Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 1

6-3 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 focusing on historical data. Cost estimation

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 2

6-5 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 Total Pay Per View Bill

6-6 Variable Cost Per Unit Example Number of Pay Per View shows watched Cost per Pay Per View show The cost per Pay Per View show is constant. For example, $4.95 per show.

6-7 Step-Variable Costs Activity Cost Total cost remains constant within a narrow range of activity.

6-8 Step-Variable Costs Activity Cost Total cost increases to a new higher cost for the next higher range of activity.

6-9 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 Monthly Basic Cable Bill

6-10 Fixed Cost Per Unit Example Number of hours watched Monthly Basic cable Bill per hour watched The average cost per hour decreases as more hours are spent watching cable television.

6-11 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. Step-Fixed Costs Continue

6-12 Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 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

6-13 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

6-14 A semivariable cost is partly fixed and partly variable. Semivariable Cost Consider the following example.

6-15 Fixed Monthly Utility Charge Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost Total semivariable cost Semivariable Cost Slope is variable cost per unit of activity.

6-16 Curvilinear Cost Curvilinear Cost Function Relevant Range Activity Total Cost Curvilinear Cost Function A straight-line (constant unit variable cost) closely approximates a curvilinear line within the relevant range.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 3

6-18 Curvilinear Cost Curvilinear Cost Function Relevant Range Activity Total Cost Curvilinear Cost Function A straight-Line (constant unit variable cost) closely approximates a curvilinear line within the relevant range.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 4

6-20 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

6-21 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

6-22 Examples of fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes Insurance Sales salaries Depreciation Cost Behavior in Other Industries

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 5

6-24 Account-Classification Method Visual-Fit Method High-Low Method Least-Squares Regression Method Cost Estimation

6-25 Account Classification Method Cost estimates are based on a review of each account making up the total cost being analyzed.

6-26 A scatter diagram of past cost behavior may be helpful in analyzing mixed costs. Visual-Fit Method

6-27 Plot the data points on a graph (total cost vs. activity) * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced Visual-Fit Method

6-28 Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. Visual-Fit Method * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced

6-29 Visual-Fit Method Vertical distance is total cost, approximately $16, * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced Estimated fixed cost = $10,000

6-30 OwlCo recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute: Ê the variable cost per unit. Ë the total fixed cost. The High-Low Method

6-31 The High-Low Method

6-32 Ê Unit variable cost =  in cost  in units The High-Low Method

6-33 Ê Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit The High-Low Method

6-34 Ê Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit Ë Fixed cost = Total cost – Total variable cost The High-Low Method

6-35 Ê Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit Ë Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) The High-Low Method

6-36 Ê Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit Ë Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600 The High-Low Method

6-37 Regression is a statistical procedure used to determine the relationship between variables such as activity and cost. Least-Squares Regression Method Activity Total Cost The objective of the regression method is the general cost equation: Y = a + bX

6-38 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

6-39 Statistics courses and computer courses deal with detailed regression computations using computer spreadsheet software. Accountants and managers must be able to interpret and use regression estimates. Least-Squares Regression Method

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 6

6-41 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 + b 1 X 1 + b 2 X 2

6-42 Engineering Method of Cost Estimation Cost estimates are based on measurement and pricing of the work involved.

6-43 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

6-44 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.

6-45 Learning Curve Cumulative Production Output Average Labor Time per Unit Learning effects are large initially. Learning effects become smaller, eventually reaching steady state.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 7

6-47 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.

6-48 End of Chapter 6