Lecture Aaa_cost Mngmt
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Manageme nt Accounting A
Performance Management
Cost Behaviour, Drivers and Estimation
1
Manageme nt Accounting A
Topic Learning Objectives
Cost management Cost drivers Basic types of cost behaviour Cost estimation approaches Cost function via high-low method Cost function via regression analysis Cost estimation issues 2
Manageme nt Accounting A
Cost Management
Component of management accounting system …..focuses on improving the organisation’s cost effectiveness through understanding and managing the real causes of costs …..
3
Manageme nt Accounting A
Cost Understanding
Cost estimation The process of determining the cost behaviour of a particular cost item
Cost behaviour The relationship between a cost and the level of activity or cost driver
Cost prediction Using knowledge of cost behaviour to focus the level of cost at a particular 4 level of
Manageme nt Accounting A
Cost drivers
An activity or factor that causes costs to be incurred
The higher the correlation between the cost and cost driver, the more accurate is the description and understanding of cost behaviours Conventional understandings regarded costs as variable or fixed, based on the level of production volume Contemporary viewpoints recognise that there are a range of possible costs drivers other than production volume (non-volume cost drivers) 5
Manageme nt Accounting A
Cost drivers
Activity-based approaches classify costs and cost drivers into four levels: Unit level costs Relate to activities that are performed for each unit produced Uses conventional volumebased cost drivers
Batch level costs
Relate to activities performed
6
continued
Manageme nt Accounting A
Cost drivers
Product-sustaining
Relate to activities performed for specific products or product groups
Facility level
Cost incurred to run the business but not caused by any particular product
7
continued
Manageme nt Accounting A
Selecting the best cost drivers
Input or outputs?
An example of an input cost driver is the weight of material, and an output driver is the number of units of production Which one? Cost/benefit analysis to determine the choice
How detailed should the analysis be?
How much effort
8
Manageme nt Accounting A
Long or short term
Cost behaviour and cost drivers can change over time
Depends on the purpose of the cost prediction
9
Cost estimation or management?
Manageme nt Accounting A
Cost drivers that are used to predict costs, may differ from those used to manage costs Effective cost management requires the identification of root cause cost drivers
The true causes of costs The underlying decisions that cause a cost to be incurred 10
Manageme nt Accounting A
Exhibit 3.1 Costs and Cost drivers
11
Manageme nt Accounting A
Cost drivers analysis
In choosing cost drivers the costs and benefits of each driver must be assessed:
Reasons for analysing cost behaviour Timeframes for analysing the cost behaviour Availability of data on cost drivers, and Any other uses for the cost behaviour information
12
Manageme nt Accounting A
Tasty Bread Cost Drivers
Direct materials for wholemeal rolls
Premises costs
Number of deliveries
Electricity costs
Lease costs
Delivery truck costs
Number of rolls produced
Number of batches baked
Shop manager’s salaries
Shop trading hours 13
Manageme nt Accounting A
Cost behaviour patterns
Cost behaviour patterns
Variable costs Fixed costs Semi-variable costs Curvilinear costs Linear costs
14
Manageme nt Accounting A
Cost behaviour patterns
Cost behaviour patterns
Curvilinear Linear i.e. a straight line, expressed as: Y = a + bX, where Y = total cost X = level of driver
15
Manageme nt Accounting A
Variable costs
Change in total in direct proportion to a change in activity Constant per unit The variable cost is the slope of the cost line
Y = a + bX, where b = variable cost per unit of activity
16
Manageme nt Accounting A
Variable cost graph
17
Manageme nt Accounting A
Fixed costs
Remains unchanged in total as the level of activity varies As activity increases, total fixed costs do not change, but fixed cost per unit declines
Contemporary approaches to cost analysis recognise that there are cost drivers for some of these “fixed” costs, and very few costs remain fixed 18
Manageme nt Accounting A
Fixed cost graph
19
Manageme nt Accounting A
Step-fixed costs
Remain fixed over a wide range of activity levels but jump to a different amount for levels outside that range
20
Manageme nt Accounting A
Semi-variable costs
Has both fixed and variable components Identify then treat separately
21
Manageme nt Accounting A
Curvilinear costs
Has a curved cost line, but is often approximated as a semivariable cost
22
Manageme nt Accounting A
Cost behaviour patterns
Cost structures are shifting towards a decreasing proportion of costs that vary with production due to:
Labour being replaced by equipment, which does not vary with production output Production wages moving towards fixed salaries that do not vary with production activity levels 23
Manageme nt Accounting A
Cost estimation Managerial judgement The account classification method involves managers using their judgement to classify costs as exhibiting certain behaviours Engineering approach Quantitative analysis
24
Manageme nt Accounting A
Engineering approach
To estimating costs
Studying processes that result in the incurrence of a cost Focus on the relationships that should exist between inputs and outputs Using time and motion studies (or task analysis) where employees are observed as they undertake work tasks Activity-based approaches extend task analysis to the study of indirect activities and costs
25
Manageme nt Accounting A
Quantitative analysis
The analysis of past data to identify relationships between costs and activities Past data may be a poor guide to future cost behaviour Three approaches include
Visual fit method high-low method Regression analysis 26
Manageme nt Accounting A
Visual fit method
Visually fitting a line to data on a scatter diagram to estimate the cost function A scatter plot can be useful in allowing us to plot the data points to visualise the relationship between cost and the level of activity 27
Manageme nt Accounting A
Scatter Diagram Cost
Volume of Activity 28
Manageme nt Accounting A
Fitting the cost line Cost
Important: Cost function is only relevant within relevant range
Analyst can fit line based on his or her experience
Volume of Activity 29
Manageme nt Accounting A
Visual fit method evaluation
Lacks objectivity
different lines can be drawn from the same data Quality of graph ~ drawing & interpretation
can be a first step to more indepth analysis
30
Manageme nt Accounting A
High-low Method
The high-low method involves taking the two observations with the highest and lowest level of activity to calculate the cost function
31
Manageme nt Accounting A
High-low method
~ step 1
Cost
Identify the highest and lowest activity levels.
Volume of Activity 32
Manageme nt Accounting A
High-low Method
~ step 2
Cost
Determine the differences between the high and low points coordinates.
Volume of Activity 33
Manageme nt Accounting A
High-low method Cost
~ step 3
Variable cost per unit = slope of the line between the two points (which reflect total mixed costs). Rise Run
=
Variable Cost per Unit
Volume of Activity 34
Manageme nt Accounting A
High-low method Cost
~ step 4
To find fixed costs, use slope and coordinates of one point in y = bx + a Rise
Y1 – Y2 Run
X1 – X2
Variable Cost =per Unit
Volume of Activity 35
Manageme nt Accounting A
High-low method
Select one of the two point Substitute into y = bx + a, where
~ step 5
y = y coordinate of point x = x coordinate of point b = step 4 calculations
Find a, ie total fixed costs
36
Manageme nt Accounting A
High–low method evaluation
More objective than visual fit Uses only two data points, and ignores the rest
37
Manageme nt Accounting A
Regression analysis
Allows us to estimate the line of best fit by making the deviations between the cost line and the data points as small as possible
i.e. all data points considered
Simple regression involves estimating the relationship between the dependent variable (Y) and one independent variable (X) Y = a + bX
38
Manageme nt Accounting A
39
Manageme nt Accounting A
Manual Regression analysis Uses all available data in defining the line of best fit Formula
40
Manageme nt Accounting A
Evaluation of regression line
In terms of
economic plausibility goodness of fit
Further analysis techniques
41
Manageme nt Accounting A
Multiple regression
estimates a linear relationship between one dependent variable and two or more independent variables
Multiple regression allows us to include two or more independent variables, that is, cost drivers Y = a + b1X1 + b2X2
42
Manageme nt Accounting A
Practical issues in cost estimation
Data collection problems
Missing data Outliers Mismatched time periods for dependent and independent variables Trade-offs in choosing the number of observations and the reliability of past data points as predictors of future cost behaviour Allocated fixed costs Inflation 43 continued
Manageme nt Accounting A
Issues in cost estimation
Effect of learning on cost behaviour
In estimating labour costs for relatively new product or processes, labour times per unit may decrease at varying rates
44
Manageme nt Accounting A
Issues in cost estimation
Activity-based costing (ABC)
Allows us to consider more complex cost behaviour patterns Costs are assigned to activities Unit, batch and product level costs are assumed to vary in proportion to their cost drivers
45
Manageme nt Accounting A
The accuracy of cost functions
Sometimes approximate estimates are used to estimate cost functions within firms Why is the case? ❖
❖
❖
❖
Limited time and knowledge to undertake quantitative techniques The data required to estimate reliable cost functions may not exist A low priority may be given to determining accurate cost behaviour and cost estimation Subjective cost estimates may be considered good enough for the firm’s
46
Manageme nt Accounting A
Cost estimation assumptions
All cost functions are based on simplifying assumptions, such as:
Cost behaviour depends on a single activity Cost behaviours are linear within a relevant range
Costs and benefits of producing accurate cost information need to be assessed. Refer to handout – Ex.2 - Q.3.49 47
Manageme nt Accounting A
Any Questions?
48
Performance Management
Cost Behaviour, Drivers and Estimation
1
Manageme nt Accounting A
Topic Learning Objectives
Cost management Cost drivers Basic types of cost behaviour Cost estimation approaches Cost function via high-low method Cost function via regression analysis Cost estimation issues 2
Manageme nt Accounting A
Cost Management
Component of management accounting system …..focuses on improving the organisation’s cost effectiveness through understanding and managing the real causes of costs …..
3
Manageme nt Accounting A
Cost Understanding
Cost estimation The process of determining the cost behaviour of a particular cost item
Cost behaviour The relationship between a cost and the level of activity or cost driver
Cost prediction Using knowledge of cost behaviour to focus the level of cost at a particular 4 level of
Manageme nt Accounting A
Cost drivers
An activity or factor that causes costs to be incurred
The higher the correlation between the cost and cost driver, the more accurate is the description and understanding of cost behaviours Conventional understandings regarded costs as variable or fixed, based on the level of production volume Contemporary viewpoints recognise that there are a range of possible costs drivers other than production volume (non-volume cost drivers) 5
Manageme nt Accounting A
Cost drivers
Activity-based approaches classify costs and cost drivers into four levels: Unit level costs Relate to activities that are performed for each unit produced Uses conventional volumebased cost drivers
Batch level costs
Relate to activities performed
6
continued
Manageme nt Accounting A
Cost drivers
Product-sustaining
Relate to activities performed for specific products or product groups
Facility level
Cost incurred to run the business but not caused by any particular product
7
continued
Manageme nt Accounting A
Selecting the best cost drivers
Input or outputs?
An example of an input cost driver is the weight of material, and an output driver is the number of units of production Which one? Cost/benefit analysis to determine the choice
How detailed should the analysis be?
How much effort
8
Manageme nt Accounting A
Long or short term
Cost behaviour and cost drivers can change over time
Depends on the purpose of the cost prediction
9
Cost estimation or management?
Manageme nt Accounting A
Cost drivers that are used to predict costs, may differ from those used to manage costs Effective cost management requires the identification of root cause cost drivers
The true causes of costs The underlying decisions that cause a cost to be incurred 10
Manageme nt Accounting A
Exhibit 3.1 Costs and Cost drivers
11
Manageme nt Accounting A
Cost drivers analysis
In choosing cost drivers the costs and benefits of each driver must be assessed:
Reasons for analysing cost behaviour Timeframes for analysing the cost behaviour Availability of data on cost drivers, and Any other uses for the cost behaviour information
12
Manageme nt Accounting A
Tasty Bread Cost Drivers
Direct materials for wholemeal rolls
Premises costs
Number of deliveries
Electricity costs
Lease costs
Delivery truck costs
Number of rolls produced
Number of batches baked
Shop manager’s salaries
Shop trading hours 13
Manageme nt Accounting A
Cost behaviour patterns
Cost behaviour patterns
Variable costs Fixed costs Semi-variable costs Curvilinear costs Linear costs
14
Manageme nt Accounting A
Cost behaviour patterns
Cost behaviour patterns
Curvilinear Linear i.e. a straight line, expressed as: Y = a + bX, where Y = total cost X = level of driver
15
Manageme nt Accounting A
Variable costs
Change in total in direct proportion to a change in activity Constant per unit The variable cost is the slope of the cost line
Y = a + bX, where b = variable cost per unit of activity
16
Manageme nt Accounting A
Variable cost graph
17
Manageme nt Accounting A
Fixed costs
Remains unchanged in total as the level of activity varies As activity increases, total fixed costs do not change, but fixed cost per unit declines
Contemporary approaches to cost analysis recognise that there are cost drivers for some of these “fixed” costs, and very few costs remain fixed 18
Manageme nt Accounting A
Fixed cost graph
19
Manageme nt Accounting A
Step-fixed costs
Remain fixed over a wide range of activity levels but jump to a different amount for levels outside that range
20
Manageme nt Accounting A
Semi-variable costs
Has both fixed and variable components Identify then treat separately
21
Manageme nt Accounting A
Curvilinear costs
Has a curved cost line, but is often approximated as a semivariable cost
22
Manageme nt Accounting A
Cost behaviour patterns
Cost structures are shifting towards a decreasing proportion of costs that vary with production due to:
Labour being replaced by equipment, which does not vary with production output Production wages moving towards fixed salaries that do not vary with production activity levels 23
Manageme nt Accounting A
Cost estimation Managerial judgement The account classification method involves managers using their judgement to classify costs as exhibiting certain behaviours Engineering approach Quantitative analysis
24
Manageme nt Accounting A
Engineering approach
To estimating costs
Studying processes that result in the incurrence of a cost Focus on the relationships that should exist between inputs and outputs Using time and motion studies (or task analysis) where employees are observed as they undertake work tasks Activity-based approaches extend task analysis to the study of indirect activities and costs
25
Manageme nt Accounting A
Quantitative analysis
The analysis of past data to identify relationships between costs and activities Past data may be a poor guide to future cost behaviour Three approaches include
Visual fit method high-low method Regression analysis 26
Manageme nt Accounting A
Visual fit method
Visually fitting a line to data on a scatter diagram to estimate the cost function A scatter plot can be useful in allowing us to plot the data points to visualise the relationship between cost and the level of activity 27
Manageme nt Accounting A
Scatter Diagram Cost
Volume of Activity 28
Manageme nt Accounting A
Fitting the cost line Cost
Important: Cost function is only relevant within relevant range
Analyst can fit line based on his or her experience
Volume of Activity 29
Manageme nt Accounting A
Visual fit method evaluation
Lacks objectivity
different lines can be drawn from the same data Quality of graph ~ drawing & interpretation
can be a first step to more indepth analysis
30
Manageme nt Accounting A
High-low Method
The high-low method involves taking the two observations with the highest and lowest level of activity to calculate the cost function
31
Manageme nt Accounting A
High-low method
~ step 1
Cost
Identify the highest and lowest activity levels.
Volume of Activity 32
Manageme nt Accounting A
High-low Method
~ step 2
Cost
Determine the differences between the high and low points coordinates.
Volume of Activity 33
Manageme nt Accounting A
High-low method Cost
~ step 3
Variable cost per unit = slope of the line between the two points (which reflect total mixed costs). Rise Run
=
Variable Cost per Unit
Volume of Activity 34
Manageme nt Accounting A
High-low method Cost
~ step 4
To find fixed costs, use slope and coordinates of one point in y = bx + a Rise
Y1 – Y2 Run
X1 – X2
Variable Cost =per Unit
Volume of Activity 35
Manageme nt Accounting A
High-low method
Select one of the two point Substitute into y = bx + a, where
~ step 5
y = y coordinate of point x = x coordinate of point b = step 4 calculations
Find a, ie total fixed costs
36
Manageme nt Accounting A
High–low method evaluation
More objective than visual fit Uses only two data points, and ignores the rest
37
Manageme nt Accounting A
Regression analysis
Allows us to estimate the line of best fit by making the deviations between the cost line and the data points as small as possible
i.e. all data points considered
Simple regression involves estimating the relationship between the dependent variable (Y) and one independent variable (X) Y = a + bX
38
Manageme nt Accounting A
39
Manageme nt Accounting A
Manual Regression analysis Uses all available data in defining the line of best fit Formula
40
Manageme nt Accounting A
Evaluation of regression line
In terms of
economic plausibility goodness of fit
Further analysis techniques
41
Manageme nt Accounting A
Multiple regression
estimates a linear relationship between one dependent variable and two or more independent variables
Multiple regression allows us to include two or more independent variables, that is, cost drivers Y = a + b1X1 + b2X2
42
Manageme nt Accounting A
Practical issues in cost estimation
Data collection problems
Missing data Outliers Mismatched time periods for dependent and independent variables Trade-offs in choosing the number of observations and the reliability of past data points as predictors of future cost behaviour Allocated fixed costs Inflation 43 continued
Manageme nt Accounting A
Issues in cost estimation
Effect of learning on cost behaviour
In estimating labour costs for relatively new product or processes, labour times per unit may decrease at varying rates
44
Manageme nt Accounting A
Issues in cost estimation
Activity-based costing (ABC)
Allows us to consider more complex cost behaviour patterns Costs are assigned to activities Unit, batch and product level costs are assumed to vary in proportion to their cost drivers
45
Manageme nt Accounting A
The accuracy of cost functions
Sometimes approximate estimates are used to estimate cost functions within firms Why is the case? ❖
❖
❖
❖
Limited time and knowledge to undertake quantitative techniques The data required to estimate reliable cost functions may not exist A low priority may be given to determining accurate cost behaviour and cost estimation Subjective cost estimates may be considered good enough for the firm’s
46
Manageme nt Accounting A
Cost estimation assumptions
All cost functions are based on simplifying assumptions, such as:
Cost behaviour depends on a single activity Cost behaviours are linear within a relevant range
Costs and benefits of producing accurate cost information need to be assessed. Refer to handout – Ex.2 - Q.3.49 47
Manageme nt Accounting A
Any Questions?
48
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