1. Cost Behaviors Management Accounting

3. Cost Classifications Association with cost object Cost object is anything for which management wants to collect or accumulate costs –Direct - traceable to a cost object –Indirect - not conveniently or practically traceable to a cost object treated as overhead allocated

4. Cost Categories Association with cost object Reaction to changes in activity –Variable –Fixed –Mixed –Step Relevant Range – normal operating range

5. Variable Cost Fixed Cost Cost Reaction to Changes in Activity Total $ # of Units $ Within the relevant range

6. Variable Cost Fixed Cost Cost Reaction to Changes in Activity Total Unit $ # of Units $ $ $ Within the relevant range

7. Total and Unit Cost Behavior Varies in direct proportion to changes in activity Remains constant throughout the relevant range Remains constant throughout the relevant range Varies inversely with changes in activity throughout the relevant range Variable Cost Fixed Cost Total CostUnit Cost

8. Step Cost (Fixed) Cost Reaction to Changes in Activity $ Units Within the relevant range

9. Mixed Cost Cost Reaction to Changes in Activity $ Units fixed Within the relevant range variable

10. Determining Cost Behavior Cost Predictor –Activity accompanied by consistent, observable changes in a cost item –Predicts but may not cause the cost to change Cost Driver –Activity that has a direct cause-effect relationship on cost –Directly causes the cost to change

11. Cost Classifications Association with cost object Reaction to changes in activity Classification on the financial statements –Unexpired –Expired –Product –Period

12. Cost Classifications Classification on the financial statements –Unexpired – balance sheet assets –Expired – income statement expenses –Product – inventoriable costs Prime – direct material and direct labor Conversion – direct labor and overhead –Period – expensed in period incurred

13. Product Costs Direct material –Measurable part of a product Direct labor –Labor used to manufacture a product or perform a service Overhead –Indirect production cost

14. Product Costs First appear on the balance sheet in inventory accounts Transferred to the income statement when product is sold

15. Period Costs Selling and administrative costs Distribution costs –Cost to warehouse, transport, and/or deliver a product or service –Major impact on managerial decision making

16. Period Costs Appear on the income statement when incurred Expensed when incurred

17. Purchase raw materials or supplies Input Product or Service Output Conversion Process Change Inputs into Outputs CONVERSION

18. Low Degree of Conversion Department stores Gas stations Jewelry stores Travel agencies

19. Moderate Degree of Conversion Florists Meat markets Oil-change businesses

20. High Degree of Conversion Manufacturing Construction Agriculture Architecture Auditing Mining Printing Restaurants

21. Product Cost - Direct Direct Material –Conveniently and economically traced to cost object

22. Product Cost - Direct Direct Material –Conveniently and economically traced to cost object Direct Labor –to manufacture a product or perform a service –includes wages paid to direct labor employees, production bonuses, payroll taxes –may include holiday and vacation pay, insurance, retirement benefits

23. Product Cost - Indirect Overhead - indirect production costs –Fringe benefits, if cannot be easily traced to product –Overtime, if due to random scheduling –Cost of quality Prevention costs Appraisal costs Failure costs

24. Product Cost Behavior Direct MaterialVariable Direct LaborVariable OverheadVariable, fixed, or mixed

25. Overhead Cost Allocation Assign indirect costs to one or more cost objects To determine full absorption cost (GAAP) To motivate management To compare alternative courses of action for planning, controlling, and decision making Allocation process should be rational and systematic

26. Allocating Overhead Actual Cost System Product Cost Direct Materials Direct Labor Overhead Cost Used Actual

27. Allocating Overhead Actual Cost System The Actual Cost System is not timely All costs must be known before calculating product cost

28. Allocating Overhead Actual vs. Normal Product Cost Direct Materials Direct Labor Overhead Actual Cost System Actual Normal Cost System Actual Predetermined Overhead Rate

29. Predetermined Overhead Rate Allows overhead to be assigned during the period Compensates for fluctuations –that are not related to activity level –in activity level that do not affect fixed overhead

31. Flow of Product Costs Raw Materials Inventory Accounts Payable Work in Process Inventory Raw Materials Inventory

32. Flow of Product Costs Work in Process Inventory Variable Overhead Control Fixed Overhead Control Finished Goods Inventory Work in Process Inventory

33. Flow of Product Costs Accounts Receivable Sales Cost of Goods Sold Finished Goods Inventory Matches revenues and expenses on the income statement

34. Cost Functions Basic linear cost function equation: y = a + bx where:y =total cost a = fixed cost component b =slope coefficient (variable cost rate) x =the volume of the cost driver Volume (x) Total Cost (y) a Slope = b

35. Estimating Cost Functions Assume variations in total cost are explained by a single cost driver Assume that cost behaviour can be explained adequately assuming a linear cost function within the relevant range How a cost is classified depends on: –the cost object selected –the time span under consideration –the relevant range Always look for a cause-effect relationship when selecting a cost driver

36. Cost Estimation Approaches 1. Industrial Engineering Method –also called work measurement –analyze the input-output relationship in physical terms 2.Conference Method –speak to managers familiar with how costs are incurred 3.Account Analysis –analyze accounting data directly 4.Quantitative Analyses –high-low method –linear regression

37. Steps in Estimating a Cost Function 1. Choose the dependent variable (the cost to be predicted using the cost function) 2.Identify the cost driver (x in the equation y = a + bx) 3.Collect data 4.Plot the data and eliminate “extreme” observations 5.Estimate the cost function 6.Evaluate the estimated cost function

38. High-Low Method of Cost Estimation Indirect$1,456 Labour Costs $$710 46 96 Machine Hours xxxxxxxxxxxxxxxxxxx Variable cost= Change in cost / Change in volume = ($1,456 - $710) / (96 - 46) = $14.92 per MH Fixed cost= Mixed cost at high point - variable cost = $1,456 - (96 x $14.92) = $23.68 per week Cost function = $23.68 + $14.92 per machine hour

39. Regression Analysis Method Regression analysis is a statistical method that measures the average amount of change in the dependent variable (x) that is associated with a unit change in one or more independent variable (s) Simple linear regression - one independent variable Multiple regression - more than one independent variable Allows for the evaluation of the quality of the cost function –Coefficient of determination (R-Squared) measures the goodness of fit of the line to the underlying data –t-value measures the potential error of the estimated variables

40. Evaluating and Choosing Cost Drivers 1. Economic plausibility –Does it make sense that the cost driver would explain changes in the cost 2.Goodness of fit –Does the cost equation match the underlying data 3.Slope of the regression line –A flat regression line (small amount of slope) indicates a weak relationship between the dependent and independent variables

41. Step Cost Function a cost function in which the cost is constant over various ranges of the cost driver, but increases in discrete amounts (or steps) as the cost driver moves from one range to the next $ Volume Step Variable Cost Function $ Volume Step Fixed Cost Function

42. Nonlinearity Cost Function Nonlinear cost function a cost function in which the graph of total costs versus a single cost driver does not form a straight line within the relevant range Time Cumulative Total Volume Nonlinear Cost Function (Learning Curve)

43. Data “Problems” 1.Collection periods for variables differ 2.Some “variable” costs are actually allocated fixed costs 3.Missing data points 4.Errors in recording data points 5.Lack of a homogeneous relationship between the dependent variable pool and cost driver 6.Relationship between cost and cost driver is unstable 7.Impact of inflation on data points over time