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Cost Cost AnalysisAnalysis
Prepared by Douglas Cloud
Pepperdine University
Prepared by Douglas Cloud
Pepperdine University
33
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Understand the importance of cost management. Describe the two aspects of managing costs. Distinguish between value-added and non-value-
adding activities and costs. Describe and use methods of analyzing cost behavior. Understanding the limitations of methods of cost
behavior and analysis. Classify costs along several dimensions including
whether managers can change them at short notice.
ObjectivesObjectivesObjectivesObjectives
After reading this After reading this chapter, you should chapter, you should
be able to:be able to:
After reading this After reading this chapter, you should chapter, you should
be able to:be able to:
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Cost Drivers and PoolsCost Drivers and PoolsCost Drivers and PoolsCost Drivers and Pools
Activities that cause costs are cost drivers and include sales, production, and items
such as the number of products the company
makes and the number of customers it serves.
Activities that cause costs are cost drivers and include sales, production, and items
such as the number of products the company
makes and the number of customers it serves.
A group of costs driven by the
same activity is a cost pool.
A group of costs driven by the
same activity is a cost pool.
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Estimated Cost BehaviorEstimated Cost BehaviorEstimated Cost BehaviorEstimated Cost Behavior
Fixed Cost Behavior Variable Cost Behavior
$$
Activity Activity
Unit Cost Varies with Volume Unit Cost Rate is Constant
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Total Costs = Fixed Amount + (Variable Cost Per Unit x Number of Units)Total Costs = Fixed Costs + Variable Costs
Total Costs
$ Cost
Number of Units Produced
Fixed amount
Variable Costs
Estimated Cost BehaviorEstimated Cost BehaviorEstimated Cost BehaviorEstimated Cost Behavior
Mixed Cost
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Estimating Cost BehaviorEstimating Cost Behavior
Account AnalysisEngineering ApproachInterviewsThe (High-Low) Two-Point MethodScatter-Diagram MethodRegression
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Account AnalysisAccount AnalysisAccount AnalysisAccount Analysis
Manager decides how to classify a cost by looking at its name and then checking this judgment by scanning the account for that cost for several periods.
Example: Rent, depreciation, salaries, and advertising are generally fixed.
Weakness: It only shows what costs have been, not what they should be.
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Engineering ApproachEngineering ApproachEngineering ApproachEngineering Approach
Engineers study the material and labor requirements of products and related operations, then make per-unit estimates of the costs that should vary with production.
Advantage: It indicates what costs should be rather than what they have been.
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InterviewsInterviewsInterviewsInterviews
This is a simple tool that has proven useful in determining what drives many costs, and to determine what is likely to happen to particular costs, given specific actions.
Advantage: It does help to identify cost drivers.
Weakness: Interviewing does not help determine how much of a particular cost is fixed or variable.
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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method
The high-low (two-point) method is a relatively unsophisticated, yet widely used, method of estimating the components of a mixed cost.
Approach: This method uses two past levels of activity and the amounts of the cost incurred at those levels; more specifically, the highest and lowest levels of activity.
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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method
Variable cost component of
mixed cost=
change in cost
change in activity
Variable cost component of
mixed cost=
$40,800 – $14,800
18,000 – 5,000
Variable cost component of
mixed cost=
$26,000
13,000
$2 per machine hour=
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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method
Fixed cost component of
mixed cost=
total cost
– volume xvariable
cost components
At the high point: 18,000At the high point: 18,000Fixed cost
component of mixed cost
= $40,800 – (18,000 x $2)
Fixed cost component of
mixed cost= $4,800
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High-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) MethodHigh-Low (Two-Point) Method
Fixed cost component of
mixed cost=
total cost
– high volume
xvariable
cost components
At the low point: 5,000 machine hoursAt the low point: 5,000 machine hours
Total cost at low volume $14,800
Fixed cost component of mixed cost = $4,800
Less variable portion (5,000 x $2)
=
10,000
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Scatter-Diagram MethodScatter-Diagram MethodScatter-Diagram MethodScatter-Diagram Method
The scatter-diagram (or graphical) method requires cost and volume data from prior periods, and derives an equation (cost prediction formula) based on those data.
Weakness: The placement and slope of the line are matters of
judgment; the manager “eyeballs” the data and fits the line visually.
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x
Scatter-Diagram MethodScatter-Diagram MethodScatter-Diagram MethodScatter-Diagram Method
Machine Hours
Maintenance Cost
$45,000
35,000
25,000
20,000
10,000
7.2
5,000
0 0 2 4 6 8 10 12 14 16 18 20
Analyst can fit line
based on his or her
experience x
x x
x
x
x x
x
(Thousands)
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Regression MethodRegression MethodRegression MethodRegression Method
Regression analysis (or just regression) is a more sophisticated method for estimating the fixed and variable components of a mixed cost.
Regression uses cost and volume data from prior periods to yield an equation of the form y = a + bx.The appendix covers regression in more detail.
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Problems and Pitfalls in Cost Behavior Analysis
Historical DataHistorical Data
High-low, scatter-diagram, and regression methods all use historical information.
Formulas based on historical data can give useful predictions only if past conditions prevail in the future.
Outliers should be ignored
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Problems and Pitfalls in Cost Behavior Analysis
Correlation and AssociationCorrelation and Association
For an equation to be useful for planning, the relationship between the cost and the activity must
be fairly close.
For an equation to be useful for planning, the relationship between the cost and the activity must
be fairly close.
The visual aspect of the scatter-diagram method allows the manager to see whether the
activity chosen as the independent variable is a good
predictor of cost.
The visual aspect of the scatter-diagram method allows the manager to see whether the
activity chosen as the independent variable is a good
predictor of cost.
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Step Variable CostsStep Variable CostsStep Variable CostsStep Variable Costs
$ Cost
Number of Units Produced
Linearity Assumption
Narrow Width
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DefinitionsDefinitionsDefinitionsDefinitions
Discretionary costs are fixed costs that can be quickly altered by managerial action.
Example: Advertising, employee training, and research and development
Committed costs are fixed costs that cannot be changed so quickly.
Example: Depreciation
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DefinitionsDefinitionsDefinitionsDefinitions
Avoidable costs are costs that can be avoided by adding, dropping, or curtailing some activities.
Example: Advertising, sales salaries
A company that drops a product line might not be able to reduce its sales force or its rent.
Such costs are unavoidable.
A company that drops a product line might not be able to reduce its sales force or its rent.
Such costs are unavoidable.
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A direct cost is incurred specifically because of a particular activity of a firm, like a product line, or geographical area.
Direct costs are sometimes called separable or traceable costs.
An indirect cost does not relate to one specific activity, but rather to several.
An indirect cost is sometimes called a common or joint cost.
DefinitionsDefinitionsDefinitionsDefinitions
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Manufacturing CostsManufacturing Costs
Direct materials Direct labor Manufacturing overhead
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Regression Output (Appendix)Regression Output (Appendix)Regression Output (Appendix)Regression Output (Appendix)Regression Output:
Constant $7,731.78
Standard Error of Y Estimate $1,763.16 R
Squared .0954921 No. of
Observations 12
Degrees of Freedom 10 X
Coefficient(s) $1.76678
Standard Error of Coefficient $0.12139
Model: Y = $7,731.78 + $1.76678X
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Goodness of Fit (Appendix)Goodness of Fit (Appendix)Goodness of Fit (Appendix)Goodness of Fit (Appendix)
Goodness of fit tells us how well the regression line fits the data, and therefore suggests to managers how good their predictions are likely to be. Two potential measures are:
1. the coefficient of determination (R-squared).
2. the standard error of the estimate (Standard Error of Y Estimate).
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Y = a + b1X1 + b2X3 + … + bnXn
Multiple Regression Equation (Appendix)
Multiple Regression Equation (Appendix)
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The EndThe End
Chapter 3Chapter 3
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