Chapter 3

Cost drivers, cost behaviour and cost estimation

Costs and costing systems

Cost estimation - process of determining cost behaviour of a particular cost item

Cost behaviour - relationship between cost and activity (often cost driver)

Cost prediction - using cost behaviour knowledge to forecast future costs at a particular level of activity

Cost drivers

Any activity or factor that causes costs to be incurred

Volume-based cost drivers - assumes all costs are driven, or caused, by the volume of production (or sales)

Non-volume-based cost drivers - costs are not directly related to production volume

Cont.

Cost drivers

Activity-based costing classifies costs into four categories unit level - activities performed for each unit batch level - activities performed for a group of

product units, such as batch or a delivery load product level- activities performed for specific

products or product families facility level - costs incurred to support the whole

business

Selecting the best cost drivers

Input or output measure? strong correlation between cost and cost driver cost driver must be easy to measure

Level of detail? accuracy increases with increased cost

categories, but so does cost

Long-term or short-term perspective?Consider costs and benefits

Cost estimation vs cost management

Managing costs by managing cost driversEffective cost management involves the

identification of root-cause drivers the underlying factor that causes a cost to be

incurred

Cost behaviour patterns

Cost function - an equation used to describe cost behaviour: Y = a + bX

Variable cost (bX) - total changes in direct proportion to a change in level of activity

Fixed cost (a) - total remains unchanged as the level of activity varies

Relevant range - range of activity over which cost behaviour patterns are valid

Cont.

Cost behaviour patterns

Step-fixed costs - fixed over a range of activity, but jumps to a different amount for levels outside that range

Semivariable costs - fixed and variable components

Curvilinear costs - approximated as a curved line

Marginal cost - cost of producing the next unit of production

Using cost behaviour to predict costsEngineered costs - defined relationship to

the cost driverCommitted costs - results from an

organisation’s ownership or use of premises and its basic organisation structure

Discretionary costs - arise from management decisions

Cost structures in modern manufacturing

Fewer costs vary with production volume automation - replacement of labour with

machinery relatively stable workforce which cannot be

varied in the short run

It is important to understand the nature of the industry when analysing cost behaviour

Cost estimation

Cost estimation the process of determining the cost behaviour

of a cost item

Three approaches to cost estimation managerial judgement engineering approach quantitative analysis

Managerial judgement

Use of experience rather than formal analysis to estimate cost behaviours

Account classification method where managers use their judgement to classify

the accounts in the general ledger as fixed, variable or semivariable costs

adjusted by factors which may affect future costs

The engineering approach

Study of processes that result in the incurrence of a cost engineering studies - focus on the relationships

that should exist between inputs and outputs time and motion studies (task analysis or work

measurement) - observation of the steps required and time taken by employees to perform particular activities

Quantitative analysis

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

Visual fit method

Visually fitting a line to data on a scatter diagram to estimate the cost function

Lacks objectivity different lines can be drawn from the same data can be a first step to more in-depth analysis

High–low method

Estimate a cost function by considering data at the highest and lowest levels of activity

More objective than visual fitUses only two data points, and ignores the

rest

Variable cost = difference in cost levels

difference in activity levels

Regression analysis

Statistical technique for estimating cost behaviour by minimising the difference between the cost line and data points

Least squares regression: Y= a + bX independent variable (X) dependent variable (Y)

Cont.

Regression analysis

Uses all available data in defining the line of best fit

Evaluation of regression line economic plausibility goodness of fit

Multiple regression - estimates a linear relationship between one dependent variable and two or more independent variables

Data collection problems

Cost estimates are only as good as the data upon which they are based

Data problems missing data outliers mismatched time periods trade-offs in choosing time periods allocated fixed costs

Effect of learning on cost behaviour

Learning curve effect reduction in labour time per unit which occurs

in the early stages of producing a new product

As the number of units produced increases, the total labour cost will increase but at a decreasing rate

Labour costs are unlikely to have a linear relationship with cost

Cost behaviour, cost estimation and activity-based costing

Activity-based costing (ABC) cost are assigned to activities costs driven by volume are unit level costs cost drivers are identified for batch-level and

product-level costs, but not for facility-level costs assumed that unit, batch and product-level costs

vary proportionally with their cost driver understanding cost behaviour and estimating cost

functions is still important

Accuracy of cost functions in businessObjective techniques are not widely used to

estimate cost behaviours insufficient time or knowledge to use appropriate

quantitative methods data required to estimate reliable cost functions

not available low priority given to analysing cost behaviour

and cost estimation approximations considered “accurate enough”

Costs and benefits of accurate cost information

Difficult to assess the benefits flowing from more accurate cost estimation

Common simplifying assumptions underlying cost estimation include cost behaviour depends on one activity cost behaviours are linear within the relevant

range

Exhibit 3.2

Exhibit 3.3

Exhibit 3.5

Exhibit 3.9