©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Measurement of Cost Behavior Chapter 3

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 1 Describe step- and mixed-cost behavior.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Step- and Mixed-Cost Behavior Patterns Step costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Step- and Mixed-Cost Behavior Patterns Lease cost example Oil and gas exploration activity Relevantrange Actual cost behavior Fixed cost approximation Lease cost

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Step- and Mixed-Cost Behavior Patterns Supermarket checker wage cost example Supermarket checker wage cost example Shoppers per hour Relevant range Variablecostapproximation Actual cost behavior Wage cost

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Step- and Mixed-Cost Behavior Patterns Mixed costs contain elements of both fixed- and variable-cost behavior. The fixed-cost element is unchanged over a range of cost-driver activity. The variable-cost element varies proportionately with cost-driver activity.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Step- and Mixed-Cost Behavior Patterns Facilities maintenance department cost Number of patient-days per month $10,000 1,0005,000 Totalvariablecost Fixedcost Relevant range $5.00 per patient day

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 2 Describe management influences on cost behavior.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Product and Service Decisions and the Value Chain Distribution channels Choice of process and product design Quality levels Product features

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Capacity Decisions They are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Committed Fixed Costs Salaries of key personnel Committed fixed costs usually arise from the possession of facilities, equipment, and a basic organization. Lease payments Property taxes

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Discretionary Fixed Costs Discretionary fixed costs are costs fixed at certain levels only because management decided that these levels of cost should be incurred to meet the organization’s goals. These discretionary fixed costs have no obvious relationship to levels of output activity but are determined as part of the periodic planning process.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Discretionary Fixed Costs Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next planning period.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Examples of Discretionary Fixed Costs Advertising and promotion Research and development Management salaries Employee training

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Technology Decisions Choice of technology (e-commerce versus in-store or mail-order sales) positions the organization to meet its current goals and to respond to changes in the environment.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost-Control Incentives Managers use their knowledge of cost behavior to set cost expectations. Employees may receive rewards that are tied to meeting these expectations.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 3 Measure and mathematically express cost functions and use them to predict costs.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost Functions Planning and controlling the activities of an organization require accurate and useful estimates of future fixed and variable costs.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost Functions Understanding relationships between costs and their cost drivers allows managers to... evaluate strategic plans and operational improvement programs. make short- and long-run decisions. plan or budget the effects of future activities.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost Functions The first step in estimating or predicting costs is measuring cost behavior as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of cost-driver activity.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost Function Equation Y = Total cost F = Fixed cost V = Variable cost per unit X = Cost-driver activity in number of units

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost Function Equation Mixed-cost function: Y = F + VX The mixed-cost function is called a linear-cost function. Y = $10,000 + $5.00X

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Developing Cost Functions A cost function’s estimates of costs at actual levels of activity must reliably conform with actually observed costs. The cost function must be believable.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 4 Describe the importance of activity analysis for measuring cost functions.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis Choosing a cost function starts with choosing cost drivers. Managers use activity analysis to identify appropriate cost drivers. Activity analysis directs management accountants to the appropriate cost drivers for each cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis Northwestern Computers makes two products: Mozart-Plus and Powerdrive In the past, most of the support costs were twice as much as labor costs. Northwest has upgraded the production function, which has increased support costs and reduced labor cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis Using the old cost driver, labor cost, the prediction of support costs would be: Labor cost$ 8.50$ Support cost: 2 × Direct labor cost$17.00$ Mozart-PlusPowerdrive

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis Using the more appropriate cost driver, the number of components added to products, the predicted support costs are:

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Choice of Cost Drivers: Activity Analysis Support cost at $20/component at $20/component $20 × 5 components$ $20 × 5 components$ $20 × 9 components$ $20 × 9 components$ Difference in predicted support cost$ 83.00$ support cost$ 83.00$ higher lower higher lower Mozart-PlusPowerdrive

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 5 Measure cost behavior using the account analysis, high-low, visual-fit, and least-squares regression methods.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Methods of Measuring Cost Functions  1. Engineering analysis  2. Account analysis  3. High-low analysis  4. Visual-fit analysis  5. Least-squares regression analysis

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Engineering Analysis It measures cost behavior according to what costs should be, not by what costs have been. Engineering analysis entails a systematic review of materials, supplies, labor, support services, and facilities needed for products and services.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Account Analysis The simplest method of account analysis selects a plausible cost driver and classifies each account as a variable or fixed cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Account Analysis Example Supervisor’s salary and benefits$ 3,800$3,800 Hourly workers’ wages and benefits 14,674$14,674 Equipment depreciation and rentals 5,873 5,873 Equipment repairs 5,604 5,604 Cleaning supplies 7,472 7,472 Total maintenance costs$37,423$9,673$27,750 Monthly cost AmountFixedVariable

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Account Analysis Example Fixed cost per month = $9,673 Variable cost per patient-day = $27,750 ÷ 3,700 = $7.50 per patient-day 3,700 patient-days Y = $9,673 + ($7.50 × patient-days)

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton High-Low Method The focus of this method is normally on the highest- and lowest-activity points. The first step if to plot the historical data points on a graph.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton High-Low Method Example High month: April Maintenance cost: $47,000 Number of patient-days: 4,900 Low month: September Maintenance cost: $17,000 Number of patient-days: 1,200 What is the variable cost?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton High-Low Method Example ($47,000 – $17,000) ÷ (4,900 – 1,200) = $30,000 ÷ 3,700 = $ What is the fixed cost?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton High-Low Method Example $47,000 = Fixed cost + ($8.1081× 4,900) $47,000 – $39,730 = $7,270 $17,000 = Fixed cost + ($8.1081× 1,200) $17,000 – $9,730 = $7,270

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Visual-Fit Method In the visual-fit method, the cost analyst visually fits a straight line through a plot of all of the available data, not just between the high point and the low point, making it more reliable than the high-low method.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Least-Squares Regression Method Regression analysis measures a cost function more objectively by using statistics to fit a cost function to all the data. Regression analysis measures cost behavior more reliably than other cost measurement methods.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Coefficient of Determination One measure of reliability, or goodness of fit, is the coefficient of determination, R² (or R-squared). The coefficient of determination measures how much of the fluctuation of a cost is explained by changes in the cost driver.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton End of Chapter 3