Copyright © 2013 Nelson Education Ltd. PowerPoint Presentations for Cornerstones of Cost Accounting First Canadian Edition Adapted by George Gekas Ryerson University Copyright © 2013 Nelson Education Ltd.

Copyright © 2013 Nelson Education Ltd. COST BEHAVIOUR 2 CHAPTER 2-2 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Cost Objects An item for which managers want cost information For manufacturing or merchandising firms: the tangible product For service firms: the service provided 2-3 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Activity Drivers Cause the costs of activities to change: In a restaurant the cost of tomatoes used in making salads is driven by the number of tomato salads customers order Unit-level drivers change with the number of units produced (number of salads) Non-unit-level drivers change by non-unit-based output (number of orders, number of inspections) 2-4 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Fixed Costs Fixed costs are costs that in total are constant within the relevant range as the level of the activity driver varies Echo Audio Systems Inc. produces speakers for home audio systems. One department produces voice coils. There are two production lines that can each make up to 100,000 voice coils per year. The production-line manager is paid $60,000 per year. For production up to 100,000 units only one manager is needed; above that (to 200,000 units), two are needed. 2-5 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Fixed Costs The total cost of supervision remains the same within the relevant range, but the unit cost decreases as production increases. 2-6 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Fixed Costs The total cost of supervision remains the same within the relevant range, but the unit cost decreases as production increases. 2-7 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Fixed Costs 2-8 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Variable Costs Variable costs are costs that in total vary in direct proportion to changes in an activity driver. The cost of direct materials for each voice coil is $3. The total cost of direct materials for each level of production varies, but the unit cost stays the same. 2-9 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Variable Costs 2-10 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Variable Costs 2-11 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Variable Costs 2-12 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Variable Costs 2-13 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Nonlinearity of Variable Costs 2-14 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Relevant Range for Variable Costs 2-15 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Mixed Costs Mixed costs are costs that has both a fixed and a variable component. Y = Fixed cost + Total variable cost Y = F + VX where Y = Total cost (Usually a mixed cost) 2-16 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Mixed Costs Echo’s sales costs are mixed. There are 10 sales representatives who each earn $30,000 plus receive a commission of $5 per speaker sold. This function can be represented by the following equation: Y = $300,000 + $5X Fixed - salaries Variable - commission 2-17 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Mixed Costs Echo Audio Systems, Inc. Fixed Cost of Selling Variable Cost of Selling Total Cost Speakers Sold Selling Cost Per Unit $300,000 $200,000 $ 500,000 40,000 $12.50 300,000 400,000 700,000 80,000 8.75 300,000 600,000 900,000 120,000 7.50 300,000 800,000 1,100,000 160,000 6.88 300,000 1,000,000 1,300,000 200,000 6.50 2-18 Copyright © 2013 Nelson Education Ltd.

Basics of Cost Behaviour OBJECTIVE 1 Mixed Costs 2-19 Copyright © 2013 Nelson Education Ltd.

Resources, Capacity, and Cost Behaviour OBJECTIVE 2 Resources Economic elements that enable one to perform activities When a firm acquires the resources needed to perform an activity, it obtains activity capacity Practical capacity is the activity level where the activity is performed efficiently Discretionary resources—resource spending is flexible Committed resources—resource spending is fixed independent of the actual usage 2-20 Copyright © 2013 Nelson Education Ltd.

Resources, Capacity, and Cost Behaviour OBJECTIVE 2 Flexible Resources Supplied as needed and used Quantity of resource supplied equals quantity demanded No unused capacity Committed Resources Supplied in advance of usage A given quantity is obtained, whether or not that full amount is used Unused capacity is possible 2-21 Copyright © 2013 Nelson Education Ltd.

Resources, Capacity, and Cost Behaviour OBJECTIVE 2 Step-Cost Behaviour A step-cost function displays a constant level of cost for a range of output, then at some point, costs jumps to a higher level Step-Variable Costs Many variable costs must be purchased in “chunks” Step-Fixed Costs Many fixed costs are actually step-fixed costs Beyond the relevant range, fixed costs increase “one step” 2-22 Copyright © 2013 Nelson Education Ltd.

Resources, Capacity, and Cost Behaviour OBJECTIVE 2 Step-Cost Function 2-23 Copyright © 2013 Nelson Education Ltd.

Resources, Capacity, and Cost Behaviour OBJECTIVE 2 Step-Fixed Costs 2-24 Copyright © 2013 Nelson Education Ltd.

Resources, Capacity, and Cost Behaviour OBJECTIVE 2 Activities and Mixed Cost Behaviour Many activities have characteristics of both flexible and committed resources. Example: Fuel-powered plant acquires buildings and equipment in advance of actual usage an in excess of immediate demands. However, it also acquires fuel to produce power on an as-needed basis. Need to separate mixed cost into variable and fixed costs Sometimes easy to spot the variable and fixed portion of a cost Other times, it is not: thus, the need for a method to separate costs into their fixed and variable components 2-25 Copyright © 2013 Nelson Education Ltd.

Quantitative Methods for Separating Mixed Costs OBJECTIVE 3 Y = F + VX where: Y = Total cost (the dependent variable) F = Fixed cost (the intercept parameter) V = Variable cost per unit (the slope parameter) X = Measure of output (the independent variable) 2-26 Copyright © 2013 Nelson Education Ltd.

Quantitative Methods for Separating Mixed Costs OBJECTIVE 3 The High-Low Method Take two points (the high and the low by volume of activity) and determine the slope and intercept. Advantages Objective Simple Disadvantages High and low points may be “outliers” High and low points may not be representative of the distribution of points in general 2-27 Copyright © 2013 Nelson Education Ltd.

Quantitative Methods for Separating Mixed Costs OBJECTIVE 3 Scattergraphs Use a scattergraph to visually assess the relationship between cost and output. Advantages Allows for visual inspection of the data Disadvantages Subjective Next let’s look at some scattergraphs… 2-28 Copyright © 2013 Nelson Education Ltd.

Scattergraph of a Nonlinear Relationship OBJECTIVE 3 2-29 Copyright © 2013 Nelson Education Ltd.

Scattergraph of an Upward Shift OBJECTIVE 3 2-30 Copyright © 2013 Nelson Education Ltd.

Scattergraph with Outliers OBJECTIVE 3 2-31 Copyright © 2013 Nelson Education Ltd.

The Method of Least Squares: Deviations of Data from a Line OBJECTIVE 3 The Method of Least Squares: Deviations of Data from a Line 2-32 Copyright © 2013 Nelson Education Ltd.

Copyright © 2013 Nelson Education Ltd. OBJECTIVE 3 The Method of Least Squares Interpreting the least squares results: The intercept is the fixed cost The slope is the variable cost per unit That is, the cost function equation is: Y = 854.50 +12.39X Use the equation to make a point estimate: At a point of 350 moves the total cost is predicted to be: Y = 854.50 + 12.39(350) Y = $4336.50 See Cornerstone 2-4 2-33 Copyright © 2013 Nelson Education Ltd.

Copyright © 2013 Nelson Education Ltd. OBJECTIVE 4 Reliability of Cost Formulas Coefficient of Determination, or R2 Shows the percentage of variability in the dependent variable explained by the independent variable(s) The adjusted R2 takes into account how many independent variables used; therefore, we prefer it to the unadjusted R2 Coefficient of Correlation, or R Square root of the coefficient of determination Ranges from positive to negative one The higher the R, the greater the correlation 2-34 Copyright © 2013 Nelson Education Ltd.

Copyright © 2013 Nelson Education Ltd. OBJECTIVE 4 Reliability of Cost Formulas Regression Helps assessing the reliability of the estimated cost formula (HL method does not provide for that) Goodness Fit Measures the degree of fit between cost and output. The method of least squares is the best fitting line but does not say how good the fit is. Confidence Interval Allows for predicting a rage of actual costs with a predetermined degree of confidence (say 95%) instead of a single prediction where the actual cost will coincide exactly with the anticipated costs. 2-35 Copyright © 2013 Nelson Education Ltd.

Methods of Determining Cost Behaviour OBJECTIVE 5 Industrial Engineering Method Cost estimation relies on physical observation and analysis of activities needed and in what amounts, including time and motion studies for the production process. Account Analysis Method Cost estimation relies on determining and classifying ledger accounts in to fix and variable costs See Cornerstone 2-5, text p. 68 2-36 Copyright © 2013 Nelson Education Ltd.

Methods of Determining Cost Behaviour OBJECTIVE 5 Managerial Judgment Most widely used method in practice Managers may use their experiences and observations to determine fixed and variable costs Simple method When manager has good understanding of processes, it can yield good results However, poor judgment yields poor results 2-37 Copyright © 2013 Nelson Education Ltd.

Copyright © 2013 Nelson Education Ltd. Multiple Regression OBJECTIVE 6 Multiple Regression Uses more than one independent variable to explain the dependent variable The single independent variable, number of moves, explained 85% of the variance material handling the dependent variable. Adding the weight (kg) moved better explained the material handling costs; that is, adding another independent variable might increase the explanatory power of the model 2-38 Copyright © 2013 Nelson Education Ltd.

Copyright © 2013 Nelson Education Ltd. Multiple Regression OBJECTIVE 6 Multiple regression would look like: Y = 7.84X1 + 0.11X2 + 507.31 X1 number of moves X2 kilograms moved Fixed cost is 507.31 Interpreting the results: Like in the single regression “coefficients” represent the intercept and the slope 2-39 Copyright © 2013 Nelson Education Ltd.

The Learning Curve and Nonlinear Cost Behaviour OBJECTIVE 7 Learning Curve Shows how labour hours worked per unit decrease as the volume produced increases Relates cost to increased efficiency (the more you perform a task the lower the cost is of doing it) Management must estimate a learning rate for a process, usually on basis of past experience Two common forms: Cumulative average-time learning curve model Incremental unit-time learning curve model 2-40 Copyright © 2013 Nelson Education Ltd.

The Learning Curve and Nonlinear Cost Behaviour OBJECTIVE 7 Cumulative Average-Time Learning Curve Model Cumulative average time per unit decreases by a constant percentage Learning rate is expressed as a percent See Cornerstone 2-6 2-41 Copyright © 2013 Nelson Education Ltd.

The Learning Curve and Nonlinear Cost Behaviour OBJECTIVE 7 Incremental Unit-Time Learning Curve Model Decreases by a constant percentage each time the cumulative quantity of units produced doubles Use of learning curve enables management to be more accurate in budgeting and in performance evaluations for processes in which learning occurs 2-42 Copyright © 2013 Nelson Education Ltd.

End of Chapter 2 2-43