Jul 2006 MAF 1

Cost Behaviour, Cost

Estimation, and Product

Costing

Chapter Two

Jul 2006 MAF 2

Chapter Outline

Introduction

Classification of costs

Determining product and service costs

Cost estimation methods

Data collection problems

Conclusion

Jul 2006 MAF 3

What Do We Mean By a Cost?

A Cost

is the measure of

resources given

up to achieve a

particular purpose.

Jul 2006 MAF 4

Why Do We Need the information?

To assist managers in planning,

controlling and decision making

e.g. Naza Motors need to decide on

the selling price of the Naza Sutera

– require the total production costs

of the model

Jul 2006 MAF 5

Cost Objects

A cost object is something for which a company wants to know the cost. It may be a product, service, customer, department and so on, for which costs are measured and assigned.

E.g. To know the cost of its Bachelor of Accounting programme, then the Bachelor of Accounting programme is the cost object.

All costs related to the Bachelor of Accounting programme are accumulated and assigned to the cost object, such as the cost of the salaries of lecturers teaching in the programme, the cost of printing brochures on the programme, the cost of salaries of administrative staff servicing the programme, and so on.

Jul 2006 MAF 6

Cost terms and classifications

Fixed and Variable

Direct vs Indirect

Product vs Period

Manufacturing vs Non-manufacturing

Opportunity cost

Sunk cost

Prime costs

Conversion costs

Jul 2006 MAF 7

Cost Classifications

Cost behavior means how a cost will react to changes in the level of business activity.

Total variable costs change when activity changes.

Total fixed costs remain unchanged when activity

changes.

Jul 2006 MAF 8

Variable Costs (a)total (b) per unit

Paper Costs

No. of students No. of students

(a) (b)

Paper Costs

Jul 2006 MAF 9

Fixed Costs (a) Total (b) Per unit

Professor’s

salary (RM)

No. of students No. of students

(b)

Professor’s

salary (RM)

(a)

Jul 2006 MAF 10

Cost Classifications

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over

wide ranges of activity.

Total fixed cost remains Fixed cost per unit

Fixed the same even when the goes down as activity

activity level changes. level goes up.

Jul 2006 MAF 11

Some costs are neither

fixed nor variable but a

little bit of both.

A semivariable cost is

partly fixed and partly

variable.

Semi variable

Consider the

following electric

utility example.

Jul 2006 MAF 12

Fixed Monthly

Utility Charge

Variable

Utility Charge

Activity (Kilowatt Hours)

To

tal U

tili

ty C

ost

Semivariable(mixed) Cost

Slope is

variable cost

per unit

of activity.

Jul 2006 MAF 13

Semi fixed or step fixed costs

Within a given time period and within specific

activity level, they are fixed, but that

eventually increase or decrease by a constant

amount at various critical activity levels

Supe

rvis

or’s

Sala

ry

Output

Jul 2006 MAF 14

Activity (Hours)

To

tal C

ost

Step-variable Cost

Nearly variable but

increases in small

steps instead of

continously. e.g. part time

employees called upon

for relatively small

increments of time such

as few hours (delivery

truck drivers of a

bakery )

Jul 2006 MAF 15

Product Costs, and Period Costs

Product costs are costs associated with

goods for sale until the time period during

which the products are sold, at which time the

costs become expenses. e.g. costs of raw

materials

Period costs are costs that are expensed

during the time period in which they are

incurred. Includes all non manufacturing costs

e.g. salary of clerks

Jul 2006 MAF 16

Product Costs

Cost of goods sold

Period Costs

Operating expenses

Cost Classifications on Financial

Statements – Income Statement

Jul 2006 MAF 17

Direct and Indirect Costs

Direct costs

Costs that can be easily and conveniently traced to a product or department.

example: cost of paint in the paint department of an automobile assembly plant.

Indirect costs

Costs that must be allocated in order to be assigned to a product or department.

example: cost of national advertising for an airline is indirect to a particular flight.

Jul 2006 MAF 18

Manufacturing Costs

The

Product

Direct

Labor

Direct

Material Manufacturing

Overhead

Jul 2006 MAF 19

Manufacturing Companies

There are 3 major categories of

manufacturing costs:

Direct Materials

resources that

can be feasibly

observed being

used to make a

specific product.

Direct Labor

The cost of

paying

employees who

convert direct

materials into

finished product.

Manufacturing

Overhead

Indirect material

Indirect labor

Other overhead

Jul 2006 MAF 20

Direct Material

Example:

Steel used to

manufacture

the automobile.

Cost of raw material that is used to

make, and can be conveniently

traced, to the finished product.

Jul 2006 MAF 21

Cost of salaries, wages, and fringe

benefits for personnel who work

directly on manufactured products.

Direct Labor

Example:

Wages paid to an

automobile assembly

worker.

Jul 2006 MAF 22

Committed Costs

Fixed costs that have been incurred to

provide facilities to enable firms to

produce its products.

e.g.: space, equipment, factory buildings

Jul 2006 MAF 23

Discretionary costs

Costs that are decided by management

Sometimes called “managed costs”

e.g.: advertising, repairs, research and development expenses

May be changed when company is experiencing a difficult time

Jul 2006 MAF 24

Opportunity Cost

The potential benefit that

is given up when one

alternative is selected

over another. Example: If you were

not attending college,

you could be earning

$60,000 per year.

Your opportunity cost

of attending college for one

year is $60,000.

Jul 2006 MAF 25

Sunk Costs

All costs incurred in the past that cannot be changed

by any decision made now or in the future are sunk

costs.

Sunk costs should not be considered in decisions.

Example: You bought an automobile that cost $72,000

two years ago. The $72,000 cost is sunk because

whether you drive it, park it, trade it, or sell it, you

cannot change the $72,000 cost.

Jul 2006 MAF 26

Cost

prediction

Using knowledge

of cost behavior

to forecast

level of cost at

a particular

activity. Focus

is on the future.

Cost estimation, cost behaviour and

cost prediction

Cost

behavior

Relationship

between

cost and

activity.

Process of

determining

cost behavior,

often focusing

on historical

data.

Cost

estimation

Jul 2006 MAF 27

Assumptions in Cost-Behavior

Estimation

Changes in total costs can be explained by

changes in the level of a single activity.

Cost behavior can adequately be

approximated by a linear function of the

activity level within the relevant range.

Using equation TC = TFC + TVC

TC = TFC + VC per unit x Q (Q = activity level)

Jul 2006 MAF 28

Cost Estimation Methods

Account classification method

Conference method

Industrial engineering method

Visual fit method

High low method

Least squares regression method

Multiple regression

Jul 2006 MAF 29

Cost Estimation Approaches

These methods differ in terms of:

The costs of undertaking the analysis

The assumptions they make

The accuracy of the estimated cost

Jul 2006 MAF 30

Account classification method

Estimates cost by classifying cost

accounts in the subsidiary ledger as

variable, fixed or mixed with respect to

the identified level of activity

Use qualitative analysis when making

cost classifications

Jul 2006 MAF 31

Overhead Costs for 1,000 Units

Total Variable Fixed

Account Cost Cost Cost

Indirect Labor 450$ 450$

Indirect Material 700 700

Depreciation 1,000 1,000

Property Taxes 200 200

Insurance 300 300

Utilities 400 350 50

Maintenance 600 500 100

Totals 3,650$ 2,000$ 1,650$

Account Classification Method

Example

Jul 2006 MAF 32

Conference Method

Estimates cost functions on the basis of

ANALYSIS and OPINIONS about costs

and their drivers gathered from various

departments of a company (e.g.

purchasing dept, process engineering,

production dept and so on)

Jul 2006 MAF 33

Industrial Engineering Method

Also known as work measurement method

Estimates cost functions by analyzing the relationship between inputs and outputs in physical terms

e.g. carpet manufacturer use INPUTS – cotton, wool, dyes, direct labor, machine time, power to produce OUTPUT- square yards of carpet

TIME AND MOTION STUDY may conclude that to produce 10 square yards require 1 hour of direct labor

Jul 2006 MAF 34

Quantitative Analysis Method

Uses a formal mathematical method to fit cost functions to past data observations

Visual fit method

High low method – the simplest method

Regression analysis – simple and multiple regression

Jul 2006 MAF 35

Plot the data points on a

graph (total cost vs. activity).

0 1 2 3 4

*

To

tal C

ost

in

1,0

00’s

of

Do

llars

10

20

0

* * *

* *

* *

*

*

Activity, 1,000’s of Units Produced

Visual-Fit Method

Jul 2006 MAF 36

Draw a line through the plotted data points so that about

equal numbers of points fall above and below the line

Visual-Fit Method

0 1 2 3 4

*

To

tal C

ost

in

1,0

00’s

of

Do

llars

10

20

0

* * *

* *

* *

*

*

Activity, 1,000’s of Units Produced

Jul 2006 MAF 37

Visual-Fit Method Total variable cost = Total cost – Total fixed cost

Total variable cost = $16,000 – $10,000 = $6,000

Unit variable cost = $6,000 ÷ 3,000 units = $2

Vertical distance

is total cost,

approximately

$16,000.

0 1 2 3 4

*

To

tal

Co

st

in

1,0

00

’s o

f D

oll

ars

10

20

0

* * *

* *

* *

*

*

Activity, 1,000’s of Units Produced

Estimated fixed cost =

$10,000

Jul 2006 MAF 38

MiraCo recorded the following production activity and maintenance costs for two

months:

Using these two levels of activity, compute:

the variable cost per unit.

the total fixed cost.

The High-Low Method

Units Cost

High activity level 9,000 9,700$

Low activity level 5,000 6,100

Change 4,000 3,600$

Jul 2006 MAF 39

Units Cost

High activity level 9,000 9,700$

Low activity level 5,000 6,100

Change 4,000 3,600$

The High-Low Method

Jul 2006 MAF 40

The High-Low Method

Question 1

If sales commissions are $10,000 when 80,000

units are sold and $14,000 when 120,000 units

are sold, what is the variable portion of sales

commission per unit sold?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit

Jul 2006 MAF 41

The High-Low Method

Question 2

If sales commissions are $10,000 when 80,000

units are sold and $14,000 when 120,000 units

are sold, what is the fixed portion of the sales

commission?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

Jul 2006 MAF 42

Statistics courses and

computer courses deal

with detailed regression

computations using

computer spreadsheet

software.

Accountants and

managers must be able

to interpret and use

regression estimates.

Least-Squares Regression

Method

Jul 2006 MAF 43

Regression Analysis

The regression equation and regression line

are derived using the least-squares technique.

The objective of least-squares is to develop

estimates of the parameters a and b.

Jul 2006 MAF 44

Regression is a statistical procedure used

to determine the relationship between

variables such as activity and cost.

Least-Squares Regression

Method

Activity

To

tal C

os

t The objective of

the regression

method is the

general cost equation:

Y = a + bX

in cost terms

TC = F + VX

Jul 2006 MAF 45

Data collection problems

Missing data

Outliers

Allocated and discretionary costs

Inflation

Mismatched time periods

All cost-estimation methods are based on simplifying assumptions so that the benefits of use outweigh the costs of data collection and manipulation.

Jul 2006 MAF 46

End of Chapter 2