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Determining How Costs Behave

Dr. Hisham Madi

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When managers make decisions, they need to compare the costs (and benefits) among alternative actions

Therefore, managers need to estimate the costs associated with each alternative.

Good decisions require good information about costs; the better these estimates, the better the decision managers will make.

Basic Cost Behavior Patterns

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The most important characteristic of costs for decision making is how they behave— how they vary with activity is the key distinction for decision making.

Therefore, the basic idea in cost estimation is to estimate the relation between costs and the variables affecting costs, the cost drivers

It is focused on the relation between costs and one important variable that affects them: activity level.

Activities can be measured by volume (for example, units of output, machine-hours, pages typed, miles driven), by complexity (for example, number of different products, number of components in a product), or by any other cost driver.

Basic Cost Behavior Patterns

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How to determine cost behaviour

understanding how costs change with changes in activity levels, units of products produced, and so on.

Knowing how costs vary by identifying the drivers of costs and by distinguishing fixed from variable costs is frequently the key to making considered management decisions.

Many managerial functions such as planning and control rely on knowing how costs will behave Should a component part be made or purchased?

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How to determine cost behaviour

Should we make the item or buy it?

What effect will a 20% increase in units sold have on operating profit?

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A cost function is a mathematical function describing cost behaviour patterns – how costs change with changes in the cost driver

Cost functions can be plotted on graph paper by measuring the cost driver on the x-axis and the corresponding amount of total costs on the y-axis

Basic assumptions and examples of cost functions

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Basic assumptions and examples of cost functions

Two assumptions are frequently made when estimating cost functions:1.Variations in the total costs of a cost-object are explained by variations in a single cost driver. 2. Cost behavior is approximated by a linear cost function within

the relevant range.

a relevant range is the range of the activity in which there is a relationship between total cost and the level of activity.

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Cost Terminology

Variable costs

Costs that change in total in relation to some chosen activity or output

Fixed costs

Costs that do not change in total in relation to some chosen activity or output

Mixed costs

Costs that have both fixed and variable components; also called semivariable costs.

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y = a + bX

Linear Cost Function

The dependentvariable:

the cost that isbeing predicted

The intercept:fixed costs

The slope ofthe line:

variable cost per unit

The independent

variable:the cost driver

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Bridging Accounting and Statistical Terminology

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Linear Cost Functions Illustrated

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Criteria for Classifying Variable and Fixed Components of a Cost

Choice of cost object—A particular cost item could be variable with respect to one cost object and fixed with respect to another.

For example, annual van registration and licence costs would be a variable cost with respect to the number of vans owned and operated by PLUS Company.

But registration and licence costs for a particular van are a fixed cost with respect to the number of kilo/meters that the van covered during the year.

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Time span

The longer the period, the more likely the cost will be variable

For example, inspection costs at Boeing Company are typically fixed in the short run with respect to inspection-hours used because inspectors earn a fixed salary in a given year regardless of the number of inspection-hours of work done

But, in the long run, Boeing’s total inspection costs will vary with the inspection-hours required: More inspectors will be hired if more inspection-hours are needed, and some inspectors will be reassigned to other tasks

Criteria for Classifying Variable and Fixed Components of a Cost

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Criteria for Classifying Variable and Fixed Components of a Cost

Relevant rangeBehavior is predictable only within this band of activity.Outside the relevant range, variable and fixed cost-behavior patterns change, causing costs to become nonlinear

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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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The Cause-and-Effect Criterion

The cause-and-effect relationship may arise as a result of:A physical relationship between the level of activity and costs. There is a physical relationship between direct materials and the number of units produced A contractual arrangement. For example, in a car rental contract that charges by the mile, miles driven is specified in the contract as the activity that affects the rental costKnowledge of operations. A product with many parts will incur higher ordering costs than a product with few parts. If the company is measuring ordering costs, the activity driver could be number of parts

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The Cause-and-Effect Criterion

Managers must be careful not to interpret a high correlation, or connection, in the relationship between two variables to mean that either variable causes the other

Be careful not to interpret a high correlation, or connection, between two variables to mean that either variable causes the other

A high correlation between two variables, u and v, indicates merely that the two variables move together

It is possible that u may cause v; v may cause u; u and v may interact; both may be affected by a third variable z; or the correlation may be due to chance

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The Cause-and-Effect Criterion

No conclusions about cause and effect are warranted by high correlations.

For example, higher production generally results in higher materials costs and higher labour costs. Materials costs and labour costs are highly correlated, but neither causes the other.

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