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Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 1 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Introduction Cost estimation Cost behavior Cost prediction Process of determining cost behavior, often focusing on historical data. Relationship between cost and activity. Using knowledge of cost behavior to forecast level of cost at a particular activity. Focus is on the future. 6-3 Learning Objective 2 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Total Variable Cost Example Total Pay Per View Bill Your total Pay Per View bill is based on how many Pay Per View shows that you watch. Number of Pay Per View shows watched 6-5 Variable Cost Per Unit Example Cost per Pay Per View show The cost per Pay Per View show is constant. For example, $4.95 per show. Number of Pay Per View shows watched 6-6 Step-Variable Costs Cost Total cost remains constant within a narrow range of activity. Activity 6-7 Step-Variable Costs Cost Total cost increases to a new higher cost for the next higher range of activity. Activity 6-8 Total Fixed Cost Example Monthly Basic Cable Bill Your monthly basic cable TV bill probably does not change no matter how many hours you watch. Number of hours watched 6-9 Fixed Cost Per Unit Example Monthly Basic cable Bill per hour watched The average cost per hour decreases as more hours are spent watching cable television. Number of hours watched 6-10 Step-Fixed Costs Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost. Continue 6-11 Step-Fixed Costs Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Rent Cost in Thousands of Dollars 90 60 30 0 1,000 2,000 3,000 Rented Area (Square Feet) 6-12 Step-Fixed Costs How does this type of fixed cost differ from a step-variable cost? Step-variable costs can be adjusted more quickly and . . . The width of the activity steps is much wider for the step-fixed cost. 6-13 Semivariable Cost A semivariable cost is partly fixed and partly variable. Consider the following example. 6-14 Semivariable Cost Total Utility Cost Slope is variable cost per unit of activity. Variable Utility Charge Fixed Monthly Utility Charge Activity (Kilowatt Hours) 6-15 Curvilinear Cost Total Cost Curvilinear Cost Function Relevant Range A straight-line (constant unit variable cost) closely approximates a curvilinear line within the relevant range. Activity 6-16 Learning Objective 3 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Curvilinear Cost Total Cost Curvilinear Cost Function Relevant Range A straight-Line (constant unit variable cost) closely approximates a curvilinear line within the relevant range. Activity 6-18 Learning Objective 4 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Engineered, Committed and Discretionary Costs Committed Discretionary Long-term, cannot be reduced in the short term. May be altered in the short term by current managerial decisions. Engineered Physical relationship with activity measure. Depreciation on Buildings and equipment Direct Materials Advertising and Research and Development 6-20 Cost Behavior in Other Industries Merchandisers Service Organizations Cost of Goods Sold Supplies and travel Examples of variable costs Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Merchandisers and Manufacturers Sales commissions and shipping costs 6-21 Cost Behavior in Other Industries Examples of fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes Insurance Sales salaries Depreciation 6-22 Learning Objective 5 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Cost Estimation Account-Classification Method Visual-Fit Method High-Low Method Least-Squares Regression Method 6-24 Account Classification Method Cost estimates are based on a review of each account making up the total cost being analyzed. 6-25 Visual-Fit Method A scatter diagram of past cost behavior may be helpful in analyzing mixed costs. 6-26 Visual-Fit Method Total Cost in 1,000’s of Dollars Plot the data points on a graph (total cost vs. activity). 20 10 * * * * * ** * ** 0 0 1 2 3 4 Activity, 1,000’s of Units Produced 6-27 Visual-Fit Method Total Cost in 1,000’s of Dollars Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. 20 10 * * * * * ** * ** 0 0 1 2 3 4 Activity, 1,000’s of Units Produced 6-28 Visual-Fit Method Total Cost in 1,000’s of Dollars Estimated fixed cost = $10,000 20 10 * * * * * ** * Vertical distance ** is total cost, approximately $16,000. 0 0 1 2 3 4 Activity, 1,000’s of Units Produced 6-29 The High-Low Method OwlCo recorded the following production activity and maintenance costs for two months: High activity level Low activity level Units 9,000 5,000 Cost $ 9,700 6,100 Using these two levels of activity, compute: the variable cost per unit. the total fixed cost. 6-30 The High-Low Method U n its C o st H ig h a ctivity le ve l 9,000 $ 9,700 L o w a ctivity le ve l 5,000 6,100 Cha nge 4,000 $ 3,600 6-31 The High-Low Method U n its C o st H ig h a ctivity le ve l 9,000 $ 9,700 L o w a ctivity le ve l 5,000 6,100 Cha nge 4,000 $ 3,600 in cost Unit variable cost = in units 6-32 The High-Low Method U n its C o st H ig h a ctivity le ve l 9,000 $ 9,700 L o w a ctivity le ve l 5,000 6,100 Cha nge 4,000 $ 3,600 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit 6-33 The High-Low Method U n its C o st H ig h a ctivity le ve l 9,000 $ 9,700 L o w a ctivity le ve l 5,000 6,100 Cha nge 4,000 $ 3,600 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit Fixed cost = Total cost – Total variable cost 6-34 The High-Low Method U n its C o st H ig h a ctivity le ve l 9,000 $ 9,700 L o w a ctivity le ve l 5,000 6,100 Cha nge 4,000 $ 3,600 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) 6-35 The High-Low Method U n its C o st H ig h a ctivity le ve l 9,000 $ 9,700 L o w a ctivity le ve l 5,000 6,100 Cha nge 4,000 $ 3,600 Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600 6-36 Least-Squares Regression Method Total Cost Regression is a statistical procedure used to determine the relationship between variables such as activity and cost. The objective of the regression method is the general cost equation: Y = a + bX Activity 6-37 Equation Form of Least-Squares Regression Line Y = a + bX Total Cost is the dependent variable. The intercept term (a) is the estimate of fixed costs. The activity (X) is the independent variable. The X term coefficient (b) is the estimate of variable cost per unit of activity, the slope of the cost line. 6-38 Least-Squares Regression Method • Statistics courses and computer courses deal with detailed regression computations using computer spreadsheet software. • Accountants and managers must be able to interpret and use regression estimates. 6-39 Learning Objective 6 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Multiple Regression Multiple regression includes two or more independent variables: Y = a + b1X1 + b2X2 Terms in the equation have the same meaning as in simple regression with only one independent variable. 6-41 Engineering Method of Cost Estimation Cost estimates are based on measurement and pricing of the work involved. 6-42 Engineering Method of Cost Estimation Direct Labor Direct Material •Analyze the kind of work performed. •Estimate the time required for each labor skill for each unit. •Material required for each unit is obtained from engineering drawings and specification sheets. •Use local wage rates to obtain labor cost per unit. •Material prices are determined from vendor bids. 6-43 Effect of Learning on Cost Behavior As I make more of these things it takes me less time for each one. It must be the learning curve effect that the boss was talking about. I’ve noticed the same thing. And if you include all the variable overhead costs that are also declining, that must be the experience curve. 6-44 Learning Curve Average Labor Time per Unit Learning effects are large initially. Learning effects become smaller, eventually reaching steady state. Cumulative Production Output 6-45 Learning Objective 7 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Data Collection Problems 1. Missing data. 2. Outlier data points. 3. Mismatched time periods costs. 4. Trade-offs in choosing the time period. 5. Allocated and discretionary costs. 6. Inflation. 6-47 End of Chapter 6 6-48