Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith Chapter 3 Cost behaviour, cost drivers and cost estimation

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 2 Basic concepts  Cost behaviour ÙThe relationship between a cost and the level of activity or cost driver  Cost estimation ÙThe process of determining the cost behaviour of a particular cost item  Cost prediction ÙUsing knowledge of cost behaviour to focus the level of cost at a particular level of activity

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 3

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 4 Cost drivers  A cost driver ÙAn activity or factor that causes costs to be incurred ÙThe higher the correlation between the cost and cost driver, the more accurate is the description and understanding of cost behaviours  Conventional understandings of cost behaviour regarded costs as variable or fixed, based on the level of production volume continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 5 Cost drivers  Contemporary viewpoints recognise that there are a range of possible costs divers other than production volume (non-volume cost drivers)  Activity-based approaches classify costs and cost drivers into four levels: ÙUnit ÙBatch ÙProduct, and ÙFacility continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 6 Cost drivers  Unit level costs ÙRelate to activities that are performed for each unit produced ÙUses conventional volume-based cost drivers  Batch level costs ÙRelate to activities performed for a group of product units  Product (or product-sustaining) level ÙRelate to activities performed for specific products or product groups  Facility level ÙCosts incurred to run the business continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 7 Cost drivers  Selecting the best cost drivers ÙInput or outputs? vAn example of an input cost driver is the weight of material, and an output driver is the number of units of production vCost benefit principles will determine the choice ÙHow detailed should the analysis be? ÙLong or short term? vCost behaviour and cost drivers can change over time vDepends on the purpose of the cost prediction continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 8 Cost drivers  Cost drivers for cost estimation or cost management? ÙCost drivers that are used to predict costs, may differ from those used to manage costs ÙEffective cost management requires the identification of root cause cost drivers vThe basic costs that cause a cost to be incurred vThe true causes of costs continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 9 Cost drivers  In choosing cost drivers the costs and benefits of each driver must be assessed: ÙReasons for analysing cost behaviour ÙTimeframes for analysing the cost behaviour ÙAvailability of data on cost drivers, and ÙAny other uses for the cost behaviour information

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 10

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 11 Cost behaviour patterns  Cost behaviour patterns ÙVariable costs ÙFixed costs ÙStep-fixed costs ÙSemi-variable costs ÙCurvilinear costs continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 12 Cost behaviour patterns  Variable costs ÙChange in total in direct proportion to a change in activity ÙThe variable cost is the slope of the cost line in 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 continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 13

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 14 Cost behaviour patterns  Fixed costs ÙRemains unchanged in total as the level of activity varies ÙAs activity increases, total fixed costs do not change, but unit fixed cost declines ÙContemporary approaches to cost analysis recognise that there are cost drivers for some of these “fixed” costs, and very few costs remain fixed continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 15

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 16 Cost behaviour patterns  Step-fixed costs ÙRemain fixed over a wide range of activity levels but jump to a different amount for levels outside that range  Semi-variable cost ÙHas both fixed and variable components  Curvilinear cost ÙHas a curved cost line, but is often approximated as a semi-variable cost function continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 17

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 18

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 19

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 20 Cost behaviour patterns  Cost structures are shifting towards a decreasing proportion of costs that vary with production due to: ÙLabour being replaced by equipment, which does not vary with production output ÙProduction wages moving towards fixed salaries that do not vary with production activity levels

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 21 Cost estimation  Approaches to cost estimation ÙManagerial judgement ÙEngineering approach, and ÙQuantitative analysis  Using managerial judgment to estimate costs ÙThe account classification method involves managers using their judgement to classify costs as exhibiting certain behaviours continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 22 Cost estimation  The engineering approach to estimating costs ÙStudying processes that result in the incurrence of a cost ÙFocus on the relationships that should exist between inputs and outputs ÙUsing time and motion studies (or task analysis) where employees are observed as they undertake work tasks ÙActivity-based approaches extend task analysis to the study of indirect activities and costs continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 23 Cost estimation  Estimating costs using quantitative analysis ÙA scatter plot can be useful in allowing us to plot the data points to visualise the relationship between cost and the level of activity ÙThe high-low method involves taking the two observations with the highest and lowest level of activity to calculate the cost function ÙRegression analysis is a statistical technique that uses all observations to determine the cost function continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 24 Cost estimation  Regression analysis ÙAllows us to estimate the line of best fit by making the deviations between the cost line and the data points as small as possible ÙSimple regression involves estimating the relationship between the dependent variable (Y) and one independent variable (X) Y = a + bX continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 25 Cost estimation  Regression analysis ÙMultiple regression allows us to include two or more independent variables, that is, cost drivers Y = a + b 1 X 1 + b 2 X 2 ÙThe regression line can be evaluated using several criteria: vEconomic plausibility vGoodness of fit

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 26

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 27 Practical issues in cost estimation  Data collection problems 1.Missing data 2.Outliers 3.Mismatched time periods for dependent and independent variables 4.Trade-offs in choosing the number of observations and the reliability of past data points as predictors of future cost behaviour 5.Allocated fixed costs 6.Inflation continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 28 Practical issues in cost estimation  Effect of learning on cost behaviour ÙIn estimating labour costs for relatively new product or processes, labour times per unit may decrease at varying rates  Activity-based approaches allows us to consider more complex cost behaviour patterns ÙCosts are assigned to activities ÙUnit, batch and product level costs are assumed to vary in proportion to their cost drivers continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 29 Practical issues in cost estimation  The accuracy of cost functions ÙSometimes approximate estimates are used to estimate cost functions within firms ÙWhy is the case? vLimited time and knowledge to undertake quantitative techniques vThe data required to estimate reliable cost functions may not exist vA low priority may be given to determining accurate cost behaviour and cost estimation vSubjective cost estimates may be considered good enough for the firm’s needs continued

Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith 30 Practical issues in cost estimation  All cost functions are based on simplifying assumptions, such as: ÙCost behaviour depends on a single activity ÙCost behaviours are linear within a relevant range  Costs and benefits of producing accurate cost information need to be assessed