Chapter 7

Activity Analysis, Cost Behavior, and Cost Estimation

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Copyright 2008 by The McGraw-Hill Companies, Inc. All

Learning Objective 1

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Introduction
Cost estimation
Process of determining cost behavior, often focusing on historical data.

Cost behavior
Relationship between cost and activity.

Cost prediction
Using knowledge of cost behavior to forecast level of cost at a particular activity. Focus is on the future.

Learning Objective 2

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Copyright 2008 by The McGraw-Hill Companies, Inc. All

Total Variable Cost Example

Your total Pay Per View bill is based on how many Pay Per View shows that you watch.
Total Pay Per View Bill
Number of Pay Per View shows watched

Variable Cost Per Unit Example

The cost per Pay Per View show is constant. For example, $4.95 per show.
Cost per Pay Per View show
Number of Pay Per View shows watched

Step-Variable Costs
Total cost remains constant within a narrow range of activity.

Activity

Cost

Step-Variable Costs
Total cost increases to a new higher cost for the next higher range of activity.

Activity

Cost

Total Fixed Cost Example

Your monthly basic cable TV bill probably does not change no matter how many hours you watch.

Monthly Basic Cable Bill

Number of hours watched

Fixed Cost Per Unit Example

The average cost per hour decreases as more hours are spent watching cable television.
Monthly Basic cable Bill per hour watched

Number of hours watched

Step-Fixed Costs
Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost.

Continue

Step-Fixed Costs
Total cost doesnt change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. 90

Rent Cost in Thousands of Dollars

60

30

1,000 2,000 3,000 Rented Area (Square Feet)

Step-Fixed Costs

How does this type of fixed cost differ from a step-variable cost?

Step-variable costs can be adjusted more quickly and . . . The width of the activity steps is much wider for the step-fixed cost.

Semivariable Cost
A semivariable cost is partly fixed and partly variable.

Consider the following example.

Semivariable Cost
Slope is variable cost per unit of activity.

Total Utility Cost

v mi e ls ota T

iab ar

os ec

Variable Utility Charge Fixed Monthly Utility Charge

Activity (Kilowatt Hours)

Curvilinear Cost

Curvilinear Cost Function

Total Cost

Relevant Range

A straight-line (constant unit variable cost) closely approximates a curvilinear line within the relevant range.

Activity

Learning Objective 3

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Copyright 2008 by The McGraw-Hill Companies, Inc. All

Curvilinear Cost

Curvilinear Cost Function

Total Cost

Relevant Range

A straight-Line (constant unit variable cost) closely approximates a curvilinear line within the relevant range.

Activity

Learning Objective 4

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Copyright 2008 by The McGraw-Hill Companies, Inc. All

Engineered, Committed and Discretionary Costs

Committed
Long-term, cannot be reduced in the short term.

Discretionary
May be altered in the short term by current managerial decisions.

Engineered
Physical relationship with activity measure. Depreciation on Buildings and equipment Direct Materials Advertising and Research and Development

Shifting Cost Structure in the New Manufacturing Environment

A trend toward more fixed costs because of

Increased automation. Stable workforce.

Implications
Managers are more locked-in with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions.

Cost Behavior in Other Industries

Merchandisers
Cost of Goods Sold

Service Organizations
Supplies and travel

Examples of variable costs

Manufacturers
Direct Material, Direct Labor, and Variable Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Cost Behavior in Other Industries

Examples of fixed costs
Merchandisers, manufacturers, and service organizations
Real estate taxes Insurance Sales salaries Depreciation

Learning Objective 5

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Copyright 2008 by The McGraw-Hill Companies, Inc. All

Cost Estimation
Account-Classification Method Visual-Fit Method High-Low Method Least-Squares Regression Method Engineering Method of Cost Estimation

Account Classification Method

Cost estimates are based on a review of each account making up the total cost being analyzed.

Visual-Fit Method
A scatter diagram of past cost behavior may be helpful in analyzing mixed costs.

Visual-Fit Method
Plot the data points on a graph (total cost vs. activity).

Total Cost in 1,000s of Dollars

20

10

* * * *

* ** * **

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

Visual-Fit Method
Draw a line through the plotted data points so that about equal numbers of points fall above and below the line.

Total Cost in 1,000s of Dollars

20

10

* * * *

* ** * **

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

Visual-Fit Method
Estimated fixed cost = $10,000

Total Cost in 1,000s of Dollars

20

10

* * * *

* ** * Vertical distance ** is total cost,

approximately $16,000.

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

The High-Low Method

OwlCo recorded the following production activity and maintenance costs for two months:
Units 9,000 5,000 Cost $ 9,700 6,100

High activity level Low activity level

Using these two levels of activity, compute: the variable cost per unit. the total fixed cost.

The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

v in cost Unit variable cost = v in units

The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit

The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit Fixed cost = Total cost Total variable cost

The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($0.90 per unit 9,000 units)

The High-Low Method

High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600

Unit variable cost = $3,600 4,000 units = $.90 per unit Fixed cost = Total cost Total variable cost
Fixed cost = $9,700 ($.90 per unit 9,000 units) Fixed cost = $9,700 $8,100 = $1,600

Learning Objective 6

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Copyright 2008 by The McGraw-Hill Companies, Inc. All

Regression is a statistical procedure used to determine the relationship between variables such as activity and cost.

Least-Squares Regression Method

Total Cost

The objective of the regression method is the general cost equation: Y = a + bX Activity

Equation Form of Least-Squares Regression Line

Y = a + bX
Total Cost is the dependent variable. The activity (X) is the independent variable.

The intercept term (a) is the estimate of fixed costs.

The X term coefficient (b) is the estimate of variable cost per unit of activity, the slope of the cost line.

 Statistics courses and computer courses deal with detailed regression computations using computer spreadsheet software. Accountants and managers must be able to interpret and use regression estimates.

Least-Squares Regression Method

Multiple Regression
Multiple regression includes two or more independent variables: Y = a + b 1 X 1 + b2 X 2

Terms in the equation have the same meaning as in simple regression with only one independent variable.

Engineering Method of Cost Estimation

Cost estimates are based on measurement and pricing of the work involved.

Engineering Method of Cost Estimation

Direct Labor Direct Material

Analyze the kind of work performed. Estimate the time required for each labor skill for each unit. Use local wage rates to obtain labor cost per unit.

Material required for each unit is obtained from engineering drawings and specification sheets. Material prices are determined from vendor bids.

Effect of Learning on Cost Behavior

As I make more of these things it takes me less time for each one. It must be the learning curve effect that the boss was talking about.

Ive noticed the same thing. And if you include all the variable overhead costs that are also declining, that must be the experience curve.

Learning Curve
Learning effects are large initially.

Average Labor Time per Unit

Learning effects become smaller, eventually reaching steady state.

Cumulative Production Output

Learning Objective 7

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Copyright 2008 by The McGraw-Hill Companies, Inc. All

Data Collection Problems

Missing data. Outlier data points. Mismatched time periods costs. Trade-offs in choosing the time period. Allocated and discretionary costs. Inflation.

End of Chapter 7