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Chapter 7 Outline

Activity Analysis, Cost Behavior, and Cost Estimation

1. Cost Behavior Patterns
1. Generally: Understanding cost behavior patterns is important to managers as they plan, control, and make decisions in the operation of their organizations. (e.g., a manager must understand how costs behave across various levels of activity before a budget can be prepared.)
2. Constant on units, fluctuate on total: Variable costs are costs that remain constant on a per-unit basis and fluctuate in total in direct response to changes in the cost driver. (e.g., the paper costing in giving exams varies with the number of students in a class).
3. Increase in steps: Step-variable costs are nearly variable, but such costs increase in small steps rather than in direct proportion to change in the cost driver. (e.g., if a class is a bit larger than usual, an additional exam proctor may have to be hired. This increase in part-time hourly help increases by a step as the number of students in the class grows.
4. Constant in total but fluctuate individually: Fixed costs stay constant in total but fluctuate on a per-unit basis across the ranges of activity.
1. Example: Professors’ salaries are fixed, and more students enrolling in the individual courses will not affect the salaries. The salary cost per student will, however, fluctuate depending on the number of students in each class.
1. Fixed over a wide range: Step-fixed costs are fixed within a wide range of activity but will change outside the range.
1. Example: If a course increases by a large number of students, it will be necessary to add another section and hire another instructor. The fixed cost then jumps to another step.
1. Change in response to cost driver: A semivariable cost (mixed cost) is one that changes in response to a change in a cost driver, but not in direct proportion. Such costs have both variable and fixed elements.
1. Example: A printer’s fee for brochures, which includes a fixed set-up cost per page and a per-copy (i.e., variable) charge for running the total copies needed.
1. Represented by a curve: A curvilinear cost function cannot be represented with a straight line but instead is represented with a curve that reflects either increasing or decreasing marginal costs.
2. Range which manager expect: The relevant range is the range of activity within which managers expect a company to operate and within which managers can predict cost behavior with some certainty. Within the relevant range, even curvilinear costs may behave in a linear fashion.
1. COST CATEGORIES AND STRUCTURES
1. Definite physical relationship to cost drivers: An engineered cost is one that bears a definite physical relationship to the cost driver.
1. Example: The food cost of a restaurant, as it is impossible to serve more meals without incurring more food costs.
1. Committed costs continue: Managers must distinguish between committed costs and discretionary costs. Committed costs will continue even if an organization shuts down for a short time (e.g., the cost of facilities and top management). These costs cannot be eliminated without endangering an organization’s overall health and existence.
2. Result from decisions: Discretionary costs exist as a result of a management decision (for example, a training program, an advertising campaign, corporate contributions, and so forth). In comparison with committed costs, such costs are more easily changed in bad economic time without doing serious long-run harm to the entity.
3. Automation and labor union cause more fixed costs: Fixed costs are becoming more prevalent in many industries because of automation and labor unions’ success in negotiating for a stable workforce. Costs that were once variable are becoming fixed, which makes a company less able to respond rapidly to changing economic conditions.
1. Cost Estimation Methods
1. Classification uses account information and judgment: The account-classification method (also called account analysis) requires a study of an account in the general ledger. The experienced analysts use the account information as well as their own judgment to determine how costs will behave in the future.
1. Visual-fit uses graphing: With the visual-fit method, an analyst examines a cost by plotting points on a graph (called a scatter diagram) and places a line through the points to yield a cost function. This method is more objective than the account-classification method, but it is still lacking because two cost analysts could (and likely would) visually fit different lines. Such an approach is useful, though, because it helps spot nonrepresentative data points, or outliers.
2. High-low considers only two points: The high-low method of approximating cost behavior considers only two points of data, the highest and lowest, for activity within the relevant range. The method first focuses on cost changes, allowing an analyst to determine the presence of any variable cost. Next, fixed costs are determined by subtracting variable cost from the total cost at either of the two data points.
3. Least-squares statistically based: The least-squares method is a statistical approach that is both objective and considers all the data points. By using mathematical formulas to arrive at the best possible cost line (i.e., the regression line), it is more accurate than the methods mentioned previously. The regression line is in the form Y=a + bX, where X is the independent variable and Y is the dependent variable. The coefficient of determination (R2) can be used to judge the line’s goodness of fit.
4. Multiple regression statistically based with multiple varaibles: Multiple regression is a statistical method that can be used to estimate a cost function when there is more than one independent variable.
1. Example: The fuel cost for an airline is determined by the number of miles flown and by other variables such as wind speed and load.
1. Data Collection Problems
1. Cost important: The process of collecting appropriate data to use in any cost-estimation method is very important. The best method will yield worthless predictions if it is based upon poor data. Common pitfalls to avoid are listed of page 262 of the test and include such items as missing data, outliers, mismatched time periods, inflation and other factors.
2. No historical data: The previously mentioned of cost estimation assume that there is a historical pool of data to based your decisions upon. In new environments without such a pool, the engineering method of estimation may be used. Instead of beginning with past cost, the engineering method begins by asking how much a product should cost given design specs and manufacturing techniques. (e.g., the industrial engineers time and motion study).
1. Cost Behavior Issues
1. More experiences labor is more efficient: A learning curve expresses the relationship between labor time and output. As the labor force becomes more experienced with a new process, workers become more efficient and the cost per units falls. This phenomenon is considered in the prediction of costs, particularly the cost of new products.
2. Simplify assumptions to reduce costs: All cost-estimation methods are based on simplyfying assumptions so that the benefits of use outweigh the costs of data collection and manipulation. These assumptions include: cost behavior depends on one activity variable (except for the multiple-regression method), and cost behavior is linear over the relevant range.
3. Work measures facilitates cost estimation: Cost estimation is facilitated by a technique known as work measurement, which is often used in nonmanufacturing enviroments. Work is divided into indivdual activities, or control factor units, and costs are accumulated for each activity.
1. Example: The U.S. Postal Service would consider the sorting of mail as an activity and would measure this activity in terms of the number of pieces sorted.

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