© 2007 Pearson Education Canada Slide 3-1

Measurement ofCost Behaviour

3

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Measurement of Cost Behavior

Cost Driver• an activity which influences a cost

Relevant Range• range over which we can assume

that the cost behavior is linear

Variable Costs• vary in proportion to changes in

their cost driver

Fixed Costs• are not affected by changes in the

cost driver

$

Volume

$

Volume

$

Volume

© 2007 Pearson Education Canada Slide 3-3

Variations in Cost Behaviour

Step Costs• change abruptly at intervals of

activity because the resources and their costs come in indivisible chunks

• supervisory salaries

Mixed Costs• contain both variable and fixed

cost elements• e.g. maintenance costs

Volume

$

Volume

$

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Management’s Influence on Cost Functions

Capacity Costs• fixed costs related to being able to achieve a desired level of

production or service• setting capacity is very important if long-run demand

fluctuates

Committed Fixed Costs• arise from the possession of facilities, equipment, and a

basic organization• large, indivisible chunks of cost that the organization is

obligated to incur and usually would not consider avoiding• mortgage, lease payments, property taxes, insurance, salaries

of key personnel• committed fixed costs can only be changed by changing the

basic philosophy, scale or scope of the organization's operations

© 2007 Pearson Education Canada Slide 3-5

Management’s Influence on Costs Functions II

Discretionary Fixed Costs

• each planning period, management will determine how much to spend

• advertising, promotion, research and development, employee training

• the amount of spending may vary, but only because management has decided to spend more or less

• management can influence spending on these costs in the short run

© 2007 Pearson Education Canada Slide 3-6

Measuring Cost BehaviourCost Function• algebraic equation of the cost and its cost driver• linear cost function is as follows: Y = F + VX

where • F is the intercept of the vertical axis or the fixed cost• V is the slope or the variable cost per unit of activity

Total Maintenance Costs per month= fixed cost per month + variable cost per unit= $10,000 + $5.00 per unit

Criteria for Choosing A Cost Function• Use activity analysis to determine which cost driver best

explains how the cost behaves• Economic plausibility (it must make sense that X causes Y)• Reliability (the estimates derived by the cost equation must

conform with actually observed costs)

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Methods of Measuring Cost FunctionsEngineering Analysis• systematic review of costs based on past experienceAccount Analysis• review of accounting records and the subjective determination

of cost behavior patternsHigh-Low Analysis• use of simple linear algebra to determine variable and fixed

costs• may yield unreliable resultsVisual Fit Analysis• fit a representative line to the data as shown in a scatter

diagramRegression Analysis• using mathematical formula, determine the cost equation which

best fits the data• may be simple least squares regression with one X variable or

multiple least squares regression with more than one X variable• enables user to measure the "quality" of the predictive equation

© 2007 Pearson Education Canada Slide 3-8

High-Low Approach to Cost Analysis

Equation: Y = F + VX

Variable cost= change in cost / change in volume= $30,000 / 3,700= $8.108 per patient-day

Fixed cost= total mixed cost - variable cost= $47,000 - ($8.108 x 4,900)= $47,000 - $39,730= $7,270 per month

Maintenance Costs= $7,270 + $8.108 per patient-day

FacilitiesMaintenanceDepartment

Costs

Number ofPatient-Days

x xx

x

x

x

x

x

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Regression AnalysisCheck for Economic Plausibility• Does it make sense that X and Y are related?

Plot the data• to see if basic relationship is linear and identify "outliers"

Generate Regression OutputConstant $9,329Std Error of Y Estimate $2,145 Observations 12R-Squared 0.954 Degrees of Freedom 10X Coefficient(s) $6.95 Std Error of Coefficient0.479

Interpret Regression Output• R-squared (R2) varies between 0 and 1• The closer to R2 is to 1 the more X explains the changes in Y• Standard error of Y estimate and standard error of X coefficient(s)

can be used to set confidence intervals for the cost function estimates and the predicted value of the variable cost per unit