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Lecture 2 Topic 2: Cost behaviour Ref: LS chapter 3

What are cost behaviour, cost 2 estimation and cost prediction?

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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

Cost drivers
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A cost driver is an activity or factor that causes costs to be incurred Conventional approaches to understanding manufacturing cost behaviour assume that production volume is the only cost driver Contemporary viewpoints recognise that there is a range of other possible cost drivers A non-volume cost driver is a cost driver not directly related to production volume

Cost behaviour patterns

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Variable costs change in total in direct proportion to changes in the related level of total activity or volume. Fixed costs do not change in total for a given time period despite wide changes in the related level of total activity or volume.

Cost behaviour patterns

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Assume that bicycle handlebars cost $52 each 1,000 bicycles produced x $52 = $52,000 What is the total handlebar cost when 3,500 bicycles are assembled? 3,500 x $52 = $182,000 This is a variable cost

Cost behaviour patterns Variable Costs

Total costs (Y) $182 000 Y = 52X

$52 000

0 1,000

3,500

Units (X)

Cost behaviour patterns

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The cost driver of variable costs is the level of activity or volume, whose change causes the (variable) costs to change proportionately.
The number of bicycles assembled is the cost driver of the cost of handlebars for a bicycle maker.

Cost behaviour patterns

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Variable costs increase 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
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

Cost behaviour patterns

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Fixed costs As activity increases or decreases total fixed costs do not change but fixed cost per unit changes Fixed cost per unit is often calculated to use in product costs but is of limited use in management decision making as it does not reflect the way that fixed costs actually behave

Cost behaviour patterns

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Assume that Metairie Bicycles incurred $94,500 in a given year for the leasing of its plant. This is an example of a fixed cost with respect to the number of bicycles assembled. This cost will remain unchanged in total over a designated range of the number of bicycles assembled during a given time span.

Cost behaviour patterns

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What is the leasing (fixed) cost per bicycle when Metairie assembles 1,000 bicycles? $94,500 1,000 = $94.50 What is the leasing (fixed) cost per bicycle when Metairie assembles 3,500 bicycles? $94,500 3,500 = $27

Fixed cost per unit of output declines as total output increases

Cost behaviour patterns

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Step-fixed costs - remain fixed over a wide range of activity levels but jump to a different amount for levels outside that range Semi-variable (or mixed) costs - have both fixed and variable components Curvilinear costs - have a curved cost line but they are often approximated as a semi-variable cost function At lower levels of activity there is decreasing variable cost per unit At higher levels of activity there is increasing variable cost per unit

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Engineered, committed and discretionary costs

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The distinction between these types of costs is useful when estimating costs for budgeting and planning purposes Engineered costs Bear a defined physical relationship to the level of output If we know the level of activity, we can predict total cost

Engineered, committed and discretionary costs

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Committed costs Arise from an organisations basic structure and facilities, and are difficult to change in the short term Discretionary costs Are the result of a management decision to spend a particular amount of money for some purpose Can be changed easily

Relevant range

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the range of activity or volume over which a specific relationship between the level of activity or volume and the cost in question is valid. Assume that fixed (leasing) costs are $94,500 for a year and that they remain the same for a certain volume range (1,000 to 5,000 bicycles). 1,000 to 5,000 bicycles is the relevant range.

Relevant range
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If annual demand for Metairies bicycles increases, and the company needs to assemble more than 5,000 bicycles, it would need to lease additional space which would increase its fixed costs.

Relevant range
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Total fixed costs ($000) Relevant Range $ 94.5

1,000

5,000 Volume

Cost estimation
Approaches to cost estimation 1. Managerial judgment Managers use their experience and knowledge rather than formal analysis to classify costs as variable, fixed or semivariable Future costs are estimated by examining past costs and identifying factors that might affect future costs Reliability of cost estimates is dependent upon the ability of the manager

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Cost estimation

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2. The engineering approach Studying processes that result in the incurrence of a cost. The focus is 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 tasks (expensive and timeconsuming) Useful when there is no reliable past data

Cost estimation
3. Quantitative analysis Formal analysis of past data to identify the relationships between costs and activities A scatter diagram can be useful to plot the data points and to visualise the relationship between cost and the level of activity The highlow method involves taking the two observations with the highest and lowest level of activity to calculate the cost function Y = a + bX

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Scatter diagram
Y Total Cost in 1,000s of Dollars
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Draw a line through the data points with about an equal numbers of points above and below the line.

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* * * * Intercept (a) is the

* ** * **
X

estimated fixed cost = $10,000

0 1 2 3 4 Activity, 1,000s of Units Produced

Scatter diagram
The slope (b) is the estimated variable cost per unit. Slope = Change in cost Change in activity

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Y Total Cost in 1,000s of Dollars

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* * * * Horizontal
distance is the change in activity.

* ** * **
Vertical distance is the change in cost.

0 1 2 3 4 Activity, 1,000s of Units Produced

The high-low method

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Wise Co recorded the following production activity and maintenance costs for two months:
Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

High activity level Low activity level Change

Using these two levels of activity, calculate: the variable cost per unit; the fixed cost; and then express the costs in equation form Y = a + bX.

The high-low method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

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Variable cost per unit = Change in cost change in units

The high-low method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

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Variable cost per unit = $2,400 3,000 units

= $0.80 per unit

The high-low method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

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Variable cost = $2,400 3,000 units = $0.80 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)

Fixed cost = $9,800 $6,400 = $3,400

The high-low method

High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

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Variable cost = $2,400 3,000 units = $0.80 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,800 ($0.80 per unit 8,000 units)

Fixed cost = $9,800 $6,400 = $3,400 Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $3,400 + $0.80X

Cost estimation

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Regression analysis a statistical technique that uses a range of observations to determine the cost function used to estimate the relationship between a dependent variable (cost) and one or more independent variables (the cost drivers) Produces the least squares regression line

33 The line of best fit makes 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 than the highlow method as it makes use of all the available data and has statistical properties that allows inferences to be drawn between cost and activity levels

Cost estimation

Cost estimation
Multiple regression analysis This estimates a linear relationship between one dependent variable and two or more independent variables Y = a + b1X1 + b2X2

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The regression line can be evaluated using several criteria:

Economic plausibilitydoes the regression line make sense? Goodness of fithow well does the line fit the data points?

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Practical issues in cost estimation

Data collection problems Missing data Outliersextreme observations of activity or costs (a problem with the High-Low method) Mismatched time periods for dependent and independent variables

Practical issues in cost estimation

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Trade-offs in choosing the time periodthe 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

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Practical issues in cost estimation

All cost functions are based on simplifying assumptions, such as: Cost behaviours depend on a single or only 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 the likely benefits

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Costs in manufacturing businesses

Non-manufacturing costs (period costs) upstream costs downstream costs Manufacturing costs (product costs) direct material direct labour manufacturing overhead

Non-manufacturing Costs
Marketing and selling costs . . .

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Costs necessary to get the order and deliver the product. All executive, organisational, and clerical costs.

Administrative costs . . .

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Product Costs Versus Period Costs

Product costs include direct materials, direct labor, and manufacturing overhead.
Inventory
Cost of Good Sold

Period costs are not included in product costs. They are expensed on the income statement.
Expense

Sale Balance Sheet Income Statement

Income Statement

Balance Sheet
Merchandiser
Current Assets Cash Receivables Prepaid Expenses Merchandise Inventory

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Manufacturer
Current Assets - Cash - Receivables - Prepaid Expenses - Inventories: Raw Materials Work in Process Finished Goods

Balance Sheet

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Work in Process Inventory the products on which manufacture has begun but which are only partly completed at balance date

The Income Statement

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Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.
Merchandising Company
Cost of goods sold: Beg. merchandise inventory $ 14,200 + Purchases 234,150 Goods available for sale $ 248,350 - Ending merchandise inventory (12,100) = Cost of goods sold $ 236,250

Manufacturing Company
Cost of goods sold: Beg. finished goods inv. + Cost of goods manufactured Goods available for sale - Ending finished goods inventory = Cost of goods sold

$ 14,200 234,150 $248,350

(12,100) $236,250

Manufacturing Cost Flows

Costs
Material Purchases Direct Labour

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Balance Sheet Inventories

Raw Materials Work in Process

Income Statement Expenses

Manufacturing Overhead

Finished Goods

Cost of Goods Sold

Selling and Administrative

Period Costs

Selling and Administrative

Inventory Flows
Beginning balance $$

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Additions $$$

Available $$$$$

_
Withdrawals $$$

=
Ending balance $$

Product Costs - A Closer Look

Raw Materials
Beginning raw materials inventory Raw materials purchased Raw materials available for use in production Ending raw materials inventory Raw materials used in production

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Manufacturing Costs
Direct materials + Direct labor + Mfg. overhead = Total manufacturing costs

Work In Process
Beginning work in process inventory Total manufacturing costs Total work in process for the period Ending work in process inventory Cost of goods manufactured.

+ =

+ =

Product Costs - A Closer Look

Work In Process
Beginning work in process inventory Manufacturing costs for the period Total work in process for the period Ending work in process inventory Cost of goods manufactured

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Finished Goods
Beginning finished goods inventory + Cost of goods manufactured = Cost of goods available for sale - Ending finished goods inventory Cost of goods sold

+ = =

Resource Flows

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Assume that beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? a. $276,000 b. $272,000 c. $280,000 d. $ 2,000

Resource Flows

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Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What Beg.used? raw materials $ 32,000 is the cost of direct material + Raw materials a. $276,000 purchased 276,000 b. $272,000 = Raw materials available for use in production $ 308,000 c. $280,000 Ending raw materials inventory 28,000 d. $ 2,000 = Raw materials used
in production $ 280,000

Resource Flows

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Direct materials used in production totaled $280,000. Direct Labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month? a. $555,000 b. $835,000 c. $655,000 d. Cannot be determined.

Resource Flows

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Direct materials used in production totaled $280,000. Direct Labor was $375,000 and factory overhead was Direct Materials $ 280,000 $180,000. What were total manufacturing costs + Direct Labor 375,000 incurred for the month? + Mfg. Overhead 180,000 a. $555,000 = Mfg. Costs Incurred for the Month $ 835,000 b. $835,000 c. $655,000 d. Cannot be determined.

Resource Flows

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Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? a. $1,160,000 b. $ 910,000 c. $ 760,000 d. Cannot be determined.

Resource Flows

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Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the Beginning month. work What in was the process inventory $ 125,000 cost of goods manufactured during the month? + Mfg. costs incurred for the period 835,000 a. $1,160,000 = Total work in process b. $ 910,000 during the period $ 960,000 work in c. $ 760,000 Ending process inventory 200,000 = Cost of goods d. Cannot be determined.
manufactured $ 760,000

Costs in service businesses

Costs are classified in service businesses to provide information for managers decisions Direct labour costs are significant Direct material costs are insignificant Overhead costs may refer to all indirect costs, including production, upstream and downstream costs

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End of lecture 2