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Cost Cost AnalysisAnalysis

Prepared by Douglas Cloud

Pepperdine University

Prepared by Douglas Cloud

Pepperdine University

33

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Understand the importance of cost management. Describe the two aspects of managing costs. Distinguish between value-added and non-value-

adding activities and costs. Describe and use methods of analyzing cost behavior. Understanding the limitations of methods of cost

behavior and analysis. Classify costs along several dimensions including

whether managers can change them at short notice.

ObjectivesObjectivesObjectivesObjectives

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

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Cost Drivers and PoolsCost Drivers and PoolsCost Drivers and PoolsCost Drivers and Pools

Activities that cause costs are cost drivers and include sales, production, and items

such as the number of products the company

makes and the number of customers it serves.

Activities that cause costs are cost drivers and include sales, production, and items

such as the number of products the company

makes and the number of customers it serves.

A group of costs driven by the

same activity is a cost pool.

A group of costs driven by the

same activity is a cost pool.

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Estimated Cost BehaviorEstimated Cost BehaviorEstimated Cost BehaviorEstimated Cost Behavior

Fixed Cost Behavior Variable Cost Behavior

$$

Activity Activity

Unit Cost Varies with Volume Unit Cost Rate is Constant

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Total Costs = Fixed Amount + (Variable Cost Per Unit x Number of Units)Total Costs = Fixed Costs + Variable Costs

Total Costs

$ Cost

Number of Units Produced

Fixed amount

Variable Costs

Estimated Cost BehaviorEstimated Cost BehaviorEstimated Cost BehaviorEstimated Cost Behavior

Mixed Cost

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Estimating Cost BehaviorEstimating Cost Behavior

Account AnalysisEngineering ApproachInterviewsThe (High-Low) Two-Point MethodScatter-Diagram MethodRegression

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Account AnalysisAccount AnalysisAccount AnalysisAccount Analysis

Manager decides how to classify a cost by looking at its name and then checking this judgment by scanning the account for that cost for several periods.

Example: Rent, depreciation, salaries, and advertising are generally fixed.

Weakness: It only shows what costs have been, not what they should be.

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Engineering ApproachEngineering ApproachEngineering ApproachEngineering Approach

Engineers study the material and labor requirements of products and related operations, then make per-unit estimates of the costs that should vary with production.

Advantage: It indicates what costs should be rather than what they have been.

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InterviewsInterviewsInterviewsInterviews

This is a simple tool that has proven useful in determining what drives many costs, and to determine what is likely to happen to particular costs, given specific actions.

Advantage: It does help to identify cost drivers.

Weakness: Interviewing does not help determine how much of a particular cost is fixed or variable.

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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method

The high-low (two-point) method is a relatively unsophisticated, yet widely used, method of estimating the components of a mixed cost.

Approach: This method uses two past levels of activity and the amounts of the cost incurred at those levels; more specifically, the highest and lowest levels of activity.

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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method

Variable cost component of

mixed cost=

change in cost

change in activity

Variable cost component of

mixed cost=

$40,800 – $14,800

18,000 – 5,000

Variable cost component of

mixed cost=

$26,000

13,000

$2 per machine hour=

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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method

Fixed cost component of

mixed cost=

total cost

– volume xvariable

cost components

At the high point: 18,000At the high point: 18,000Fixed cost

component of mixed cost

= $40,800 – (18,000 x $2)

Fixed cost component of

mixed cost= $4,800

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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method

Fixed cost component of

mixed cost=

total cost

– high volume

xvariable

cost components

At the low point: 5,000 machine hoursAt the low point: 5,000 machine hours

Total cost at low volume $14,800

Fixed cost component of mixed cost = $4,800

Less variable portion (5,000 x $2)

=

10,000

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Scatter-Diagram MethodScatter-Diagram MethodScatter-Diagram MethodScatter-Diagram Method

The scatter-diagram (or graphical) method requires cost and volume data from prior periods, and derives an equation (cost prediction formula) based on those data.

Weakness: The placement and slope of the line are matters of

judgment; the manager “eyeballs” the data and fits the line visually.

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x

Scatter-Diagram MethodScatter-Diagram MethodScatter-Diagram MethodScatter-Diagram Method

Machine Hours

Maintenance Cost

$45,000

35,000

25,000

20,000

10,000

7.2

5,000

0 0 2 4 6 8 10 12 14 16 18 20

Analyst can fit line

based on his or her

experience x

x x

x

x

x x

x

(Thousands)

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Regression MethodRegression MethodRegression MethodRegression Method

Regression analysis (or just regression) is a more sophisticated method for estimating the fixed and variable components of a mixed cost.

Regression uses cost and volume data from prior periods to yield an equation of the form y = a + bx.The appendix covers regression in more detail.

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Problems and Pitfalls in Cost Behavior Analysis

Historical DataHistorical Data

High-low, scatter-diagram, and regression methods all use historical information.

Formulas based on historical data can give useful predictions only if past conditions prevail in the future.

Outliers should be ignored

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Problems and Pitfalls in Cost Behavior Analysis

Correlation and AssociationCorrelation and Association

For an equation to be useful for planning, the relationship between the cost and the activity must

be fairly close.

For an equation to be useful for planning, the relationship between the cost and the activity must

be fairly close.

The visual aspect of the scatter-diagram method allows the manager to see whether the

activity chosen as the independent variable is a good

predictor of cost.

The visual aspect of the scatter-diagram method allows the manager to see whether the

activity chosen as the independent variable is a good

predictor of cost.

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Step Variable CostsStep Variable CostsStep Variable CostsStep Variable Costs

$ Cost

Number of Units Produced

Linearity Assumption

Narrow Width

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DefinitionsDefinitionsDefinitionsDefinitions

Discretionary costs are fixed costs that can be quickly altered by managerial action.

Example: Advertising, employee training, and research and development

Committed costs are fixed costs that cannot be changed so quickly.

Example: Depreciation

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DefinitionsDefinitionsDefinitionsDefinitions

Avoidable costs are costs that can be avoided by adding, dropping, or curtailing some activities.

Example: Advertising, sales salaries

A company that drops a product line might not be able to reduce its sales force or its rent.

Such costs are unavoidable.

A company that drops a product line might not be able to reduce its sales force or its rent.

Such costs are unavoidable.

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A direct cost is incurred specifically because of a particular activity of a firm, like a product line, or geographical area.

Direct costs are sometimes called separable or traceable costs.

An indirect cost does not relate to one specific activity, but rather to several.

An indirect cost is sometimes called a common or joint cost.

DefinitionsDefinitionsDefinitionsDefinitions

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Manufacturing CostsManufacturing Costs

Direct materials Direct labor Manufacturing overhead

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Regression Output (Appendix)Regression Output (Appendix)Regression Output (Appendix)Regression Output (Appendix)Regression Output:

Constant $7,731.78

Standard Error of Y Estimate $1,763.16 R

Squared .0954921 No. of

Observations 12

Degrees of Freedom 10 X

Coefficient(s) $1.76678

Standard Error of Coefficient $0.12139

Model: Y = $7,731.78 + $1.76678X

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Goodness of Fit (Appendix)Goodness of Fit (Appendix)Goodness of Fit (Appendix)Goodness of Fit (Appendix)

Goodness of fit tells us how well the regression line fits the data, and therefore suggests to managers how good their predictions are likely to be. Two potential measures are:

1. the coefficient of determination (R-squared).

2. the standard error of the estimate (Standard Error of Y Estimate).

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Y = a + b1X1 + b2X3 + … + bnXn

Multiple Regression Equation (Appendix)

Multiple Regression Equation (Appendix)

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The EndThe End

Chapter 3Chapter 3

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