Cost behaviour, cost drivers and cost estimation

Chapter 3Cost behaviour, cost drivers and cost estimation3-1Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOutlineWhat are cost behaviour, cost estimation and cost prediction?Cost driversCost behaviour patternsThe relevant rangeEngineered, committed and discretionary costsCost structures in modern business environmentsCost estimationPractical issues in cost estimation3-2Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithWhat are cost behaviour, cost estimation and cost prediction?Cost behaviourThe relationship between a cost and the level of activity or cost driverCost estimationThe process of determining the cost behaviour of a particular cost itemCost predictionUsing knowledge of cost behaviour to forecast the level of cost at a particular level of activity 3-3Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCopyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-4Cost driversA cost driverAn activity or factor that causes costs to be incurredConventional approaches to understanding cost behaviour assume that production or sales are the only cost driverVariable costs are assumed to vary in proportion to the level of production volumeFixed costs remain unchanged as production costs increase or decreaseVolume-based cost drivers include units produced, direct labour hours, direct labour cost and machine hours3-5Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost drivers (cont.)Contemporary viewpoints recognise that there are a range of possible cost drivers other than production volume A non-volume cost driver is a cost driver not directly related to production volumeActivity-based approaches classify activities and costs into four levelsUnitBatch ProductFacility3-6Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost drivers (cont.)Unit level costsRelate to activities performed for each unit producedUse conventional volume-based cost driversBatch level costsRelate to activities performed for a group of product units, such as a batch or a delivery loadProduct (or product-sustaining) levelRelates to activities performed for specific products or product groupsFacility level Costs incurred to run the business, not caused by any particular product3-7Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost drivers (cont.)Selecting the best cost driversInput or outputs?Example of an input cost driver is the weight of materialExample of an output driver is the volume of productionCost–benefit principles will determine the choiceHow detailed should the analysis be?As the number of cost categories increases, the accuracy of the resulting information should increaseAgain, cost–benefit criteria are importantLong or short term?Cost behaviour and cost drivers can change over timeChoice depends on the intended purpose of the cost analysis3-8Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost drivers (cont.)Cost drivers for cost estimation or cost management?Cost drivers that are used to predict costs may differ from those used to manage costsEffective cost management requires the identification of root cause cost driversThe basic factors that cause a cost to be incurredSearch for the true causes of costs3-9Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost drivers (cont.)When choosing cost drivers the costs and benefits of each driver must be assessed, taking into accountReasons for analysing cost behaviour, such as cost prediction, product costing, cost management, pricingTimeframe for analysing the cost behaviour (short term or long term)Availability of data on cost driversAny other uses that the cost behaviour information might serve3-10Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCopyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-11Cost behaviour patternsCost behaviour The relationship between a cost and the level of activity (or cost driver)Cost behaviour patternsVariable costsFixed costsStep-fixed costsSemivariable costsCurvilinear costs3-12Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost behaviour patterns (cont.)3-13Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithVariable costsTotal variable costs increase in direct proportion to changes in the level of activity but the variable cost per unit remains constantThe variable cost per unit is the slope of the cost line in the following cost function: Y = a + bXWhere 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(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-14Cost behaviour patterns (cont.)Fixed costsAs activity increases or decreases total fixed costs do not change but fixed cost per unit changesFixed 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 behaveContemporary approaches to cost analysis recognise that there are cost drivers for some of these fixed costs and very few costs remain fixed3-15Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-16Cost behaviour patterns (cont.)Step-fixed costsRemain fixed over a wide range of activity levels but jump to a different amount for levels outside that rangeSemivariable (or mixed) costHas both fixed and variable componentsCurvilinear costHas a curved cost line but is often approximated as a semivariable cost functionAt lower levels of activity there is decreasing marginal costAt higher levels of activity there is increasing marginal cost3-17Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-18Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-19Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-20Cost behaviour and the relevant rangeThe relevant range is the range of activity over which a particular cost behaviour pattern is assumed to be valid. For example,The relevant range for the variable cost of electricity may hold for 200 to 800 batches of production per month, but outside of that range the variable cost per unit may differThe direct material cost per unit may only hold for production up to 1000 units per day, and for higher volumes the cost per unit may decrease due to cheaper cost of buying material in larger quantitiesThe range of activity which is relevant for a particular cost estimate should be specified3-21Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithEngineered, committed and discretionary costsDistinction is useful when estimating costs for budgeting and planning purposesEngineered costsBear a defined physical relationship to the level of outputIf we know the level of activity, we can predict total costCommitted costsArise from an organisation’s basic structure and facilities, and are difficult to change in the short termDiscretionary costsAre the result of a management decision to spend a particular amount of money for some purposeCan be changed easily3-22Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithShifting cost structures in modern business environmentsA decreasing proportion of production costs no longer vary directly with production volumeAs production becomes more automated there is less reliance on labour and more reliance on equipment. Equipment costs do not vary with production volumeSome employee wage agreements specify fixed salaries and a stabilised workforceWages do not vary with production activity levelsMore difficult to change the number of staff employed as activity levels change3-23Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCost estimationApproaches to cost estimationManagerial judgment Engineering approachQuantitative analysisManagerial judgmentUsing experience and knowledge rather than formal analysis to classify costs as variable, fixed or semivariableFuture costs are estimated by examining past costs and identifying factors that might affect future costsReliability of cost estimates is dependent upon the ability of the manager3-24Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost estimation (cont.)The engineering approachStudying processes that result in the incurrence of a costFocuses on the relationships that should exist between inputs and outputsUsing time and motion studies (or task analysis), where employees are observed as they undertake tasksThese techniques are expensive and time-consumingUseful when there is no reliable past data on which to base cost estimatesMost effective when there is a direct relationship between inputs and outputsActivity-based approaches extend task analysis to the study of indirect activities and costs3-25Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost estimation (cont.)Quantitative analysisFormal analysis of past data to identify the relationships between costs and activitiesA scatter diagram can be useful to plot the data points and to visualise the relationship between cost and the level of activityThe high–low method involves taking the two observations with the highest and lowest level of activity to calculate the cost functionRegression analysis is a statistical technique that uses a range of observations to determine the cost function3-26Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost estimation (cont.)Regression analysisA statistical technique used to estimate the relationship between a dependent variable (cost) and independent variables (cost driver)The line of best fit makes deviations between the cost line and the data points as small as possibleSimple regression involves estimating the relationship between the dependent variable (Y) and one independent variable (X) Y = a + bXMore accurate than high–low method as it makes use of all data and has statistical properties that allows inferences to be drawn between cost and activity levels3-27Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Cost estimation3-28Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithRegression analysisMultiple regression estimates a linear relationship between one dependent variable and two or more independent variablesY = a + b1X1 + b2X2The regression line can be evaluated using several criteria:Economic plausibility—does the regression line make sense?Goodness of fit—how well does the line fit the data points?Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith3-29Practical issues in cost estimationData collection problemsMissing data Outliers—extreme observations of activity or costsMismatched time periods for dependent and independent variablesTrade-offs in choosing the time period—the number of observations compared to the reliability of past data points as predictors of future cost behaviourAllocated fixed costs may be misleadingInflation may cause past cost data to be less relevant3-30Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Practical issues in cost estimation (cont.)Effect of learning on cost behaviourIn estimating labour costs for relatively new products or processes, labour times per unit may decrease at varying ratesActivity-based approaches allow more complex cost behaviour patterns to be consideredCosts are assigned to activitiesUnit, batch and product level costs are assumed to vary in proportion to their cost drivers3-31Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Practical issues in cost estimation (cont.)The accuracy of cost functionsSometimes budgets and cost estimates capture only approximations of cost behavioursWhy?Limited time and knowledge to undertake appropriate quantitative techniquesThe data required to estimate reliable cost functions may not existA low priority may be given to determining accurate cost behaviour and cost estimation Subjective cost estimates may be considered good enough for the firm’s needs3-32Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Practical issues in cost estimation (cont.)All cost functions are based on simplifying assumptions, such as:Cost behaviours depend on a single or only a few types of activityCost behaviours are linear within a relevant rangeCosts of producing more accurate cost estimates need to be assessed against the likely benefits3-33Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithSummaryUnderstanding cost behaviour allows cost prediction for planning and controlConventional cost drivers are volume-based, but more recently may be non-volume relatedCost behaviours range from variable to fixedCosts can be estimated using managerial judgment, engineering approaches and quantitative techniquesCost estimation is fraught with a range of practical difficulties, and the choice of technique involves a cost-benefit trade-off3-34Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith