Determining

How Costs Behave

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 COST BEHAVIOR PATTERNS
 Understanding cost behavior patterns (i.e., the
relationship between cost and activity) is important to
managers as they plan, control, and make decisions in
the operation of their organizations.
 For example, a manager must understand how costs
behave across various levels of activity before a budget
can be prepared.

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 COST BEHAVIOR PATTERNS
 Cost Estimation: The process of determining cost
behavior. Often focuses on historical data.
 Cost Behavior: The relationship between cost and
activity.
 Cost Prediction: Using knowledge of cost behavior to
forecast the level of cost at a particular level of activity.
Focus is on the future.

 Cost estimation Cost behavior Cost prediction

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Cost Terminology
 Variable Costs – costs that change in total in relation
to some chosen activity or output (cost driver)
 Example: the paper cost in giving exams varies with the
number of students in a class.
 Step-variable costs are nearly variable, but such costs
increase in small steps rather than in direct proportion
to cost-driver changes.
 Example: if a class is a bit larger than usual, an
additional exam proctor may have to be hired. This
increase in part-time hourly help increases by a step as
the class size grows.
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Cost Terminology
 Fixed Costs – costs that do not change in total in
relation to some chosen activity or output
 Example: a professor’s salary is fixed, and more students
enrolled in his or her course will not affect salary.
However, the salary cost per student will vary depending
on class size.
 Step-fixed costs are fixed within a wide range of
activity but will change outside that range
 Example: if a course increases by a large number of
students, it will be necessary to add another section and
hire another instructor. The fixed cost then jumps to
another step.
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Cost Terminology
 Mixed Costs – costs that have both fixed and variable
components; also called semivariable costs
 Example: a printer’s fee for brochures, which includes a
fixed set-up cost and a per-copy (i.e., variable) charge for
running the total copies needed.

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Cost Terminology
 An engineered cost is one that bears a definite
physical relationship to the cost driver.
 Example: the food cost of a restaurant, as it is
impossible to serve more meals without incurring
more food cost.
 Committed costs result from an organization’s
ownership or use of facilities and its basic
organizational structure. These costs cannot be
eliminated without endangering the entity’s overall
health and existence.
 Examples: property taxes, depreciation on buildings
and equipment, top management salaries.
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Cost Terminology
 Discretionary costs exist as the result of a
management decision. In comparison with committed
costs, such costs are more easily changed in bad
economic times without doing serious long-run harm
to the entity.
 Examples: a training program, an advertising campaign,
corporate contributions.
 Fixed costs are becoming more prevalent in many
industries because of automation and labor unions’
success in negotiating for a stable workforce. Costs
that were once variable are becoming fixed, which
makes a company less able to respond rapidly to
changing economic conditions.
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
Cost Terminology
• A curvilinear cost function cannot be
represented with a straight line but instead is
represented with a curve that reflects either
increasing or decreasing marginal costs.
• Relevant range—the range of activity within
which managers expect a company to operate
and within which managers can predict cost
behavior with some certainty.
 Within the relevant range, even curvilinear costs may
behave in a linear fashion.
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Cost Functions
 A cost function is a mathematical representation
(description) of how a cost changes with changes in
the level of an activity relating to that cost
 Cost functions can be plotted on a graph by measuring
the level of activity, such as number of batches
produced or number of hours used, on horizontal axis.
The amount of total costs corresponding to or
dependent on the level of that activity are measured
on the vertical axis

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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 range

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Bridging Accounting & Statistical
Terminology

Accounting Statistics
Variable Cost Slope
Fixed Cost Intercept
Mixed Cost Linear Cost Function

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The Linear Cost Function
y = a + bX
The Dependent The Independent
Variable: Variable:
The cost that is The cost driver
being predicted

The slope of
The Intercept: the line:
Fixed Costs variable cost
per unit

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Linear Cost Functions Illustrated

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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

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The
Relevant
Range
Illustrated

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Cause and Effect as It Relates to
Cost Drivers

 The most important issue in estimating a cost function

is determining whether a cause-and-effect relationship
exists between the level of an activity and the costs
related to that level of activity.
 Without a cause-and-effect relationship, managers will
be less confident about their ability to estimate or
predict costs.

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10-17
Cause and Effect as It Relates to
Cost Drivers, cont’d
A cause-and-effect relationship might arise as a result
of:
 A physical relationship between the level of activity and
the costs. Direct material costs and production are an
example.
 A contractual agreement specify the exact specification
of parts required for an operation.
 Knowledge of operations means that when the cost driver
(number of parts is used as a measure of ordering cost) is
known.

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10-18
Cause and Effect as It Relates to
Cost Drivers, cont’d
Note: A high correlation (connection) between
activities and costs does not necessarily mean
causality. Direct materials costs and labor costs for
Winston Furniture which makes two types of
(otherwise identical) tables, one with granite surface
(10,000) and other with a wooden surface (30,000).
A) 20% of more of each table
B) 20% more but 4,000 granite and 44,000 wooden.
Only a cause-and-effect relationship – not merely
correlation – establishes an economically plausible
relationship between the level of an activity and its
costs.
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Cost drivers & the decision making
process
To correctly identify cost drivers in order to make
decisions, managers should always use a long time
horizon.
Managers should follow the five-step decision-making
process outlined in Chapter 1 to evaluate how changes
can affect costs and product decisions.
1. Identify the problem and uncertainties
2. Obtain information
3. Make predictions about the future
4. Make decisions by choosing among alternatives
5. Implement the decision, evaluate performance, and
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10-20
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

These method are not mutually exclusive and often more

than one is used.

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10-21
Industrial Engineering
Method(work-measurement
method)
 Estimates cost functions by analyzing the relationship
between inputs and outputs in physical terms. Elegant
Rugs uses inputs of cotton, wool, dyes, direct
manufacturing labor, machine time, and power.
Production output is square yards of carpet.
 Includes time-and-motion studies
 Very thorough and detailed, but also costly and time-
consuming
 Also called the Work-Measurement Method

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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, increasing credibility.
 Reliance on opinions makes this method subjective,
though often quicker and less expensive.

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10-23
Account Analysis Method
 The account-classification method (also called
account analysis) requires the study of an account in
the general ledger. The experienced analyst uses the
account information as well as his or her own
judgment to determine future cost behavior
 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
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Account Analysis Method
 Estimates cost functions by classifying various cost
accounts as variable, fixed, or mixed with respect to
the identified level of activity.
 Typically, managers use qualitative rather than
quantitative analysis when making these cost-
classification decisions.
 Widely used because it is reasonably accurate, cost-
effective, and easy to use, but is subjective.

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10-25
Quantitative Analysis
 Uses a formal mathematical method to fit cost
functions to past data observations.
 Advantage: results are objective.
 Advantage: most rigorous approach to estimate costs.
 Challenge: requires more detailed information about
costs, cost drivers, and cost functions and is therefore
more time-consuming.

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10-26
Quantitative Analysis Method
 Uses a formal mathematical method to fit cost
functions to past data observations
 Advantage: results are objective

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Steps in Estimating a Cost Function Using
Quantitative Analysis
1. Choose the dependent variable (the cost to be
predicted)
2. Identify the independent variable or cost driver
3. Collect data on the dependent variable and the
cost driver
4. Plot the data
5. Estimate the cost function using the High-Low
Method or Regression Analysis
6. Evaluate the cost driver of the estimated cost
function

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AN EXAMPLE
Week Cost Driver : Indirect Manufacturing:
machine Hours Labor Costs ($)
(X) (Y)
1 68 1,190
2 88 1,211
3 62 1,004
4 72 917
5 60 770
6 96 1,456
7 78 1,180
8 46 710
9 82 1,316
10 94 1,032

11 68 752
12 48 963
Total 862 12,501
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 Visual-Fit method
 With the visual-fit method, an analyst examines a
cost by plotting points on a graph (called a scatter
diagram) and places a line through the points to yield
a cost function.
 This method is more objective than the account-
classification method, but it is still lacking because
two cost analysts could visually fit different lines.

 The visual-fit method is useful because it helps spot
nonrepresentative data points, or outliers.
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Sample Cost – Activity Plot

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High-Low Method
 Simplest method of quantitative analysis
 Uses only the highest and lowest observed values

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Steps in the High-Low Method

1. Calculate variable cost per unit of activity

Variable Cost associated with Cost associated with

Cost per = { highest activity level - lowest activity level }
Unit of Activity Highest activity level - Lowest activity level

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Steps in the High-Low Method
2. Calculate Total Fixed Costs
Total Cost from either the highest or lowest activity level
- (Variable Cost per unit of activity X Activity associated with above total cost)
Fixed Costs

3. Summarize by writing a linear equation

Y = Fixed Costs + ( Variable cost per unit of Activity * Activity )

Y = FC + (VCu * X)

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AN EXAMPLE
Week Cost Driver : Indirect Manufacturing:
machine Hours Labor Costs ($)
(X) (Y)
1 68 1,190
2 88 1,211
3 62 1,004
4 72 917
5 60 770
6 96 1,456 Highest Level
7 78 1,180
8 46 710 lowest level
9 82 1,316
10 94 1,032

11 68 752
12 48 963
Total 862 12,501
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High low Method
Cost Driver: Indirect Manufacturing
Machine Hours (X) Labor Costs(Y)
Highest observation of cost driver ( week 6) 96 1,456
lowest observation of cost driver ( week 8) 46 710
Difference 50 746
The Slope Co-efficient is calculated as:

Difference between costs associated with Highest and

Lowest observations of the cost driver
Slope Co-efficient = ____________________________________________

Difference between Highest and Lowest observations of the

cost driver

= 746/50 Machine hours

= $14.92 per machine-hour

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High low Method
 At the highest observation of the cost driver, the
constant, a, is calculated as :
Constant= $1,456-($14.92 per machine hr * 96 Machine hrs) = $23.68
 At the lowest observation of the cost driver
Constant= $710-($14.92 per machine hr * 46 Machine hrs) = $23.68
 Thus, the high-low estimate of the cost function is :
Y= a + bX
Y= $23.68 + ($14.92 per Machine Hr * Number of Machine Hrs)

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High – Low Method Plot

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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

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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

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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 is widely used because it helps
managers understand why costs behave as they do and
what managers can do to influence them.

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10-41
AN EXAMPLE
Week Cost Driver : Indirect Manufacturing:
machine Hours Labor Costs ($)
(X) (Y)
1 68 1,190
2 88 1,211
3 62 1,004
4 72 917
5 60 770
6 96 1,456
7 78 1,180
8 46 710
9 82 1,316
10 94 1,032

11 68 752
12 48 963
Total 862 12,501
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Sample Regression Model Plot

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AN EXAMPLE
Month Cost Driver : Indirect Manufacturing:
Direct Labor Hours Electricity Costs ($)
(X) (Y)
January 34,000 640
February 30,000 620
March 34,000 620
April 39,000 590
May 42,000 500
June 32,000 530
July 26,000 500
August 26,000 500
September 31,000 530
October 35,000 550

November 43,000 580

December 48,000 680
Total 420,000 6,840
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Alternative Regression Model Plot

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Terminology
 Goodness of Fit – indicates the strength of the
relationship between the cost driver and costs
 Residual Term – measures the distance between actual
cost and estimated cost for each observation

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Evaluating and choosing
Cost Drivers
How does a company determine the best cost driver
when estimating a cost function? An understanding
of both operations and cost accounting is helpful.
Here are the three criteria used:
1. Economic plausibility
2. Goodness of fit
3. Significance of the independent variable.

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10-47
Evaluating and choosing
Cost Drivers – significance of

QUESTION: Why is choosing the correct cost driver to

estimate costs important?

ANSWER: Identifying the wrong drivers or

misestimating cost functions can lead management to
incorrect and costly decisions along a variety of
dimensions.

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10-48
Cost drivers and activity-based
costing
Estimating cost drivers in an activity-based costing
system doesn’t differ in general from what’s been
discussed.
However, since ABC systems have a great number and
variety of cost drivers and cost pools, managers must
estimate many cost relationships.
They will do so using the same methods, taking special
care with the cost hierarchy. If a cost is batch-level, for
example, only batch-level cost drivers can be used.

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10-49
Nonlinear cost functions,
defined
 Cost functions are not always linear.
 A nonlinear cost function is a cost function for
which the graph of total costs is not a straight
line within the relevant range.
 Some examples of nonlinear cost functions
follow.

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10-50
Nonlinear Cost Functions,
examples
1. Economies of scale (produce double the number
of advertisements for less than double the cost).
2. Quantity discounts (direct material costs rise but
not in direct proportion to increases in quantity
due to the nonlinear relationship caused by the
quantity discounts).
3. Step cost functions—resources increase in “lot-
sizes”, not individual units.

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10-51
Nonlinear Cost Functions,
examples cont’d
4. Learning curve—a function that measures how
labor-hours per unit decline as units of production
increase because workers are learning and
becoming better at their jobs.
5. Experience curve —measures the decline in the
cost per unit of various business functions as the
amount of these activities increases. It is a
broader application of the learning curve that
extends to other business functions in the value
chain such as marketing, distribution and
customer service.

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10-52
Nonlinear Cost Functions
Illustrated

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10-53
Nonlinear Cost Functions Illustrated

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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.

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10-55
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

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Sample Cumulative Average-Time
Model

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Sample Incremental Unit-Time
Model

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Time Learning Model Comparative
Plots

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Predicting Costs Using Alternative
Time Learning Models

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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

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Data Problems
 The time period for measuring the dependent variable
does not match the period for measuring the cost
driver
 Fixed costs are allocated as if they are variable
 Data are either not available for all observations or are
not uniformly reliable

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Data Problems
 Extreme values of observations occur from errors in
recording costs
 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

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Data Problems
 The relationship between the cost driver and the cost
is not stationary
 Inflation has affected costs, the driver, or both

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