Chapter 6

Activity Analysis,
Cost Behavior,
and Cost
Estimation

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

McGraw-Hill/Irwin

Copyright 2011 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.

1-3

Learning
Objective
2

McGraw-Hill/Irwin

Copyright 2011 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
1-5

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
1-6

Step-Variable Costs

Cost

Total cost remains

constant within a
narrow range of
activity.

Activity

1-7

Step-Variable Costs

Cost

Total cost increases to a

new higher cost for the
next higher range of
activity.

Activity

1-8

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

1-9

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

1-10

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

1-11

Step-Fixed Costs
Total cost doesnt 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

1,000
2,000
3,000
Rented Area (Square Feet)

1-12

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.
1-13

Semivariable Cost
A semivariable
cost is partly
fixed and partly
variable.

Consider the
following
example.
1-14

Semivariable Cost

Total Utility Cost

Slope is
variable cost
per unit
of activity.

Variable
Utility Charge
Fixed Monthly
Utility Charge
Activity (Kilowatt Hours)
1-15

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
1-16

Learning
Objective
3

McGraw-Hill/Irwin

Copyright 2011 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
1-18

Learning
Objective
4

McGraw-Hill/Irwin

Copyright 2011 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
1-20

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
1-21

Cost Behavior in Other Industries

Examples of fixed costs

Merchandisers, manufacturers, and

service organizations
Real estate taxes
Insurance
Sales salaries
Depreciation

1-22

Learning
Objective
5

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost Estimation
Account-Classification Method
Visual-Fit Method
High-Low Method

Least-Squares Regression Method

1-24

Account Classification Method

Cost estimates are based on a

review of each account making up
the total cost being analyzed.
1-25

Visual-Fit Method
A scatter diagram of past cost behavior
may be helpful in analyzing mixed costs.

1-26

Visual-Fit Method

Total Cost in
1,000s of Dollars

Plot the data points on a

graph (total cost vs. activity).

20

10

* *
* *

* ** *
**

0
0
1
2
3
4
Activity, 1,000s of Units Produced
1-27

Visual-Fit Method

Total Cost in
1,000s 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, 1,000s of Units Produced
1-28

Visual-Fit Method

Total Cost in
1,000s of Dollars

Estimated fixed cost = $10,000

20

10

* *
* *

* ** *
Vertical distance
**
is total cost,
approximately
$16,000.

0
0
1
2
3
4
Activity, 1,000s of Units Produced
1-29

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.
1-30

The High-Low Method

High activity level

Low activity level
Change

Units
9,000
5,000
4,000

Cost
$ 9,700
6,100
$ 3,600

1-31

The High-Low Method

High activity level
Low activity level
Change

Unit variable cost =

Units
9,000
5,000
4,000
in cost
in units

Cost
$ 9,700
6,100
$ 3,600

1-32

The High-Low Method

High activity level

Low activity level
Change

Units
9,000
5,000
4,000

Cost
$ 9,700
6,100
$ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per

unit

1-33

The High-Low Method

High activity level

Low activity level
Change

Units
9,000
5,000
4,000

Cost
$ 9,700
6,100
$ 3,600

Unit variable cost = $3,600 4,000 units = $0.90 per unit

Fixed cost = Total cost Total variable cost

1-34

The High-Low Method

High activity level
Low activity level
Change

Units
9,000
5,000
4,000

Cost
$ 9,700
6,100
$ 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)

1-35

The High-Low Method

High activity level

Low activity level
Change

Units
9,000
5,000
4,000

Cost
$ 9,700
6,100
$ 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

1-36

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
1-37

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.
1-38

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.

1-39

Learning
Objective
6

McGraw-Hill/Irwin

Copyright 2011 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.
1-41

Engineering Method
of Cost Estimation

Cost estimates are based on measurement

and pricing of the work involved.
1-42

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.
1-43

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.

Ive noticed the same

thing. And if you include
all the variable overhead
costs that are also
declining, that must be
the experience curve.

1-44

Learning Curve

Average Labor
Time per Unit

Learning effects
are large initially.

Learning effects
become smaller, eventually
reaching steady state.

Cumulative Production Output

1-45

Learning
Objective
7

McGraw-Hill/Irwin

Copyright 2011 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.
1-47

End of Chapter 6

1-48