Manageme

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Performance Management
Accounting
A

Cost Behaviour, Drivers and Estimation

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Manageme
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Accounting
A Topic Learning Objectives

 Cost management
 Cost drivers
 Basic types of cost behaviour
 Cost estimation approaches
 Cost function via high-low method
 Cost function via regression analysis
 Cost estimation issues

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Manageme
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Accounting
A Cost Management

 Component of management
accounting system
 …..focuses on improving the
organisation’s cost effectiveness
through understanding and
managing the real causes of costs
…..

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Cost Understanding
Accounting
A

Cost Cost Cost

estimation behaviour prediction
The process The
of  Using
relationship
determining between a knowledge of
the cost cost and cost
behaviour of the level of behaviour to
a particular activity or focus the
cost item cost driver level of cost
at a
particular
level of 4
Manageme
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Cost drivers
Accounting
A

 An activity or factor that causes costs to

be incurred
 The higher the correlation between the cost
and cost driver, the more accurate is the
description and understanding of cost
behaviours
 Conventional understandings regarded costs as
variable or fixed, based on the level of
production volume
 Contemporary viewpoints recognise that there
are a range of possible costs drivers other than
production volume (non-volume cost drivers)
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Accounting

Cost drivers
A

 Activity-based approaches
classify costs and cost drivers
into four levels:
 Unit level costs


Relate to activities that are
performed for each unit
produced

Uses conventional volume-
based cost drivers
 Batch level costs

Relate to activities performed 6
continued
Manageme
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Accounting
A Cost drivers

 Product-sustaining
 Relate to activities performed for
specific products or product
groups
 Facility level
 Cost incurred to run the business
but not caused by any particular
product

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continued
Manageme
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Accounting
A Selecting the best cost drivers

 Input or outputs?
 An example of an input cost driver is
the weight of material, and an
output driver is the number of units
of production
 Which one?
 Cost/benefit analysis to determine

the choice
 How detailed should the analysis
be?
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 How much effort
Manageme
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Accounting
A Long or short term

 Cost behaviour and cost drivers

can change over time

 Depends on the purpose of the

cost prediction

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Manageme
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Accounting
Cost estimation or
A
management?

 Cost drivers that are used to

predict costs, may differ from
those used to manage costs
 Effective cost management
requires the identification of root
cause cost drivers
 The true causes of costs
 The underlying decisions that

cause a cost to be incurred

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Exhibit 3.1 Costs and Cost
drivers
Accounting
A

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Cost drivers analysis

Accounting
A

 In choosing cost drivers the costs

and benefits of each driver must
be assessed:
 Reasons for analysing cost
behaviour
 Timeframes for analysing the cost
behaviour
 Availability of data on cost drivers,
and
 Any other uses for the cost
behaviour information 12
Manageme
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Accounting
A Tasty Bread Cost Drivers
 Direct materials for wholemeal rolls
 Number of rolls produced
 Premises costs
 Lease costs
 Delivery truck costs
 Number of deliveries
 Electricity costs
 Number of batches baked
 Shop manager’s salaries
 Shop trading hours

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Manageme
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Accounting
A Cost behaviour patterns

 Cost behaviour patterns

 Variable costs
 Fixed costs
 Semi-variable costs
 Curvilinear costs
 Linear costs

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Manageme
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Accounting
A Cost behaviour patterns

 Cost behaviour patterns

 Curvilinear
 Linear
 i.e. a straight line, expressed as:

 Y = a + bX, where

 Y = total cost


X = level of driver

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Manageme
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Accounting
A Variable costs

 Change in total in direct

proportion to a change in activity
 Constant per unit
 The variable cost is the slope of
the cost line
 Y = a + bX, where
 b = variable cost per unit of activity

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Accounting
A
Variable cost graph

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Manageme
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Accounting
A Fixed costs

 Remains unchanged in total as

the level of activity varies
 As activity increases, total fixed
costs do not change, but fixed
cost per unit declines
 Contemporary approaches to cost
analysis recognise that there are
cost drivers for some of these
“fixed” costs, and very few costs
remain fixed
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Accounting
A
Fixed cost graph

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Accounting
A Step-fixed costs

 Remain fixed over a wide range

of activity levels but jump to a
different amount for levels
outside that range

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Accounting
A Semi-variable costs

 Has both fixed and variable

components
 Identify then treat separately

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Manageme
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Accounting
A Curvilinear costs

 Has a curved cost line, but is

often approximated as a semi-
variable cost

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Manageme
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Accounting
A Cost behaviour patterns

 Cost structures are shifting

towards a decreasing proportion
of costs that vary with production
due to:
 Labour being replaced by
equipment, which does not vary
with production output
 Production wages moving towards
fixed salaries that do not vary with
production activity levels
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Manageme
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Accounting
A Cost estimation

 Managerial judgement

The account classification
method involves managers using
their judgement to classify costs
as exhibiting certain behaviours
 Engineering approach

 Quantitative analysis

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Manageme
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Accounting
A
Engineering approach

 To estimating costs
 Studying processes that result in the
incurrence of a cost
 Focus on the relationships that
should exist between inputs and
outputs
 Using time and motion studies (or
task analysis) where employees are
observed as they undertake work
tasks
 Activity-based approaches extend
task analysis to the study of indirect 25
activities and costs
Manageme
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Quantitative analysis
Accounting
A

 The analysis of past data to

identify relationships between
costs and activities
 Past data may be a poor guide to
future cost behaviour
 Three approaches include
 Visual fit method
 high-low method
 Regression analysis
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Visual fit method

Accounting
A

 Visually fitting a line to data on a

scatter diagram to estimate the
cost function
 A scatter plot can be useful in
allowing us to plot the data points
to visualise the relationship
between cost and the level of
activity

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Accounting
A
Scatter Diagram

Cost

Volume of Activity
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Fitting the cost line

Accounting
A

Important: Cost function is only

Cost relevant within relevant range

Analyst can fit line

based on his or her
experience

Volume of Activity
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Visual fit method evaluation

Accounting
A

 Lacks objectivity
 different lines can be drawn from
the same data
 Quality of graph ~ drawing &
interpretation
 can be a first step to more in-
depth analysis

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High-low Method
Accounting
A

 The high-low method involves

taking the two observations with
the highest and lowest level of
activity to calculate the cost
function

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Accounting
A
High-low method ~ step 1

Cost

Identify the highest and

lowest activity levels.

Volume of Activity
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Accounting
A
High-low Method ~ step 2

Cost

Determine the
differences
between the
high and low
points
coordinates.

Volume of Activity
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Manageme
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Accounting
A High-low method ~ step 3

Cost Variable cost per

unit = slope of the
line between the
two points (which
reflect total mixed
costs).
Rise Variable

Run
= Cost
per Unit

Volume of Activity
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Manageme
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Accounting
A
High-low method ~ step 4

Cost To find fixed costs,

use slope and co-
ordinates of one
point in y = bx + a
Rise

Y1 – Y2 Variable
=per
Cost
Unit
Run X1 – X2
Volume of Activity
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Manageme
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High-low method
Accounting
A ~ step 5

 Select one of the two point

 Substitute into y = bx + a, where
 y = y coordinate of point
 x = x coordinate of point
 b = step 4 calculations
 Find a, ie total fixed costs

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High–low method evaluation

Accounting
A

 More objective than visual fit

 Uses only two data points, and
ignores the rest

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Accounting
A Regression analysis

 Allows us to estimate the line of

best fit by making the deviations
between the cost line and the
data points as small as possible
 i.e. all data points considered
 Simple regression involves
estimating the relationship
between the dependent variable
(Y) and one independent variable
(X)
Y = a + bX 38
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Accounting
A

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Accounting
A
Manual Regression analysis

 Uses all available data in defining

the line of best fit
 Formula

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Evaluation of regression line

Accounting
A

 In terms of
 economic plausibility
 goodness of fit
 Further analysis techniques

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Manageme
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Accounting
A Multiple regression

 estimates a linear relationship

between one dependent variable
and two or more independent
variables
 Multiple regression allows us to
include two or more independent
variables, that is, cost drivers
Y = a + b1X1 + b2X2

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Practical issues in cost estimation

Accounting
A

 Data collection problems

 Missing data
 Outliers
 Mismatched time periods for dependent
and independent variables
 Trade-offs in choosing the number of
observations and the reliability of past
data points as predictors of future cost
behaviour
 Allocated fixed costs
 Inflation continued
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Issues in cost estimation

Accounting
A

 Effect of learning on cost

behaviour
 In estimating labour costs for
relatively new product or processes,
labour times per unit may decrease
at varying rates

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Issues in cost estimation

Accounting
A

 Activity-based costing (ABC)

 Allows us to consider more complex
cost behaviour patterns
 Costs are assigned to activities
 Unit, batch and product level costs
are assumed to vary in proportion to
their cost drivers

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Manageme
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Accounting
A The accuracy of cost functions

 Sometimes approximate estimates are

used to estimate cost functions within
firms
 Why is the case?
❖ Limited time and knowledge to undertake
quantitative techniques
❖ The data required to estimate reliable cost
functions may not exist
❖ A low priority may be given to determining
accurate cost behaviour and cost
estimation
❖ Subjective cost estimates may be 46
considered good enough for the firm’s
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Cost estimation assumptions

Accounting
A

 All cost functions are based on

simplifying assumptions, such as:
 Cost behaviour depends on a single
activity
 Cost behaviours are linear within a
relevant range
 Costs and benefits of producing
accurate cost information need to
be assessed.
 Refer to handout – Ex.2 - Q.3.49
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Manageme
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Accounting
A Any Questions?

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