CHAPTER 3

MEASUREMENT OF COST

BEHAVIOUR

CHAPTER 3LEARNING OBJECTIVES

1Explain step- and mixed-cost behaviour.

2Explain management influences on cost behaviour.

CHAPTER 3LEARNING OBJECTIVES

3Measure and mathematically express cost functions and use them to predict costs.

4Describe the importance of activity analysis for measuring cost functions.

CHAPTER 3LEARNING OBJECTIVES

5Measure cost behaviour using the account analysis, high-low, visual-fit, and least-squares regression methods.

Introduction

This chapter focuses on measurement of

cost behaviour.

WHAT DOES THAT MEAN?

Linear-Cost Behaviour

Linear-cost behaviour can be graphed with a straight line when a cost changes proportionately with changes in a single cost driver.

Progressive or digressive behaviour

Volume

Cost

Marginal cost (MC)

The extra cost for producing 1 unit more

or

TC’(x)

Relevant Range

Recall that the relevant range specifies the limits of cost-driver activity within which a specific relationship between a cost and its cost driver will be valid.

Step- and Mixed-Cost Behaviour Patterns

Chapter 2 describes two patterns of cost behaviour:

variable and fixed costs.Recall that a purely variable cost

varies in proportion to the selected cost driver, while a

purely fixed cost is not affected by the cost-driver level.

Step- and Mixed-Cost Behaviour Patterns

In addition to these pure versions of cost, two additional

types of costs combine characteristics of both fixed-

and variable-cost behaviour.These are

step costs and mixed costs.See exhibit 3-2 page 88

Step Costs

Step costs change abruptly at intervals of activity because the resources and their costs come in indivisible chunks.

Capacity Costs

Capacity costs are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, such as quality.

Mixed Costs

Mixed costs contain elements of both fixed- and variable-cost behaviour.

Committed Fixed Costs

Committed fixed costs usually arise from the possession of facilities, equipment, and a basic organization. These are large, indivisible chunks of cost that the organization is obliged to incur or usually would not consider avoiding.

Discretionary Fixed Costs

Discretionary fixed costs are costs fixed at certain levels only because management decided that these levels of cost should be incurred to meet the organization’s goals.

Discretionary Fixed Costs

Each planning period, management will determine

how much to spend on discretionary items. These

costs then become fixed until the next planning

period.

Examples ofDiscretionary Fixed Costs

Advertising & promotion

Public relations

Research & development

Charitable donations

Employee training programs

Management consulting services

Cost Functions

The first step in estimating or predicting costs is cost measurement or measuring cost behaviour as a function of appropriate cost drivers.

Cost Functions

The second step is to use these cost measures to estimate future costs at expected, future levels of cost-driver activity.

Form of Cost Functions

An algebraic equation used by managers to describe the relationship between a cost and its cost driver(s) is called a cost function.

Cost Function Equation

Let:Y = Total costF = Fixed costV = Variable cost per

unitX = Cost-driver activity

in number of units

Cost Function Equation

We can rewrite the mixed-cost function as:

Y = F + VX

The mixed-cost function has the familiar form of a straight line

-- it is called a linear-cost function.

Other examples

Y = VX + F

Y = AX2 + BX + F

Y = AX3 + BX2 + CX + F

V1X + F1 for X<100

Y = 1200000

V2X + F2 for X>100

Plausibility

The cost function must be plausible or believable.

Activity Analysis

Activity analysis is especially important for measuring and

predicting costs for which cost drivers are not obvious.

Cost Prediction

Cost prediction applies cost measures to expected future activity levels to forecast future costs.

Methods of Measuring Cost FunctionsOnce managers for a firm have

determined the most plausible drivers behind different costs, they can choose from a broad selection of methods of approximating cost functions, including:

Methods of Measuring Cost Functions Engineering analysis Account analysis High-low analysis Visual-fit analysis Simple least-squares regression, & Multiple least-squares regression.

Engineering Analysis

Engineering analysis entails a systematic review of materials, supplies, labour, support services, and facilities needed for products and services.

Engineering Analysis

It measures cost behaviour

according to what costs

should be, not by what costs have

been.

Account Analysis

The simplest method of account analysis selects a volume-related cost driver and classifies each account as a variable or fixed cost.

Account Analysis

The cost analyst then looks at each cost account

balance and estimates either the variable cost per unit of cost-driver activity or the periodic

fixed cost.

High-Low Analysis A simple method for

measuring a linear-cost function from past cost data is the high-low method. It focuses on the highest-activity and lowest-activity points and fitting a line through these two points.

Visual-Fit Analysis

In the visual-fit method the cost analyst visually fits a straight line through a plot of all of the available data, not just between the high point and the low point, making it more reliable than the high-low method.

Simple Least-Squares Regression Least-squares regression

(regression analysis) measures a cost function more objectively by using statistics to fit a cost function to all the data.