1. PPT 3 -1 Don R. Hansen Maryanne M. Mowen COST MANAGEMENT

2. PPT 3 -2 Activity Cost Behavior Chapter Three

3. PPT 3 -3 Learning Objectives l Define and describe fixed, variable, and mixed costs. l Explain the use of resources and activities and their relationship to cost behavior. l Separate mixed costs into their fixed and variable components using the high-low method, the scatterplot method, and the method of least squares.

4. PPT 3 -4 Learning Objectives (continued) l Evaluate the reliability of the cost formula. l Explain how multiple regression can be used to assess cost behavior l Discuss the use of managerial judgment in determining cost behavior.

5. PPT 3 -5 Fixed Cost BehaviorVariable Cost Behavior $ $ Relevant Range Activity Activity Cost Behavior

6. PPT 3 -6 Total Costs $Cost Number of Units Produced Fixed Costs Variable Costs Linearity Assumption Y = F + VX The Behavior of a Mixed Cost

7. PPT 3 -7 Basic Terms Activity capacity is the ability to perform activities. Practical capacity is the efficient level of activity performance. Resources are economic inputs that are consumed in performing activities.

8. PPT 3 -8 Types of Fixed Resources l Flexible Resources l Committed Resources l Discretionary Fixed Costs

9. PPT 3 -9 Flexible Resources Flexible resources are supplied as used and needed. They are acquired from outside sources, where the terms of acquisition do not require any long-term commitment for any given amount of the resource. Example: Materials and energy

10. PPT 3 -10 Committed Resources Committed resources are supplied in advance of usage. They are acquired by the use of either an explicit or implicit contract to obtain a given quantity of resource, regardless of whether the amount of the resource available is fully used or not. Committed resources may have unused capacity. Example: Buying or leasing a building or equipment

11. PPT 3 -11 Committed Resources (continued) Committed fixed expenses are costs incurred for the acquisition of long-term capacity. Example: Plant, equipment, warehouses, vehicles, and salaries of top employees Discretionary fixed expenses are shorter-term committed resources. Example: The hiring of new receiving clerks

12. PPT 3 -12 Resource Relationships The relationship between resources supplied and resources used is expressed by the following equation: Resources available = Resources used + Unused capacity

13. PPT 3 -13 Available orders = Orders used + Orders unused 7,500 orders = 6,000 orders + 1,500 orders Fixed engineering rate = $150,000/7,500 = $20 per change order Variable engineering rate = $90,000/6,000 = $15 per change order Example

14. PPT 3 -14 Cost of orders supplied= Cost of orders used + Cost of unused orders = [($20 + $15) x 6,000] + ($20 x 1,500) = $240,000 Of course, the $240,000 is precisely equal to the $150,000 spent on engineers and the $90,000 spent on supplies. The $30,000 of excess engineering capacity means that a new product could be introduced without increasing current spending on engineering. Example (continued)

15. PPT 3 -15 $Cost Number of Units Produced Linearity Assumption Narrow Width Step-Variable Costs

16. PPT 3 -16 $Cost Number of Units Produced Linearity Assumption Wider Width Step-Fixed Costs

17. PPT 3 -17 Methods for Measuring the Fixed and Variable Components of a Mixed Cost l The High-Low Method l Scatterplot Method l The Method of Least Squares

18. PPT 3 -18 Month Utility Costs Units Produced January $2,000200 February 2,500400 March 4,500600 April 5,000800 May 7,5001,000 High-Low Method: An Example

19. PPT 3 -19 Y= F + VX Variable Cost Rate (V)= (Y 2 - Y 1 )/(X 2 - X 1 ) V= ($7,500-$2,000)/(1,000-200) V= $5,500/800 V= $6.875 per unit The High-Low Method (continued)

20. PPT 3 -20 Y=F + VX $7,500= F + $6.875 (1,000) F=$7,500 - $6,875 F= $625 The cost formula using the high-low method is: Y = $625 + $6.875 (X) The High-Low Method (continued)

21. PPT 3 -21 Units Produced Utility Cost $8,000 6,000 4,000 2,000 0 200 400 600 800 1,000..... Analyst can fit line based on his or her experience Important: Cost function is only relevant within relevant range Scatterplot Method

22. PPT 3 -22 Nonlinear Relationship Activity Cost 0 Activity Output * * * * *

23. PPT 3 -23 Upward Shift in Cost Relationship Activity Cost 0 Activity Output * * * * * *

24. PPT 3 -24 Presence of Outliers Activity Cost 0 Activity Output * * * * * *

25. PPT 3 -25 Least Squares Constant250 Std Err of Y Est299.304749934466 R squared0.944300518134715 No. of Observations5 Degrees of Freedom3 X Coefficient(s) 6.75 Std Err of Coef. 0.9464847243

26. PPT 3 -26 Least Squares (continued) The results gives rise to the following equation: Utility Costs = $250 + ($6.75 x # of units produced) R 2 =.944, or 94.4 percent of the variation in setup costs is explained by the number of setup hours variable.

27. PPT 3 -27 Using Confidence Intervals: Given: *T-value for sample size of 5 at 95% confidence level is 3.182 (two-tale test and 3 degrees of freedom) *Standard error of estimate for this sample at the 95% confidence level is 598.6 The confidence interval for 300 units is: TC = $250 + 6.75 (300) + (3.192 x $598.6) = $2275 + $1911 Least Squares (continued)

28. PPT 3 -28 TC = b 0 + b 1 X 1 + b 2 X 2 +... b 0 = the fixed cost or intercept b i = the variable rate for the ith independent variable X i = the ith independent variable Multiple Regression

29. PPT 3 -29 Utility MonthMHrsSummerCost January1,3400$1,688 February1,29801,636 March1,37601,734 April1,40501,770 May1,50012,390 June1,43212,304 July1,32212,166 August1,41612,284 September1,37011,730 October1,58001,991 November1,46001,840 December1,45501,833 Multiple Regression (continued)

30. PPT 3 -30 Constant243.1115 Std Err of Y Est55.5083 R squared0.9672 No. of Observations12 Degrees of Freedom9 X Coefficient(s)1.0972510.4907 Std Err of Coef.0.210232.5490 Multiple Regression (continued)

31. PPT 3 -31 Multiple Regression (continued) The results gives rise to the following equation: Utilities cost = $243.11 + $1.097(MH) + $510.49(Summer) R2 = 0.967, or 96.7 percent of the variation in utilities cost is explained by the machine hours and summer variables.

32. PPT 3 -32 l Use past experience l Try to confirm results with operating personal l Use common sense to confirm statistical studies Some Tips Cost Behavior and Managerial Judgment

33. PPT 3 -33 End of Chapter 3