10 Cost Behavior HIGH - LOW METHOD.ppt

CHAPTER 10
Determining
How Costs Behave

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 10-2
Cost Functions
 A cost function is a mathematical
representation of how a cost changes with
changes in the level of an activity relating to
that cost
 Cost = f(x),
 x=activity level

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 semi-
variable costs

Cost Function Assumptions
1. Variations in the level of a single activity
(the cost driver) explain the variations in the
related total costs
2. Cost behavior is approximated by a linear
cost function within the relevant range
 Graphically, the total cost versus the level of
a single activity related to that cost is a
straight line within the relevant rage

Bridging Accounting and Statistical
Terminology
Accounting Statistics
Variable Cost Slope
Fixed Cost Intercept
Mixed Cost Linear Cost Function

The Linear Cost Equation
y = a + bX
The Dependent
Variable:
The cost that is
being predicted
The Independent
Variable:
The cost driver
The Intercept:
Fixed costs
The Slope of
the Line:
Variable cost
per unit

Fixed Cost Function, Graphically
Total Cost Function: Y = $10,000
$-
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
0 2000 4000 6000 8000 10000 12000

Variable Cost Function, Graphically
Total Cost Function: Y = $5X
$-
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
0 2000 4000 6000 8000 10000 12000

Total Cost Function, Graphically
Total Cost Function: Y = $10,000 + $5X
$-
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
0 2000 4000 6000 8000 10000 12000

Cost Functions Combined
$-
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
0 2000 4000 6000 8000 10000 12000
Variable Cost Y = $5X
Fixed Cost Y = $10,000
Total Cost Y = $10,000 + $5X

Criteria for Classifying Variable and
Fixed Components of a Cost
1. Choice of Cost Object – different objects
may result in different classification of the
same cost
2. Time Horizon – the longer the period, the
more likely the cost will be variable
3. Relevant Range – behavior is predictable
only within this band of activity

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.

Cause and Effect as It Relates to
Cost Drivers
 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

Cost Estimation Methods
1. Industrial Engineering Method
2. Conference Method
3. Account Analysis Method
4. Quantitative Analysis Methods
- High-Low Method
- Regression Analysis

Industrial Engineering Method
 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

Conference 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

Account Analysis Method
 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

Qualitative Analysis
 Uses a formal mathematical method to fit cost
functions to past data observations
 Advantage: results are objective

Steps in Estimating a Cost Function
Using Quantitative Analysis
1. Choose the dependent variable (the cost to be
predicted)
2. Identify the independent variable or cost driver
3. Collect data on the dependent variable and the cost
driver
4. Plot the data
5. Estimate the cost function using the High-Low
Method or Regression Analysis
6. Evaluate the cost driver of the estimated cost
function

High-Low Method
 Simplest method of quantitative analysis
 Uses only the highest and lowest observed
values

Steps in the High-Low Method
1. Calculate variable cost per unit of activity
Variable Cost associated with Cost associated with
Cost per = highest activity level highest activity level
Unit of Activity Highest activity level - Lowest activity level
{ - }

Steps in the High-Low Method
2. Calculate Total Fixed Costs
3. Summarize by writing a linear equation
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
Y = Fixed costs + ( Variable cost per unit of Activity * Activity )
Y = FC + (VCu * X)

1 2 3 4 5 6
Hours 350 250 440 750 650 550
Cost 5,200 5,000 6,700 9,500 7.700 7,000

-10,500
9,500
-9000
-6000 x
x
-7500
x
-6000 x
5000 x
-4500
-3000
-150
0 0 250 350 450 550 650 750

Regression Analysis
 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
 Is more accurate than the High-Low method because
the regression equation estimates costs using
information from all observations; the High-Low
method uses only two observations

Types of Regression
 regression– 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

Regression analysis output:
Regression constant (a)
Regression coefficient(s) (bi)
Goodness of fit:
R2
Standard erroe of the estimate

Terminology
 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

Criteria for Evaluating
Alternative Cost Drivers
1. Economic Plausibility
2. Goodness of Fit
3. Significance of the Independent Variable

Nonlinear Cost Functions
1. Economies of Scale
2. Quantity Discounts
3. Step Cost Functions – resources increase in “lot-
sizes,” not individual units
4. Learning Curves – labor hours consumed decrease
as workers learn their jobs and become better at
them
5. Experience Curve – broader application of learning
curve that includes downstream activities including
marketing and distribution

Types of Learning Curves
 Cumulative Average-Time Learning Model –
cumulative average time per unit declines by a
constant percentage each time the cumulative
quantity of units produced doubles
 (e.g., 80% learning curve)
 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

The Ideal Database
1. The database should contain numerous
reliably measured observations of the cost
driver and the costs
2. In relation to the cost driver, the database
should consider many values spanning a
wide range

Data Problems
 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

Data Problems
 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 (cost pool) has the
same cost driver

Data Problems
 The relationship between the cost driver and
the cost is not stationary
 Inflation has affected costs, the driver, or both

10 Cost Behavior HIGH - LOW METHOD.ppt

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10 Cost Behavior HIGH - LOW METHOD.ppt