Topic 2. Determining How Costs Behave PDF

Cost Accounting: A Managerial Emphasis Chapter 10 Determining How Costs Behave Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Learning Objectives (1 of 2) 10.1 Describe linear cost functions and three common ways in which they behave 10.2 Explain...

Cost Accounting: A Managerial Emphasis Chapter 10 Determining How Costs Behave Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Learning Objectives (1 of 2) 10.1 Describe linear cost functions and three common ways in which they behave 10.2 Explain the importance of causality in estimating cost functions 10.3 Understand various methods of cost estimation 10.4 Outline six steps in estimating a cost function using quantitative analysis 10.5 Describe three criteria used to evaluate and choose cost drivers Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Learning Objectives (2 of 2) 10.6 Explain nonlinear cost functions, in particular those arising from learning-curve effects 10.7 Be aware of data problems encountered in estimating cost functions Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Cost Function Defined A cost function is a mathematical description of how a cost changes with changes in the level of an activity relating to that cost. Managers often estimate cost functions based on two assumptions: – Variations in the level of a single activity (the cost driver) explain the variations in the related total costs. – Cost behavior is approximated by a linear cost function within the relevant range. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Cost Terminology From prior chapters, we are familiar with the distinction between variable and fixed costs. In this chapter, we introduce mixed costs. Variable costs—costs that change in total in relation to some chosen activity or output Fixed costs—costs that do not change in total in relation to some chosen activity or output Mixed costs—costs that have both fixed and variable components; also called semivariable costs Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Linear Cost Function Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Bridging Accounting and Statistical Terminology Accounting Statistics Variable Cost Slope or Slope Coefficient Fixed Cost Intercept or Constant Mixed Cost Linear Cost Function Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Linear Cost Functions Illustrated Exhibit 10.1 Examples of Linear Cost Functions Panel A: Variable Cost Panel B: Fixed Cost Panel C: Mixed Cost Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Review of Cost Classification 1. Choice of cost object—different objects may result in different classification of the same cost. 2. Time horizon—the longer the period, the more likely the cost will be variable. 3. Relevant range—behavior is predictable only within this band of activity. Better management decisions, cost predictions, and estimation of cost functions can be achieved only if managers correctly identify the factors that affect costs. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved The Cause-and-Effect Criterion (1 of 3) The most important issue in estimating a cost function is determining whether a cause-and-effect relationship exists between the level of an activity and the costs related to it. Without a cause-and-effect relationship, managers will be less confident about their ability to estimate or predict costs. Recall from Chapter 2 that when a cause-and-effect relationship exists between a change in the level of an activity and a change in the level of total costs, we refer to the activity measure as a cost driver. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved The Cause-and-Effect Criterion (2 of 3) A cause-and-effect relationship might arise as a result of – a physical relationship between the level of activity and the costs, – a contractual agreement, or – knowledge of operations. Only a cause-and-effect relationship—not merely correlation—establishes an economically plausible relationship between the level of an activity and its costs. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved The Cause-and-Effect Criterion (3 of 3) Economic plausibility is critical because it gives analysts and managers confidence that the estimated relationship will appear repeatedly in other sets of data. Identifying cost drivers also gives managers insights into ways to reduce costs and the confidence that reducing the quantity of the cost drivers will lead to a decrease in costs. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Cost Drivers and the Decision-Making Process To correctly identify cost drivers in order to make decisions, managers should always use a long time horizon. Costs may be fixed in the short run (during which time they have no cost driver), but they are usually variable and have a cost driver in the long run. Managers should follow the five-step decision-making process outlined in Chapter 1 to evaluate how changes can affect costs and product decisions. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Cost Estimation Methods Four Methods of Cost Estimation 1. Industrial engineering method 2. Conference method 3. Account analysis method 4. Quantitative analysis methods – High-low method – Regression analysis These methods are not mutually exclusive, and often more than one is used. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Industrial Engineering Method Estimates cost functions by analyzing the relationship between inputs and outputs in physical terms Includes time-and-motion studies Very thorough and detailed when there is a physical relationship between inputs and outputs, but also costly and time-consuming Also called the work-measurement method Use mandated by some government contracts Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Conference Method Estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company Pools expert knowledge, increasing credibility Because opinions are being used, the accuracy of the cost estimates depends largely on the care and skill of the people providing the inputs. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Account Analysis Method This method estimates cost functions by classifying various cost accounts as variable, fixed, or mixed in respect to the identified level of activity. Typically, managers use qualitative rather than quantitative analysis when making these cost-classification decisions. The method is widely used because it is reasonably accurate, cost-effective, and easy to use. The accuracy of the account analysis method depends on the accuracy of the qualitative judgments that managers and management accountants make about which costs are fixed and which are variable. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Quantitative Analysis Uses a formal mathematical method to fit cost functions to past data observations Advantage: results are objective Advantage: most rigorous approach to estimate costs Challenge: requires more detailed information about costs, cost drivers, and cost functions and is therefore more time- consuming Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Six Steps in Estimating a Cost Function Using Quantitative Analysis 1. Choose the dependent variable (the cost to be predicted and managed). 2. Identify the independent variable (the level of activity or cost driver). 3. Collect data on the dependent variable and the cost driver. 4. Plot the data to observe the general relationship. 5. Estimate the cost function using two common forms of quantitative analysis: the high-low method or regression analysis. 6. Evaluate the cost driver of the estimated cost function. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved High-Low Method Simplest method of quantitative analysis Uses only the highest and lowest observed values “Fits” a line to data points that can be used to predict costs Three steps in the high-low method to obtain the estimate of the cost function Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved High-Low Method – example Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Steps in the High-Low Method (1 of 3) Step 1: Calculate the slope coefficient (the variable cost per unit of activity). Slope coefficient  Difference between costs associated with highest and lowest observations of the cost driver / Difference between highest and lowest observations of the cost driver. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Step 2: Calculate the constant (the total fixed costs). Total cost from either the highest or lowest activity level  (Variable Cost per unit of activity  Activity associated with above total cost) = Fixed Costs Continuing our example, let’s calculate fixed costs using both the high and low levels of activity. Recall the our VC from the previous slide was calculated at $5/call: High: $45 - $5* 5 calls = $20 Low: $20 - $5* 0 calls = $20 Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved  Step 3: Summarize by writing a linear equation: Y = MX + C Total Costs = (Variable cost per unit of Activity * Activity) + Fixed Costs Y = ($5 * X) + $20. If we wondered what total costs would be at an activity level of 120 calls , we’ll simply plug that number for X in our equation: Y = ($5 * 120) + $20 = $620 Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Regression Analysis Method Regression analysis is a statistical method that measures the average amount of change in the dependent variable associated with a unit change in one or more independent variables. Regression analysis is more accurate than the high- low method because the regression equation estimates costs using information from All observations, whereas the high-low method uses only Two observations. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Types of Regression Analysis Simple regression estimates the relationship between the dependent variable and One independent variable. Multiple regression estimates the relationship between the dependent variable and Two or More independent variables. Regression analysis is widely used because it helps managers understand why costs behave as they do and what managers can do to influence them. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Regression Analysis Terminology Goodness of fit indicates the strength of the relationship between the cost driver and costs. Residual term measures the difference between actual cost and estimated cost for each observation. The smaller the residual term, the better is the fit between the actual cost observations and estimated costs. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Sample Regression Model Plot Exhibit 10.6 Regression Model for Weekly Indirect Manufacturing Labor Costs (y) and Machine-Hours (X) Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Y = bX+a TC = (VC * Activity)+ FC Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Support for prior calculations Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Evaluating and Choosing Cost Drivers How does a company determine the best cost driver when estimating a cost function? An understanding of both operations and cost accounting is helpful. Three criteria are used: 1. Economic plausibility 2. Goodness of fit 3. Significance of the independent variable Determining the correct cost driver to estimate costs is critical. Identifying the wrong drivers or misestimating cost functions can lead management to incorrect and costly decisions along a variety of dimensions. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Cost Drivers and Activity-Based Costing Estimating cost drivers in an activity-based costing (ABC) system doesn’t differ in general from what’s been discussed. However, since ABC systems have a great number and variety of cost drivers and cost pools, managers must estimate many cost relationships. They will do so using the same methods, taking special care with the cost hierarchy. If a cost is batch-level, for example, only batch-level cost drivers can be used. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Nonlinear Cost Functions Defined Cost functions are not always linear. A nonlinear cost function is a cost function for which the graph of total costs is not a straight line within the relevant range. Some examples of nonlinear cost functions follow. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Nonlinear Cost Functions Examples (1 of 2) 1. Economies of scale (produce double the number of advertisements for less than double the cost). 2. Quantity discounts (direct material costs rise but not in direct proportion to increases in quantity due to the nonlinear relationship caused by the quantity discounts). 3. Step cost functions—resources increase in “lot-sizes,” not individual units. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Nonlinear Cost Functions Examples (2 of 2) 4. Learning curve—a function that measures how labor- hours per unit decline as units of production increase because workers are learning and becoming better at their jobs. 5. Experience curve—measures the decline in the cost per unit of various business functions as the amount of these activities increases. It is a broader application of the learning curve that extends to other business functions in the value chain such as marketing, distribution, and customer service. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Nonlinear Cost Functions Illustrated Exhibit 10.9 Examples of Nonlinear Cost Functions Panel A: Effects of Panel B: Step Variable- Panel C: Step Fixed- Quantity Discounts on Cost Function Cost Function Slope Coefficient of Direct Material Cost Function Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Learning Curves Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Qu 1 Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Qu 2 Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Qu 3 Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Types of Learning Curves Now, we’ll take a look at two learning curve models: Cumulative average-time learning model—cumulative average time per unit declines by a constant percentage each time the cumulative quantity of units produced doubles. Incremental unit-time learning model—incremental time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of units produced doubles. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Sample Cumulative Average -Time Model Exhibit 10.11 Cumulative Average-Time Learning Model for Rayburn Corporation Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Sample Incremental Unit—Time Learning Model Exhibit 10.12 Incremental Unit-Time Learning Model for Rayburn Corporation Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Data Collection and Adjustment Issues The ideal database for estimating cost functions quantitatively has two characteristics: 1. The database should contain numerous reliably measured observations of the cost driver and the related costs. 2. The database should consider many values spanning a wide range for the cost driver. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Data Problems (1 of 3) Managers should ask about these problems and assess how they have been resolved before they rely on cost estimates generated from the data. 1. The time period for measuring the dependent variable does not properly match the period for measuring the cost driver. 2. Fixed costs are allocated as if they are variable. 3. Data are either not available for all observations or are not uniformly reliable. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Data Problems (2 of 3) 4. Extreme values of observations occur. 5. There is no homogeneous relationship between the cost driver and the individual cost items in the dependent variable-cost pool. (A homogeneous relationship exists when each activity whose costs are included in the dependent variable has the same cost driver.) Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved Data Problems (3 of 3) 6. The relationship between the cost driver and the cost is not stationary. This can occur when the underlying process that generated the observations has not remained stable over time. 7. Inflation has affected the costs, the cost driver, or both. Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved