Financial & Managerial Accounting for MBAs 5th Edition - Module 15

Peter D.
EASTON
Robert F.
HALSEY
Mary Lea
McANALLY
Al L.
HARTGRAVES
Wayne J.
MORSE
© Cambridge Business Publishers, 2018
FINANCIAL & MANAGERIAL
ACCOUNTING for MBAs5e
Cost Behavior,
Activity Analysis,
and Cost Estimation
MODULE 15

Learning Objective
© Cambridge Business Publishers, 2018 2
Identify basic patterns
of how costs respond to changes
in activity cost drivers.
1

Basic Cost Behavior Patterns
Variable
Costs
Change in total in direct proportion
to changes in activity
Fixed
Costs
Do not change in response to a change
in activity volume
Mixed
Costs
Contain a fixed and variable cost element;
sometimes called semi-variable costs
Step
Costs
Constant within a narrow range of
activity, but shift to a higher level
when activity exceeds the range

Variable Costs
 Increases as activity increases
 Equals zero dollars when activity is zero
Total
variable
costs
(Y)
Total activity (X)
0
Total variable cost: Y = bX
b = Variable cost per unit
Higher variable
cost per unit creates
a steeper line slope.

Fixed Costs
 No change as activity increases or decreases
 No response to short-run changes in activity cost
drivers
Total fixed cost: Y = a
a = Total fixed costs
Total
fixed
costs
(Y)
Total activity (X)
0
Slope is zero,
represented by
a flat line.

Mixed Costs
 Increase in a linear fashion when activity increases
 Positive in amount when activity is zero
Total mixed cost: Y = a + bX
Contains both
fixed and
variable cost
elements.
Total
mixed
costs
(Y)
Total activity (X)
0
Fixed portion
Variable portion

Step Costs
 Increase in a step-like fashion as activity increases
 Total cost shifts to a higher level when activity exceeds
a range
Total step cost: Y = ai
Total step
costs
(Y)
Total activity (X)
0

Shift in Cost Structure
 Total cost function in recent years
 Has shifted to more fixed costs and lower variable
costs
 Important for organizations to manage their fixed
costs
 Example: Vizio acquires television components
rather than manufacturing them
The importance of managers understanding
cost behavior continues to increase efforts
to monitor and minimize total cost.

Cost Behavior Pattern Assumptions
The four cost behavior patterns assume…
 A unit of final output is the primary cost driver
 The time period is too short to incorporate changes in
strategic cost drivers such as the scale of operations
 Causes some costs to be viewed as fixed in the short term,
but appear variable in the long run

Learning Objective
Determine a linear total cost
estimating equation.
2

Total Cost Behavior
Y = a + bX
Total Cost Equation =
Total Fixed Costs + (Variable Costs per Unit x Number of Units)

Relevant Range
 A portion of a range of activity associated with the
fixed cost of the current or expected capacity
 A normal range of activity in which a company
expects to operate, where the fixed costs remain
linear, i.e., total cost remains the same
EXAMPLE
During normal operations, factory space is adequate for Mattel.
However, during the three months preceding the holiday season,
Mattel’s operations are out of the relevant range and storage trailers
must be rented for the additional merchandise.

Relevant Range
Economist’s
total cost function,
referred to as curvilinear
Accountant’s
linear approximation
of total cost function

Marginal Cost
Marginal cost is the varying
increment in total cost of
making one more unit.

Marginal Costs and Activity Levels
Excess capacity
resulting in high
marginal costs
Optimal circumstances
with marginal costs
relatively low
Capacity constraints
resulting in high
marginal costs

Predicting Total Costs with a Graph
Total cost graph is useful
in predicting total costs
for the coming period.
Total
costs
0 100 200 300 400 500
$0
$6,000 -
$5,000 -
$4,000 -
$3,000 -
$2,000 -
$1,000 -
| | | | |
Customer repairs

Unit Variable Costs
$ -
$ -
$ -
$ -
0 -
Costs
Per
unit
100 200 300 400 500
Customer repairs
Unit variable costs
stay the same at
all activity levels.

Average cost graph is useful if a manager wants to
know the cost of serving a customer.
Average Costs
Number of Average Cost
Customers Per customer
100 $35.00
300 $15.00
500 $11.00
Notice: Average costs decrease as the
number of units produced increases.

Classifying Fixed Costs
Classification depends on the immediate impact if
the company attempts to change the fixed costs.
Committed fixed
costs, known also as
capacity costs, are
required to
maintain the
current service or
production capacity
or to fill previous
legal
commitments.
Discretionary
fixed costs,
known also as
managed
fixed costs,
are set at a
fixed amount
each period by
management.

Learning Objective
Calculate and compare
three different approaches
to cost estimation.
3

Cost Estimation
 What is it?
 The determination of the relationship between
activity and cost
 An important part of cost management
 Identifying variable or fixed costs
 Analyzing available accounting records
 Interviews
 Purpose of cost estimation
 Cost prediction
 i.e., forecasting future costs

Estimating Mixed Cost Components
Methods of estimating fixed and variable cost
components
 High-low method
 Scatter diagrams
 Least-squares regression analysis
Variable
Costs
Fixed
Costs
Mixed
Costs

High-Low Cost Estimation
 Uses data from two time periods
 A high activity period, and a low activity period
Select a representative high point and a
representative low activity point.
Step 1:
Subtract total variable costs from total fixed costs
using either the high or low point:
Step 3:
Total costs – [Variable cost per unit × Number of units]
Total Fixed Costs =
Difference in total costs
Difference in activity
Variable costs
per unit
=
Determine variable costs per unit:
Step 2:

High-Low Example: Variable Costs
The variable cost of each unit produced is $2.20.
Low activity period
High activity period
Number of
Shipments
Packaging
Costs
January 8,600 $25,000
February 9,800 26,000
March 11,600 31,600
April 11,200 33,000
Variable cost
per unit (b)
$31,600 – $25,000
11,600 – 8,600
= $2.20
=

High-Low Example: Fixed Costs
Calculate fixed costs:
Variable cost per unit (b) = $2.20 per unit
a = Total costs – Variable costs
$25,000 = a + ($2.20 x 8,600 units)
a = $6,080
January
$31,600 = a + ($2.20 x 11,600 units)
a = $6,080
March
The same total fixed costs result using
either the high or low activity point.

High-Low Cost Estimation
Total Cost Equation: Y = $2.20X + $6,080

Scatter Diagrams
A graph of past activity and cost data, with
individual observations represented by dots.
When used
alone to
estimate costs,
professional
judgment is
required.

Least-Squares Regression
 Also known as simple regression (one variable)
 A mathematical technique to fit a cost-estimating
equation to observed data
 Minimizes the vertical squared difference between
the estimated and actual costs at each data point
 Accomplished using
 Microsoft Excel®
 Statistical software
 Some calculators
 Time consuming math calculations

Least-Squares Criterion
The least-squares method minimizes the sum
of all squared vertical deviations between
individual observations and the cost-estimating line.

Least-Squares Advantage
 Superior to the high-low and scatter diagram
methods
 Because it uses all data points, and
 Does not rely on subjective judgment
 Statistical measures are available to determine
how well the equation fits the line
 Coefficient of determination
 Measures the percent of variation in the dependent
variable that the independent variable explains
 Also called R-squared (R2
)

Simple and Multiple Regression
 Multiple regression
 Often contains more than two variables
 Can be used to determine the effect of individual
product features on the market value of a product
Simple Regression
Equation
(one variable)
Multiple Regression
Equation
(two variables)
Y = a + bX Y = a + b1X1 + b2X2

Cautions in Developing
Cost Estimate Equations
 Managers are responsible for making decisions
 Mathematical models do not make decisions; they
are tools to aid decision making
 Not all data are based on normal
operating conditions
 Nonlinear relationships may exist
 Results should make sense

Learning Objective
Identify and discuss problems
encountered in cost estimation.
4

Cost Estimation Problems:
Technology & Price
Data used in developing
cost estimates must be based
on the same technology.
Changes in
Technology
Data used must reflect
the same price level, or be
restated to a single price level.
Changes in
Prices

Matching Activity & Costs
EXAMPLES
 Cell phone bills arrive at the end of the month, but usage occurs
throughout the month.
 Vehicle mileage is used consistently but maintenance costs
occur every few months.
Actual costs are not known
until a future time period.
Time Lags
Shorter time periods have higher probabilities of
error in matching costs and activities.

Identifying Activity Cost Drivers
 Selection of a driver requires judgment and
professional experience
 Cost driver should have a logical, casual
relationship with costs
 Scatter diagrams and statistical measures are
helpful
Which cost driver should be used?

Learning Objective
Describe and develop
alternative classifications for
activity cost drivers.
5

Unit-Level Cost Behavior
 Assumes changes in costs are best explained
by changes in the number of units of product (or
service provided)
 Inaccurate for analyzing cost behavior when a
company changes…
 From labor-based to automated manufacturing
 From a limited number related products to multiple
products, with variations in volume and complexity
 From a set of similar customers to a diverse set of
customers

Manufacturing Costs
Direct Labor
Wages earned by
production employees
for the time they spend
converting raw materials
into finished products
Manufacturing
Overhead
All manufacturing costs
other than direct
materials and direct
labor
Direct Materials
Cost of primary raw
materials converted
to finished goods
“Direct costs: easily
or directly traceable to
a finished product
or service

Changing Composition
of Total Manufacturing Costs

Changing Composition
of Total Manufacturing Costs
 The problem
 Past tendency was to ignore overhead and focus on
direct materials and labor
 Units produced is no longer adequate in explaining
manufacturing costs
 Dealing with overhead causing activities
 Include non-unit activity drivers
 Hierarchy scheme frameworks
 Manufacturing cost hierarchy, or
 Customer cost hierarchy

Manufacturing Cost Hierarchy
A separate cost driver is selected for each level of cost.
• Performed for each unit of product
produced
Unit level
activities
• Performed for each unit of product
produced
Batch level
activities
• Performed to support the production
of each different type of product
Product level
activities
• Performed to maintain general
manufacturing capabilities
Facility level
activities

Unit Level Activity
This activity is
performed for each
UNIT of product
produced or sold.
Examples
 Cost of raw materials
 Cost of cutting a component
 Cost of a box to package
cereal
 Sales commission
 Cost of paint brushes used by a painting
company to paint an office
building

Batch Level Activity
This activity is
performed for each
BATCH of product
produced or sold.
Examples
 Cost of processing sales orders
 Cost of tracking work orders
 Cost of equipment setup
 Cost of moving a batch
between workstations
 Cost of inspecting batches

Product Level Activity
This activity is performed
to support the production
of each different type
of product.
Examples
 Cost of product development
 Cost of specialized equipment
 Cost of maintaining
specialized equipment

Facility Level Activity
This activity is performed
to maintain general
manufacturing capabilities.
Examples
 Cost of maintaining factory
building and grounds
 Cost of real property taxes
 Cost of non-specialized
equipment
 Cost of general advertising
 Cost of factory supervisor

Customer Cost Hierarchies
for Merchandising and Sales Divisions
 Often used by
 Merchandising organizations
 Sales divisions of manufacturers
 Customer classification scheme
 Unit-level activities
 Order-level activities
 Customer-level activities
 Facility-level activities
Answers questions about the cost of individual
orders or costs of individual customers.

Customer Cost Hierarchy
for Distinct Market Segments
 Often used by companies that sell to distinct market
segments such as:
 Not-for-profit
 For-profit
 Government
 Unit-level activities
 Order-level activities
 Customer-level activities
Answers questions about the profitability of a segment.
 Market-segment-level
activities
 Facility-level activities

Customer Cost Hierarchy
for Unique Projects
 Often used by
 Builders
 Special contracts with the government
 Project-level activities
 Market-segment-level activities
 Facility-level activities
Answers questions about the cost of individual projects.

Financial & Managerial Accounting for MBAs 5th Edition - Module 15

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