Copyright 2014 Pearson Education 33 -- 1

Chapter 3

Copyright 2014 Pearson Education 33 -- 2

 Chapter 3 Learning Objectives

When you have finished studying this chapter, you

should be able to:

1. Explain management influences on cost behavior.

2. Measure and mathematically express cost functions

and use them to predict costs.

3. Describe the importance of activity analysis for

measuring cost functions.

4. Measure cost behavior using the engineering

analysis, high-low, visual-fit, and least-squares
regression methods .

Copyright 2014 Pearson Education 33 -- 3

 Cost Drivers and Cost Behavior

Accountants and managers often assume that

cost behavior is linear over some relevant range
of activity or cost-driver levels.
We can graph linear-cost behavior with a straight
line because we assume each cost to be either
fixed or variable.
Recall that the relevant range specifies the
interval of cost-driver activity within which a
specific relationship between a cost and its driver
will be valid.
Managers usually define the relevant range
based on their previous experience operating the
organization at different levels of activity.

Copyright 2014 Pearson Education 33 -- 4

 Linear-Cost Behavior

Costs are assumed to be fixed or variable

within the relevant range of activity

Copyright 2014 Pearson Education 33 -- 5

Learning
Objective 1 Managements Influence on Cost Behavior

Product and service decisions

and the value chain

Capacity

Technology

Policies to create incentives to control costs

Copyright 2014 Pearson Education 33 -- 6

 The Value Chain

Managers influence cost behavior throughout

the value chain through their choices of:
process and product design,
quality levels,
product features,
distribution channels, etc..
Each decision contributes to the organizations
performance.

Managers must consider the costs and benefits

of each decision.
Copyright 2014 Pearson Education 33 -- 7
 Capacity Decisions

They are the fixed costs of being able

to achieve a desired level of production or
to provide a desired level of service while
maintaining product or service attributes.

Copyright 2014 Pearson Education 33 -- 8

 Committed Fixed Costs

Committed fixed costs arise

from the possession of facilities,
equipment, and a basic organization.

Lease payments

Property taxes

Salaries of key personnel

Copyright 2014 Pearson Education 33 -- 9

 Discretionary Fixed Costs

Discretionary fixed costs are costs fixed at certain levels

only because management decided that these levels of cost
should be incurred to meet the organizations goals.

These discretionary fixed costs have no obvious

relationship to levels of output activity but
are determined as part of the periodic planning process.

Each planning period, management will determine

how much to spend on discretionary items. These costs
then become fixed until the next planning period.

Copyright 2014 Pearson Education 33 -- 10

 Examples of Committed
and Discretionary Fixed Costs

Fixed Costs Planned

Amounts
Advertising and promotion $ 50,000
Depreciation 400,000
Employee training 100,000
Management salaries 800,000
Mortgage payment 250,000
Property taxes 600,000
Research and development 1,500,000
Total $3,700,000

Copyright 2014 Pearson Education 33 -- 11

 Examples of Committed
and Discretionary Fixed Costs

Fixed Costs Planned Amounts

Committed
Depreciation $ 400,000
Mortgage payment 250,000
Property taxes 600,000
Total committed $1,250,000

Discretionary (potential savings)

Advertising and promotion $ 50,000
Employee training 100,000
Management salaries 800,000
Research and development 1,500,000
Total discretionary $2,450,000
Total committed and discretionary $3,700,000
Copyright 2014 Pearson Education 33 -- 12
 Technology Decisions

Choosing the type of technology an

organization will use to produce products
or deliver services is a critical decision
for management.

Choice of technology (e-commerce versus

in-store or mail-order sales) positions the
organization to meet its current goals and
to respond to changes in the environment.

The use of high-technology methods rather

than labor usually means a much greater
fixed-cost component to the total cost.

Copyright 2014 Pearson Education 33 -- 13

 Cost-Control Incentives

Managers use their knowledge of

cost behavior to set cost expectations.

Employees may receive rewards that

are tied to meeting these expectations.

Copyright 2014 Pearson Education 33 -- 14

 Learning
Objective 2 Cost Functions

Managers will use cost functions often as

a planning and control tool.

Planning and controlling the activities of

an organization require useful and
accurate estimates of future fixed and
variable costs.

Cost measurement involves estimating or

predicting costs as a function of
appropriate cost drivers.

Copyright 2014 Pearson Education 33 -- 15

 Cost Functions

Understanding relationships between costs

and their cost drivers allows managers to...

Make better operating, marketing,

and production decisions

Plan and evaluate actions

Determine appropriate costs for

short-run and long-run decisions.

Copyright 2014 Pearson Education 33 -- 16

 Cost Functions

The first step in estimating or predicting

costs is measuring cost behavior as a
function of appropriate cost drivers.

The second step is to use these cost

measures to estimate future costs at
expected levels of cost-driver activity.

Copyright 2014 Pearson Education 33 -- 17

 Cost Function Equation

Let:
Y = Total cost
F = Fixed cost
V = Variable cost per unit
X = Cost-driver activity in number of units

The mixed-cost function is called a linear-cost function.

Mixed-cost function:
Y = F + VX
Y = $10,000 + $5.00X

Copyright 2014 Pearson Education 33 -- 18

 Developing Cost Functions

The cost function must be believable.

A cost functions estimates of costs

at actual levels of activity must reliably
conform with actually observed costs.

Copyright 2014 Pearson Education 33 -- 19

 Learning
Objective 3 Choice of Cost Drivers: Activity Analysis

Choosing a cost function starts

with choosing cost drivers.

Managers use activity analysis to

identify appropriate cost drivers.

Activity analysis directs management

accountants to the appropriate
cost drivers for each cost.
Copyright 2014 Pearson Education 33 -- 20
Choice of Cost Drivers: Activity Analysis

Northwestern Computers makes two

products: Mozart-Plus and Powerdrive

In the past, most of the support costs

were twice as much as labor costs.

Northwest has upgraded the production

function, which has increased support
costs and reduced labor cost.

Copyright 2014 Pearson Education 33 -- 21

Choice of Cost Drivers: Activity Analysis

Using the old cost driver, labor cost, the

prediction of support costs would be:

Mozart-Plus Powerdrive
Labor cost $ 8.50 $130.00
Support cost:
2 Direct labor
cost $17.00 $260.00

Copyright 2014 Pearson Education 33 -- 22

Choice of Cost Drivers: Activity Analysis

Using the more appropriate cost driver,

the number of components added to products,
companies can predict support costs more accurately.

Mozart-Plus Powerdrive
Support cost at $20
per component
$20 5 components $100.00
$20 9 components $180.00
Difference in predicted
support cost $ 83.00 $ 80.00
higher lower

Managers will make better decisions with this more

accurate information.

Copyright 2014 Pearson Education 33 -- 23

 Learning
Objective 4 Methods of Measuring Cost Functions

1. Engineering analysis
2. Account analysis
3. High-low analysis
4. Visual-fit analysis
5. Least-squares regression analysis

Copyright 2014 Pearson Education 33 -- 24

 Engineering Analysis

Engineering analysis measures cost behavior

according to what costs should be,
not by what costs have been.

Engineering analysis entails a systematic

review of materials, supplies, labor,
support services, and facilities
needed for products and services.

Copyright 2014 Pearson Education 33 -- 25

 Account Analysis

The simplest method of account analysis selects a plausible

cost driver and classifies each account as a variable or fixed cost.

Parkview Medical Center

Monthly cost Amount Fixed Variable

Supervisors salary and benefits $ 3,800 $3,800

Hourly workers wages and benefits 14,674 $14,674
Equipment depreciation and rentals 5,873 5,873
Equipment repairs 5,604 5,604
Cleaning supplies 7,472 7,472
Total maintenance costs $37,423 $9,673 $27,750

Copyright 2014 Pearson Education 33 -- 26

 Account Analysis Example

3,700 patient-days

Fixed cost per month = $9,673

Variable cost per patient-day

= $27,750 3,700
= $7.50 per patient-day

Y = $9,673 + ($7.50 patient-days)

Copyright 2014 Pearson Education 33 -- 27

 High-Low Method

Plot historical data points on a graph.

Focus on the highest- and lowest-activity points.

High month: April

Maintenance cost: $47,000
Number of patient-days: 4,900

Low month: September

Maintenance cost: $17,000
Number of patient-days: 1,200

Copyright 2014 Pearson Education 33 -- 28

 High-Low Method Example

The point at which the line intersects the Y axis is

the intercept, F, or estimate of Fixed Costs, and the
slope of the line measures the variable cost.
Copyright 2014 Pearson Education 33 -- 29
 High-Low Method Example

What is the variable cost (V)?

Using algebra to solve for variable and fixed costs.

Variable costs = Change in costs

change in activity

V = ($47,000 $17,000) (4,900 1,200)

= $30,000 3,700 = $8.1081

Copyright 2014 Pearson Education 33 -- 30

 High-Low Method Example

What is the fixed cost (F)?

F = Total mixed cost total variable cost

At X (high): F = $47,000 - ($8.1081 4,900 patient-days)
= $47,000 $39,730
= $7,270 a month

At X (low): F = $17,000 = ($8.1081 1,200 patient-days)

= $17,000 $9,730
= $7,270 a month

Cost function measured by high-low method:

Y = $7,270 per month + ($8.1081 patient-days)

Copyright 2014 Pearson Education 33 -- 31

 Visual-Fit Method

In the visual-fit method, the cost analyst

visually fits a straight line through a plot
of all of the available data, not just
between the high point and the
low point, making it more reliable
than the high-low method.

Copyright 2014 Pearson Education 33 -- 32

Least-Squares Regression Method

Regression analysis measures

a cost function more objectively
by using statistics to fit a cost
function to all the data.

Regression analysis measures

cost behavior more reliably than
other cost measurement methods.

Copyright 2014 Pearson Education 33 -- 33

 Least-Squares Regression Method

Y = $9,329 + ($6.951 patient-days)

Copyright 2014 Pearson Education 33 -- 34
 Coefficient of Determination

One measure of reliability,

or goodness of fit, is the
coefficient of determination,
R (or R-squared).

The coefficient of determination

measures how much of the
fluctuation of a cost is explained
by changes in the cost driver.

Copyright 2014 Pearson Education 33 -- 35

All rights reserved. No part of this publication
may be reproduced, stored in a retrieval system,
or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.

Copyright 2014 Pearson Education 33 -- 36