Activity Analysis, Cost Behavior,

and CostEstimation

Chapter 6

McGraw-Hill/Irwin Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective1

6-2

Costprediction

Using knowledgeof cost behavior

to forecastlevel of cost at

a particularactivity. Focusis on the future.

IntroductionIntroduction

Costbehavior

Relationshipbetweencost andactivity.

Process ofdetermining

cost behavior,often focuseson historical

data.

Costestimation

6-3

Learning Objective 2

6-4

Total Variable Cost ExampleTotal Variable Cost Example Your total Pay Per View bill is based on how

many Pay Per View shows that you watch.

Number of Pay Per View shows watched

Tot

al P

ay P

er V

iew

Bill

6-5

Variable Cost Per Unit ExampleVariable Cost Per Unit ExampleThe cost per Pay Per View show is constant.

For example, $4.95 per show.

Number of Pay Per View shows watched

Cos

t per

Pay

Per

Vie

w

show

6-6

Step-Variable CostsStep-Variable Costs

Activity

Co

st

Total cost remainsconstant within anarrow range of

activity.

6-7

Step-Variable CostsStep-Variable Costs

Activity

Co

st

Total cost increases to a new higher cost for the

next higher range of activity.

6-8

Total Fixed Cost ExampleTotal Fixed Cost ExampleYour monthly basic cable TV bill probably does

not change no matter how many hours you watch.

Number of hours watched

Mon

thly

Bas

ic

Cab

le B

ill

6-9

Fixed Cost Per Unit ExampleFixed Cost Per Unit ExampleThe average cost per hour decreases as more

hours are spent watching cable television.

Number of hours watched

Mon

thly

Bas

ic c

able

Bill

pe

r ho

ur w

atch

ed

6-10

Step-Fixed CostsStep-Fixed Costs

Example: Office space is available at a rental

rate of $30,000 per year in increments of 1,000 square feet. As

the business grows more space is rented, increasing the total

cost. Continue

6-11

Ren

t C

ost

in

T

ho

usa

nd

s o

f D

oll

ars

0 1,000 2,000 3,000 Rented Area (Square Feet)

30

60

90

Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the

next higher range of activity.

Step-Fixed CostsStep-Fixed Costs

6-12

Step-variable costs can be adjusted more

quickly and . . .

The width of the activity steps is much

wider for thestep-fixed cost.

How does this type of fixed cost differ

from a step-variable cost?

Step-Fixed CostsStep-Fixed Costs

6-13

Semivariable CostSemivariable Cost

A semivariable cost is partly

fixed and partly

variable.Consider the

following example:.

6-14

Fixed Monthly

Rental Charge

Variable Lease

Charge Per Hour

Rental Charge Per Hour

To

tal

Lea

se C

ost

Total semivariable cost

Semivariable CostSemivariable Cost The slope isthe variable cost per unitof activity.

6-15

Curvilinear CostCurvilinear CostCurvilinear

Cost Function

Relevant Range

Activity

To

tal

Co

stCurvilinear

Cost Function

A straight-line(constant unit

variable cost) closely approximates a

curvilinear line withinthe relevant range.

6-16

Learning Objective 3

6-17

Curvilinear CostCurvilinear CostCurvilinear

Cost Function

Relevant Range

Activity

To

tal

Co

stCurvilinear

Cost Function

A straight-Line(constant unit

variable cost) closely approximates a

curvilinear line withinthe relevant range.

6-18

Learning Objective 4

6-19

Engineered, Committed, and Engineered, Committed, and Discretionary CostsDiscretionary Costs

DiscretionaryMay be altered in the short term by current managerial decisions.

CommittedLong-term, cannot be reduced in the short

term.

Engineered

Physical relationship with activity measure.

Depreciation on Buildings and

equipment

Advertising and Research and Development

Direct Materials

6-20

Cost Behavior in Other Cost Behavior in Other IndustriesIndustries

Merchandisers

Cost of Goods Sold

Manufacturers

Direct Material, Direct Labor, and Variable

Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Service Organizations

Supplies and travel

Examples of variable costs

6-21

Examples of fixed costs

Merchandisers, manufacturers, and service organizations

Real estate taxesInsurance

Sales salariesDepreciation

Cost Behavior in Other Cost Behavior in Other IndustriesIndustries

6-22

Learning Objective 5

6-23

Account-Classification Method

Visual-Fit Method

High-Low Method

Least-Squares Regression Method

Cost EstimationCost Estimation

6-24

Account Classification MethodAccount Classification Method

Cost estimates are based on areview of each account making up

the total cost being analyzed.

6-25

Visual-Fit MethodVisual-Fit Method

A scatter diagram of past cost behavior may be helpful in analyzing mixed costs.

6-26

Plot the data points on a graph (total cost vs. activity).

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

Visual-Fit MethodVisual-Fit Method

6-27

Draw a line through the plotted data points so that about equal numbers of points fall above and below the line.

Visual-Fit MethodVisual-Fit Method

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced6-28

Visual-Fit MethodVisual-Fit Method

Vertical distance is total cost,

approximately $16,000.

0 1 2 3 4

*

To

tal

Co

st i

n1,

000’

s o

f D

oll

ars

10

20

0

***

**

**

*

*

Activity, 1,000’s of Units Produced

Estimated fixed cost = $10,000

6-29

The High-Low MethodThe High-Low MethodOwl Co recorded the following production

activity & maintenance costs for two months:

Using these two levels of activity, compute: the variable cost per unit. the total fixed cost.

Units Cost

High activity level 9,000 9,700$ Low activity level 5,000 6,100

6-30

Units Cost

High activity level 9,000 9,700$Low activity level 5,000 6,100 Change 4,000 3,600$

The High-Low MethodThe High-Low Method

6-31

Units Cost

High activity level 9,000 9,700$Low activity level 5,000 6,100 Change 4,000 3,600$

Unit variable cost =in costin units

The High-Low MethodThe High-Low Method

6-32

Units Cost

High activity level 9,000 9,700$Low activity level 5,000 6,100 Change 4,000 3,600$

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

The High-Low MethodThe High-Low Method

6-33

Units Cost

High activity level 9,000 9,700$Low activity level 5,000 6,100 Change 4,000 3,600$

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

Fixed cost = Total cost – Total variable cost

The High-Low MethodThe High-Low Method

6-34

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

Fixed cost = Total cost – Total variable cost

Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)

Units Cost

High activity level 9,000 9,700$Low activity level 5,000 6,100 Change 4,000 3,600$

The High-Low MethodThe High-Low Method

6-35

Units Cost

High activity level 9,000 9,700$Low activity level 5,000 6,100 Change 4,000 3,600$

Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit

Fixed cost = Total cost – Total variable cost

Fixed cost = $9,700 – ($.90 per unit × 9,000 units)

Fixed cost = $9,700 – $8,100 = $1,600

The High-Low MethodThe High-Low Method

6-36

Least-Squares Regression Least-Squares Regression MethodMethod Regression is a statistical procedure used

to determine the relationship between variables such as activity and cost.

Activity

To

tal

Co

st The objective ofthe regressionmethod is the

general cost equation:Y = a + bX

6-37

Y = a + bX

Total Cost is thedependent variable.

The activity (X) is theindependent variable.

The X term coefficient (b)is the estimate of variablecost per unit of activity,

the slope of the cost line.

The intercept term (a) isthe estimate of fixed costs.

Equation Form of Least-Squares Equation Form of Least-Squares Regression LineRegression Line

6-38

Least-Squares Regression Least-Squares Regression MethodMethodStatistics courses and

computer courses deal with detailed regression computations using Microsoft Excel.

Accountants and managers must be able to interpret and use regression estimates.

6-39

Learning Objective 6

6-40

Terms in the equation have the samemeaning as in simple regression with

only one independent variable.

Multiple RegressionMultiple Regression Multiple regression includes two or more

independent variables:

Y = a + b1X1 + b2X2

6-41

Engineering MethodEngineering Methodof Cost Estimationof Cost Estimation

Cost estimates are based on measurement and pricing of the work involved.

6-42

Direct Labor

•Material requiredfor each unit isobtained from

engineering drawings and specification sheets.

•Material prices are determined from

vendor bids.

•Analyze the kindof work performed.

•Estimate the time required for each labor

skill for each unit.

•Use local wage rates to obtain labor cost

per unit.

Direct Material

Engineering MethodEngineering Methodof Cost Estimationof Cost Estimation

6-43

Effect of LearningEffect of Learningon Cost Behavioron Cost BehaviorAs I make more of thesethings it takes me less

time for each one. It mustbe the learning curve effect

that the boss wastalking about.

I’ve noticed the same thing. And if you

include all the variable overhead costs that are also declining, that must be the experience curve.

6-44

Learning CurveLearning Curve

Cumulative Production Output

Ave

rag

e L

abo

rT

ime

per

Un

it

Learning effectsare large initially.

Learning effectsbecome smaller, eventually

reaching steady state.

6-45

Learning Objective 7

6-46

Data Collection ProblemsData Collection Problems1. Missing data.

2. Outlier data points.

3. Mismatched time periods costs.

4. Trade-offs in choosing the time period.

5. Allocated and discretionary costs.

6. Inflation.6-47

End of End of Chapter 6Chapter 6

6-48