© 2007 Pearson Education Canada Slide 3-1 Measurement of Cost Behaviour 3

© 2007 Pearson Education Canada Slide 3-2 Measurement of Cost Behavior Cost Driver an activity which influences a cost Relevant Range range over which we can assume that the cost behavior is linear Variable Costs vary in proportion to changes in their cost driver Fixed Costs are not affected by changes in the cost driver $ Volume $ $

© 2007 Pearson Education Canada Slide 3-3 Variations in Cost Behaviour Step Costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks supervisory salaries Mixed Costs contain both variable and fixed cost elements e.g. maintenance costs Volume $ $

© 2007 Pearson Education Canada Slide 3-4 Management’s Influence on Cost Functions Capacity Costs fixed costs related to being able to achieve a desired level of production or service setting capacity is very important if long-run demand fluctuates Committed Fixed Costs arise from the possession of facilities, equipment, and a basic organization large, indivisible chunks of cost that the organization is obligated to incur and usually would not consider avoiding mortgage, lease payments, property taxes, insurance, salaries of key personnel committed fixed costs can only be changed by changing the basic philosophy, scale or scope of the organization's operations

© 2007 Pearson Education Canada Slide 3-5 Management’s Influence on Costs Functions II Discretionary Fixed Costs each planning period, management will determine how much to spend advertising, promotion, research and development, employee training the amount of spending may vary, but only because management has decided to spend more or less management can influence spending on these costs in the short run

© 2007 Pearson Education Canada Slide 3-6 Measuring Cost Behaviour Cost Function algebraic equation of the cost and its cost driver linear cost function is as follows: Y = F + VX where F is the intercept of the vertical axis or the fixed cost V is the slope or the variable cost per unit of activity Total Maintenance Costs per month = fixed cost per month + variable cost per unit = $10,000 + $5.00 per unit Criteria for Choosing A Cost Function Use activity analysis to determine which cost driver best explains how the cost behaves Economic plausibility (it must make sense that X causes Y) Reliability (the estimates derived by the cost equation must conform with actually observed costs)

© 2007 Pearson Education Canada Slide 3-7 Methods of Measuring Cost Functions Engineering Analysis systematic review of costs based on past experience Account Analysis review of accounting records and the subjective determination of cost behavior patterns High-Low Analysis use of simple linear algebra to determine variable and fixed costs may yield unreliable results Visual Fit Analysis fit a representative line to the data as shown in a scatter diagram Regression Analysis using mathematical formula, determine the cost equation which best fits the data may be simple least squares regression with one X variable or multiple least squares regression with more than one X variable enables user to measure the "quality" of the predictive equation

© 2007 Pearson Education Canada Slide 3-8 High-Low Approach to Cost Analysis Equation: Y = F + VX Variable cost = change in cost / change in volume = $30,000 / 3,700 = $8.108 per patient-day Fixed cost = total mixed cost - variable cost = $47,000 - ($8.108 x 4,900) = $47,000 - $39,730 = $7,270 per month Maintenance Costs = $7,270 + $8.108 per patient-day Facilities Maintenance Department Costs Number of Patient-Days x x x x x x x x

© 2007 Pearson Education Canada Slide 3-9 Regression Analysis Check for Economic Plausibility Does it make sense that X and Y are related? Plot the data to see if basic relationship is linear and identify "outliers" Generate Regression Output Constant$9,329 Std Error of Y Estimate$2,145Observations12 R-Squared0.954Degrees of Freedom10 X Coefficient(s)$6.95Std Error of Coefficient0.479 Interpret Regression Output R-squared (R 2 ) varies between 0 and 1 The closer to R 2 is to 1 the more X explains the changes in Y Standard error of Y estimate and standard error of X coefficient(s) can be used to set confidence intervals for the cost function estimates and the predicted value of the variable cost per unit