1. Copyright © 2003 Pearson Education Canada Inc. Slide 10-107 Chapter 10 Determining How Costs Behave

2. Copyright © 2003 Pearson Education Canada Inc. Slide 10-108 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 Pages 355 - 356 Volume (x) Total Cost (y) a Slope = b

3. Copyright © 2003 Pearson Education Canada Inc. Slide 10-109 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 Pages 357 - 358

4. Copyright © 2003 Pearson Education Canada Inc. Slide 10-110 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 Pages 359 - 361

5. Copyright © 2003 Pearson Education Canada Inc. Slide 10-111 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 Pages 361 - 362

6. Copyright © 2003 Pearson Education Canada Inc. Slide 10-112 High-Low Method of Cost Estimation Indirect$1,456 Labour Costs $$710 Pages 363 - 364 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

7. Copyright © 2003 Pearson Education Canada Inc. Slide 10-113 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 Pages 364 - 366

8. Copyright © 2003 Pearson Education Canada Inc. Slide 10-114 Evaluating and Choosing Cost Drivers In evaluating a cost driver look for: 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 Pages 366 - 357

9. Copyright © 2003 Pearson Education Canada Inc. Slide 10-115 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 Pages 368 - 370 $ Volume Step Variable Cost Function $ Volume Step Fixed Cost Function

10. Copyright © 2003 Pearson Education Canada Inc. Slide 10-116 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 Pages 370 - 374 Time Cumulative Total Volume Nonlinear Cost Function (Learning Curve)

11. Copyright © 2003 Pearson Education Canada Inc. Slide 10-117 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 Pages 374 - 375