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Analysis
Lecture 2
• What is a cost?
o Relevant Range
• Cost estimation
o High-low method
o Regression analysis
Knowing how costs vary by identifying the drivers of costs and being able to
distinguish fixed from variable costs are essential to good management
decision making. Many managerial functions in the planning and control areas
require and rely on knowing how costs behave in relation to activities (e.g.
production output/volume). Analysis of cost behaviour patterns allow
managers to prepare standard costs, formulate budgets and to predict and
control costs.
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Cost Management and Analysis: 22753 University of Technology, Sydney
What is a cost?
Rent
Stationary Office
Furniture
Machines (Depreciation)
(Depreciation)
Resources
used to Electricity
generate some
Labour
(Time!) beneficial
output
Materials
Spare Parts
Insurance
Water Computers
(Depreciation)
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What is a cost?
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What is a cost?
Although costs move with output changes, the cost movement tends to be less
sensitive than the activity change, that is, if output doubles, total costs will
increase, but not by 100 per cent.
1 $200
2 $300
Why in the above example do the costs of producing two units not double the
cost of producing just one unit? (i.e. Why is the cost not $400?)
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Cost Management and Analysis: 22753 University of Technology, Sydney
Basic Cost Terminology
Cost Pools: Groups of a particular type of cost (e.g. material costs, labour costs,
electricity costs, depreciation costs). Cost pools vary by the type of costs
included and the level of aggregation.
Cost Drivers: Activities or factors that drive (cause) costs to occur. Drivers allow
cost pools to be allocated to cost objects.
The basic (linear) cost function can be represented in the following manner:
Y = a + bX
Total Cost = FC + VC x Activity
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Cost behaviour patterns
Cost Behaviour: The relationship between a cost and the level of activity (i.e.
production volume) or cost driver. There are a number of cost behavior
patterns:
Stepped-fixed Costs
Curvilinear Costs
o We assume in this subject that all costs are linear
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Cost Management and Analysis: 22753 University of Technology, Sydney
Cost behaviour patterns
Variable costs: Costs that change in total in direct proportion to a change in
activity.
Cost ($)
X
Activity (e.g. units produced)
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University of Technology, Sydney
Cost behaviour patterns
Fixed costs: Costs that remain unchanged in total as the level of activity
varies.
o Committed cost: Results from the basic organisation structure and difficult to
adjust in the short term.
Y
Cost ($)
X 11
Activity (e.g. units produced) University of Technology, Sydney
Cost behaviour patterns
Step-fixed costs: Costs that remain fixed within a certain range of activity, but
change to a different amount outside that range.
Cost ($)
Step-Fixed
Cost
X
Activity (e.g. units produced)
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Cost behaviour patterns
Semi-variable (mixed) costs: Costs that contain both fixed and variable components.
The basic (linear) cost function can be represented in the following manner:
Semi-Variable Cost
Cost ($)
Variable Cost
Fixed Cost Component
Component
X
Activity (e.g. units produced)
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Cost behaviour patterns
Curvilinear costs: Costs that exhibit cost behaviour that can be described by a
curved line.
o Convex costs have increasing marginal costs.
o Concave costs have decreasing marginal costs.
Y
Curvilinear Cost
Cost ($)
Concave
Convex
X
Activity (e.g. units produced)
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Cost behaviour patterns
Relevant Range: Refers to a the range of activity (i.e. the upper and lower limits
of production) for which assumptions about cost behaviour hold.
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Cost Management and Analysis: 22753 University of Technology, Sydney
Cost behaviour patterns
Y
Relevant Range 1 Relevant Range 2
Cost ($)
TC2
VC per unit
TC1
FC
X
Activity (e.g. units produced)
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Cost behaviour: Problem 3.32
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For each of the following cost items (1 to 11), choose the graph, (a) to (i), that best represents it: Graph
1 Cost of electricity at a university. For low student enrolments, electricity costs increase with enrolment, but at a
decreasing rate. For high student enrolments, electricity costs increase at an increasing rate.
2 Charges for international telephone calls, which are based on the number of minutes per month. The charge is $0.25
per minute, up to 600 minutes. Additional minutes (above 600) are free.
3 Cost of outsourcing pathology testing by a hospital. The hospital pays an independent lab a fee of $10 000 per
month plus $5 for each test performed.
4 Salary costs of the shift supervisors at a courier company. Each shift is eight hours. The depot operates with one, two
or three shift supervisors simultaneously, at various times of the year, depending on the volume of delivery work.
6 Wages of waiters in a restaurant. Waiters are part-time workers who are scheduled to work in three hour blocks.
11 Tariffs paid by a wine exporter. On one Pacific island, a tariff must be paid by the wine exporter for every case of wine
brought into that country. The tariff schedule is the following
0 to 6000 cases per year: $11 per case
6001 to 12 000 cases per year: $14 per case
Above 12 000 cases per year: $19 per case
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Cost estimation
Cost estimation is the process of determining the cost behaviour
pattern of a particular cost item.
2. Contractual arrangement
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Cost estimation
There are three methods to identify cause-and-effect relationships.
1. Engineering method
Identifies the relationship that should exist between input and outputs.
Relationships are determined through “time and motion” studies which observe
the steps required and time taken to perform particular activities.
2. Managerial judgement
a. Conference method
Estimates cost functions on the basis of opinion about costs and their
drivers gathered from various departments of an organisation – purchasing,
human resources, engineering, manufacturing, etc. This method relies on
the expert knowledge and judgement of managers.
Step 1: Choose the dependent variable (the cost variable you want to
estimate)
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Cost estimation
Step 3: Collect data on the dependent variable and the cost driver(s)
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Cost estimation
Step 4: Plot the data – use a scatterplot to visually observe the
relationship between the cost and its’ driver(s)
VC calculation: Two periods of data (high and low) are chosen at based on
the levels of activity – both levels should be within the same relevant range.
FC calculation: Substitute the VC with either the high or low values into the
total cost formula.
TC = FC + ( VC x Activity )
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Cost estimation: High-low method
Select the highest and lowest values of the cost driver.
Hours.
Fixed costs are the same at
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both levels of activity!
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Cost estimation: High-low method
The dependent variable (Y) is electricity. This is predicted or explained by the
independent variable (X) of machine hours.
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Cost estimation: High-low method
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Cost estimation: Regression analysis
Regression analysis is a statistical method that measures the average amount
of change in the dependent variable that is associated with a unit change in
one or more independent variables. It has two advantages over high-low:
o All available data points are used (high-low uses just two data points). The
difference can be seen in the scatterplot below.
Regression
estimated line
Outlier
High-low
estimated line
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Cost estimation: Regression analysis
Regression analysis for the previous example would give the following output:
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.698
R Square 0.487
Adjusted R Square 0.436
Fixed Cost
Standard Error 5565.3
Observations 12
Variable Cost
ANOVA
df SS MS F Significance F
Regression 1 294540335.4 294540335.4 9.5096 0.0116
Residual 10 309729181.4 30972918.14
Total 11 604269516.8
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 43293.4148 8110.6279 5.3379 0.0003 25221.8 61365.0 25221.8 61365.0
Machine Hours 0.8430 0.2734 3.0838 0.0116 0.2339 1.4521 0.2339 1.4521
Regression Statistics
Multiple R 0.853
R Square 0.728
Adjusted R Square 0.668
Standard Error 4272.2
Observations 12
ANOVA
df SS MS F Significance F
Regression 2 440007799.2 220003899.6 12.0541 0.0028
Residual 9 164261717.6 18251301.95
Total 11 604269516.8
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 27576.2781 8352.071 3.302 0.009 8682.580 46469.976 8682.580 46469.976
Machine Hours 0.9880 0.216 4.573 0.001 0.499 1.477 0.499 1.477
Batches 3.2431 1.149 2.823 0.020 0.644 5.842 0.644 5.842
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Cost estimation
Step 6: Evaluate the estimated cost function
The four most important criteria in evaluating the cost function are:
2. Goodness of fit – How well does the line fit the data points?
Regression Statistics
Multiple R 0.846
R Square 0.716
Adjusted R Square 0.687
Standard Error 913.370
Observations 12
ANOVA
df SS MS F Significance F
Regression 1 21000052.7 21000052.7 25.173 0.001
Residual 10 8342447.3 834244.7
Total 11 29342500
Coefficients Std Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 6039.2405 1810.287 3.336 0.008 2005.670 10072.811 2005.670 10072.811
X Variable 1 13.3122 2.653 5.017 0.001 7.400 19.224 7.400 19.224
Cost Estimation Function: Total Cost = Fixed Cost + Unit variable Cost * Hours
Total cost for 720 Hours =
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Lecture demonstration problem 2
You are the management accountant at Lion Nathan for the product line “Tooheys
Extra Dry”. You think that there is an economies of scale advantage to production for
certain variable resources, but are unsure what the actual cost effect is. You think that
the relevant range to get this cost advantage starts at around 1500 units per day. Use
the following data to calculate the reduction in variable costs.
1 600 $6,000
2 750 $6,300
3 800 $6,650
4 1000 $7,200
5 1300 $7,750
6 1400 $8,000
7 1750 $9,000
8 1800 $9,200
9 1950 $9,500
10 2000 $9,600
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Lecture demonstration problem 2
Y Change in slope is due to
economies of scale
Cost
TC
VC
FC
X
1500 Production
Working Out:
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Tutorial 2 (Week 3): Cost Behaviour, Cost Drivers and
Cost Estimation
Next week’s tutorial will take place in computer labs.
You need to submit your group assignment registration form to your lecturer
before the start of this tutorial.
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