Chapter 7Cost Drivers and Cost

Behavior

IDIS 364 – Spring 2007

Nature of Fixed & Variable Costs

Variable costs - change in total as the level of activity changes Also known as an engineered cost There is a definitive physical

relationship to the activity measure Fixed costs - do not change in total

with changes in activity levels

Nature of Fixed & Variable Costs

Accounting concepts of variable and fixed costs are short run concepts Apply to a particular period of time Relate to a particular level of production

Relevant range is the range of activity over which the firm expects cost behavior to be consistent Outside the relevant range, estimates of

fixed and variable costs may not be valid

Types of Fixed Costs Capacity costs- fixed costs that provide

a firm with the capacity to produce and/or sell its goods and services Also know as committed costs and typically

relate to a firm’s ownership of facilities and its basic organizational structure

Capacity costs may cease if operations shut down, but continue in fixed amounts at any level of operations

Examples: property taxes, executive salaries

Types of Fixed Costs Discretionary costs - need not be

incurred in the short run to operate the business, however, usually they are essential for achieving long-run goals Also referred to as programmed or

managed costs Examples: research and development

costs, advertising

Other Cost Behavior Patterns

Curvilinear variable costs - costs may vary with the volume of activity, but not in constant proportion For example, as volume increases, the

cost of materials may decrease per unit (perhaps due to quantity discounts), exhibiting decreasing marginal costs

Marginal cost - the cost of producing the next unit

Other Cost Behavior Patterns

Learning curves - shows how the time required to perform a task goes down, per unit, as the number of units increases Some companies experience learning

effects on costs Compete by learning quickly so they

become low-cost leaders and capture market share

Semivariable Costs Refers to costs that have both

variable and fixed components Examples: repair and maintenance

costs, utility costs

Semifixed Costs Refers to costs that increase in steps

Example: A quality-control inspector can examine 1,000 units per day. Inspection costs are semifixed with a step up for every 1,000 units per day

Distinction between fixed and semifixed is subtle

Change in fixed costs usually involves a change in long-term assets: a change in semifixed costs often does not

Cost Estimation Methods Cost estimates are used in various

business decisions, planning exercises, and performance evaluations

Three methods discussed Statistical regression analysis Account analysis Engineering estimation

Estimating Costs Using Historical Data

Trying to estimate fixed and variable costs using the following formula

TC=F + VX

Where: TC = Total CostsF = Fixed CostsV = Variable CostsX = Activity Variable

Estimating Costs Using Historical Data

The following steps should be taken in analyzing cost data: Review alternative cost drivers Plot the data Examine the data and method of

accumulation

Statistical Regression Analysis

Used to estimate the relationship between costs and the activity that caused, or is closely associated with, those costs Costs are the dependent variable(s) Activity level is the independent variable

Fits the data points to a line using least-squares criterion

Statistical Regression Analysis

Results of this analysis yield an estimate of both the fixed component and the cost driver rates (variable component)

Account Analysis Analysts review each cost account and

classifies it according to its relation to a cost driver The sum of costs for each activity are

divided by the sum of the cost driver volumes to determine the cost driver rates

These cost driver rates correspond to the coefficients calculated using regression analysis

Engineering Method of Estimating Costs

The engineering method indicates what costs should be Analysts study the physical relation

between the quantity of inputs and outputs Determine the steps required to perform the

task, the time needed to complete each step, the number and type of employees required, and the materials and other inputs needed

The accountant assigns costs to each of the inputs to estimate the cost of the outputs

Data Problems Missing Data Outliers Allocated and discretionary costs Inflation Mismatched time periods Trade-offs in choosing the time

period

Interpreting Regression Analysis Output

Standard errors of the coefficients indicate the degree of confidence we can have in the fixed and variable cost coefficients The smaller the standard error, the more precise

the estimate The t-statistic is the ratio between an

estimated coefficient and its standard error If about 2 or larger, we can be relatively

confident that the actual coefficient differs from 0

Interpreting Regression Analysis Output

If a variable cost coefficient has a small t-statistic, it may indicate that little relation exists between the activity and changes in costs

If a fixed cost coefficient has a small t-statistic, it may indicate that these costs have little, if any, fixed cost component

R2

R2 measures how well the line fits the data An R2 of 1 means that the regression

explains all of the variance An R2 of 0 means that the regression

explains none of the variance Many believe that a low R2 indicates

a weak relationship between total costs and the activity base

Cautions When Using Regression

Users of regression analysis should be cautious in drawing inferences from regression results unless they are familiar with statistical estimation problems such as: Multicollinearity Autocorrelation, and Heteroscedasticity

End of Chapter 7