Measurement of Cost Behaviour

Chapter 3
Measurement of
Cost Behavior
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
3-1
Learning Objective 1
Explain step- and
mixed-cost behavior.
Linear-Cost Behavior
Linear-cost behavior can be graphed with
a straight line when a cost changes
proportionately with changes
in a single cost driver.
Relevant Range
Relevant Range
The relevant range specifies the limits of
cost-driver activity within which a specific
relationship between a cost and its cost
driver will be valid.
Step- and Mixed-Cost

Behavior Patterns
A purely variable cost varies in
proportion to the selected cost driver.
A purely fixed cost is not affected

by the cost-driver level.
Step- and Mixed-Cost

Behavior Patterns
1
2
In addition to these pure versions of cost,

two additional types of costs combine
characteristics of both fixed- and variablecost behavior.
Step costs
Mixed costs
Step Costs
Step costs change

abruptly at intervals
of activity because
the resources and
their costs come in
indivisible chunks.
Step Costs
A. Lease Cost
Relevant
Range
Actual Cost
Behavior
Fixed Cost
Approximation
Oil and Gas Exploration Activity

Step Costs
B. Supermarket Checker Wage Cost
Relevant Range
Actual Cost
Behavior
Variable
Cost
Approximation
40
Shoppers per Hour
440
Step Costs
The total step cost at a level of activity is
the amount of fixed cost appropriate for the
range containing that activity level.
When the steps are relatively small, the step
cost behaves much like a variable cost and
could be used as such for planning with
little loss of accuracy.
Mixed Costs
Mixed costs contain elements of both fixedand variable-cost behavior.
Unlike step costs, there is usually only one
relevant range of activity and one level of
fixed costs in a mixed cost.
Facilities Maintenance
Department Cost
Mixed Costs
Relevant Range
$5.00 per
Patient Day
Total
Variable
Cost
$10,000
Fixed
Cost
1,000
5,000
Number of Patient-Days per Month

Explain management influences
on cost behavior.
Product and Service Decisions

and the Value Chain
Managers influence cost behavior.
Choice of process and product design
Quality levels
Distribution
Capacity Decisions
What are capacity costs?
Capacity costs are the fixed costs of being
able to achieve a desired level of production
or to provide a desired level of service.
Committed Fixed Costs

Committed fixed costs usually arise from
the possession of facilities, equipment,
and a basic organization.
These are large, indivisible chunks of cost
that the organization is obliged to incur or
usually would not consider avoiding.
Discretionary Fixed Costs

Discretionary fixed costs are costs fixed at
certain levels only because management
decided that these levels of cost should be
incurred to meet the organizations goals.
These discretionary fixed costs have no
obvious relationship to levels of output
activity but are determined as part of the
periodic planning process.

Each planning period, management will determine
how much to spend on discretionary items.
These costs then become fixed until the next
planning period.
Examples of
What are some examples?
Employee training programs
Advertising and promotion
Research and development
Charitable donations
Public relations
Cost-Control Incentives
Managers use their knowledge of cost behavior to
set cost expectations.
Employees may receive rewards that are tied to
meeting these expectations.
Measure and mathematically
express cost functions and
use them to predict costs.
Cost Functions
The first step in estimating or predicting
costs is measuring cost behavior as a
function of appropriate cost drivers.
The second step is to use these cost
measures to estimate future costs at
expected, future levels of cost-driver
activity.
Cost Function Equation

Y = Total cost
F = Fixed cost
V = Variable cost per unit
X = Cost-driver activity in number of units
Cost Function Equation

Mixed Cost Function:
Y = F + VX
The mixed-cost function is called a
linear-cost function.
Criteria for Choosing Functions

Plausibility
The cost function must be believable.
Reliability
A cost functions estimates of costs at levels
of activity must reliably conform
to actually observed costs.
Describe the importance
of activity analysis for
measuring cost functions.
Choice of Cost Drivers:

Activity Analysis
Choosing a cost function starts

with choosing cost drivers.

Activity Analysis
Managers use activity analysis to identify
appropriate cost drivers.
Activity analysis is especially important for
measuring and predicting costs for which
cost drivers are not obvious.

Activity Analysis
What are some cost drivers?
Direct labor hours
Machine hours
Units of sales
Transactions
Work cells
Order size
Methods of Measuring
Cost Functions
Engineering analysis
Account analysis
High-low analysis
Visual-fit analysis
Least-squares regression analysis
Engineering Analysis
Engineering analysis entails a systematic
review of materials, supplies, labor, support
services, and facilities needed for products
and services.
It measures cost behavior according to what
costs should be, not by what costs have
been.
Measure cost behavior using the
account analysis, high-low,
visual-fit, and least-squares
regression methods.
Account Analysis
The simplest method of account analysis

selects a volume-related cost driver
and classifies each account as a
variable or fixed cost.
High-Low Method
This method selects the lowest and the
highest activity levels.
These levels should be within the relevant
range.
The costs chosen should represent the
normal cost incurred at these levels.
High-Low Method Example

High capacity January: 55,000 machine hours
Cost of electricity $80,450
Low capacity September: 30,000 machine hours
Cost of electricity: $64,200
What is the variable rate?

($80,450 $64,200)
$16,250 = .65
=
(55,000 30,000)
25,000
What is the fixed cost

$80,450 = Fixed cost + 55,000($ 0.65)
$80,450 $35,750 = $44,700
$64,200 = Fixed cost + 30,000($0.65)
$64,200 $19,500 = $44,700
Visual-Fit Method
In the visual-fit method, the cost analyst

visually fits a straight line through a plot of
all of the available data, not just between
the high point and the low point, making it
more reliable than the high-low method.
Least-Squares Regression
Method
Regression analysis measures a cost
function more objectively by
using statistics to fit a cost
function to all the data.
Regression analysis usually measures
cost behavior more reliably than
other cost measurement methods.
Coefficient of Determination
One measure of reliability, or goodness
of fit, is the coefficient of determination,
R (or R-squared).
The coefficient of determination measures
how much of the fluctuation of a cost is
explained by changes in the cost driver.
Understand the relationship
between management
decision making and
cost behavior.
Management Decision Making

and Cost Behavior
Understanding cost behavior provides
managers with valuable insights about
how cost will respond to managers
decisions as well as to outside influences.
End of Chapter 3
3 - 43

Measurement of Cost Behaviour

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Chapter 3

Step- and Mixed-Cost

A purely fixed cost is not affected

Step- and Mixed-Cost

In addition to these pure versions of cost,

Step costs change

Oil and Gas Exploration Activity

Shoppers per Hour

Number of Patient-Days per Month

Product and Service Decisions

Committed Fixed Costs

Discretionary Fixed Costs

Discretionary Fixed Costs

Cost Function Equation

Cost Function Equation

Criteria for Choosing Functions

Choice of Cost Drivers:

Choosing a cost function starts

Choice of Cost Drivers:

Choice of Cost Drivers:

The simplest method of account analysis

High-Low Method Example

High-Low Method Example

What is the fixed cost

High-Low Method Example

In the visual-fit method, the cost analyst

Management Decision Making

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