Chapter 3

Cost behaviour, cost drivers

and cost estimation

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 Outline
What are cost behaviour, cost
estimation and cost prediction?
Cost drivers
Cost behaviour patterns
The relevant range
Engineered, committed and
discretionary costs
Cost estimation
Practical issues in cost estimation
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 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
Application of cost behaviour to forecast
the level of cost at a set level of activity
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 The relationship between cost
behaviour, cost estimation and
cost prediction

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 Cost drivers
A cost driver Hot ng v yu t m nguyn nhn gy ra chi ph

An activity or factor that causes costs to be

incurred
Prior to the 1980s cost behaviour
estimates assumed that production volume
was the only cost driver
More recent viewpoints recognise that
there are a range of possible cost drivers
other than production volume

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 Types of cost drivers
A non-volume cost driver is a cost
driver that is not directly related to
production volume
Activity-based approaches classify
costs and cost drivers into four levels
Unit
Batch
Product
Facility
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 Activity-based cost drivers
Unit level costs
Uses conventional volume-based cost
drivers
Batch level costs
Based of the group of product units, such
as a batch or a delivery load
Product (or product-sustaining) level
Specific to products or product groups
Facility level
Non-specific cost drivers
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Selecting the best cost drivers
Input or outputs?
Costbenefit considerations will influence
the choice
How detailed should the analysis be?
Increasing cost categories and specific
cost drivers will increase the accuracy of
the resulting information
Long or short term?
Cost behaviour and cost drivers can
(cont.)
change over time
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Selecting the best cost drivers
(cont.)
Cost drivers for cost estimation or cost
management?
Businesses can manage costs by
managing their drivers
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 (cont.)
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Selecting the best cost drivers
(cont.)
The costs and benefits of each driver
must be assessed, taking into account
Reasons for analysing cost behaviour
Timeframe for analysing cost behaviour
Availability of data on cost drivers
Other uses that the cost behaviour
information might serve

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Costs and cost drivers at Tasty Bread

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 Cost behaviour patterns
Cost behaviour
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
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 Variable costs
Variable costs change in total Thay i theo mc
hot ng tuy nhin tng sp th
khng thay i
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

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Variable cost: direct material cost for
wholemeal rolls, Tasty Bread

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 Fixed costs
Khng thay i trn tng s lng tuy nhin thay i trn tng sn phm

Fixed costs remain unchanged in

total but fixed cost per unit changes
Fixed cost per unit does not reflect
the way that fixed costs actually
behave
Contemporary approaches track
these costs to activities to find a cost
driver and very few costs remain fixed

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Fixed cost: premises cost, Tasty Bread

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Other cost behaviour patterns
Step-fixed costs activity
C nh trong 1 activity, tuy nhin s thay i
level cao hn c nh.

Remain fixed over a wide range of activity

levels but change outside that range
Semivariable (or mixed) cost
Has both fixed and variable components
Curvilinear cost
Has a curved cost line
Activity levels impact the marginal cost

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 Step-fixed cost: shop mangers
salaries, Tasty Bread

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Semivariable cost: cost of operating
delivery trucks, Tasty Bread

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 Curvilinear cost: electricity cost,
Tasty Bread

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 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
Outside the relevant range the cost
behaviour pattern may not hold
The range of activity that is relevant for a
particular cost estimate should be
specified
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 Engineered, committed and
discretionary costs
Classifications of costs for budgeting and
planning purposes
Engineered costs Chi ph c tnh

Defined physical relationship to the level of output

When level of activity is known total cost can be
predicted
Committed costs Nhng ci cn thit bt u sn xut
Cost of organisations basic structure and facilities
Discretionary costs Thay i quyt nh nng cao sn xut - Flexible
Management decision to spend money
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 Shifting cost structures in
modern business environments
A decreasing proportion of production
costs no longer vary directly with
production volume
Automation has led to 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

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 Cost estimation

Three approaches to cost estimation

Managerial judgment
Engineering method
Quantitative analysis

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 Managerial judgment
Estimate theo ch quan

Uses experience and knowledge to

classify costs
Estimates future costs by examining
past costs and identifying factors that
might affect costs in the future
Reliability of cost estimates is
dependent upon the ability of the
manager

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 Engineering approach
C c s, cng thc tnh

Studying processes that result in the

incurrence of a cost Nghin cu
Using time and motion studies (task
analysis) for estimating cost behaviour
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 Da trn hot ng
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 Quantitative analysis
Formal analysis of past data to identify
relationships between costs and activities
Methods include:
A scatter diagram plots the data points
The highlow method involves taking the
two observations with the highest and lowest
level of activity to calculate the cost function
Regression analysis uses a range of data
points to estimate the relationship between
cost and cost drivers
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 Regression analysis
Estimates the relationship between a
dependent variable Y(cost) and independent
variables X (cost driver)
Utilises all of the data points to determine the
line of best fit
A simple regression line may be represented
by the equation
Y = a + bX
More accurate than high-low method as it
uses all the data (cont.)

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 Regression analysis (cont.)
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
How well it fits
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 Least squares regression method:
electricity cost, Tasty Bread

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 Practical issues in cost
estimation
Data collection problems
Missing data
Outliersextreme observations of
activity/cost relationships Tri hn so vi nhng cp khc
Mismatched time periods for dependent
and independent variables \;;
Trade-offs in choosing the time period
Allocated fixed costs
Impact of inflation (cont.)

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 Practical issues in cost
estimation (cont.)
Effect of learning on cost behaviour
Labour time per unit decreases as the
labour force gains experience in
manufacturing a new product
Activity-based approaches allow more
complex cost behaviour patterns to be
recognised
Costs are assigned to activities
Unit, batch and product level costs (cont.)

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 Practical issues in cost
estimation (cont.)
Accuracy of cost functions in business
Budgets and cost estimates capture only
approximations of cost behaviours
Limited time and knowledge
Data required to estimate reliable cost
functions may not exist
Low priority given to determining accurate
cost behaviour and cost estimation
Cost estimates considered accurate
(cont.)

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 Practical issues in cost
estimation (cont.)
All cost functions are based on
simplifying assumptions, such as:
Cost behaviours depend on a single or 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 likely benefits (cont.)

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 Practical issues in cost
estimation (cont.)
Simplifying underlying assumptions
Cost behaviour depends on one or a few
activities, whereas costs may be
impacted by a range of factors and costs
Cost behaviours are modelled as linear
lines within the relevant range
Costs and benefits of accurate cost
information
Cost benefit analysis of simplified vs
sophisticated methods required
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 Summary
Understanding cost behaviour enables cost
prediction for planning and control
Conventional cost drivers are volume-based,
but non-volume related cost drivers are
becoming more recognised
Cost behaviours range from variable to fixed
Costs can be estimated using managerial
judgment, engineering methods 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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Example
Yang Manufacturing makes a product called Yin. The
relevant range of operations is between 2500 units and
10 000 units of Yin per month. Per unit costs at two
activity levels are as follows: 5000 units at $17.00 per
unit; 7500 units at $13.00 per unit. Determine their total
cost if Yang produces 10 000 units.
A. $130 000 High: 7500 * 13 = 97500
Low: 5000*17 = 85000
B. $140 000 --> Variable cost : $5/unit
--> Fixed cost: 60000
--> 60000 + 5*10000 = 110000
C. $110 000
D. $150 000

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