Chapter 10 Flashcards
A 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 based on two assumptions:
Variations in the level of a single activity (the cost driver) explain the variations in the related total costs, and
•Cost behavior is approximated by a linear cost function within the relevant range.
Variable costs
Fixed costs
Mixed costs
Variable costs—costs that change in total in relation to some chosen activity or output.
•Fixed costs—costs that do not change in total in relation to some chosen activity or output.
•Mixed costs—costs that have both fixed and variable components; also called semivariable costs.
Choice of cost object
Choice of cost object—different objects may result in different classification of the same cost.
Time horizon
Time horizon—the longer the period, the more likely the cost will be variable
Relevant range
Relevant range—behavior is predictable only within this band of activity.
Better management decisions, cost predictions and estimation of cost functions can be achieved only if
managers correctly identify the factors that affect costs.
The most important issue in estimating a cost function is determining
whether a cause-and-effect relationship exists between the level of an activity and the costs related to it.
•Without a cause-and-effect relationship, managers will be less confident about their ability to estimate or predict costs.
cause-and-effect relationship might arise as a result of:
A physical relationship between the level of activity and the costs
•A contractual agreement
•Knowledge of operations
Only a cause-and-effect relationship—not merely
not merely correlation—establishes an economically plausible relationship between the level of an activity and its costs.
Economic plausibility is critical because
it gives analysts and managers confidence that the estimated relationship will appear repeatedly in other sets of data.
Identifying cost drivers also gives managers insights into ways to
Identifying cost drivers also gives managers insights into ways to reduce costs and the confidence that reducing the quantity of the cost drivers will lead to a decrease in costs
To correctly identify cost drivers in order to make decisions, managers should always use
Long time horizon
Costs may be fixed in the short run (during which time they have no cost driver), but they
they are usually variable and have a cost driver in the long run.
FOUR METHODS OF COST ESTIMATION ARE:
Industrial engineering method •Conference method •Account analysis method •Quantitative analysis methods •High-low method •Regression analysis These method are not mutually exclusive and often more than one is used.
Industrial Engineering Method
Estimates cost functions by analyzing the relationship between inputs and outputs in physical terms.
•Includes time-and-motion studies.
•Very thorough and detailed when there is a physical relationship between inputs and outputs, but also costly and time-consuming.
•Also called the work-measurement method.
•Some government contracts mandate its use.
Conference Method
Estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company.
•Pools expert knowledge, increasing credibility.
•Because opinions are being used, the accuracy of the cost estimates depends largely on the care and skill of the people providing the inputs.
Account Analysis Method
Estimates cost functions by classifying various cost accounts as variable, fixed, or mixed in respect to the identified level of activity.
•Typically, managers use qualitative rather than quantitative analysis when making these cost-classification decisions.
•Widely used because it is reasonably accurate, cost-effective, and easy to use.
•The accuracy of the account analysis method depends on the accuracy of the qualitative judgments that managers and management accountants make about which costs are fixed and which are variable.
Quantitative Analysis
Uses a formal mathematical method to fit cost functions to past data observations.
•Advantage: results are objective.
•Advantage: most rigorous approach to estimate costs.
•Challenge: requires more detailed information about costs, cost drivers, and cost functions and is therefore more time-consuming.
Six Steps in Estimating a Cost Function Using Quantitative Analysis
Choose the dependent variable. (the cost to be predicted and managed)
•Identify the independent variable. (the level of activity or cost driver)
•Collect data on the dependent variable and the cost driver.
•Plot the data to observe the general relationship.
•Estimate the cost function using two common forms of quantitative analysis: the high-low method or regression analysis.
•Evaluate the cost driver of the estimated cost function.
High-Low Method
Simplest method of quantitative analysis.
•Uses only the highest and lowest observed values.
•“Fits” a line to data points which can be used to predict costs.
•Three steps in the high-low method to obtain the estimate of the cost function.
Regression Analysis Method
Regression analysis is a statistical method that measures the average amount of change in the dependent variable associated with a unit change in one or more independent variables.
–Regression analysis is more accurate than the high-low method because the regression equation estimates costs using information from ALL observations whereas the high-low method uses only TWO observations
Types Of Regression Analysis
Simple regression estimates the relationship between the dependent variable and ONE independent variable
•Multiple regression estimates the relationship between the dependent variable and TWO OR MORE independent variables.
Regression analysis is widely used because it helps managers understand why costs behave as they do and what managers can do to influence them.
Regression Analysis: Terminology
Goodness of fit indicates the strength of the relationship between the cost driver and costs.
•Residual term measures the difference between actual cost and estimated cost for each observation.
•The smaller the residual term, the better is the fit between the actual cost observations and estimated costs.
How does a company determine the best cost driver when estimating a cost function? An understanding of both operations and cost accounting is helpful. Here are the three criteria used:
Economic plausibility
- Goodness of fit
- Significance of the independent variable
Why is choosing the correct cost driver to estimate costs important?
Identifying the wrong drivers or misestimating cost functions can lead management to incorrect and costly decisions along a variety of dimensions.
Nonlinear Cost Functions, Defined
A nonlinear cost function is a cost function for which the graph of total costs is not a straight line within the relevant range.
Nonlinear Cost Functions, Examples
Economies of scale (produce double the number of advertisements for less than double the cost).
•Quantity discounts (direct material costs rise but not in direct proportion to increases in quantity due to the nonlinear relationship caused by the quantity discounts).
•Step cost functions—resources increase in “lot-sizes”, not individual units.
Learning curve—a function that measures how labor-hours per unit decline as units of production increase because workers are learning and becoming better at their jobs.
2.Experience curve—measures the decline in the cost per unit of various business functions as the amount of these activities increases. It is a broader application of the learning curve that extends to other business functions in the value chain such as marketing, distribution and customer service.
Types of Learning Curves
Cumulative average-time learning model—cumulative average time per unit declines by a constant percentage 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 percentage each time the cumulative quantity of units produced doubles.
The ideal database for estimating cost functions quantitatively has two characteristics:
The database should contain numerous reliably measured observations of the cost driver and the related costs.
•The database should consider many values spanning a wide range for the cost driver.
Managers should ask about these problems and assess how they have been resolved before they rely on cost estimates generated from the data.
The time period for measuring the dependent variable does not properly match the period for measuring the cost driver.
- Fixed costs are allocated as if they are variable.
- Data are either not available for all observations or are not uniformly reliable.
