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Cost Drivers and Cost Behavior

CHAPTER 5

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PowerPoint Presentation by

LuAnn BeanProfessor of AccountingFlorida Institute of Technology

Managerial Accounting 11E

Maher/Stickney/Weil

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1Distinguish between variable and fixed costs and between short run and long run, and define the relevant range.

LEARNING OBJECTIVE

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VARIABLE COSTS: Definition

Are costs that change in total as the level of activity changes.

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What are fixed costs?

Fixed costs do not changein total with changes in activity levels.

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SHORT RUN, LONG RUN

In the short run, a firm has only the capacity of the existing plant. Management can change production only in the long run.

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RELEVANT RANGE: Definition

Is the range of activity over which the firm expects a set of cost behaviors to be consistent.

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EXAMPLE

Exotic Eats, a profitable restaurant located in the financial district and featuring Far Eastern dishes, opens from 11am – 2pm Monday through Friday. The maximum capacity of the restaurant is 210 and the daily average is 200 customers.

Management wants to know the effect of doubling the capacity.

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Continued

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EXOTIC EATS: Operating Profits

Revenues $1,000Less Variable costs $ 400

Less Fixed costs 350 750

Operating Profits $ 250

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Continued

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EXOTIC EATS: Profit Projections

Revenues $ 1,000 $ 2,000 $ 2,000Less Variable costs 400 800 800

Contribution margin $ 600 $ 1,200 $ 1,200

Less Fixed costs 350 350 550

Operating Profits $ 250 $ 850 $ 650

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Current capacity

Incorrect capacity

New capacity

Click the button to skip Exercise 8

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EXERCISE 8

Press “Enter” or click left mouse button for answer.

True or False: “My variable costs are $2 per unit. If I want to increase production from

100,000 units to 150,000 units, my total costs should go up by only $100,000.”

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FALSE. This reasoning does not consider relevant range and fixed costs.

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2 Identify capacity costs, committed costs, and discretionary costs.

LEARNING OBJECTIVE

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FIXED COSTS

Fixed (capacity) costs are divided between ¯Committed costs

¯Capacity costs that will continue to exist even if operations are temporarily reduced

¯Discretionary (programmed or managed) costs¯Need not be incurred in the short run to operate the

business

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3 Describe the nature of the various cost behavior patterns.

LEARNING OBJECTIVE

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VARIABLE and FIXED COSTS: A Reminder

Variable costs change with the volume of activity.

Fixed costs remain constant over the relevant range of activity.

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CURVILINEAR VARIABLE COSTS: Definition

Are costs that vary with the volume of activity but not in

constant proportion.

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What is the significance of learning

curves?

Learning curves illustrate how costs that are initially high for a new process, decrease over time with experience.

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SEMIVARIABLE COSTS: Definition

Are costs that have both fixed and variable components. Also called

Mixed Costs.

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What are examples of semivariable costs?

Two examples of semivariable costs are:

¯Repairs and Maintenance

¯Utility costs

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4 Describe how managers use cost behavior patterns.

LEARNING OBJECTIVE

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EXERCISE 3

Press “Enter” or click left mouse button for answer.

Name three methods of cost estimation.

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Statistical regression, Account analysis, and Engineering estimation

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5 Explain how to use historical data to estimate costs.

LEARNING OBJECTIVE

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ANALYZING HISTORICAL COSTS

Two steps to analyze historical cost data¯Make an estimate of the past relation¯Update for current, future periods

¯Adjust costs for inflation and other changes

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TOTAL COST EQUATIONLO 5

Total costs =

Fixed costs + (Variable costs × Activity)

Independent Variables

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6Describe how analysts estimate cost behavior using regression, account analysis, and engineering methods.

LEARNING OBJECTIVE

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CHICAGO HOSPITAL 1

The Chicago Hospital operating room suite has 12 operating rooms. Can we estimate the overhead costs that can be directly traced to a particular surgery?

Continued

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CHICAGO HOSPITAL: Overhead Costs

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Continued

EXH

IBIT

5.8

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TOTAL OVERHEAD COST ESTIMATE

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A computer program using least squares fits a straight line to observed data points to minimize the sum of squares of vertical distances between observed points and the regression line. The line will depict the best fit of projected costs.

Total overhead costs (estimated) = Fixed costs + (Variable costs × Activity) =$18,600 + ($908 × Operating room hours)

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The hospital administrator estimates that there will be 600 operating

room hours next month. What will

the total overhead costs be?

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$563,400

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MULTIPLE REGRESSION: Definition

Has more than one independent variable.

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CHICAGO HOSPITAL 2Our first regression example was simplified

by lumping all overhead costs into one variable. The Chicago Hospital operating room suite is used for different kinds of surgery. By looking at more than just hours and using multiple regression, we can get a better handle of these costs.

Continued

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CHICAGO HOSPITAL: Multiple Cost Drivers

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Continued

EXH

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5.9

Cost Driver Volumes

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TOTAL OVERHEAD COST ESTIMATE 2

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A computer program using least squares fits a straight line to observed data points to minimize the sum of squares of vertical distances between observed points and the regression line.

Total overhead costs (estimated) = Fixed costs + (Hours + Setup + VIP + # rooms used + Special surgeries) =

$90,592 + ($175 × Operating Room Hours) + ($257 × Operating Room Setup Hours) + ($3,839 × VIP patients) + ($2,043 × # operating

rooms used) + ($6,050 × Special surgeries)

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The hospital administrator estimates that there will be 600 operating

room hours, 280 setup hours, 6 VIP patients,8 operating rooms used on average,

and 40 special surgeries. What will

the total overhead costs be?

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$548,930

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CHICAGO HOSPITAL: Profitability Analysis

Chicago Hospital (CH) is considering an offer to become the site for knee and hip replacement surgeries for a flat fee. The administrator believe 3 overhead cost drivers will be affected:

1. Operating hours increase by 100 per month2. Setup hours increase by 40 per month3. Average operating rooms used increase by 1 per

dayContinued

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CHICAGO HOSPITAL: Cost Projections

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EXHIBIT 5.10B

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CHICAGO HOSPITAL: Fixed Fee

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Once the costs associated with becoming a knee and hip replacement center have been estimated and the HMO’s fixed fee offer is received, Chicago Hospital can decide whether the offer will be profitable.

Remember, the estimate has been made on the basis of historical costs which will change with inflation and other changes in cost drivers.

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CHICAGO HOSPITAL: Account Analysis

Step 1: Using account analysis, the Chicago Hospital administrator will classify each overhead cost related to surgery to a cost driver. For example, staff wages for operating room clean up between surgeries will be classified as “Operating room setup.”

Continued

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CHICAGO HOSPITAL: Account Analysis Step 2

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EXHIBIT 5.11

Overhead costs are estimated

by:

Cost ÷ Cost driver volume

A

÷

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CHICAGO HOSPITAL: Engineering Estimation

Engineering method of cost estimation indicates what costs should be. This is a very costly method to put into practice because it requires experts to make the estimates, especially for indirect costs.

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7Explain the costs, benefits, and weaknesses of the various cost estimation methods.

LEARNING OBJECTIVE

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LO 7

EXHIBIT 5.12

Every method of

cost estimation

has strengths and

weaknesses.

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8Identify the derivation of learning curves. (Appendix 5.1).

LEARNING OBJECTIVE

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DERIVING LEARNING CURVES

¯Mathematically, the learning curve effect can be expressed by the equation: Y=aX b, where

¯Y = average number of labor hours required per unit for X units

¯a = number of labor hours required for the first unit¯X = cumulative number of units produced¯b = index of learning, equal to the log of the learning

rate divided by the log of 2.

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9 Interpret the results of regression analyses. (Appendix 5.2).

LEARNING OBJECTIVE

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STANDARD ERRORS OF THE COEFFICIENTS

¯The standard errors of the coefficients give an idea of the confidence we can have in the fixed and variable cost coefficients.

¯The smaller the standard error relative to its coefficient, the more precise the estimate.

¯Such computational precision does not necessarily indicate that the estimating procedure is theoretically correct, however.

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T-STATISTIC¯The ratio between an estimated regression coefficient

and its standard error is known as the t-value or t-statistic.

¯If the absolute value of the t-statistic is approximately 2 or larger, we can be relatively confident that the actual coefficient differs from zero.

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R-SQUARED¯The R2 attempts to measure how well the line fits the

data (that is, how closely the data points cluster about the fitted line).

¯If all the data points were on the same straight line, the R2 would be 1.00—a perfect fit. If the data points formed a circle or disk, the R2 would be zero, indicating that no line passing through the center of the circle or disk fits the data better than any other.

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R-SQUARED (CONTINUED)

¯Technically, R2 is a measure of the fraction of the total variance of the dependent variable about its mean that the fitted line explains.

¯An R2 of 1 means that the regression explains all of the variance; an R2 of zero means that it explains none of the variance.

¯R2 is sometimes known as the “coefficient of determination.”

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CAUTIONS WHEN USING REGRESSION

¯Users of regression analysis should be wary of drawing too many inferences from the results unless they are familiar with the following statistical estimation problems:¯Multicollinearity - independent variables are not

independent of each other but are correlated¯Autocorrelation - a linear regression is fit to data where a

nonlinear relation exists¯Heteroscedasticity - the dependent variable from the best-

fitting linear relation is systematically larger in one part of the range of independent variable(s) than in others

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