CH 10

CHAPTER 10
Determining
How Costs Behave
2009 Pearson Prentice Hall. All rights reserved.
Learning Objective 1
Explain the two assumptions
frequently used in
cost-behavior estimation.
Cost Functions
A cost function is a mathematical
representation of how a cost changes with

changes in the level of an activity relating to
that cost
Cost Function Assumptions

1. Variations in the level of a single activity
(the cost driver) explain the variations in the

related total costs
2. Cost behavior is approximated by a linear
cost function within the relevant range
Graphically, the total cost versus the level of
a single activity related to that cost is a

straight line within the relevant rage
Bridging Accounting & Statistical

Terminology
Accounting
Statistics
Variable Cost /unit
Slope
Fixed Cost
Intercept
Mixed Cost
Linear Cost Function
y = a + bX
The Dependent
Variable:
The cost that is
being predicted
The Independent
Variable:
The cost driver
The Intercept:
Fixed Costs
The slope of
the line:
variable cost
per unit
Describe linear cost functions
and three common ways in
which they behave.
Linear Cost Functions

Costs usually behave in one of three
commonly encountered manners. They can
be variable, fixed, or semivariable.
A variable cost function represents a cost
that increases in total as the level of the cost
driver increases. The amount by which the
cost increases as the cost driver increases
by one is the slope coefficient, represented
by b in the equation for a cost function.

A fixed cost function is one in which the cost
does not change in response to changes in
the level of activity. It is referred to as the
constant, and is represented by a in the
equation.
A mixed cost function represents a cost that
has both variable and fixed components.

Illustrated
Criteria for Classifying Variable &

Fixed Components of a Cost
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
Choice of Cost Object

Example
If the number of taxis owned by a taxi company
is the cost object, annual taxi registration and
license fees would be variable costs.
If miles driven during a year on a particular taxi
is the cost object, registration and license fees
for that taxi are fixed costs.
The
Relevant
Range
Illustrate
d
Cost Estimation
What is cost estimation?
It is the attempt to measure a past
cost relationship between costs
and the level of an activity.
Past cost-behavior functions can help
managers make more accurate
cost predictions.
Cause & Effect as it relates to

Cost Drivers
The most important issue in estimating a cost
function is determining whether a cause-andeffect relationship exists between the level of

an activity and the costs related to that level
of activity.
Cause & Effect as it relates to

Cost Drivers
A cause-and-effect relationship might arise as
a result of:
A physical relationship between the level of
activity and costs

A contractual agreement
Knowledge of operations
Note: a high correlation (connection) between
activities and costs does not necessarily mean

causality
Understand various approaches
to cost estimation.
Cost Estimation Methods

1. Industrial Engineering Method
2. Conference Method
3. Account Analysis Method
4. Quantitative Analysis Methods
1. High-Low Method
2. Regression Analysis
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, but also costly
and time-consuming
Also called the Work-Measurement Method
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
Reliance on opinions still make this method
subjective
Account Analysis Method

Estimates cost functions by classifying various
cost accounts as variable, fixed or mixed with

respect to the identified level of activity
Is reasonably accurate, cost-effective, and
easy to use, but is subjective
Account Analysis Example

The cost analyst uses experience and
judgment to separate total costs into
fixed and variable.
Avisha & Co. sells software programs.
Total sales = $390,000
The company sold 1,000 programs.

Cost of goods sold = $130,000
Managers salary = $60,000
Secretarys salary = $29,000
Commissions = 12% of sales
What is the total fixed cost?
$60,000 + $29,000 = $89,000

What is the variable cost per unit sold?
Cost of goods sold: $130,000
Commissions: $390,000 .12 = $46,800
($130,000 + $46,800) 1,000 = $176.80
Quantitative Analysis
Uses a formal mathematical method to fit cost
functions to past data observations

Advantage: results are objective
Outline six steps in estimating
a cost function on the basis
of past cost relationships.
Steps in Estimating a Cost Function

Using Quantitative Analysis
1. Choose the dependent variable (the cost
2.
3.
4.
5.
6.
to be predicted)
Identify the independent variable or cost
driver
Collect data on the dependent variable
and the cost driver
Plot the data
Estimate the cost function using the HighLow Method or Regression Analysis
Evaluate the cost driver of the estimated
cost function
Sample Cost Activity Plot
High-Low Method
Simplest method of quantitative analysis
Uses only the highest and lowest observed
values
Steps in the High-Low

Method
1. Calculate variable cost per unit of activity
(c) 2009 Pearson Prentice Hall. All rights reserved.
Steps in the High-Low

Method
2. Calculate Total Fixed Costs
3. Summarize by writing a linear equation
(c) 2009 Pearson Prentice Hall. All rights reserved.
High Low Method Plot
Regression Analysis
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
Is more accurate than the High-Low method
because the regression equation estimates
costs using information from all
observations; the High-Low method uses
only two observations
Types of Regression
Simple estimates the relationship between
the dependent variable and one independent

variable
Multiple estimates the relationship between
the dependent variable and two or more
independent variables
Regression Analysis
The regression equation and regression line
are derived using the least-squares technique.
The objective of least-squares is to develop
estimates of the parameters a and b.
Regression Analysis
The vertical difference (residual term) measures
the distance between the actual cost and the
estimated cost for each observation.
The regression method is more accurate than
the high-low method.
Sample Regression Model

Plot
Describe three criteria used to
evaluate and choose cost drivers.
Terminology
Goodness of Fit indicates the strength of the
relationship between the cost driver and costs
Criteria for Evaluating

Alternative Cost Drivers
1. Economic Plausibility
Do the cost driver and the level of costs
seem to be related? Does it make sense
that an increase in the independent variable
will cause an increase in the costs?
Criteria for Evaluating

Alternative Cost Drivers
2. Goodness of Fit
Are the differences between the actual costs
and predicted costs small? In a regression
analysis, goodness of fit is measured by the r2
statistic.
3. Significance of the Independent Variable
If the regression line (or total cost line) has a
steep slope, this indicates a strong relationship
between the cost driver and the costs incurred.
Explain and give examples
of nonlinear cost functions.
Nonlinearity and Cost

Functions
A nonlinear cost function is a cost function in
which the graph of total costs versus the level
of a single activity is not a straight line within
the relevant range.
Economies of scale
Quantity discounts

Functions
Economies of scale in advertising may enable
an advertising agency to double the number
of advertisements for less than double the cost.
Quantity discounts on direct materials
purchases produce a lower cost per
unit purchased with larger orders.

Functions
A step cost function is a cost function in which the
cost is constant over various ranges of the level
of activity, but the cost increases by discrete
amounts as the level of activity changes
from one range to the next.
Nonlinear Cost Functions

Illustrated
Distinguish the cumulative
average-time learning model
from the incremental
unit-time learning model.
Learning Curves
A learning curve is a function that shows
how labor-hours per unit decline as units
of output increase.
Managers use learning curves to predict
how labor-hours, or labor costs will decrease
as more units are produced.
Experience Curve
This is a function that shows how the costs
per unit in various value chain areas decline
as units produced and sold increase.
An experience curve is a broader application of
a learning curve in which measures the decline
in costs per unit in functions of the value chain
increase.
Types of Learning Curves

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
Sample Cumulative AverageTime Model
Sample Incremental UnitTime Model
Time Learning Model

Comparative Plots
Predicting Costs Using

Alternative
Time
Learning
Suppose variable costs:
Models
Diect MFG labor $20/hour
Overhead
$30/hour

Alternative Time Learning
Models

Alternative
Time
Learning
In setting prices, preparing budgets, and
determining standards a company needs to
Models
consider the learning curve effect. As

production increases to meet demand, cost
per unit decreases. All of this needs to be
factored into the planning undertaken by the
company.
Be aware of data problems
encountered in estimating
cost functions.
The Ideal Database

1. The database should contain numerous
reliably measured observations of the cost

driver and the costs
2. In relation to the cost driver, the database
should consider many values spanning a
wide range
Data Problems
1. The time period for measuring the
dependent variable does not 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
Data Problems
4. Extreme values of observations occur from
errors in recording costs

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
Data Problems
6. The relationship between the cost driver
and the cost is not stationary

7. Inflation has affected costs, the driver, or
both

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CHAPTER 10

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

representation of how a cost changes with

2009 Pearson Prentice Hall. All rights reserved.

Cost Function Assumptions

(the cost driver) explain the variations in the

a single activity related to that cost is a

2009 Pearson Prentice Hall. All rights reserved.

Bridging Accounting & Statistical

Variable Cost /unit

Linear Cost Function

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Linear Cost Functions

Linear Cost Functions

2009 Pearson Prentice Hall. All rights reserved.

Linear Cost Functions

2009 Pearson Prentice Hall. All rights reserved.

Criteria for Classifying Variable &

may result in different classification of the

2009 Pearson Prentice Hall. All rights reserved.

Choice of Cost Object

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Cause & Effect as it relates to

function is determining whether a cause-andeffect relationship exists between the level of

2009 Pearson Prentice Hall. All rights reserved.

Cause & Effect as it relates to

A physical relationship between the level of

activity and costs

Note: a high correlation (connection) between

activities and costs does not necessarily mean

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Cost Estimation Methods

2009 Pearson Prentice Hall. All rights reserved.

Estimates cost functions by analyzing the

relationship between inputs and outputs in

2009 Pearson Prentice Hall. All rights reserved.

analysis and opinions about costs and their

2009 Pearson Prentice Hall. All rights reserved.

Account Analysis Method

cost accounts as variable, fixed or mixed with

2009 Pearson Prentice Hall. All rights reserved.

Account Analysis Example

Account Analysis Example

Account Analysis Example

functions to past data observations

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Steps in Estimating a Cost Function

Sample Cost Activity Plot

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Steps in the High-Low

(c) 2009 Pearson Prentice Hall. All rights reserved.

Steps in the High-Low

3. Summarize by writing a linear equation

(c) 2009 Pearson Prentice Hall. All rights reserved.

High Low Method Plot