOD –USEFUL AND EASIER WAY TO ESTIMATE COSTS. IT MAKES USE OF THE EXPERIENCE AND JUDGMENT OF MANAGERS AND ACCOUNTANTS WHO ARE FAMILIAR WITH COMPANY OPERATIONS AND THE WAY COSTS REACT TO CHANGE IN ACTIVITY LEVEL.  STEPS INVOLVES IN ACCOUNT ANALYSIS: 1. REVIEW EACH COST ACCOUNT AND IS IDENTIFIED AS EITHER FIXED OR VARIABLE. 2. EACH MAJOR CLASS OF MANUFACTURING OVERHEAD OR MIXED COST IS ITEMIZED AND THEN THE COST IS DIVIDED INTO ESTIMATED VARIABLE AND FIXED COMPONENTS.(BASED ON EXPERIENCE AND JUDGMENT) AN ADVANTAGE OF THIS METHOD IS IT INVOLVES A DETAILED EXAMINATION OF THE DATA BASE BY ACCOUNTANTS AND MANAGERS WHO ARE FAMILIAR WITH IT. A DISADVANTAGE IS THAT IT USES JUDGMENTAL APPROACH SO THAT DIFFERENT ANALYST MAY PROVIDE DIFFERENT ESTIMATES OF COST BEHAVIOR. 2. INDUSTRIAL ENGINEERING METHOD – ESTIMATES COST FUNCTIONS BY ANALYZING THE RELATIONSHIP BETWEEN INPUTS AND OUTPUTS IN PHYSICAL FORMS. THIS IS NOT JUST FOR MANUFACTURING COMPANIES BUT CAN BE USED ALSO BY BANKS, FAST FOOD COMPANIES, HOSPITALS AND OTHER NON-MANUFACTURING COMPANIES.  AN ADVANTAGE OF THIS APPROACH IS THAT CAN DETAIL EACH STEP REQUIRED TO PERFORM AN OPERATION. IT ENABLES THE COMPANY TO REVIEW MANUFACTURING PRODUCTIVITY AND IDENTIFY STRENGHTS AND WEAKNESSES. IT CAN ALSO ESTIMATE COSTS FOR TOTALLY NEW ACTIVITIES BECAUSE IT DOES NOT REQUIRE DATA FROM PRIOR ACTIVITIES IN THE FIRM. A DISADVANTAGE IS THAT IT CAN BE QUITE EXPENSIVE TO USE BECAUSE EACH ACTIVITY IS USING ENGINEERING NORMS AND EXPERT ENGINEERS WHICH ARE COSTLY. IT IS ALSO DIFFICULT TO ESTIMATE THE INDIRECT COSTS OF PRODUCTION. 3. CONFERENCE METHOD – COST FUNCTIONS ARE ESTIMATED BASED ON THE ANALYSIS AND OPINIONS ABOUT COSTS AND THEIR DRIVERS OBTAINES FROM VARIOUS DEPARTMENTS. THE INFORMATION IS USED TO DETERMINE THE SELLING PRICE OF THE PRODUCT AND EVALUATE COST IMPROVEMENTS OVER TIME. THIS METHOD ALLOWS QUICK DEVELOPMENT OF COST FUNCTIONS AND COST ESTIMATES. THE ACCURACY OF THE ESTIMATED IS DEPENDENT ON THE OBJECTIVITY, CARE AND THE DETAIL TAKEN BY THE PEOPLE PROVIDING THE INFORMATION. 4.QUANTITATIVE ANALYSIS OF CURRENT AND PAST COSTS RELATIONSHIPS A. HIGH-LOW METHOD – BASED ON COSTS OBSERVED AT BOTH THE HIGH AND LOW LEVELS OF ACTIVITY WITHIN THE RELEVANT RANGE. B. REGRESSION ANALYSIS METHOD - USES ALL AVAILABLE DATA TO ESTIMATE THE COST FUNCTION. SIMPLE REGRESSION ANALYSIS ESTIMATED THE RELATIONSHIP BETWEEN THE DEPENDENT VARIABLE AND ONE INDEPENDENT VARIABLE WHILE MULTIPLE REGRESSION ANALYSIS ESTIMATED THE RELATIONSHIP BETWEEN THE DEPENDENT VARIABLE AND MULTIPLE INDEPENDENT VARIABLES. THIS IS USED WHEN THE DEPENDENT VARIABLE IS CAUSED BY MORE THAN ONE FACTOR. THE PRINCIPLES INVOLVED HERE ARE THE SAME AS IN THE SIMPLE REGRESSION ANALYSIS ALTHOUGH THE ADDING OF MORE VARIABLES MAKE THE COMPUTATION MORE COMPLEX. 1. LEAST-SQUARE REGRESSION METHOD – IT IS A STATISTICAL TECHNIQUE WHICH IS OFTEN USED IN SEPARATING MIXED COSTS INTO THEIR FIXED AND VARIABLE COMPONENTS. 2. SCATTERGRAPH OR VISUAL FIT – A ROUGH GUIDE FOR COST ESTIMATION WHICH PLOT THE COST AGAINST PAST ACTIVITY LEVELS. CORRELATION ANALYSIS MANAGEMENT MUST EVALUATE WHETHER OR NOT THE FACTOR SELECTED FOR ESTIMATING COST BEHAVIOR IS SUITABLE FOR THAT PURPOSE. COSTS MAY OR MAY NOT REACT WITH CHANGES IN THE FACTOR SELECTED FOR COST ANALYSIS. THE DEGREE OF CORRELATION BETWEEN THE LEVEL OF ACTIVITY AND COSSTS MAY BE MEASURED BY THE COEFFICIENT OF DETERMINATION.  THE MOST IMPORTANT ISSUE IN ESTIMATING A COST FUNCTION IS TO DETERMINE WHETHER A CAUSE AND EFFECT RELATIONSHIP EXISTS BETWEEN THE COST DRIVER AND THE RESULTING COSTS. A HIGHER CORRELATION BETWEEN TWO VARIABLES MAY NOT MEAN THAT EITHER VARIABLE CAUSES THE OTHER BUT IT MERELY INDICATE THAT THE TWO VARIABLES MOVE TOGETHER. FOR EXAMPLE HIGHER MATERIAL COSTS AND HIGHER LABOR COSTS ARE CAUSED BY HIGHER PRODUCTION. MATERIAL COSTS AND LABOR COSTS ARE HIGLY CORRELATED BUT NEITHER CAUSES THE OTHER. A VITAL ASPECT OF COST ESTIMATIONIS ESTABLISHING ECONOMIC PLAUSIBILITY WHICH GIVES THE AANLYST CONFIDENCE THAT THE ESTIMATED RELATIONSHIP WILL REPEATEDLY APPEAR IN OTHER SIMILAR SETS OF DATA. THE LEARNING CURVE THEORY ALSO CALLED IMPROVEMENT CURVE THEORY. IT IS BASED ON THE PROPOSITION THAT AS WORKERS GAIN EXPERIENCE IN A TASK, THEY NEED LESS TIME TO COMPLETE THE JOB AND PRODUCTIVITY INCREASES. THE LEARNING CURVE IS A POWEER FUNCTION AND WILL APPEAR AS A STRAIGHT LINE IF PLOTTED ON DOUBLE LOGARITHMIC PAPER.  USES OF LEARNING CURVE: 1. PREPARING COST ESTIMATES FOR BIDDING PURPOSES 2. SETTING STANDARDS AND BUDGET ALLOWANCES 3. SCHEDULING LABOR REQUIREMENTS 4. EVALUATING PERFORMANCE BY COMPARING PROGRESS REPORTS WITH THE ACCOMPLISHMENTS ANTICIPATED UNDER THE LEARNING CURVE 5. SETTING INCENTIVE WAGE RATES WITH DUE CONSIDERATION FOR THE FACT THAT LABOR TIMES WILL NORMALLY BE REDUCED AS THE WORKER BECOMES MORE EXPERIENCED.