COST BEHAVIOR ANALYSIS AND USE
What is Cost Behavior Analysis?
Cost behavior analysis refers to management’s attempt to understand how operating costs
change in relation to a change in an organization’s level of activity. These costs may include
direct materials, direct labor, and overhead costs that are incurred from developing a
product. Manage ment typically performs cost behavior analysis through mathematical cost
functions.
Cost functions are descriptions of how a cost (e.g., material, labor, or overhead) changes
with changes in the level of activity relating to that cost. For example, total variable costs
will change in relation to increased activity, while fixed costs will remain the same. Cost
functions may come in various forms.
Cost Function Assumptions
Cost functions are usually given in the form of y = mx + b and can be plotted on a graph.
In order to determine these cost functions, managers typically make the following
assumptions for simplicity reasons:
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Variations in the cost driver explain the variations in the related total costs.
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Cost behavior can be summarized into a linear cost function within a relevant range.
The relevant range here refers to the range of activity in which the relationship between
the total cost and the level of activity is maintained. However, in real-life situations, not all
cost functions are linear, and also are not explained by a single cost driver.
Regression analysis is another method that uses statistical me thods to measure the average
amount of change in the dependent variable associated with changes in the independent
variable. The regression approach is a much better indication of the relationship between
the variables. Software such as Microsoft Excel is a useful tool for performing regression
analysis.
Therefore, the full cost function is: Y = 8.33x + 46,667. This means that for every additional
labor hour, total overhead costs will increase by 8.33.
Cost Behavior Patterns
3 basic cost behavior patterns:
1. Variable Costs. Describes a cost that varies in total with changes in volume of activity.
The total activity in this example is the number of bikes produced and sold. However, the
activity can take many different forms depending on the organization. The two most
common variable costs are direct materials and direct labor. Other examples include
indirect materials and energy costs.
2. Fixed Costs. Fixed costs describe as cost that is fixed (does not change) in total with
changes in volume of ac tivity. Assuming the activity of bikes produced and sold, examples
of fixed costs include salaried personnel, building rent, and insurance.
3. Mixed Costs. Describes a cost that has mix of fixed and variable costs. Example, assume
sales personnel at Bikes Unlimited are paid a total of 10,000 in monthly salary plus
commission of 7 for every bike sold. This is mixed cost because it has a fixed component of
10,000 per month and a variable component of 7 per unit.
COST ESTIMATION ANALYSIS
1. Account Analysis. The account analysis approach is perhaps the most common starting
point for estimating fixed and variable costs. How is the account analysis approach used to
estimate fixed and variable costs? The approach requires that an experienced employee or
group of employees review the appropriate accounts and determine whether the costs in
each account are fixed or variable. Totaling all costs identified as fixed provides the
estimate of total fixed costs. To determine the variable cost per unit, all costs identified as
variable are totaled and divided by the measure of activity (units produced is the measure
of activity for Bikes Unlimited.
2. High-low method. Another approach to identifying fixed and variable costs for cost
estimation purposes is the High-low method. Accountants who use this approach are
looking for a quick and easy way to estimate costs, and will follow-up their analysis with
other more accurate techniques. How is the high-low method used to estimate fixed and
variable costs? The High-low method uses historical information from several reporting
periods to estimate costs.
3. Scatter graph method. Many organizations prefer to use the scatter graph method to
estimate costs. Accountants who use this approach are looking for an approach that does
not simply use the highest and lowest data points.
How is the scatter graph method used to estimate fixed and variable costs?
IDENTIFYING THE RELEVANT COSTS
The scatter graph method considers all data points, not just the highest and lowest levels of
activity. Again the goal is to develop an estimate of fixed and variable costs stated in
equation form Y=f+vx
Relevant cost is defined as a cost, which is applicable to a specific decision because it will
have a bearing on which alternative the manager, chooses. Relevant costs are expected
future costs, which differ depending on which alternative to chose. They will increase or
decrease as a result of a decision.
DIFFERENTIAL/RELEVANT COSTS FOR DECISION MAKING
Decision Making is the process of studying and evaluating two or more available
alternatives, which lead to final choice.
Steps in the decision-making process are:
1. Define strategies (business goals and strategies to achieve them).
2. Identify alternative choices.
3. Collect and analyze the relevant data on the choices
4. Choose the best alternative to achieve the goals.
CRITERION FOR SHORT-TERM DECISIONS:
The economic criterion for short-term decisions is simple. These actions that you expect will
give the highest income (or at least cost) to the firm. This rule is not always simple. It will be
of help if the following sub-rules are applied:
1. The only revenue and costs that are relevant in making decisions are expected future
revenues and costs that will differ among the choices that are available. These are called
differential revenues and costs (because many decisions result in increases in revenues and
costs, some use the terms incremental revenues and costs.)
2. Revenues and costs that have already been earned or incurred are irrelevant in making
decisions. Their only use is that they might help in predicting future revenues and costs.
Under the concept of relevant costs, decision-m aking process involves the following steps:
1. Determine all cost associated with each alternative being considered.
2. Drop costs that are sunk or historical.
3. Drop costs that do not differ between alternatives.
4. Make decision based on the remaining costs; these costs will be futur e differential
or avoidable costs, hence relevant to decision to be made.
COSTS that are avoidable are relevant for decision-making Avoidable cost is defined as cost,
which can be eliminated as a result of choosing one alternative over another in a decisionmaking situation.
DIFFERENTIAL (INCREMENTAL) REVENUES AND COSTS
The term differential is more inclusive that incremental. The latter term suggests increases,
and some decisions produce decreases in both revenues and costs.
Differential Costs are avoidable costs. If the firm can change a cost by taking one action as
opposed to another, the cost is avoidable and therefore differential.
Example: Suppose a company could save 100,000 in salaries and other fixed costs if it
stopped selling a product in a particular branch. The 100,000 is avoidable (differential)
because it will be incurred if the company continues to sell in the region and it will not be
incurred if the firm stop selling in that branch. Hence the lost revenue is also differential in
a decision to stop selling in the branch.
IN MANAGERIAL ACCOUNTING, AVOIDABLE COST, DIFFRENTIAL COST, INCREMENTAL COSTS
AND RELEVANT COST ARE OFTEN USED INTECHANGABLY.
SUNK COSTS AND OPPORTUNITY COSTS
Sunk Cost IS ONE THAT HAS ALREADY BEEN INCURRED A ND THEREFORE WILL BE THE SAME
NO MATTER WHICH ALTERNTATIVE A MANAGER SEL ECTS. Thus, sunk costs are never
relevant for decision-making because they are not differential.
Example: Kellog’s spent P500,000 in developing a new cereal product and had problems
refining the taste and producing the individual pieces of cereal in the right size. The
managers must now decide whether or not market the cereal. The P500,000 is not relevant
to the decision because it is not differential; that is, the cost will be the same whether or
not the company markets the product.
Month
Total Overhead Costs
Labor Hours
What is Total Quality Management?
Total Quality Management ( TQM) is a management approach that seeks to provide longterm success by providing unparalleled customer satisfaction through the constant delivery
of quality IT services. To properly execute on TQM methods, the entire organization needs
to operate as a single unit in the pursuit of excellence.
Achieving this is accomplished with a laser-focus on the principles of TQM:
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Customer first - TQM’s first and foremost pillar of success is an unwavering focus
on the customer’s experience in all interactions with the organization. From first
contact through purchase and continued support, the customer should always be
the main priority.
Employee ownership - TQM requires the involvement of every team member to
ensure that complete qu ality control is offered at every level. TQM doesn’t focus
on a single department because the goal is to provide customers with a great
experience from every level of the organization.
Process-based - TQM focuses on the creation and imple mentation of processes
that provide organizations with the ability to find success and repeat it.
Quantifying success and defining the steps taken to get there are essential for
successful implementation of TQM.
System integration - TQM strategies revolve around leveraging every asset
available to the company. This is best achieved through syste m integrations that
combine disparate parts of the organization into a single, well-oiled machine
working in complete synergy.
Communication - TQM requires every team member to be at their best and to
function as a value-adding member of that team. This means communication and
transparency is a core tenet of successful TQM practices.
Data-driven - TQM doesn’t e mploy guesswork. Instead, data is leveraged for the
improvement of the organization and decisions are made based on quantifiable
facts.
Constant improvement - TQM isn’t a one and done process. Perfection is
impossible, so it must always be pursued to get the organization as close as
possible to it.
How to implement TQM?
The first step for implementing any ne w system is an honest assessment of the organization
as it is today. Imple mentation of TQM is something that has to be applied to the current
structure of the organization; there is no step-by-step guide that will tell you how to do it
for your business. Each business is unique and requires its own approach, but the core
tenets of TQM can guide each decision.
Then, you can proceed with these areas of opportunity.
Emphasize customer satisfaction - Creating an emphasis on customer satisfaction will
change the way departments think about their duties. If something they are doing isn’t
aiding in the improvement of the quality of the product or increasing the customer’s
experience, they aren’t headed in the right direction. Each employee should take ownership
of their role and be ready to consider ways in which they can improve their own
department and outputs.
Communicate with everyone - Communication throughout the organization is essential for
educating everyone about the changes that are coming while also providing an avenue for
receiving feedback. As they say, communication is a two-way street. Employees will have a
much easier time establishing a feeling of ownership over the process when they know
their voice is heard and they had a hand in guiding the changes.
Manage errors - One of the most important aspects of delivering quality is managing errors.
No matter how focused everyone is on driving quality, IT organizations will always run into
one issue or another.
Creating processes that mitigate issues is essential for TQM succ ess. Errors should be
addressed and dealt with as quickly as possible of course, but they should also be recorded
and tracked.
Recurrent issues could be indicative of a deeper issue, requiring large -scale changes to
current procedures. An error is an opportunity to assess a problem, but it’s also a chance to
discover what is working. Total quality management practitioners should take advantage of
errors as a chance to learn from their mistakes and find ways to avoid them in the future.
TQM is everyone’s Responsibility
TQM requires that all parties take ownership of the part they play and this applies equally
to admitting fault and giving out praise. A focus on improving the quality of products and
services requires accountability. Learning to snatch victory from the jaws of defeat is the
pursuit of quality management when it comes to dealing with incidents and outages.
Tracking metrics and comparing the results of operations before and after changes is the
best way to learn what works and what doesn’t. It’s also imperative that systems are
structured and followed to ensure that success can be replicated and then improved. The
process of improvement should never stagnate, ensuring that the pursuit of perfection
never ends.