Cost Concepts, Behaviours, and Estimation (Session 2)

Question 1

Cost

Answer 1

A cost is a resource sacrificed or forgone to
achieve a specific objective.

Question 2

Expense

Answer 2

An expense is a resource being
consumed/used under accrual accounting.

Question 3

What would be incurred at every stage of the business process

Answer 3

Costs

Question 4

Should cost be classified into different categories?

Answer 4

Yes, to help assist with strategic decision-making

Question 5

Classifying Costs

Answer 5

1) Relevance
2) Behaviour
3) Traceability
4) Function
5) Controllability

Question 6

Classifying Costs: Relevance

Answer 6

• Relevant costs:
  o Costs that differ between two alternatives (e.g., opportunity cost)
• Irrelevant costs:
  o Will not make a difference to either alternative  no bearing on
  decision-making (e.g., sunk cost)

Question 7

Opportunity Cost

Answer 7

Organization forgoes benefit when it chooses one alternative over
another

Question 8

Sunk Cost

Answer 8

The cost has already been incurred and cannot now be avoided

Question 9

Classifying Costs: Traceability

Answer 9

• Cost object:
  o Any one thing or activity for which we measure costs

o Include such things as individual products, product lines, projects,
customers, departments, and even the entire company

Question 10

Classifying Costs: Traceability

Answer 10

• Direct cost:
  o A cost that can be easily traced to a cost object because a clear cause-
  and-effect relationship generally exists between the two
• Indirect cost:
  o Incurred for the benefit of more than one cost object and not easily
  or economically traced to a particular cost object

Question 11

Classifying Costs: Function

Answer 11

• Manufacturing cost (Product cost):
  o Costs that are easily traced to a product (e.g., direct labour, direct materials,
  manufacturing overhead costs)
• Non-manufacturing cost (Period cost):
  o Costs that cannot be assigned to products

Useful question: Can this product be PRODUCED without incurring the cost? If not, it is manufacturing
(product) cost. Otherwise, it is non-manufacturing (period) cost.

Question 12

Classifying Costs: Controllability

Answer 12

• Controllable costs:
  o Managers have the authority to cut and manage costs
• Uncontrollable costs:
  o Managers do not have the authority to cut or manage these costs

Question 13

Classifying Costs: Behaviour

Answer 13

• Fixed costs: Total cost will not change within the relevant range
• Variable costs: Varies in proportion to the production level

Question 14

Cost Behaviour

Answer 14

• Cost behavior is the variation in costs relative to the variation in an
  organization’s activities

o Useful for decision-making such as production, merchandise sales, and services

Question 15

Relevant Range

Answer 15

a span of activity for a given cost object where total fixed costs remain constant and
variable costs per unit of activity remain constant

Question 16

Marginal costs

Answer 16

o the incremental cost of an activity

• Within the relevant range, variable cost approximates marginal cost, and, accordingly,
  accountants often use variable cost as a measure of marginal cost.
• Are often relevant in decision making

Question 17

Total Variable Costs

Answer 17

change proportionally with changes in activity levels

Question 18

Total fixed costs

Answer 18

do not vary with small changes in activity levels (e.g. rent)

Question 19

Mixed costs (sometimes):

Answer 19

costs that are partly fixed and partly variable

Question 20

Total costs

Answer 20

total variable costs plus total fixed costs

Question 21

Cost function

Answer 21

A cost function is an algebraic representation of the total cost of a cost
object over a relevant range of activity

TC = F + VQ

Question 22

Sometimes nonlinear costs exhibit linear cost behaviour over a range of the cost driver, that is …

Answer 22

The relevant rage of activity

Question 23

Committed Fixed Costs

Answer 23

Cannot be reduced easily without significantly impacting operations and objectives

Question 24

Discretionary fixed costs

Answer 24

Can be reduced more easily in the short run without significant changes to operations and objectives.

• Examples include advertising, R&D, and executive travel
• These expenditures are often based on past profitability and can be altered during the period

Question 25

Cost driver

Answer 25

A cost driver is some input or activity that causes changes in total
cost for a cost object

Question 26

How to estimate future costs?

Answer 26

• Past costs are often used to estimate future, non-discretionary,
  costs. In these instances, one must also consider:

o Whether the past costs are relevant to the decision at hand
o Whether the future cost behaviour is highly discretionary
o Whether the past fixed and variable cost estimates are likely to hold in
the future

Question 27

Types of Cost Estimation Techniques

Answer 27

1) Engineered estimate of cost
2) Analysis at the account level
3) Scatter plots
4) Two-point method
5) High-low method
6) Regression analysis

Question 28

Engineered estimates of cost

Answer 28

• Use accountants, engineers, employees, and/or consultants to analyze

o Each activity is analyzed according to the amount of labor time,
materials, and other resources used.
o Costs are assigned according to these measurements

Question 29

Account Analysis

Answer 29

• Review the pattern of a cost over time in the accounting system and use our knowledge of operations to classify the cost as variable, fixed, or mixed

Question 30

Scatter Plot

Answer 30

• A scatter plot is a graphical technique in which data points for past costs
  are plotted against a potential cost driver
• A scatter plot can assist in determining:
  o More about the behavior of a cost
  o Whether a potential cost driver is viable as Q in the cost function

Question 31

Two-Point Method

Answer 31

• The two-point method uses any two sets of data points for cost and
  a cost driver to algebraically calculate a mixed cost function.
• These data points can be drawn from a scatter plot.

Question 32

High-Low Method

Answer 32

• The high-low method is a two-point method

o The two data points used to estimate costs are observations with the
highest and the lowest activity levels

o The problem with this method is that the highest- and lowest-cost
driver observations are often atypical and might lie outside the
normal range of activities.

Question 33

Regression Analysis

Answer 33

• Regression analysis is a statistical technique that measures the
  average change in a dependent variable (e.g., cost) for every unit
  change in one or more independent variables (e.g., cost drivers)
• Regression analysis uses all the available data points and often
  improves the accuracy of a cost function

Question 34

Steps of Regression Analysis

Answer 34

1. Consider the behaviour of the cost
2. Generate a list of possible cost drivers
3. Gather data
4. Plot the cost for each potential cost driver
5. Perform the regression analysis
6. Evaluate the appropriateness of each cost driver
   (adjusted R-square)
7. Evaluate the sign and significance of the cost
   function’s components (p-values and t-stats)
8. Write the cost function as TC= F + VQ

Question 35

Simple regression analysis

Answer 35

• With simple regression analysis, you develop a cost function by
  calculating values for the statistical relationship between total cost
  and a single cost driver.

Question 36

Multiple regression analysis

Answer 36

With multiple regression analysis, you develop a cost function by
calculating values for the statistical relationship between total cost
and two or more cost drivers.

Question 37

Regression Analysis Adjusted R-Square

Answer 37

Goodness of fit
* How well does the cost driver explain the behavior (i.e., the
variation) in the cost?

• The adjusted R-square statistic shows the percentage of variation
  in the Y variable that is explained by the regression equation

Question 38

Regression Analysis p-value

Answer 38

Statistical significance of regression coefficients

• How confident can we be that the actual fixed cost is greater than
  zero (i.e., that there is a fixed component in the cost function)?
  o t-statistic and p-value for the alpha coefficient
• How confident can we be that the actual variable cost per unit of
  the cost driver is greater than zero (i.e., that there is a variable
  component in the cost function)?
  o t-statistic and p-value for the beta coefficient

Question 39

T-statistic

Answer 39

In general, if the t-statistic for the intercept (slope) is
> 2, we can
be about 95% confident (at least) that the slope is not zero

Question 40

Which is more precise, t-value or p-value?

Answer 40

• The p-value is more precise

o The p-value gives the statistical significance of the t-statistic, or the
probability that the coefficient is not different from zero
o If the p-value is less than 5%, we are more than 95% confident that
the true coefficient is non-zero

Question 41

Uses and Limitations

Answer 41

Common reasons that past cost information might be unavailable or too
unreliable to use include the following:

• The organization has operated for only a few periods.
• The organization’s operations have changed substantially.
• Inflation, deflation, or other economic changes have altered the
  behavior of costs.
• The organization operates in an environment where technologies and
  costs change rapidly.
• The organization’s accounting system does not currently capture and
  report the needed information.

Question 42

Information Quality

Answer 42

Is the accounting system able to directly trace costs to individual cost objects?

Question 43

Average Costs

Answer 43

o Avoid the use of financial statement costs for decision-making
o Use of average costs will result in either underestimation or overestimation of
future costs

Question 44

Quality of Estimation Techniques

Answer 44

o There are advantages and disadvantages of each cost behavior analysis
approach introduced in this chapter

o Perform a cost-benefit analysis when considering spending resources for
developing higher-quality information

Question 45

Reliance on Cost Estimates

Answer 45

o Quality of information affects the alternatives that managers may consider
and the weight they place on various pieces of information

Question 46

Multiple Regression Example

Answer 46

Multiple regression is used when more than one cost driver may
provide the best estimate of a cost function

• Several cost drivers may appear to be correlated with the cost we
  are estimating

o Include all the potential drivers in a multiple regression in order to
determine the significance of each

o Then we drop the drivers that have insignificant t-statistics