1

MANAGERIAL
ACCOUNTING Hilton Chapters
1, 2, & 6 Adobe Connect
We change gears dramatically in managerial accounting. Because of the limited
time we have, we do not cover many advanced concepts in managerial accounting.

An overview of the material we will cover for the remainder of the course:

 Introduction (Chapter 1) Read (skim) only)

 Cost behavior (Chapters 2 (basic) and 6 (more advanced))
 Different cost accounting systems
o Job-order / product costing (Chapter 3)
o Process costing (Chapter 4)
o Activity-based-costing (ABC) (Chapter 5)
 Cost-volume-profit (CVP) (Chapter 7). CVP is a major takeaway.
 Balance scorecard only (Chapter 12).
 Decision Making (Chapter 14). Decision making is a major takeaway.

Chapters 7 and 14, important topics for MBA students, will be disproportionately
weighted on the final exam.

Managerial accounting is very different from financial accounting (e.g., no

GAAP).

Essentially, we do 2 chapters per week, and one week is allocated for review and
taking the final exam.
 2

Chapter 2. Basic Cost Management Concepts

WHAT IS A COST?

A cost is the sacrifice made, usually measured by the resources given up, to
achieve a particular purpose (text and glossary).

Product vs. Period Costs

 Product costs are the costs of goods manufactured or the cost of goods
purchased for resale. These costs are inventoried until the goods are sold.

o Raw materials—materials that await production

o Work in process—partially completed production
o Finished goods—completed production that awaits sale

 Period costs are all other non-product costs in an organization (e.g., selling
and administrative), and they are not inventoried but are expensed in the
period incurred.
 3

TYPES OF PRODUCTION PROCESSES

There are various types of production processes; for example:

 Job shop—low production volume, little standardization; one-of-a-kind
products
 Batch—multiple products; low volume
 Assembly line—a few major products; higher volume
 Mass customization—high production volume; standardized components;
customized combinations of components
 Continuous flow—high volume; highly standardized commodity products
 Confirming Pages

Chapter 2 Basic Cost Management Concepts 41

have three types of inventory. Raw-material inventory includes all materials before they
are placed into production. Work-in-process inventory refers to manufactured prod- “Now the accountants are
ucts that are only partially completed at the date when the balance sheet is prepared. not only the interpreters.
Finished-goods inventory refers to manufactured goods that are complete and ready for They drive management
sale. The values of the work-in-process and finished-goods inventories are measured by toward the proper response
their product costs. to what the numbers are
On the Walmart balance sheet, the cost of acquiring merchandise is listed as the value telling us.” (2c)
of the merchandise inventories. ITT Automotive

Manufacturing Operations and Manufacturing Costs

Although there are tens of thousands of manufacturing firms, their basic production pro-
Learning Objective 2-4
cesses can be classified into four generic types. The nature of the manufacturing process
can affect the manufacturing costs incurred. Therefore, the management team is in a bet- List and describe four types of
ter position to manage these costs if the relationship of the production process to the manufacturing operations.
types of costs incurred is understood. Exhibit 2–5 defines and describes the four generic
manufacturing processes.1
We will study the role of managerial accounting and cost management in each of these
manufacturing processes. This chapter will focus on an assembly operation. Chapter 3
will examine managerial accounting techniques used in job-shop and batch-processing
operations. Chapter 4 will focus on the cost accumulation and cost management pro-
cesses in a continuous-flow production environment.

Type of Production Description Example of Exhibit 2–5

Process of Process Manufacturer Types of Production
Low production volume; little Processes
standardization; one-of-a-kind products.
Job Shop
Major film studios, such as Universal Pictures
(a scene from the box office hit Les
Misérables).

Multiple products; low volume.

Caterpillar ( batch production
Batch of heavy equipment).

A few major products; higher volume.

Ford ( automobile assembly line ).
Assembly

High production volume; highly

standardized commodity products.
Continuous Flow ExxonMobil ( production of gasoline,
a continuous-flow product).

1
The exhibit is based on the well-known and widely used Hayes-Wheelwright production process matrix. A variant
of the assembly process is mass customization, in which the manufacturer uses inventoried parts to build products to
customer specification. This approach was popularized by Dell Computer, which for many years built computers to
customer specification, often taking the orders on line. Due to competitive pressures in more recent years, however,
Dell has retreated from the mass customization approach in favor of stocking several popular computer configurations.

hiL25664_ch02_034-077.indd 41 6/27/13 1:38 AM

 4

MANUFACTURING COSTS

NOTE: THE UNDERSTANDING OF THE MANUFACTURING COST

VOCABULARY IS AN IMPORTANT TAKE-AWAY IN THE COURSE.

The following costs are used to compute the cost of inventory.

 DIRECT MATERIALS—materials easily traced directly to a finished

product
 DIRECT LABOR—the wages of anyone who works directly on the
product
 MANUFACTURING OVERHEAD—all other manufacturing costs
o INDIRECT MATERIALS—materials and supplies other than those
classified as direct materials,
o INDIRECT LABOR—personnel who do not work directly on the
product (e.g., manufacturing supervisors)
o Other Manufacturing Costs--not easily traceable to a finished good
(insurance, property taxes, depreciation, utilities, and service/support
department costs).
 Overtime premiums and the cost of idle time are also accounted
for as overhead.

KEY TAKAWAY. The concepts of direct materials, direct labor,

manufacturing overhead.

Conversion cost (the cost to convert direct materials into finished product): direct
labor + manufacturing overhead

Prime cost: direct material + direct labor

 Confirming Pages

Chapter 2 Basic Cost Management Concepts and Accounting for Mass Customization Operations 47

Overtime premiums and the cost of idle time should be classified as manufacturing
overhead, rather than associated with a particular production job, because the particular
job on which idle time or overtime may occur tends to be selected at random. Sup-
pose several production jobs are scheduled during an eight-hour shift, and the last job
remains unfinished at the end of the shift. The overtime to finish the last job is neces-
sitated by all of the jobs scheduled during the shift, not just the last one. Similarly, if a
power failure occurs during one of several production jobs, the idle time that results is
not due to the job that happens to be in process at the time. The power failure is a ran-
dom event, and the resulting cost should be treated as a cost of all of the department’s
production.
To summarize, manufacturing costs include direct material, direct labor, and manu-
facturing overhead. Direct labor and overhead are often called conversion costs, since
they are the costs of “converting” raw material into finished products. Direct material and
direct labor are often referred to as prime costs.

Manufacturing Cost Flows

Direct material, direct labor, and manufacturing overhead are the three types of produc-
tion costs incurred by manufacturers. These costs are product costs because they are
stored in inventory until the time period when the manufacturer’s products are sold. Man-
ufacturers have product-costing systems to keep track of the flow of these costs from the
time production begins until finished products are sold. This flow of manufacturing costs
is depicted in Exhibit 2–6. As direct material is consumed in production, its cost is added
to work-in-process inventory. Similarly, the costs of direct labor and manufacturing over-
head are accumulated in work in process.
“In my mind, cost
When products are finished, their costs are transferred from work-in-process inven-
accountants are going to be
tory to finished-goods inventory. The total cost of direct material, direct labor, and
business analysts.” (2f)
manufacturing overhead transferred from work-in-process inventory to finished-goods
Boeing
inventory is called the cost of goods manufactured. The costs then are stored in finished
goods until the time period when the products are sold. At that time, the product costs are
transferred from finished goods to cost of goods sold, which is an expense of the period
when the sale is made. Exhibit 2–6 concentrates on the conceptual basis of a product- Learning Objective 6
costing system. The detailed procedures and accounts used to keep track of product costs Prepare a schedule of cost
are covered in Chapters 3 and 4. of goods manufactured, a
Manufacturers generally prepare a schedule of cost of goods manufactured and a schedule of cost of goods sold,
schedule of cost of goods sold to summarize the flow of manufacturing costs during an and an income statement for a
accounting period. These schedules are intended for internal use by management and are manufacturer.

Exhibit 2–6
Flow of Manufacturing Costs

Direct Material
COmet
COmetcomp.com

Work-in-Process Finished-Goods Cost of

Direct Labor
Inventory Inventory Goods Sold

Manufacturing
Overhead

Product costs . . . . . . are stored in inventory . . . . . . until the products are sold.

hiL10912_ch02_036-079.indd 47 7/2/10 9:40 AM

 5

MANUFACTURING COST FLOWS

In financial accounting, we dealt with net purchases of goods, which assumed a

retail environment. In a manufacturing environment, net purchases is replaced
with cost of goods manufactured.

Manufacturing costs (direct materials, direct labor, and manufacturing overhead)

are attached to work-in-process inventory.

Cost of Goods Manufactured:

Beginning Work-in-Process Inventory

+ Direct Material
+ Direct Labor
+ Manufacturing Overhead
- Ending Work-in-Process Inventory
= Cost of Goods Manufactured

This amount is transferred from work-in-process inventory to finished-goods

inventory when goods are completed.
COST OF GOODS MANUFACTURED

BEGINNING WORK IN PROGRESS INVENTORY

PLUS

RAW MATERIALS USED IN PRODUCTION

PLUS

DIRECT LABOR USED IN PRODUCTION

PLUS

OVERHEAD APPLIED TO PRODUCTION

LESS

ENDING WORK IN PROGRESS INVENTORY

EQUALS

COST OF GOODS MANUFACTURED

COST OF GOODS AVAIALBLE FOR SALE

BEGINNING COMPLETED GOODS INVENTORY

PLUS

COST OF GOODS MANUFACTURED

EQUALS

COST OF GOODS AVAILABLE FOR SALE

 Confirming Pages

84 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment

Exhibit 3–1
Flow of Costs through Work-in-Process Inventory Finished-Goods Inventory
Manufacturing Accounts
Direct-material cost
Product cost transferred
Direct-labor cost
Manufacturing overhead when product is finished

Product cost transferred when product is sold

Cost of Goods Sold* Income Summary

Expense closed into

Income Summary at end

of accounting period

*Cost of Goods Sold is an expense. Although it is more descriptive, the term “cost-of-goods-sold expense” is not used as much
in practice as the simpler term “cost of goods sold.”

Example of Manufacturing Cost Flows Suppose that the Bradley Paper

Company incurred the following manufacturing costs during 20x1.
Direct material ........................................................................................ $30,000
Direct labor ............................................................................................. 20,000
Manufacturing overhead .......................................................................... 40,000

During 20x1, products costing $60,000 were finished and products costing $25,000
were sold for $32,000. Exhibit 3–2 shows the flow of costs through the Bradley Paper

Exhibit 3–2
Example of Manufacturing Bradley Paper Company
Cost Flows for Bradley Paper Partial Balance Sheet
Work-in-Process Inventory As of December 31, 20x1
Company
Direct-material cost 30,000 Current assets:
Direct-labor cost 20,000 60,000 Cash . . . . . . . . . . . . . . . xxx
Manufacturing overhead 40,000 Accounts receivable . . . . xxx
Inventory:
Raw material . . . . . . . xxx
Balance 30,000 Work in process. . . . . $30,000
Finished goods . . . . . 35,000

Finished-Goods Inventory

60,000 25,000

Balance 35,000

Cost of Goods Sold Bradley Paper Company

Partial Income Statement
25,000 For the Year 20x1
Sales revenue . . . . . . . . . . $32,000
Less: Cost of goods sold. . . 25,000

Sales Revenue Gross margin . . . . . . . . . . . $ 7,000

32,000

hiL10912_ch03_080-133.indd 84 7/2/10 2:55 PM

 Confirming Pages

48 Chapter 2 Basic Cost Management Concepts and Accounting for Mass Customization Operations

Exhibit 2–7
Manufacturing Cost
Schedules

COmet
COmetcomp.com

generally not made available to the public. The Excel spreadsheets in Exhibit 2–7 show
these two schedules along with an income statement for Comet Computer Corporation.7
Notice the extremely low inventories of raw material, finished goods, and work in pro-
cess in these schedules. With annual sales of $700 million, Comet’s year-end inventory
of raw material is only $5,020,000, which is less than 1 percent of sales. Work-in-process
inventory ($100,000) and finished-goods inventory ($190,000) are even lower. These low
inventories, relative to sales volume, are characteristic of mass customizers using the
direct-sales approach.

Production Costs in Service Industry Firms

and Nonprofit Organizations
Service industry firms and many nonprofit organizations are also engaged in produc-
tion. What distinguishes these organizations from manufacturers is that a service is con-
sumed as it is produced, whereas a manufactured product can be stored in inventory.
Such businesses as Westin Hotels, Bank of America, United Airlines, the Chicago Bulls,
and Cole Muffler are in the business of producing services. Similarly, nonprofit organi-

7
Some numerical displays in the text will be presented as Excel spreadsheets, since this tool is widely used in business.

hiL10912_ch02_036-079.indd 48 7/2/10 9:40 AM

 Confirming Pages

Chapter 2 Basic Cost Management Concepts 45

Exhibit 2–7
Manufacturing Cost
Schedules

COmet
COmetcomp.com

(continues)

hiL25664_ch02_034-077.indd 45 6/27/13 1:38 AM

 7

BASIC COST MANAGEMENT CONCEPTS

COST DRIVER

A Cost Driver Is Any Event or Activity That Causes Costs To Be Incurred.

 Possible examples include labor hours in manual assembly work and
machine hours in automated production settings.

 A cost driver refers to the way that a cost changes in relation to changes in
the activity

 The higher the degree of correlation between a cost-pool increase and the
increase in its cost driver, the better the cost management information.

 An activity refers to a measure of the organization’s output of products or

services.

Assumption. Most of the basic introductory discussion in the text (and

other managerial accounting texts and trade publications) assumes that
a single factor is associated with costs in producing a unit of output,
i.e., a single unit-level cost driver.
 8

VARIABLE AND FIXED COSTS

Variable costs move in direct proportion to a change in activity.

 The cost per unit remains constant.

Variable Costs are identical for each incremental unit of activity (over the
relevant range);
 Variable costs change in direct proportion with a change in volume within
the relevant range of activity.

Fixed costs remain constant in total as the level of activity changes within the
relevant range of activity.
 The cost per unit fluctuates because this constant total is spread over a
smaller or greater volume.
 Fixed costs are unrelated to unit-level activity;
 While fixed costs may respond to structural cost drivers and organizational
cost drivers over time, they do not respond to short-run changes in unit-level
activity cost drivers.

Understanding the concepts of fixed and variable costs are crucial take-ways
from this course.
 9

In Chapter 6, we introduce step-fixed costs, step-variable costs, and semivariable

costs.

RELEVANT RANGE

The Relevant Range (key vocabulary term) refers to the activity levels within
which a linear cost function (or linear approximation) is valid.
 The range of activities within which a given total fixed cost or unit
variable cost will be unchanged. Relevant Range is discussed in Chapter
6. See the following descriptions/definitions.
http://www.finance-lib.com/financial-term-relevant-range.html, and
http://blog.accountingcoach.com/relevant-range-activity/
 The range of activity within which management expects to operate during
the period

IN THIS COURSE, WE ASSUME THAT THE VARIABLE COST FUNCTION

IS LINEAR WITHIN A RELEVANT RANGE.
 Of course, the cost function might be curvilinear (discussed in Chapter 6).
 The simplifying assumption of a linear cost function within a relevant
range helps make the analysis in the course relative straight-forward.

Many Kelley students have engineering, logistics, or economics backgrounds and

realize that many cost functions are not linear. Examination of non-linear cost
functions is beyond the scope of this course.
 10

Graphs
 11

DIRECT AND INDIRECT COSTS

An entity (e.g., a specific product, service, or department) to which a cost is

assigned is commonly known as a cost object.
 A direct cost is one that can be easily traced to a cost object.
 An indirect cost is a cost that cannot be easily traced to a cost object.

A cost management system strives to trace costs to the objects that caused them so
that managers can isolate responsibility for spending and objectively evaluate
operations.

CONTROLLABLE AND UNCONTROLLABLE COSTS

 Controllable costs—costs over which a manager has influence (e.g., direct
materials)
 Uncontrollable costs—costs over which a manager has no influence (e.g.,
the salary of a firm's CEO from the production manager's viewpoint)
 12

COSTS AND DECISION MAKING VOCABULARY

The following cost concepts are relevant in manufacturing entities as well as for
service providers.

Opportunity cost—the benefit forgone by choosing an alternative course of

action.

Out-of-pocket cost—a cost that requires a cash outlay

Sunk cost—a cost incurred in the past that cannot be changed by future action.

 Such costs are not relevant for decision making (discussed extensively in
Chapter 14)

Differential cost—the net difference in cost between two alternative courses of

action

Incremental cost—the increase in cost from one alternative to another

Marginal cost—the extra cost incurred when one additional unit is produced

Average cost—total cost divided by the units of activity

The preceding costs are relevant in manufacturing entities as well as for service
providers.
 1

HILTON CHAPTER 6 CLASS ADOBE CONNECT

ACTIVITY ANALYSIS, COST BEHAVIOR, AND COST ESTIMATION
Chapter Overview

I. Cost Behavior Patterns

A. Types of costs
1. Variable costs
2. Step-variable costs
3. Fixed costs
4. Step-fixed costs
5. Semivariable (mixed) costs
6. Curvilinear costs
B. The relevant range

II. Cost Categories and Structures

A. Engineered costs
B. Committed costs
C. Discretionary costs
 2

III. Cost Estimation Methods

A. Account-classification method
B. Visual-fit method
C. High-low method
D. Least-squares regression method
1. Regression line
2. Independent and dependent variables
3. Coefficient of determination and goodness of fit
E. Multiple regression
IV. Data Collection Problems
 3

1. COST BEHAVIOR PATTERNS

Understanding cost behavior patterns (i.e., the relationship between cost and
activity) is important to managers as they plan, control, and make decisions in the
operation of their organizations.

Variable costs are costs that remain constant on a per-unit basis and fluctuate in
total in direct response to cost-driver changes.

Step-variable costs are nearly variable, but such costs increase in small steps
rather than in direct proportion to cost-driver changes.

Fixed costs stay constant in total but fluctuate on a per-unit basis across ranges of
activity.

Step-fixed costs are fixed within a wide range of activity but will change outside
that range.

A semivariable cost (mixed cost) changes in response to a change in a cost driver,

but not in direct proportion. Such costs have both variable and fixed elements.

A curvilinear cost function cannot be represented with a straight line but instead is
represented with a curve that reflects either increasing or decreasing marginal
costs.

The relevant range reflects the range of activity within which managers expect a
company to operate, allowing the prediction of cost behavior with some certainty.
 Confirming Pages

Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 237

Total direct-labor cost (wages and fringe benefits Total direct-labor cost (wages and fringe benefits of bakers,
of bakers, sales personnel, and delivery-truck drivers) sales personnel, and delivery-truck drivers)

Size of activity range in

one step is 5,000 dozen $45,000
$45,000
bakery items per month Step-variable cost
behavior pattern Variable cost
$30,000 behavior pattern
$30,000
used as an
Difference between approximation
$15,000 Size of cost increment $15,000 the two lines is small,
in one step is $1,500 of resulting in little loss
direct-labor cost per month of accuracy

50,000 100,000 150,000 50,000 100,000 150,000

Activity, or cost driver Activity, or cost driver

(dozens of bakery items sold) (dozens of bakery items sold)

Exhibit 6–2 Exhibit 6–3

Step-Variable Cost: Direct- Approximating a Step-
Labor Cost, Tasty Donuts Variable Cost, Tasty Donuts

STY STY
TA TA

D NUTS D NUTS

Fixed Costs
Fixed costs were covered briefly in Chapter 2. We will summarize that discussion here,
using the Tasty Donuts illustration. A fixed cost remains unchanged in total as the activ-
ity level (or cost driver) varies. Facilities costs, which include property taxes, deprecia-
tion on buildings and equipment, and the salaries of maintenance personnel, are fixed
costs for Tasty Donuts, Inc. These fixed costs are graphed in panel A of Exhibit 6–4. This
graph shows that the total monthly cost of property taxes, depreciation, and maintenance
personnel is $200,000 regardless of how many dozen bakery items are produced and sold
during the month.
The fixed cost per unit does change as activity varies. Exhibit 6–4 (panel B) shows
that the company’s facilities cost per dozen bakery items is $4.00 when 50,000 dozen
items are produced and sold. However, this unit cost declines to $2.00 when 100,000
dozen items are produced and sold. If activity increases to 150,000 dozen items, unit
fixed cost will decline further, to about $1.33.
A graph provides another way of viewing the change in unit fixed cost as activity
changes. Panel C of Exhibit 6–4 displays a graph of Tasty Donuts’ cost of property taxes,
depreciation, and maintenance personnel per dozen bakery items. As the graph shows, the
fixed cost per dozen bakery items declines steadily as activity increases. “By understanding the
To summarize, as the activity level increases, total fixed cost does not change, but costs and workload associ-
unit fixed cost declines. For this reason, it is preferable in any cost analysis to work with ated with the real business
total fixed cost rather than fixed cost per unit. activities we undertake . . .
we are better positioned to
understand where value is
Step-Fixed Costs
created. . . . From this infor-
Some costs remain fixed over a wide range of activity but jump to a different amount mation, we can then make
for activity levels outside that range. Such costs are called step-fixed costs. Tasty better decisions as to the
Donuts’ cost of indirect labor is a step-fixed cost. Indirect-labor cost consists of the management and direction
salaries and fringe benefits for the managers and assistant managers of the com- of the business.” (6b)
pany’s bakery and donut shops. Tasty Donuts’ monthly indirect-labor cost is graphed Transco
in Exhibit 6–5.

hiL10912_ch06_232-273.indd 237 7/21/10 3:29 PM

 Confirming Pages

Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 239

Total indirect-labor cost Exhibit 6–5

(salaries and fringe benefits of bakery and donut shop Step-Fixed Cost: Indirect-
management personnel) Labor Cost, Tasty Donuts, Inc.

STY
TA

D NUTS
$45,000

$35,000

$25,000

Activity, or
cost driver
50,000 100,000 150,000 (dozens of
bakery items
sold per
month)

such a decrease in demand were to occur, the company would reduce the daily operating
hours for its donut shops. This would allow the firm to operate each donut shop with only
a full-time manager and no assistant manager. As the graph in Exhibit 6–5 indicates, such
a decrease in managerial personnel would reduce monthly indirect-labor cost to $25,000.

Semivariable Cost
A semivariable (or mixed) cost has both a fixed and a variable component. The cost of
operating delivery trucks is a semivariable cost for Tasty Donuts, Inc. These costs are
graphed in Exhibit 6–6. As the graph shows, the company’s delivery-truck costs have
two components. The fixed-cost component is $3,000 per month, which is the monthly
rental payment paid under the lease contract for the delivery trucks. The monthly rental
payment is constant, regardless of the level of activity (or cost driver). The variable-cost

Total cost of Exhibit 6–6

operating delivery trucks Semivariable Cost: Cost of
Operating Delivery Trucks,
Tasty Donuts, Inc.
$20,000
STY
Slope is variable cost per Total cost line TA
unit of activity, $.10
per dozen bakery items D NUTS
$10,000 Variable cost
component

$3,000
Fixed cost
component
50,000 100,000 150,000 Activity, or
cost driver
(dozens of
bakery items
sold per month)

hiL10912_ch06_232-273.indd 239 7/21/10 3:29 PM

 4

2. COST CATEGORIES AND STRUCTURES

An engineered cost is one that bears a definite physical relationship to the cost
driver.

Committed vs. discretionary costs

Committed costs result from an organization's ownership or use of facilities and

its basic organizational structure.
 These costs cannot be eliminated without endangering the entity's overall
health and existence.

Discretionary costs exist as the result of a management decision.

 In comparison with committed costs, such costs are more easily changed in
bad economic times without doing serious long-run harm to the entity.
3. COST ESTIMATION METHODS

The account-classification method (also called account analysis) requires the

study of an account in the general ledger. The experienced analyst uses the
account information as well as his or her own judgment to determine future cost
behavior.

NOTE: Although one purpose of Chapter 6 is to introduce the concepts of mixed

costs, step-variable costs, step-fixed costs, and curvilinear costs, when we turn to
cost estimation, the goal is to estimate a linear cost function in the following
form.

Y = a + bx
Total Cost = Fixed Costs + Variable Costs
Total Cost = Fixed Costs + (variable cost per unit x # units)

We estimate the equation in a variety of ways:

 Visual fit
 High-low method
 Regression

VISUAL FIT METHOD

With the visual-fit method, an analyst examines a cost by plotting points on a

graph (called a scatter diagram) and places a line through the points to yield a
cost function.
 6

HIGH-LOW METHOD

The high-low method considers only two points of data, the highest and lowest,
for activity within the relevant range.
 To estimate fixed and variable costs, this method uses data from a
representative period of low activity and a period of high activity.
 This method is straight-forward and easy to use.
High-Low estimation computes the following:
1. Variable costs per unit = Difference in Total Costs
Difference in Activity

2. Total Fixed costs = Total Costs – Total Variable Costs

 Confirming Pages

Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 247

High-Low Method
In the high-low method, the semivariable-cost approximation is computed using exactly
two data points. The high and low activity levels are chosen from the available data set.
These activity levels, together with their associated cost levels, are used to compute the
variable and fixed cost components as follows:
Difference between the costs corresponding
Variable cost per to the highest and lowest activity levels
 ____________________________________
dozen bakery items Difference between the highest
and lowest activity levels
$7,035  $5,100 $1,935
 _______________  ______
118,000  75,000 43,000
 $.045 per dozen items
Now we can compute the total variable cost at either the high or low activity level. At the
low activity of 75,000 dozen items, the total variable cost is $3,375 ($.045  75,000).
Subtracting the total variable cost from the total cost at the 75,000 dozen activity level,
we obtain the fixed-cost estimate of $1,725 ($5,100  $3,375). Notice that the high and
low activity levels are used to choose the two data points. In general, these two points
need not necessarily coincide with the high and low cost levels in the data set.
Exhibit 6–9 presents a graph of Tasty Donuts’ utilities cost, which is based on the
high-low method of cost estimation. As in any cost estimation method, this estimate of
the cost behavior pattern should be restricted to the relevant range.

Evaluation of High-Low Method The high-low method is more objective

than the visual-fit method, since it leaves no room for the cost analyst’s judgment. How-
ever, the high-low method suffers from a major weakness. Only two data points are used
to estimate the cost behavior pattern; the remainder of the data points are ignored. In
this regard, the visual-fit method is superior to the high-low method, since the former
approach uses all of the available data.

Utilities cost (for one month) Exhibit 6–9

Graph of Utilities Cost Using
High activity level High-Low Method, Tasty
$8,000
Donuts, Inc.

STY
$7,000 TA

$6,000 Cost line based on high-low method

D NUTS
Only two data points are used;
$5,000
the remainder of the data are ignored
$4,000
Low activity level
$3,000

$1,725

Activity, or
cost driver
50,000 100,000 150,000 (dozens of
bakery items
Relevant range sold per
(75,000 to 120,000) month)

hiL10912_ch06_232-273.indd 247 7/21/10 3:29 PM

 7

The method first focuses on cost changes, allowing an analyst to determine the
presence of any variable cost.

Next, fixed costs are determined by subtracting variable cost from the total cost at
either of the two data points.

The high-low method is more objective than the visual-fit method, but it is still a
rough approximation because it considers only two points of data.

The points selected should be representative of normal behavior.

Use of the high-low method is common in practice and is common in

testing situations. It can be used easily to estimate fixed and variable
costs
 9

REGRESSION METHODS

OLS Regression

The least-squares regression method is a statistical approach that is both

objective and considers all data points.

Regression provides the best possible cost line (i.e., the regression line), and the
method is more accurate than the other methods.

 The regression line is in the form Y = a + bX, where X is the independent

variable and Y is the dependent variable.

 The coefficient of determination, R 2, can be used to judge the line's

goodness of fit, or how well the line fits the data on which it is based.

 If the goodness of fit is relatively high, a large proportion of the variation in

the dependent variable is explained by changes in the independent variable.

The text's appendix shows how a spreadsheet such as Microsoft ® Excel can be used
to calculate various parameters related to regression analysis.
 10

Multiple Regression

can be used to estimate a cost function when there is more than one independent
variable. (For example, the fuel cost for an airline is determined by the number of
miles flown and by other variables such as wind speed and load.)

4. DATA COLLECTION PROBLEMS

The process of collecting appropriate data to use in cost estimation is important, as

the best method will fail if it integrates poor data. Common problems include
missing data, outliers, mismatched time periods for the dependent and independent
variables, and inflation.
HILTON CHAPTER 6
High Low Method Example Problem
Day Total Cost Volume
1 700,000 20,000
2 725,900 21,700
3 690,000 19,300
4 661,000 17,000
5 677,000 16,400
6 714,000 20,800
7 732,300 22,400
8 730,000 23,900
9 765,000 25,500
10 747,400 24,200
11 768,000 26,600
12 773,000 27,000
13 712,500 22,200
14 702,200 20,600
15 699,800 20,100
16 678,000 19,400
17 665,300 19,100
18 685,900 19,800
19 697,200 19,900
20 705,400 21,000
21 708,100 20,800
22 711,000 20,900
23 718,000 21,100
24 723,300 21,500
25 719,600 20,000
26 732,100 21,900
27 744,600 24,400
28 763,000 27,400
29 757,400 25,800
30 752,000 25,200
HILTON CHAPTER 6
High Low Method Example Problem Solution

Day Total Cost Volume

1 700,000 20,000
2 725,900 21,700
3 690,000 19,300
4 661,000 17,000
5 677,000 16,400
6 714,000 20,800
7 732,300 22,400
8 730,000 23,900
9 765,000 25,500
10 747,400 24,200
11 768,000 26,600
12 773,000 27,000
13 712,500 22,200
14 702,200 20,600
15 699,800 20,100
16 678,000 19,400
17 665,300 19,100
18 685,900 19,800
19 697,200 19,900
20 705,400 21,000
21 708,100 20,800
22 711,000 20,900
23 718,000 21,100
24 723,300 21,500
25 719,600 20,000
26 732,100 21,900
27 744,600 24,400
28 763,000 27,400
29 757,400 25,800
30 752,000 25,200

High Volume 763,000 27,400

Low Volume 677,000 16,400
Difference 86,000 11,000
Variable Cost per unit 7.818182

FC: 763,000 - (27,400 * 7.818182) = 548,782 rounded

Check: 677,000 - (16,400 * 7.818182) - 548,782 rounded
Equation: Y = 548,782 + 7.818182 X

NOTE: EQUATION CHANGES IF DIFFERENT POINTS ARE USED

SELECT TWO RANDOM POINTS
Higher volume 757,400 25,800
Lower volume 661,000 17,000
Difference 96,400 8,800
Variable Cost per unit 10.954545

FC: 757,400 - (25,800 * 10.954545) = 474,773 rounded

Check: 661,000 - (17,000 * 10.954545) = 474,773 rounded
Equation: Y = 474,773 + 10.954545 X