CHAPTER 10
Determining How Costs Behave
ARDA RADITYA TANTRA
232011071
WA 221 C
1. Learning Objective 1
Explain the two assumptions frequently used in cost-behavior
estimation. Understanding how costs behave is a valuable technical
skill. Basic assumptions and examples of cost function. Variation in the
level of a single activity explain the variations in the related total costs.
Cost behavior can adequately be approximated by a linear function of
the activity level within the relevant range. Changes in total costs can
be explained by changes in the level of a single activity.
2. Learning Objective 2
Describe linear cost functions and three common ways in which they
behave. Cost function is a mathematical expression describing how
costs change with changes in the level of an activity.
Example : Consider the negotiation between Canon Services and
WWC for exclusive use of a telephone line between New York and Paris.
a. $5 per minute used. The slope of the cost function is $5. y = $5x
b. $10,00 per month y = $10,000. $10,000 is called a constant or
intercept. The slope of the cost function is zero.
c. $3,000 per month plus $2 per phone-minute used. This is an
example of a mixed cost.
y = $3,000 + $2x
Cost Classification and Estimation Function has three criteria for
classifying a cost into its
variable and fixed components.
a. Choice of cost object : A particular cost item could bevariable with
respect to one cost object and fixed with respect to another cost
object. 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.
b. Time span : Whether a cost is variable or fixed with respect to a
particular activity depends on the time horizon being considered in
the decision situation. Whether a cost is variable or fixed with
respect to a particular activity depends on the time span. More costs
are variable with longer time spans.
c. Relevant range : Managers should never forget that variable and
fixed cost-behavior patterns are valid for linear cost functions only
within the given relevant range. Variable and fixed cost behavior
patterns are valid for linear cost functions only within the given
relevant range. Costs may behave nonlinear outside the range.
Cost Estimation 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.
The Cause-and-Effect Criterion In Choosing Cost Drivers
a. Physical relationship : An example is when units of production is
used as the activity that affect direct material cost. Producing more
units requires more direct materials, which result in higher total
direct material costs.
b. Contractual agreements : In alternative 1 of the Canon Service
Example described earlier, number of phone-minute used is
specified in the contract as the level of activity that affects the
telephone line costs.
c. Knowledge of operations : An example is when number of parts is
used as the activity measure of ordering costs.
3. Learning Objective 3
Understand various methods of cost estimation.
a. Industrial engineering method : Estimates cost functions by
analyzing the relationship between inputs and outputs in physical
terms. Consider Elegant Rugs.
b. Conference method : Estimates soct functions on the basis of
analysis and opinions about costs and their drivers gathered from
various departments of company.
c. Account analysis method : Estimates cost functions by classifying
various cost accounts as variable, fixed, or mixed with respect to
the identified level of activity.
d. Quantitative analysis methods : This method uses a formal
mathematical method to fit cost functions to past data
observations. Excel is a useful tool for performing Quantitative
analysis.
4. Learning Objective 4
Outline six steps in estimating a cost function on the basis of past cost
relationships.
Steps In Estimating A Cost Function,
Step 1: Choose the dependent variable.
Step 2: Identify the independent variable cost driver(s).
Step 3: Collect data on the dependent variable and the cost
driver(s).
Step 4: Plot the data.
Step 5: Estimate the cost function.
Step 6: Evaluate the estimated cost function.
Regression Analysis is used to measure the average amount of change
in a dependent variable, such as electricity, that is associated with unit
increases in the amounts of one or more independent variables, such as
machine-hours. Regression analysis uses all available data to estimate the
cost function. Simple regression analysis estimates the relationship
between the dependent variable and one independent variable. Multiple
regression analysis estimates the relationship between the dependent
variable and multiple independent variables. 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. 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.
5. Learning Objective 5
Describe three criteria used to evaluate and choose cost drivers.
Criteria to Evaluate and Choose Cost Drivers
a. Economic plausibility : Both cost drivers are economically
plausible.
b. Goodness of fit : The vertical differences between actual cost and
predicted costs and predicted costs are much smaller for the
machine-hours regression than for the direct manufacturing
labour-hours regression.
c. Significance of independent variable : The machine-hours
regression line has a steep slope relative to the slope of the
direct manufacturing labor-hours regression line.
6. Learning Objective 6
Explain and give examples of nonlinear 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 straight line within the
relevant range. 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. A step 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.
7. Learning Objective 7
Distinguish the cumulative average-time learning model from the
incremental unit-time learning model.
Cumulative Average-Time Learning Model. Cumulative average time
per unit declines by a constant percentage each time the cumulative
quantity of units produced doubles. Consider rayburn corporation, a radar
system manufacturer. A learning curve is a function that shows how laborhours per unit decline as units of output increase.
Incremental Unit-Time Learning Model. The time needed to produce the
last unit is reduced by a constant percentage each time the cumulative
quantity of units produced is doubled. This is a function that shows how
the costs per unit in various value chain areas decline as units produced
and sold increase.
8. Learning Objective 8
Be aware of data problems encountered in estimating cost functions.
Data Collection and Adjustment Issues The ideal database for cost
estimation has two characteristics:
a. The database should contains numerous reliably measured
observations of the cost driver(s) and the cost that is the dependent
variable.
b. The database should considers many values spanniong for the cost
driver that span a wide range.
This section outlines some frequently encountered data problems and
steps the cost analyst can take to overcome these problems. Time periods
do not match. Fixed costs are allocated as if they were variable. Data are
either not available or not reliable. Inflation may play a role. Extreme
values of observations occur from errors in recording costs. Analysts
should adjust or eliminate unusual observations before estimating a cost
relationship. There is no homogeneous relationship. The relationship
between the cost driver and the cost is not stationary. The most difficult
task in cost estimation is collecting high-quality, reliably measured data
on the dependent variable and the cost driver(s).