Management Accounting Consultancy Report

Chapter 3

Cost Behaviour, Cost Drivers and Cost Estimation
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MONASH
BUSINESS
SCHOOL

For this topic you should be able to:
Explain the relationship between cost estimation, cost behaviour and cost prediction
Understand the concept of cost drivers, including volume-based and non-volume based cost drivers, and the hierarchy of cost drivers – unit, batch, product, facility
Identify and analyse different cost behaviours, including variable, fixed, step-fixed, semivariable & curvlinear
Use different approaches to cost estimation, including managerial judgement, the engineering approach and quantitative analysis
Explain the difficulties of estimating costs in practice and think of ways to overcome them
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The Relationship between Cost Behaviour, Estimation, and Prediction

COST
BEHAVIOUR

COST
PREDICTION

COST
ESTIMATION
The process of determining cost behaviour
The relationship between a cost and the level of activity
Using knowledge of cost behaviour to forecast the level of cost at a particular level of activity

How do We Estimate Cost Behaviour?
…by using cost drivers

What is a cost driver?
An activity or factor that drives a cost to be incurred

In choosing appropriate cost drivers, consideration needs to be given about the underlying causes of the costs

What drives it to go up or down?
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The cost of paint goes up
Why? What drives the increase?
There is an increase in the number of cars sprayed

Cost driver = number of
cars

A volume-based cost driver
Example 1: A Spray-Painting

Administration costs in the corporate headquarters has gone down. Why?
Senior managers decided to hold less face-to-face meetings and communicate electronically instead

Cost driver = number of face-to- face senior management
meetings

A non volume-based cost driver

Example 2: A Large Bank

Conventional vs. Contemporary Cost Drivers
Conventional approach:
Uses volume-based cost drivers (e.g., Units produced, DLH, DL$, MH)
Assumes that all costs are driven by the organisation’s level of activity, for example production or sales volume
This will be accurate for direct product costs such as direct material and labour….but not for other types of costs

Contemporary approach:
Recognises that there are a range of possible cost drivers other than production volume that explain cost behaviour
Uses both volume and non-volume based cost drivers

Activity-based Approach to Cost Drivers
Classifies costs and cost drivers into four levels:

Unit level
Batch level
Product (or product-sustaining) level
Facility level

Unit level costs:
Relate to activities performed for each unit produced
Use conventional volume-based cost drivers
Example: Direct material
Batch level costs:
Relate to activities performed for a group of product units
Examples include a batch or a delivery load
Example: Delivery costs
Product level costs:
Also called product sustaining costs
Relates to activities performed for specific products or product groups
Example: Research & design costs
Facility level costs:
Also called facility- sustaining costs
Costs incurred to run the business, not caused by any particular product
Example: Premises costs

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Unit
Facility
Batch
Batch
Product/Facility

Selecting the Best Cost Drivers

How detailed should the analysis be?
As total costs of the organisation are split into smaller cost categories and associated costs drivers, the accuracy of the resulting information will increase
Cost-benefit criteria are important

Long or short term?
Cost behaviour and cost drivers can change over time
Choice depends on the intended purpose of the cost analysis, for example short-term budgeting or long-term strategic decision making?

Selecting the Best Cost Drivers…. (cont’d)
Cost estimation or cost management?
Cost estimation: understand cost
behaviour so that we can estimate cost
functions or predict future costs

Cost management: analysing costs to reduce costs and manage resources more effectively
Effective cost management requires the identification of root cause cost drivers – the basic factors that cause a cost to be incurred

Cost drivers that are used to predict costs may differ from those used to manage costs

The research department sends out blood samples for examination to an external pathology lab.
What is the cost driver of this activity?

For cost estimation purposes: Number of blood samples sent
For cost management purposes: Skill level of staff

Research Cost – $1.5 million – Pharmaceutical Company

Remember last week?!

Cost-benefit Considerations

To predict costs accurately, there is a trade-off between:
Having a strong correlation between the cost and cost driver, therefore increasing the accuracy of the cost information and
Having a cost driver that is easy to measure

Many organisations select cost drivers for convenience reasons, not for their ability to predict costs accurately
Also, with more cost drivers, the costs of gathering and analysing information about costs and cost drivers will also increase
Need to consider cost vs. benefits
A matter of managerial judgement

Therefore….
When choosing cost drivers, the costs and benefits of each driver must be assessed, taking into account:

Reasons for analysing cost behaviour
Timeframe for analysing the cost behaviour
Availability of data on cost drivers

Cost Behaviour Patterns
Cost behaviour
The relationship between a cost and the level of activity (or cost driver)

Cost behaviour patterns
Variable costs
Fixed costs
Step-fixed costs
Semivariable costs
Curvilinear costs

Variable Costs
Variable costs change in total, in direct proportion to changes in the level of activity, but the variable cost per unit remains constant

Constant

Changes

Fixed Costs
Fixed costs remain unchanged in total despite changes in the level of activity, but fixed cost per unit changes

Fixed cost per unit is often calculated for use in product costs but is of limited use in management decision making as it does not reflect the way that fixed costs actually behave

Modern approaches to cost analysis recognise that there are cost drivers for some of these fixed costs and very few costs actually remain fixed
Activity based costing in Week 7

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Changes
Constant (compare with variable
costs!)

Lecture Illustration 1

The following table shows the costs during a month if 600 cars are spray-painted

Required: Fill in the values labelled (a) to (p) in the table

  Number of spray-painted cars

  500 600 700

 Fixed Costs (a) $84 000 (b)

 Variable costs (c) (d) (e)

 Total costs (f) $144 000 (g)

Cost per spray-painted car:

  Fixed cost (h) (i) (j)

  Variable cost (k) (l) (m)

 Total cost per car: (n) (o) (p)

Lecture Illustration 1

The following table shows the costs during a month if 600 cars are spray-painted

Required: Fill in the values labelled (a) to (p) in the table

  Number of spray-painted cars

  500 600 700

 Fixed Costs $84 000

 Variable costs

 Total costs $144 000

Cost per spray-painted car:

  Fixed cost

  Variable cost

 Total cost per car:

Variations in Cost Behaviour Patterns
Step-fixed costs
Remain fixed over a wide range of activity levels but jump to a different amount for levels outside that range

Semi-variable (or mixed) cost
Has both fixed and variable components

Curvilinear cost
At lower levels of activity there is decreasing marginal cost
At higher levels of activity there is increasing marginal cost
Marginal cost: the cost of producing one additional unit

As opening hours increase, more managers are employed

Mixed Costs
Most costs are mixed or semi-variable
This means they have both a fixed and variable cost component
They can be represented using the following cost function:

Y = a + bX

Where Y = total cost
a = fixed cost component (the intercept on the vertical axis)
b = variable cost per unit of activity (the slope of the line)
X = the level of activity

Petrol, oil and maintenance costs – vary proportionately with number of deliveries made
Lease, insurance, and delivery staff salary costs – remain constant irrespective of number of deliveries

For up to 1000 batches, marginal electricity costs decrease as economies of scale are achieved.
Above 1000 batches, older machinery needs to be used so marginal electricity costs increase.

Cost Behaviour and the Relevant Range
The relevant range is the range of activity over which a particular cost behaviour pattern is assumed to be valid
For example:
The direct material cost per unit may only hold for production up to 1000 units per day, and for higher volumes the cost per unit may decrease due to cheaper cost of buying material in larger quantities

Cost Estimation
Identifying the specific cost behaviour pattern for each cost

Approaches to cost estimation:
Managerial judgment
Engineering approach
Quantitative analysis
Visual fit method
High-low method
Regression analysis

Managerial Judgment
Using experience and knowledge rather than formal analysis to classify costs behaviour

Future costs are estimated by examining past costs and identifying other factors that might affect costs in the future

Reliability of cost estimates is dependent upon the ability of the manager

Engineering Approach
Studying processes that result in the incurrence of a cost
Using time and motion studies – employees are observed as they work to record the steps for each task and the times taken
Useful when there is no reliable past data on which to base cost estimates

Most effective when there is a direct relationship between inputs and outputs
However, expensive and time-consuming

Quantitative Analysis
Formal analysis of past data to identify the relationships between costs and activities
Three approaches:
Visual fit method – a scatter plot diagram involves plotting the data points to visualise the relationship between cost and level of activity

High-low method – involves taking the two observations with the highest and lowest level of activity to calculate the cost function

Regression analysis – is a statistical technique that uses a range of data points to estimate the relationship between cost and cost drivers

Example: Dental Clinic

Month No. of patients Material costs

1 160 $3,400

2 120 $3,000

3 150 $3,200

4 100 $2,500

5 80 $2,100

6 130 $3,200

7 140 $3,000

8 190 $4,100

9 230 $5,100

10 170 $3,800

11 160 $3,200

12 180 $3,900

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Visual Method – Scatter Plot Diagram

Material costs 160 120 150 100 80 130 140 190 230 170 160 180 3400 3000 3200 2500 2100 3200 3000 4100 5100 3800 3200 3900 No. of patients

Material costs

Lecture Illustration 2: High-Low Method
Nature Clinic’s data for last year in relation to in-house diagnostic blood tests are as follows:

Required: Use the high–low method to estimate the company’s cost behaviour and express it in equation form.

 Month No. of blood tests Cost

January 6,100 $63,500

February 5,300 $50,500

March 4,900 $50,500

April 4,800 $51,500

May 5,100 $51,500

June 3,000 $31,000

July 4,500 $44,500

August 7,100 $72,000

September 6,200 $57,000

October 4,700 $46,500

November 5,900 $64,500

December 6,000 $61,000

Illustration 2: High-Low method

Calculations:
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Regression Analysis
A statistical technique used to estimate the relationship between a dependent variable (cost) and independent variables (cost driver)

The line of best fit makes deviations between the cost line and the data points as small as possible

More accurate than high-low method as it makes use of all data and has statistical properties that allows inferences to be drawn between cost and activity levels

Simple regression involves estimating the relationship between the dependent variable (Y) and one independent variable (X)
Y = a + bX

Multiple regression estimates a linear relationship between one dependent variable and two or more independent variables
Y = a + b1X1 + b2X2

SUMMARY OUTPUT

Regression

Multiple R 0.973

R Square 0.947

Adjusted R Square 0.942

Standard Error 188.713

Observations 12

ANOVA

  df SS MS F Signif. F

Regression 1 6,366,372 6,366,372 178.767 0.0000

Residual 10 356,128 35,613

Total 11 6,722,500      

  Coefficients Std. Error t Stat P-value Lower 95% Upper 95%

Intercept 561.05 217.40 2.58 0.03 76.65 1045.44

No. of patients 18.66 1.40 13.37 0.00 15.55 21.77

Regression Analysis

Ŷ = $561 + $18.66X
where
Y= Material cost
X = No. of patients

Dependent Variable
Independent Variable

R2 – measures the proportion of change in the dependent variable that is explained by a change in the independent variable

Adjusted R2 – an R2 adjusted to compensate for a small sample size

Evaluating the Regression Line

Practical Issues in Cost Estimation Data

Cost estimates are only as good as the data upon which they are based

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Issues in
Cost
estimation

Missing
data

Outliers

Inflation

Mismatched
time periods

Trade-offs

Allocated
fixed costs

Data Collection Problems
Missing data

Outliers—extreme observations of activity/cost relationships

Mismatched time periods for dependent and independent variables

Trade-offs in choosing the time period—the number of observations vs the reliability of past data points as predictors of future cost behaviour

Data Collection Problems
Allocation of fixed costs (on a per unit basis) may suggest cost behaviours that are misleading

Inflation may cause historic cost data to be less relevant in predicting future cost behaviours
Effect of learning – labour costs decrease over time

Other Issues in Cost Estimation

Activity-based approaches allow more complex cost behaviour patterns to be considered.

The accuracy of cost functions.
Sometimes budgets and cost estimates capture
only approximations of cost behaviours

All cost functions are based on simplifying assumptions, such as:
Cost behaviours depend on a single or only a few types of activity.
Cost behaviours are linear within a relevant range.

Costs of producing more accurate cost estimates need to be assessed against the likely benefits.

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Acknowledgement
Some slides contained in this presentation were adapted from:

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