activity analysis, cost behavior, and cost estimation 2

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7-1

Activity Analysis, Cost

Behavior, and CostEstimation

Chapter Seven



McGraw-Hill/Irwin

7-2

Costprediction

Using knowledgeof cost behavior

to forecastlevel of cost at

a particularactivity. Focusis on the future.

Introduction

Costbehavior

Relationshipbetweencost andactivity.

Process ofdetermining

cost behavior,often focusingon historical

data.

Costestimation



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7-3

Cost Behavior Patterns

Recall the summary of our cost behaviordiscussion from Chapter 2.

Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit

Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over

wide ranges of activity.

Total fixed cost remains Fixed cost per unit

Fixed the same even when the goes down as activity

activity level changes. level goes up.



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7-4

Total Variable Cost Example

Your total long distance telephone bill isbased on how many minutes you talk.

Minutes Talked

T o t a l L

o n g D i s t a n c e

T e l e

p h o n e B i l l


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7-5

Variable Cost Per Unit Example

Minutes Talked

P e

r M i n u t e

T e l e p h

o n e C h a r g e

The cost per long distance minute talked isconstant. For example, 5 cents per minute.



7-6

Total Fixed Cost Example

Your monthly basic telephone bill probablydoes not change when you make more local

calls.

Number of Local Calls

M o n

t h l y B a s i c

T e l e p h o n e B i l l



7-7

Fixed Cost Per Unit Example

Number of Local Calls

M o n t h l y B a s i c T e l e p h o

n e

B i l l p e r L o c a l C a l l

The average cost per local call decreases asmore local calls are made.



7-8

Step-Variable Costs

Activity

C o

s t

Total cost remainsconstant within anarrow range of

activity.



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Step-Variable Costs

Activity

C o

s t

Total cost increases to anew higher cost for thenext higher range of

activity.



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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.

Step-Fixed Costs

Continue



7-11

R e n t C o s t i n

T h o u s a n d s o f D

o l l a r s

0 1,000 2,000 3,000Rented Area (Square Feet)

0

30

60

90

Total cost doesn’t

change for a widerange of activity,

and then jumps to anew higher cost for

the next higher

range of activity.

Step-Fixed Costs



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Step-variable costscan be adjusted more

quickly and . . .

The width of theactivity steps is much

wider for thestep-fixed cost.

How does this type

of fixed cost differfrom a step-variable

cost?

Step-Fixed Costs



7-13

A semivariable

cost is partlyfixed and partly

variable.

Semivariable Cost

Consider thefollowing electric

utility example.



7-14

Fixed Monthly

Utility Charge

Variable

Utility Charge

Activity (Kilowatt Hours)

T o t a l U t i l i t y C o s t

Semivariable CostSlope is

variable costper unit

of activity.



7-15

Curvilinear CostCurvilinear

Cost Function

Relevant Range

Activity

T o t a l C o s

t

Curvilinear

Cost Function

A straight-Line(constant unit variable

cost) closelyapproximates a

curvilinear line withinthe relevant range.



7-16

Engineered, Committed and

Discretionary Costs

Discretionary

May be altered in theshort term by currentmanagerial decisions.

Committed

Long-term, cannot bereduced in the short

term.

Engineered

Physical relationship

with activity measure.

Depreciation onBuildings and

equipment

Advertising andResearch andDevelopment

DirectMaterials



7-17

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 aredifficult to change with current operating decisions.



7-18

Cost Behavior in Other Industries

Merchandisers Cost of Goods Sold

Manufacturers

Direct Material, DirectLabor, and Variable

Manufacturing Overhead

Merchandisers andManufacturers

Sales commissions andshipping costs

Service Organizations

Supplies and travel

Examples of variable costs



7-19

Examples of fixed costs

Merchandisers, manufacturers, andservice organizations

Real estate taxesInsurance

Sales salariesDepreciationAdvertising

Cost Behavior in Other Industries



7-20

Account-Classification Method

Visual-Fit Method

High-Low Method

Least-Squares Regression Method

Cost Estimation

Engineering Method of Cost Estimation



7-21

Account Classification Method

Cost estimates are based on areview of each account making up

the total cost being analyzed.



7-22

Overhead Costs for 1,000 Units

Total Variable Fixed

Account Cost Cost Cost

Indirect Labor 450$ 450$Indirect Material 700 700

Depreciation 1,000 1,000

Property Taxes 200 200

Insurance 300 300

Utilities 400 350 50 Maintenance 600 500 100

Totals 3,650$ 2,000$ 1,650$

Account Classification Method

Example



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A scatter diagram of past cost behaviormay be helpful in analyzing mixed costs.

Visual-Fit Method



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Plot the data points on agraph (total cost vs. activity).

0 1 2 3 4

*

T o t a l C o s t i n

1 , 0

0 0

’ s o f D o l l a r

s

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

Visual-Fit Method



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Draw a line through the plotted data points so that aboutequal numbers of points fall above and below the line.

Visual-Fit Method

0 1 2 3 4

*


1 , 0

0 0


s

10

20

0

***

**

**

*

*




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Visual-Fit Method

Vertical distanceis total cost,

approximately$16,000.

0 1 2 3 4

*


1 , 0

0 0


s

10

20

0

***

**

**

*

*


Estimated fixed cost = $10,000



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Visual-Fit Method



0 1 2 3 4

*


1 , 0

0 0


s

10

20

0

***

**

**

*

*



Total variable cost = Total cost – Total fixed cost

Total variable cost = $16,000 – $10,000 = $6,000



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Visual-Fit MethodTotal variable cost = Total cost – Total fixed cost

Total variable cost = $16,000 – $10,000 = $6,000Unit variable cost = $6,000 ÷ 3,000 units = $2



0 1 2 3 4

*


1 , 0

0 0


s

10

20

0

***

**

**

*

*





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OwlCo recorded the following production activityand maintenance costs for two months:

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

The High-Low Method

Units Cost

High activity level 9,000 9,700$Low activity level 5,000 6,100

Change 4,000 3,600$

7 30



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Units CostHigh activity level 9,000 9,700$

Low activity level 5,000 6,100

Change 4,000 3,600$

The High-Low Method

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Change 4,000 3,600$

Unit variable cost =in costin units

The High-Low Method

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Change 4,000 3,600$

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

The High-Low Method

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Change 4,000 3,600$


Fixed cost = Total cost – Total variable cost

The High-Low Method

7 34



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Change 4,000 3,600$



Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)

The High-Low Method

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Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)



Change 4,000 3,600$

The High-Low Method

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Change 4,000 3,600$

Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit


Fixed cost = $9,700 – ($.90 per unit × 9,000 units)

Fixed cost = $9,700 – $8,100 = $1,600

The High-Low Method

7 37



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The High-Low Method Question 1

If sales commissions are $10,000 when 80,000 unitsare sold and $14,000 when 120,000 units are sold,what is the variable portion of sales commission per

unit sold?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit

7 38



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$4,000 ÷ 40,000 units= $.10 per unit

If sales commissions are $10,000 when 80,000 unitsare sold and $14,000 when 120,000 units are sold,what is the variable portion of sales commission per

unit sold?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit

Units Cost

High level 120,000 14,000$

Low level 80,000 10,000

Change 40,000 4,000$

7-39



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If sales commissions are $10,000 when 80,000 unitsare sold and $14,000 when 120,000 units are sold,what is the fixed portion of the sales commission?

a. $ 2,000

b. $ 4,000

c. $10,000d. $12,000

7-40



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7-40

If sales commissions are $10,000 when 80,000 unitsare sold and $14,000 when 120,000 units are sold,what is the fixed portion of the sales commission?

a. $ 2,000

b. $ 4,000

c. $10,000d. $12,000


Total cost = Total fixed cost +

Total variable cost

$14,000 = Total fixed cost +

($.10 × 120,000 units)

Total fixed cost = $14,000 - $12,000

Total fixed cost = $2,000

7-41



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Regression is a statistical procedure usedto determine the relationship between

variables such as activity and cost.


Activity

T o t

a l C o s t The objective of

the regressionmethod is the

general cost equation:Y = a + bX

in cost termsTC = F + VX

7-42

E i F f L S



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TC = F + VX

Total Cost is thedependent variable.

The activity (X) is theindependent variable.

The X term coefficient (V)is the estimate of variablecost per unit of activity,

the slope of the cost line.

The intercept term (F) isthe estimate of fixed costs.

Equation Form of Least-Squares

Regression Line

7-43



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Statistics courses andcomputer courses dealwith detailed regressioncomputations usingcomputer spreadsheetsoftware.

Accountants andmanagers must be ableto interpret and useregression estimates.


7-44



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Goodness of Fit

0 1 2 3 4

T o

t a l C o s t

10

20

0

Activity

****

**

****

Goodness of fit is a measure of thevariation of the dependent variable that

is explained by the independent variable.

Goodness of fit is high here as the datapoints are close to the regression line.

7-45



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Multiple Regression

Multiple regression includes two or moreindependent variables:

Terms in the equation have the samemeaning as in simple regression with

only one independent variable.

TC = FC + V1X1 + V2X2

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Data Collection Problems

Missing data.

Outlier data points.

Mismatched time periods costs.

Trade-offs in choosing the time period.

Allocated and discretionary costs.

Inflation.

7-47

Eff t f L i



McGraw-Hill/Irwin

Effect of Learning

on Cost Behavior

As I make more of thesethings it takes me less

time for each one. It mustbe the learning curve effect

that the boss was

talking about.

I’ve noticed the samething, but I’m not

improving my times asmuch as I did earlier. Imust be reaching whatthey call steady state.

7-48

Eff t f L i



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A systematic relationship betweenthe amount of experience in

performing a task and the time

required to carry out the task.

Effect of Learning

on Cost Behavior

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Eff t f L i



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A systematic relationship betweenthe amount of experience in

performing a task and the time

required to carry out the task.

The average time per task declinesby a constant percentage each time

the quantity of tasks doubles.

Effect of Learning

on Cost Behavior

7-50

Eff t f L i



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Effect of Learning

on Cost Behavior

BerryCo. makes products requiring laborthat follows an 80 percent learning rate.

If the first unit of such a product requires10 hours, what is the average time for 16

units of this product?

7-51

Eff t f L i



McGraw-Hill/Irwin

BerryCo. makes products requiring laborthat follows an 80 percent learning rate.

If the first unit of such a product requires10 hours, what is the average time for 16

units of this product?

An 80 percent learning rate means that the averagetime required to make two units is 80 percent of thetime for one unit, and that the average time for four

units is 80 percent of the time for two units, etc.

Effect of Learning

on Cost Behavior

7-52

Eff t f L i



McGraw-Hill/Irwin

Average

Number Labor Time Total

of Units per Unit Labor time

1 1 × 10 = 10 1 × 10 = 102

4

8

16

Effect of Learning

on Cost Behavior

7-53

Effect of Learning



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Average



1 1 × 10 = 10 1 × 10 = 102 .80 × 10 = 8 2 × 8 = 16

4

8

16

Effect of Learning

on Cost Behavior

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Effect of Learning



McGraw-Hill/Irwin

Average



1 1 × 10 = 10 1 × 10 = 102 .80 × 10 = 8 2 × 8 = 16

4 .80 × 8 = 6.4 4 × 6.4 = 25.6

8 .80 × 6.4 = 5.12 8 × 5.12 = 40.96

16 .80 × 5.12 = 4.096 16 × 4.096 = 65.536

The graphic presentation of the learningphenomenon is called the learning curve.

Effect of Learning

on Cost Behavior

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McGraw-Hill/Irwin

Learning Curve

Cumulative Production Output

A v e r a g e L a b o r

T

i m e p e r U n i t

Learning effectsare large initially.

Learning effectsbecome smaller, eventually

reaching steady state.

7-56



End of Chapter 7

activity analysis, cost behavior, and cost estimation 2

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