Ch 10 Flashcards
Cost function
Is a mathematical description of how a cost changes with changes in the level of an activity relating to that cost
Managers often estimate cost functions on two assumptions
- Variations in the level of a single activity (cost driver) explain the variations in the related total costs
- Cost behavior is approximated by a linear cost function within the relevant range. For a linear cost function, total cost versus the level of a single activity related to that cost is a straight line within relevant range
General form of this linear cost function is
Y = a + bX
A particular cost item could be what?
Variable for one cost object and fixed for another cost object
The longer the time horizon, all other things being equal, the more likely the cost will be?
Variable
Variable and fixed cost behavior patterns are valid for linear cost functions only within the given
Relevant range
Outside the relevant range, variable and fixed cost behavior patterns change, which causes what?
Costs to become nonlinear
Cost functions are estimated from what kind of data?
Past cost data
Cost estimation is used to
Measure a relationship based on data from past costs and the related level of activity
Why are managers interest in estimating past cost functions?
Primarily because they can help them make more accurate cost predictions or forecasts of Future costs
What is the most important issue in estimating a cost function?
Determining whether a cause and effect relationship exists between the level of an activity and the costs related to it e
Cause and effect relationship exists when?
A change in the level of an activity and a change in the level of total costs, we refer to the activity measure as a cost driver
A cause and effect relationship might arise as a result of the following
- A physical relationship between the level of activity and the costs
- A contractual agreement
- Knowledge of operations
Managers should always use a long time horizon because
Costs may be fixed in the short run (during which time they have no cost driver) but usually variable and have a cost driver in the long run
What are the 4 methods of cost estimation?
- Industrial engineering method
- Conference method
- Account analysis method
- Quantitative analysis method
Industrial engineering method also called the work measurement method, estimates
Cost functions by analyzing the relationship between inputs and outputs in physical terms
Advantages and challenges of the industrial engineering method include
Advantage
Very thorough and detailed to estimate cost function where there is a relationship between inputs and outputs
Challenges
Time consuming
Too costly or impractical
Conference method
Estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company (purchasing, process engineering, manufacturing, employee relations
Conference method advantages and challenges
Advantages
Encourages interdepartmental cooperation
The pooling of knowledge from different business functions of value chain gives conference method credibility
Does not need detailed analysis of data cost functions and cost estimates can be developed quickly
Challenges
Bc opinions are used, the accuracy of cost estimates depends largely on care and skill of people providing output
Account analysis method
Estimates cost functions by classifying various cost accounts as variable, fixed or mixed in regard to identified level of activity
What do managers typically use when making cost classification decisions?
Qualitative analysis
Advantages and challenges of account analysis method
Advantages
Widely used bc it is accurate, cost effective and easy to use.
Supplementing account analysis method with conference method improves credibility
The accuracy depends on the accuracy of qualitative judgments that managers and management accountants make about which costs are fixed and which are variable
Quantitative analysis
Used a formal mathematical method to fit cost functions to past data observations.
When estimating the cost function using quantitative analysis, we examine two techniques
- The relatively simple high low method as well as the more common quantitative tool used to examine and understand data, regression analysis
Advanatages and challenges of quantitative analysis
Challenges
Most rigorous approach to estimate costs
Advantages
Computers have Have made performing quantitative analysis & regression analysis way easier
What are the six steps in estimating a cost function using quantitative analysis of past data
- Choose the dependent variable
(Cost to be predicted & managed) - Identify the independent variable or cost driver
(IV used to predict DV)
When cost is indirect cost, the IV is also called a cost allocation base (or cost driver)
- Collect data on the DV and cost driver
Obtain data and it may be time series or cross sectional.
Time series: pertain to same entity over successive past periods
Cross sectional: pertain to different entities during the same period
- Plot the data
Plot provides insight into relevant range of cost functions. & reveals whether the relationship between driver and cost is approx. linear.
- Estimate cost function
- most two common methods: high low and regression analysis - Evaluate cost driver of estimated cost function
High low method
- simplest form of quantitative analysis to fit a line to data points
- uses highest and lowest observed values of cost driver within relevant range and their respective costs to estimate the slope coefficient & the constant of cost function
Regression analysis
A statistical method that measures the avg amount of change in the DV associated with a unit change in one or more IV
Regression analysis method is widely used because
It helps managers get behind the numbers so they can understand why costs behave the way they do and why managers can do to influence them
Simple regression
Estimates relationship between DV & one IV
Multiple regression
Estimates relationship between DV and two or more IV
Residual term
Vertical difference
Measures the distance between Actual costs & estimated cost for each observation of cost driver
The smaller the residual term is the better it is for what?
Better the fit between actual costs observations and estimated costs
Goodness of fit
Indicates strength of relationship between cost driver and costs
Why is the regression method more accurate than high low method?
Regression equation estimates costs using info from all observations
High low method uses info from only 2 observations
How does a company determine best cost driver when estimating a cost function?
Managers must understand both operations and cost accounting
What is the major advantage of quantitative method?
They are objective and managers can use them to evaluate different cost drivers
There are 3 criteria when deciding which of two cost drivers you should use
- Economic plausibility
- Goodness of fit
- Significance of IV
Choosing the correct cost driver to estimAte indirect manufacturing labor is important because
If you identify the wrong driver or misestimating cost functions can lead management to incorrect and costly decisions along a variety of dimensions
Activity based costing
Focuses on individual activities such as product design, machine setup, materials handling, distribution and customer service as fundamental cost objects
How do you implement ABC systems?
Managers must identify a cost driver for each acitvity
To choose a cost driver
The manager collects data on materials handling costs and quantities of 2 competing cost drivers over a reasonably long period
Why in the long run?
Bc in the short run materials handling costs may be fixed and therefore will not vary with changes in the level of cost driver.
Nonlinear cost function
Is a cost function for which the graph of total costs (based on level of single activity) is nog a straight line within a relevant range
Step cost function
The cost remains the same over various ranges of level of activity but the cost increases by discrete amounts that is increases in steps as the level of activity increases from one range to the next
-non linear cost function
Non linear cost functions can also result from
Learning curves
Learning curve
A function that measures how labor hours per unit decline as units of production increases because workers are learning and becoming better at their Jobs
How do managers use learning curves?
To predict how labor hours of labor costs will increase as more units are produced
Experience curve
Measures the decline in the cost per unit of these various business functions as the amount of activities increases
Cumulative average time learning model
Cumulative avg time per unit declines by a constant % each time the cumulative quantity of units produced doubles
Incremental unit time learning model
Incremental time needed to produce the last unit declines by a constant % each time the cumulative quantity of units produced doubles
Many companies use the learning curve to evaluate what?
Performance levels
Studies indicate that factors other than production output such as ______ contributes to learning that improves quality
Job rotation & organizing workers into teams
The ideal database for estimating cost functions quantitatively had two functions
- The database should contain numerous reliably measured observations of the cost driver (IV) and related costs (DV)
- The database should consider many values spanning a wide range for the cost driver
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