Activity Analysis, Cost Behavior, and Cost Estimation .docx

Activity Analysis, Cost
Behavior, and Cost
Estimation
Chapter 6
McGraw-Hill/Irwin Copyright © 2014 McGraw-Hill Education.
All rights reserved. No reproduction or distribution without the
prior written consent of McGraw-Hill Education.
Presenter
Presentation Notes
Chapter 6: Activity Analysis, Cost Behavior, and Cost
Estimation
Learning Objective1
6-2
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Presentation Notes
Learning Objective 1. Explain the relationships between cost
estimation, cost behavior, and cost prediction.
Cost
prediction

Using knowledge
of cost behavior
to forecast
level of cost at
a particular
activity. Focus
is on the future.
Introduction
Cost
behavior
Relationship
between
cost and
activity.
Process of
determining
cost behavior,
often focuses
on historical
data.
Cost
estimation
6-3
Presenter

Presentation Notes
How does a managerial accountant determine the cost behavior
pattern for a particular cost item?
The determination of cost behavior, which is often called cost
estimation, can be accomplished in a number of ways.
One way is to analyze historical data concerning costs and
activity levels.
The relationship between cost and activity, called cost behavior,
is relevant to the management functions of planning, control,
and decision making.
In order to plan operations and prepare a budget, managers need
to predict the costs that will be incurred at different levels of
activity.
Knowledge of cost behavior will help the manager to make the
desired cost prediction.
A cost prediction is a forecast of cost at a particular level of
activity. (LO1)
Learning Objective 2
6-4
Presenter
Presentation Notes
Learning Objective 2. Define and describe the behavior of the
following types of costs: variable, step-variable, fixed, step-
fixed, semivariable (or mixed), and curvilinear.
Total Variable Cost Example
Your total Pay Per View bill is based on how many Pay Per
View
shows that you watch.

Number of Pay Per View shows
watched
To
ta
l P
ay
P
er
V
ie
w
B
ill
6-5
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Presentation Notes
A variable cost changes in total in direct proportion to a change
in the activity level (or cost driver).
For example, assume that you pay $4.95 for each Pay Per View
show that you watch.
The more shows that you watch, the higher your Pay Per View
bill will be.
The total cost of the Pay Per View bill increases in direct
proportion to the number of shows watched.
Your text book describes the raw materials that goes into

making donuts are also variable costs―the more donuts you
make the higher the cost of raw materials. (LO2)
Variable Cost Per Unit Example
The cost per Pay Per View show is constant. For example,
$4.95
per show.
Number of Pay Per View
shows watched
C
os
t p
er
P
ay
P
er
V
ie
w
sh
ow
6-6

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Presentation Notes
However, the variable cost per unit is constant as activity
changes. In our Pay Per view example, the cost per show
remains at $4.95. To summarize, as activity changes, total
variable cost increases in direct proportion to the change in
activity level, but the variable cost per unit remains constant.
(LO2).
Step-Variable Costs
Activity
C
os
t
Total cost remains
constant within a
narrow range of
activity.
6-7
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Presentation Notes
Some costs are nearly variable, but they increase in small steps
instead of continuously.
Such costs, called step-variable costs, usually include inputs
that are purchased and used in relatively small increments.

For a narrow range of activity, the total cost remains the same.
For example, the hourly rate for cashiers at a local grocery store
is a set amount.
During hours when there are few customers only three cashiers
are needed.
Therefore, at these low activity levels, the total cost for cashiers
is the same. (LO2)
Step-Variable Costs
Activity
C
os
t
Total cost increases to a
new higher cost for the
next higher range of
activity.
6-8
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Presentation Notes
But when the number of customers increases, the number of
cashiers required increases.
The hourly rate, or cost per unit, stays the same but the total
cost increases at the next higher range of activity. (LO2)
Total Fixed Cost Example

Your monthly basic cable TV bill probably does not change no
matter
how many hours you watch.
Number of hours watched
M
on
th
ly
B
as
ic
C
ab
le
B
ill
6-9
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Presentation Notes
A fixed cost remains unchanged in total as the activity level
varies.
Examples of fixed costs include facilities costs, which include

property taxes, depreciation on buildings and equipment, and
the salaries of maintenance personnel.
The total cost of fixed costs remains constant, regardless of the
level of activity. (LO2)
Fixed Cost Per Unit Example
The average cost per hour decreases as more hours are spent
watching cable television.
Number of hours watched
M
on
th
ly
B
as
ic
c
ab
le
B
ill
pe
r

ho
ur
w
at
ch
ed
6-10
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Presentation Notes
However, the fixed cost per unit does change as activity varies.
The fixed cost per unit is calculated by dividing the total fixed
costs by the number of units. Therefore, as the activity level
increases, total fixed costs does not change, but unit fixed cost
declines. For this reason, it is preferable in any cost analysis to
work with total fixed cost rather than fixed cost per unit. (LO2)
Step-Fixed Costs
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.

Continue
6-11
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Presentation Notes
Some costs remain fixed over a wide range of activity but jump
to a different amount for activity levels outside that range.
Such costs are called step-fixed costs. (LO2)
R
en
t C
os
t i
n
Th
ou
sa
nd
s
of
D
ol

la
rs
0 1,000 2,000 3,000
Rented Area (Square Feet)
30
60
90
Total cost doesn’t change for a wide range of activity,
and then jumps to a new higher cost for the next
higher range of activity.
Step-Fixed Costs
6-12
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Presentation Notes
A company may rent office space at the cost of $30,000 per
1,000 square feet.
Extra space is only available in increments of 1,000 square feet.
The rent remains $30,000 regardless of activity.
As business increases, more square footage is needed.
The next 1,000 square feet costs another $30,000.
As the company expands, another 1,000 square feet is needed,
costing another $30,000. (LO2)
Step-variable costs

can be adjusted more
quickly and . . .
The width of the
activity steps is much
wider for the
step-fixed cost.
How does this type
of fixed cost differ
from a step-variable
cost?
Step-Fixed Costs
6-13
Presenter
Presentation Notes
Step-variable costs differ from step-fixed costs in that they can
be adjusted more quickly.
Also, the width of the steps is much wider for step-fixed costs.
(LO2)
Semivariable Cost
A semivariable cost
is partly fixed and
partly variable.

Consider the
following
example:.
6-14
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Presentation Notes
A semivariable (or mixed) cost has both a fixed and a variable
component.
Assume that a construction company leases a bulldozer and
incurs a flat fee of $1500 per month, regardless of how many
hours the bulldozer is used.
The company also incurs a cost of $35 per hour used. (LO2)
Fixed Monthly
Rental Charge
Variable Lease
Charge Per Hour
Rental Charge Per Hour
To
ta
l L
ea
se
C
os
t

Semivariable Cost
The slope is
the variable
cost per unit
of activity.
6-15
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Presentation Notes
The company’s monthly bill would always be at least $1,500,
the fixed portion of the lease.
The total cost would rise from $1,500, depending on how hours
were used.
Therefore, the slope of a total cost line is the variable cost per
unit of activity. (LO2)
Curvilinear Cost
Curvilinear
Cost Function
Relevant Range
Activity
To
ta
l C
os

t
Curvilinear
Cost Function
A straight-line
(constant unit
variable cost) closely
approximates a
curvilinear line within
the relevant range.
6-16
Presenter
Presentation Notes
The graphs of all of the cost behavior patterns examined so far
consist of either straight lines or several straight-line sections.
A curvilinear cost behavior pattern has a curved graph.
Assume that a company groups its trash collection, telephone
and electricity costs together as utility costs.
The company’s utilities cost may be a curvilinear cost. Recall
that a marginal cost is the cost of producing the next unit.
For low levels of activity, the utilities cost would exhibit
decreasing marginal costs because only the electricity costs
would increase as production increased.
For high levels of activity the graph would exhibit increasing
marginal costs.
If the demand for a particular month is at lower levels of
activity, the company can use its modern, energy efficient
equipment.
But at higher levels of activity, the older equipment must also
be used.

This equipment is less energy-efficient.
As a result, the marginal utilities cost rises as monthly activity
increases. (LO2)
6-17
Presenter
Presentation Notes
Learning Objective 3. Explain the importance of the relevant
range in using a cost behavior pattern for cost prediction.
Curvilinear Cost
Curvilinear
Cost Function
Relevant Range
Activity
To
ta
l C
os
t
Curvilinear
Cost Function

A straight-Line
(constant unit
variable cost) closely
approximates a
curvilinear line within
the relevant range.
6-18
Presenter
Presentation Notes
Management need not concern itself with extreme levels of
activity if it is unlikely the company will operate at those
activity levels.
Management is interested in cost behavior within the company’s
relevant range, the range of activity within which management
expects the company to operate. (LO3)
6-19
Presenter
Presentation Notes
Learning Objective 4. Define and give examples of engineered
costs, committed costs, and discretionary costs.
Engineered, Committed, and Discretionary
Costs

Discretionary
May be altered in the
short term by current
managerial decisions.
Committed
Long-term, cannot be
reduced in the short
term.
Engineered
Physical relationship
with activity measure.
Depreciation on
Buildings and
equipment
Advertising and
Research and
Development
Direct
Materials
6-20
Presenter
Presentation Notes
In the process of budgeting costs, it is often useful for
management to make a distinction between engineered,
committed, and discretionary costs.

An engineered cost bears a definitive physical relationship to
the activity measure. Direct-material cost is an engineered cost.
A committed cost results from an organization’s ownership or
use of facilities and its basic organization structure. Property
taxes, depreciation on buildings and equipment, costs of
renting facilities or equipment, and the salaries of management
personnel are examples of committed fixed costs.
A discretionary cost arises as a result of a management decision
to spend a particular amount of money for some purpose.
Examples of discretionary costs include amounts spent on
research and development, advertising and promotion,
management development programs, and contributions to
charitable organizations. (LO4)
Cost Behavior in Other Industries
Merchandisers
Cost of Goods Sold
Manufacturers
Direct Material, Direct
Labor, and Variable
Manufacturing Overhead
Merchandisers and
Manufacturers
Sales commissions and
shipping costs
Service Organizations

Supplies and travel
Examples of variable costs
6-21
Presenter
Presentation Notes
The cost behavior pattern appropriate for a particular cost item
depends on the organization and the activity base (or cost
driver). In manufacturing firms, production quantity, direct
labor hours, and machine hours are common cost drivers.
Direct-material and direct labor costs are usually considered
variable costs. Other variable costs include some
manufacturing-overhead costs, such as indirect material and
indirect labor. In merchandising firms, the activity base (or
cost driver) usually is sales revenue. The cost of merchandise
sold is a variable cost. Sales commissions and shipping costs
would be variable costs for both manufacturers and
merchandisers. In service organizations, supplies and travel
expenses are variable costs. (LO4)
Examples of fixed costs
Merchandisers, manufacturers, and
service organizations
Real estate taxes
Insurance
Sales salaries

Depreciation
Cost Behavior in Other Industries
6-22
Presenter
Presentation Notes
Property taxes, insurance expense, fixed salaries, depreciation
are all examples of fixed costs for manufacturers,
merchandisers, and service organizations. (LO4)
6-23
Presenter
Presentation Notes
Learning Objective 5. Describe and use the following cost
estimation methods: account classification, visual fit, high-low,
and least-squares regression.
Account-Classification Method
Visual-Fit Method
High-Low Method
Least-Squares Regression Method
Cost Estimation

6-24
Presenter
Presentation Notes
Different costs exhibit a variety of cost behavior patterns.
Cost estimation is the process of determining how a particular
cost behaves.
Several methods are commonly used to estimate the relationship
between cost and activity.
Some of these methods are simple, while some are quite
sophisticated.
In some firms, managers use more than one method of cost
estimation.
The results of the different methods are then combined by the
cost analyst on the basis of experience and judgment. (LO5)
Account Classification Method
Cost estimates are based on a
review of each account making up
the total cost being analyzed.
6-25
Presenter
Presentation Notes
The account-classification method of cost estimation involves a
careful examination of the organization’s ledger accounts. The
cost analyst classifies each cost item in the ledger as a variable,
fixed, or semi-variable cost. The classification is based on the
analyst’s knowledge of the organization’s activities and

experience with the organization’s costs. Once the costs have
been classified, the cost analyst estimates cost amounts by
examining job-cost records, paid bills, labor time cards, or other
source documents. This examination of historical source
documents is combined with other knowledge that may affect
costs in the future. (LO5)
Visual-Fit Method
A scatter diagram of past cost behavior
may be helpful in analyzing mixed costs.
6-26
Presenter
Presentation Notes
When a cost has been classified as semi-variable, or when the
analyst has no clear idea about the behavior of a cost item, it is
helpful to use the visual-fit method to plot recent observations
of the cost at various activity levels. (LO5)
Plot the data points on a
graph (total cost vs. activity).
0 1 2 3 4
*
To
ta
l C

os
t i
n
1,
00
0’
s
of
D
ol
la
rs
10
20
0
*
* *
*
*
* * *
*
Activity, 1,000’s of Units Produced

Visual-Fit Method
6-27
Presenter
Presentation Notes
The resulting scatter diagram helps the analyst to visualize the
relationship between cost and the level of activity (or cost
driver). (LO5)
Draw a line through the plotted data points so that about
equal numbers of points fall above and below the line.
Visual-Fit Method
0 1 2 3 4
*
To
ta
l C
os
t i
n
1,
00
0’

s
of
D
ol
la
rs
10
20
0
*
* *
*
*
* * *
*
6-28
Presenter
Presentation Notes
The cost analyst can visually fit a line to these data by laying a
ruler on the plotted points. The line is positioned so that a
roughly equal number of plotted points lie above and below the
line. The scatter diagram provides little or no information

about the cost relationship outside the relevant range. (LO5)
Visual-Fit Method
Vertical distance
is total cost,
approximately
$16,000.
0 1 2 3 4
*
To
ta
l C
os
t i
n
1,
00
0’
s
of
D
ol
la

rs
10
20
0
*
* *
*
*
* * *
*
Estimated fixed cost = $10,000
6-29
Presenter
Presentation Notes
The point where the line crosses the vertical axis is the
estimated fixed costs.
The horizontal axis is the level of activity.
The vertical distance between the horizontal axis and the plotted
line is the total cost at that level of activity. (LO5)
The High-Low Method
Owl Co recorded the following production activity &

maintenance
costs for two months:
Using these two levels of activity, compute:
the variable cost per unit.
the total fixed cost.
Units Cost
High activity level 9,000 9,700$
Low activity level 5,000 6,100
6-30
Presenter
Presentation Notes
In the high-low method, the semi-variable 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 cost per unit and the total fixed
cost. (LO5)
Units Cost

Change 4,000 3,600$
The High-Low Method
6-31
Presenter
Presentation Notes
Before you can get started you must first calculate the change or
difference in units and in cost. (LO5)
Units Cost
Change 4,000 3,600$
Unit variable cost =
The High-Low Method
6-32
Presenter
Presentation Notes
The first step of the high-low method is to divide the change in
cost by the change in units. (LO5)
Units Cost

Change 4,000 3,600$
Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit
The High-Low Method
6-33
Presenter
Presentation Notes
This will give you the variable cost per unit. (LO5)
Units Cost
Change 4,000 3,600$
Fixed cost = Total cost – Total variable cost
The High-Low Method
6-34
Presenter
Presentation Notes
The next step is to determine the fixed costs. (LO5)

Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Units Cost
Change 4,000 3,600$
The High-Low Method
6-35
Presenter
Presentation Notes
The total variable cost at either the high or low level is
deducted from the total cost at the same level.
The total variable cost is calculated by multiplying the variable
cost per unit (from step one) by the number of units. (LO5)
Units Cost
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
6-36

Presenter
Presentation Notes
The total variable costs are deducted from the total cost to
arrive at the fixed costs, $1,600. (LO5)
Regression is a statistical procedure used
to determine the relationship between variables such as
activity and cost.
Activity
To
ta
l C
os
t
The objective of
the regression
method is the
general cost equation:
Y = a + bX
6-37
Presenter
Presentation Notes
Statistical techniques may be used to estimate objectively a cost
behavior pattern using all of the available data.

The most common of these methods is called least-squares
regression.
In the least-squares regression method, the objective is the
general cost equation, Y = a + bX. (LO5)
Y = a + bX
Total Cost is the
dependent variable.
The activity (X) is the
independent variable.
The X term coefficient (b)
is the estimate of variable
cost per unit of activity,
the slope of the cost line.
The intercept term (a) is
the estimate of fixed costs.
Equation Form of Least-Squares
Regression Line
6-38
Presenter
Presentation Notes
In the equation, X denotes the independent variable, such as
activity level for a month, and Y denotes the estimated total

utilities cost for that level of activity.
The intercept of the line on the vertical axis is denoted by a,
and the slope of the line is denoted by b.
Within the relevant range, a is interpreted as an estimate of the
fixed cost component, and b is interpreted as an estimate of the
variable cost per unit of activity.
In regression analysis, X is referred to as the independent
variable, since it is the variable upon which the estimate is
based.
Y is called the dependent variable, since its estimate depends on
the independent variable. (LO5)
courses deal with detailed
regression computations using
Microsoft Excel.
be able to interpret and use
regression estimates.
6-39
Presenter
Presentation Notes
The least-squares regression method does require considerably
more computation than either the visual-fit or high-low method.
However, computer programs are readily available to perform
least-squares regression.
In addition, accountants and managers must be trained to
interpret and use regression estimates. (LO5)

6-40
Presenter
Presentation Notes
Learning Objective 6. Describe the multiple regression,
engineering, and learning-curve approaches to cost estimation.
Terms in the equation have the same
meaning as in simple regression with
only one independent variable.
Multiple Regression
Multiple regression includes two or more independent
variables:
Y = a + b1X1 + b2X2
6-41
Presenter
Presentation Notes
Multiple regression is a statistical method that estimates a
linear (straight-line) relationship between one dependent
variable and two or more independent variables.
In a multiple regression equation, a denotes the regression
estimate of the fixed-cost component, b1 denotes the regression

estimate of the variable cost of variable 1 and b2 denotes the
regression estimate of the variable cost of variable 2.
The multiple-regression equation will likely enable a controller
to make more accurate cost predictions than could be made with
the simple regression. (LO6)
Engineering Method
of Cost Estimation
Cost estimates are based on measurement
and pricing of the work involved.
6-42
Presenter
Presentation Notes
A completely different method of cost estimation is to study the
process that results in cost incurrence.
This approach is called the engineering method of cost
estimation.
Engineering cost studies are time-consuming and expensive, but
they often provide highly accurate estimates of cost behavior.
Moreover, in rapidly evolving, high-technology industries, there
may not be any historical data on which to base cost estimates.
Such industries as genetic engineering, superconductivity, and
electronics are evolving so rapidly that historical data are often
irrelevant in estimating costs. (LO6)
Direct Labor

•Material required
for each unit is
obtained from
engineering drawings
and specification sheets.
•Material prices are
determined from
vendor bids.
•Analyze the kind
of work performed.
•Estimate the time
required for each labor
skill for each unit.
•Use local wage rates to
obtain labor cost
per unit.
Direct Material
Engineering Method
of Cost Estimation
6-43
Presenter
Presentation Notes
In a manufacturing firm, for example, a detailed study is made

of the production technology, materials, and labor used in the
manufacturing process. Rather than asking what the cost of
material was last period, the engineering approach is to ask how
much material should be needed and how much it should cost.
Industrial engineers sometimes perform time and motion
studies, which determine the steps required for people to
perform the manual tasks that are part of the production
process. Cost behavior patterns for various types of costs are
then estimated on the basis of the engineering analysis. (LO6)
Effect of Learning
on Cost Behavior
As I make more of these
things it takes me less
time for each one. It must
be the learning curve effect
that the boss was
talking about.
I’ve noticed the same
thing. And if you include
all the variable overhead
costs that are also
declining, that must be
the experience curve.
6-44
Presenter
Presentation Notes

In many production processes, production efficiency increases
with experience. As cumulative production output increases, the
average labor time required per unit declines. As the labor
time declines, labor cost declines as well. This phenomenon is
called the learning curve. When the learning-curve concept is
applied to a broader set of costs than just labor costs, it is
referred to as an experience curve. The learning curve and
experience curve concepts have been applied primarily to
complex, labor-intensive manufacturing operations, such as
aircraft assembly and shipbuilding. Boeing and Airbus, for
example, make extensive use of the learning and experience
curve concepts when budgeting the cost for a new aircraft
design. However, the learning curve also has seen limited
application in the health care services industry, mainly focusing
on complex surgical procedures. (LO6)
Learning Curve
Cumulative Production Output
A
ve
ra
ge
L
ab
or

Ti
m
e
pe
r
U
ni
t
Learning effects
are large initially.
Learning effects
become smaller, eventually
reaching steady state.
6-45
Presenter
Presentation Notes
A learning curve, then, is a graphical expression of the decline
in the average labor cost required per unit as cumulative output
increases.
Initially, the effects of learning are large. But eventually, these
effects become smaller.
These cost predictions are then used in scheduling production,
budgeting, setting product prices, and other managerial
decisions. (LO6)

6-46
Presenter
Presentation Notes
Learning Objective 7. Describe some problems often
encountered in collecting data for cost estimation.
Data Collection Problems
1. Missing data.
2. Outlier data points.
3. Mismatched time periods costs.
4. Trade-offs in choosing the time period.
5. Allocated and discretionary costs.
6. Inflation.
6-47
Presenter
Presentation Notes
Regardless of the method used, the resulting cost estimation
will be only as good as the data upon which it is based. The
collection of data appropriate for cost estimation requires a
skilled and experienced cost analyst. Six problems frequently
complicate the process of data collection:
1. Missing data.

2. Outliers, which could represent errors or highly unusual
circumstances.
3. Mismatched time periods.
4. Trade-offs in choosing the time period.
5. Allocated and discretionary costs.
6. Inflation.
(LO7)
End of Chapter 6
6-48
Chapter 6Learning Objective1IntroductionLearning Objective
2Total Variable Cost ExampleVariable Cost Per Unit
ExampleStep-Variable CostsStep-Variable CostsTotal Fixed
Cost ExampleFixed Cost Per Unit ExampleStep-Fixed
CostsStep-Fixed CostsStep-Fixed CostsSemivariable Cost
Semivariable Cost Curvilinear CostLearning Objective
3Curvilinear CostLearning Objective 4Engineered, Committed,
and Discretionary CostsCost Behavior in Other IndustriesCost
Behavior in Other IndustriesLearning Objective 5Cost
EstimationAccount Classification MethodVisual-Fit
MethodSlide Number 27Slide Number 28Slide Number 29The
High-Low MethodSlide Number 31Slide Number 32Slide
Number 33Slide Number 34Slide Number 35Slide Number
36Least-Squares Regression MethodEquation Form of Least-
Squares Regression LineLeast-Squares Regression
MethodLearning Objective 6Multiple RegressionEngineering
Method�of Cost EstimationEngineering Method�of Cost
EstimationEffect of Learning�on Cost BehaviorLearning
CurveLearning Objective 7Data Collection ProblemsEnd of
Chapter 6

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