Cost Behavior Discussion Questions

Q1. What is the most common error on the hi-lo method of estimation?

Q2. When would a regression analysis yield a better answer than hi-low method?

Q3. In 2022, the data set will include the years before and the years during the global pandemic. What will be harm for estimation for predictive behavior of using the information in this data set?

Determining
How Costs Behave
Level 1: Unreliable
Level 2: Informal
Level 3: Standardized
Level 4: Monitored
Level 5: Optimized
Unpredictable environment for
which controls have not been
designed or implemented.
i.e. Basic Quickbooks clients, do-it yourself
owners’ manual records, spreadsheet
accounting, high turnover in accounting
client
Controls are present but
inadequately documented and
largely dependent on manual
intervention.
There are no formal
communications or training
programs related to the controls.
Controls are in place and
documented, and employees
have received formal
communications about them.
Undetected deviations from
controls may occur.
Standardized controls are in
place and undergo periodic
testing to evaluate their design
and operation; test results are
communicated to
management. Limited use of
automated tools may support
controls.
An integrated internal controls
framework with real-time monitoring
by management is in place to
implement continuous improvement.
Automated processes and tools
support the controls and enable the
organization to quickly change the
controls as necessary.
 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
 A cost function is a mathematical
representation of how a cost changes with
changes in the level of an activity relating to
that cost.
Variations in the level of a single activity
(the cost driver) explain the variations in the
related total costs.
Cost behavior is approximated by a linear
cost function within the relevant range.
1.
2.
◦
Graphically, the total cost versus the level of a
single activity related to that cost is a straight
line within the relevant range.
Accounting
Statistics
Variable Cost
Slope
Fixed Cost
Intercept
Mixed Cost
Linear Cost Function
The independent
variable:
the cost driver
y = mx + b
The dependent
variable:
the cost that is
being predicted
The slope of
the line:
variable cost
per unit
l
The intercept:
fixed costs
1.
2.
3.
Choice of cost object—different objects may
result in different classification of the same
cost
Time horizon—the longer the period, the
more likely the cost will be variable
Relevant range—behavior is predictable only
within this band of activity
 The most important issue in estimating a cost
function is determining whether a causeand-effect relationship exists between the
level of an activity and the costs related to
that level of activity.
 A cause-and-effect relationship might arise
as a result of:
◦ A physical relationship between the level of activity
and costs
◦ A contractual agreement
◦ Knowledge of operations
 Note: A high correlation (connection) between
activities and costs does not necessarily mean
causality.
1.
2.
3.
4.
Industrial engineering method
Conference method
Account analysis method
Quantitative analysis methods
1. High-low method
2. Regression analysis
 Estimates cost functions by analyzing the
relationship between inputs and outputs in
physical terms
 Includes time-and-motion studies
 Very thorough and detailed, but also costly
and time-consuming
 Also called the work-measurement method
 Estimates cost functions on the basis of
analysis and opinions about costs and their
drivers gathered from various departments of
a company
 Pools expert knowledge
 Reliance on opinions still makes this method
subjective
 Estimates cost functions by classifying
various cost accounts as variable, fixed, or
mixed with respect to the identified level of
activity
 Is reasonably accurate, cost-effective, and
easy to use, but is subjective
 Uses a formal mathematical method to fit
cost functions to past data observations
 Advantage: results are objective
1.
2.
3.
4.
5.
6.
Choose the dependent variable (the cost to
be predicted).
Identify the independent variable or cost
driver.
Collect data on the dependent variable and
the cost driver.
Plot the data.
Estimate the cost function using the highlow method or regression analysis.
Evaluate the cost driver of the estimated
cost function.
 Simplest method of quantitative analysis
 Uses only the highest and lowest observed
values
1.
Calculate variable cost per unit of activity.
Variable
Cost per
Unit of Activity
=
{
Cost associated with
highest activity level
Cost associated with
lowest activity level
}
Highest activity level – Lowest activity level
2.
Calculate total fixed costs.
Total Cost from either the highest or lowest activity level
– (Variable Cost per unit of activity X Activity associated with above total cost)
Fixed Costs
3.
Summarize by writing a linear equation.
Y = Fixed Costs + ( Variable cost per unit of Activity * Activity )
Y = FC + (VCu * X)
 Regression analysis is a statistical method
that measures the average amount of change
in the dependent variable associated with a
unit change in one or more independent
variables.
 Simple—estimates the relationship between
the dependent variable and one independent
variable
 Multiple—estimates the relationship between
the dependent variable and two or more
independent variables
 Goodness of fit—indicates the strength of the
relationship between the cost driver and costs
 Residual term—measures the distance
between actual cost and estimated cost for
each observation
1.
2.
3.
Economic plausibility
Goodness of fit
Significance of the independent variable
1.
2.
3.
4.
5.
Economies of scale
Quantity discounts
Step cost functions—resources increase in
“lot-sizes”, not individual units
Learning curves—labor hours consumed
decrease as workers learn their jobs and
become better at them
Experience curve —broader application of
learning curve that includes downstream
activities including marketing and
distribution
 Cumulative average-time learning model—
cumulative average time per unit declines by
a constant percentage each time the
cumulative quantity of units produced
doubles
 Incremental unit-time learning model—
incremental time needed to produce the last
unit declines by a constant percentage each
time the cumulative quantity of units
produced doubles
1.
2.
The database should contain numerous
reliably measured observations of the cost
driver and the costs.
In relation to the cost driver, the database
should consider many values spanning a
wide range.
 The time period for measuring the dependent
variable does not match the period for
measuring the cost driver.
 Fixed costs are allocated as if they are
variable.
 Data are either not available for all
observations or are not uniformly reliable.
 Extreme values of observations occur from
errors in recording costs.
 There is no homogeneous relationship
between the cost driver and the individual
cost items in the dependent variable-cost
pool. A homogeneous relationship exists
when each activity whose costs are included
in the dependent variable has the same cost
driver.
 The relationship between the cost driver and
the cost is not stationary.
 Inflation has affected costs, the driver, or
both.