CHAPTER11

• Cost behavior


  How a cost will react as changes take place in the level of business activity
• Managers who understand how costs behave are better able to predict what costs will be under various operating circumstances
• An understanding of cost behavior under varying conditions is essential to adequate decision making in the planning and control of firm activity
• Planning


  Requires that management make decisions based in part on expectations as to the future
• Control


  The process of using feedback information for comparison with expectations and the implementation of actions on the basis of that comparison
• Cost Analysis is an integral part of the planning and control function
• The key to effective cost prediction lies in an understanding of cost behavior patterns
• Variable costs


  Costs that change in total as the level of activity changes in the short run and within the relevant range
• Relevant range


  The range activity within which assumptions relative to variable cost and fixed cost behavior are valid
• Activity base (cost driver)

  A measure of whatever causes the incurrence of variable cost
• Other activity bases (cost drivers)


  • Number of miles driven by salespersons
  • Number of pounds of laundry cleaned by a hotel
  • Number of calls handled by technical support staff at a software company
  • Number of beds occupied in a hospital
• Variable costs


  • Variable cost per unit is assumed to remain constant within the relevant range
• Examples of variable costs in a manufacturing company


  • Direct materials
  • Direct labor
  • Some manufacturing overhead such as indirect materials, materials handling costs, energy costs, supplies
  • Distribution costs
  • Sales commission
• Examples of variable costs in a merchandising company


  • Cost of Sales
  • Sales Commission
• Examples of variable costs in a service organization


  • Direct labor and materials used to perform the services such as auto repair and consulting
  • Supplies
  • Travel
• Fixed costs


  Costs that remain constant in total regardless of changes in the level of activity within the relevant range
• Fixed cost per unit


  Reacts inversely with change in activity - decreases per unit as the activity level rises and increases per unit as the activity level falls
• Committed fixed costs


  Relate to the investment in facilities, equipment, and the basic organizational structure of a firm - long term in nature and can't be significantly reduced even for short periods of time without seriously impairing the profitability or long-run goals of the organization
• Discretionary fixed costs


  Arise from annual decisions by management to spend in certain fixed cost areas - can be adjusted from year to year or even perhaps during the course of a year if circumstances demand such a modification
• The planned level of activity might affect total discretionary fixed costs, but once the total discretionary fixed costs have been budgeted, they are unaffected by the actual level of activity
• Examples of costs that are generally fixed


  • Rent
  • Insurance
  • Property taxes
  • Supervisory salaries
  • Depreciation
  • Administrative salaries
  • Advertising
• Mixed costs (semivariable costs)


  Contain both variable and fixed cost elements
• Common examples of mixed or semivariable costs


  • Maintenance costs
  • Electric utility costs
• Equation for mixed cost


  Y = a + bx, where Y is the total mixed cost, a is the total fixed cost, b is the variable cost per unit of activity, and x is the level of activity
• Cost estimation


  The process of identifying the relationship between costs and the variables (factors) affecting the costs
• Methods of cost estimation


  • Account analysis method
  • Industrial engineering method or work measurement method
  • Conference method
  • Quantitative analysis of current and past costs relationships
  • High-low method
  • Regression analysis method
• Account analysis method


  • Involves a detailed examination of the data base by accountants and managers who are familiar with it
• Industrial engineering method


  • Estimates cost functions by analyzing the physical relationship between inputs and outputs
• Steps in applying the engineering method of estimating costs

  1. Study of the physical relation between the quantities of inputs (material, labor, etc.) and each unit of output

  2. Detailed step-by-step analysis of each phase of the manufacturing process together with the kinds of work performed, and time to perform each step

  3. Engineering estimates of the materials required for each unit of production are obtained from drawings and specifications sheets

  4. Costs are then assigned to each of the physical inputs (wages, material price, insurance charges, etc.) to estimate the cost of the outputs
• One advantage to the engineering approach is that it can detail each step required to perform an operation
• Engineering method of estimating costs


  Steps:

  1. Study of the physical relation between each unit of output (finished product) and the quantities of inputs (material, labor, etc.) and step-by-step analysis of each manufacturing process together with the kinds of work performed, and time to perform each step

  2. Engineering estimates of the materials required for each unit of production are obtained from drawings and specifications sheets

  3. Costs are then assigned to each of the physical inputs (wages, material price, insurance charges, etc.) to estimate the cost of the outputs
• Advantages of engineering method


  • It can detail each step required to perform an operation, enabling the company to review its manufacturing productivity and identify specific strengths and weaknesses
  • It can be used to estimate costs for totally new activities because it does not require data from prior activities in the organization
• Disadvantages of engineering method


  • It can be quite expensive to use because each activity is using engineering norms and expert engineers which are costly
  • Engineering estimates are often based on optimal condition
  • It is also difficult to estimate the indirect costs of production
• Conference method


  Cost functions are estimated based on the analysis and opinions about costs and their drivers obtained from various departments of an organization such as purchasing, process engineering, manufacturing, employee relations and so on
• Advantages of conference method


  • It allows quick development of cost functions and estimates
  • Its credibility is gained through the pooling of expert knowledge from each value-chain area
• Disadvantages of conference method


  • The accuracy of the cost estimates is dependent largely on the objectivity, care, and the detail taken by the people providing the inputs or information
• High-Low method


  Analyzing mixed costs based on costs observed at both the high and low levels of activity within the relevant range
• Steps in applying High-Low cost estimation


  Obtain relevant data on past costs and related actual activity levels

  2. Estimate the variable cost per unit or rate

  3. Compute the fixed cost
• Regression analysis


  A statistical method that measures the average amount of change in the dependent variable (costs) that is associated with a unit change of one or more independent variables (cost drivers such as number of units produced, machine hours, etc.)
• Simple regression analysis


  Estimates the relationship between the dependent variable and one independent variable