Langfield Smith 8e IRM Ch03 PDF

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CHAPTER 3 COST BEHAVIOUR, COST DRIVERS AND COST ESTIMATION ANSWERS TO REVIEW QUESTIONS 3 (a) Cost estimation: the process of determining how a particular cost behaves. (b) Cost behaviour: the relationship between cost and the level of activity (that is, cost driver). (c) Cost prediction: using knowl...

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CHAPTER 3

COST BEHAVIOUR, COST DRIVERS AND COST ESTIMATION ANSWERS TO REVIEW QUESTIONS 3.1

(a) Cost estimation: the process of determining how a particular cost behaves. (b) Cost behaviour: the relationship between cost and the level of activity (that is, cost driver). (c) Cost prediction: using knowledge of cost behaviour to forecast the level of a cost at a particular level of activity. Cost estimation is the process used to determine what the cost behaviour is for a particular cost item. The cost behaviour pattern is used to make a cost prediction about the cost at a particular level of activity.

3.2

A cost driver is an activity or factor that causes costs to be incurred. In identifying cost behaviour, the management accountant identifies the relationship between a particular cost and the level of its cost driver (also called ‘level of activity’ when the cost driver relates to an activity).

3.3

Volume-based cost drivers are used in traditional management accounting systems. This assumes that variable costs vary in proportion to production volume and that fixed costs do not change with production volume. ABC allows a range of cost drivers—such as unit level, batch level, product level, and facility level—so that for these various types of cost there is a more realistic link between the cost and its cost driver. The conventional approach only examines variability with production volume—that is, at the unit level.

3.4

Activity-based costing is a modern approach to costing that has made major advances in analysing cost behaviour by classifying costs and cost drivers. Costs are assigned to activities related to either the unit, batch, product or facility level. Governments in Australia have committed to an activity-based funding (ABF) model for public healthcare and associated services. This funding would be based on the costs of the activities involved in providing these services. A wide range of cost drivers need to be identified (cost driver analysis) in relation to the costing of these activities. These would offer a clear link between funding and service delivery. Governments are interested in understanding these cost drivers and assessing the impact on the activities in the healthcare sector.

3.5

BP targeted certain costs that needed better management. We can see in the ‘Real Life’ that, in order to reduce discretionary costs, BP identified activities that did not adequately add value to the business. Examples are the regular preparation of reports that were rarely (if ever) used, unnecessary travel (both domestic and international), outsourcing tasks to consultants, and maintaining excessive layers of management. These four root-cause cost drivers were better managed to reduce costs.

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3.6

As the level of activity (or cost driver) decreases, total variable cost decreases proportionately and the variable cost per unit remains constant.

3.7

As the level of activity (cost driver) decreases, total fixed cost remains constant. However, the fixed cost per unit of activity increases as activity decreases. Examples include factory rent, managers’ salaries, straight-line depreciation and property taxes.

3.8

As the level of activity (cost driver) increases, total fixed cost remains constant. However, the fixed cost per unit of activity declines as activity increases, and the fixed cost per unit of activity increases as activity decreases. This change in the average fixed cost per unit may not be understood by a decision making manager who has been presented with product costs that include unitised fixed costs. When product costs include unitised fixed costs, managers can mistakenly treat them as totally variable for decision making. These managers may believe that:

3.9



any short term sales that do not cover the unitised fixed costs may result in losing money, not realising that those sales would help cover fixed costs;



a 20% reduction in production will reduce costs by 20% of the total product costs, not realising that the fixed costs will not reduce at all (within the relevant range);



making 1000 more products will increase costs by one thousand times the product cost, not realising that the extra cost will be less than that since total fixed costs will not change if production is still within the relevant range.

(a)

Variable cost, assuming that rubber is the only direct material used in the manufacturing process.

(b)

Unit level cost.

(c)

The number of tyres produced determines the quantity of rubber used in production and therefore the total direct material cost. If only the quantity of rubber used is the cost driver, it ignores any abnormal wastage incurred in the process, or the effects of changing supply and/or demand on rubber prices. To identify the cost driver from a cost management perspective, it is necessary to identify the underlying causes of the direct material cost.

3.10 There are a number of ways in which the behaviour of costs may change over an extended range of activity. Let us first consider some fixed costs. We would expect rent to change if activity increases to the extent that extra premises are required, and depreciation would rise in a large step if we acquired extra equipment to meet growing demand for a product. Hence we say that fixed costs are only fixed over a particular range. With fixed costs, outside that range we would expect there to be a large step in the cost, which would then be fixed over another range. If we consider variable costs, we must recognise that they are often not perfectly linear. A simple example would be direct material. There are often discounts when large volumes of material are purchased, and there can be transportation savings for larger orders. The assumption of a defined linear relationship between cost and production levels will therefore only be valid over a particular range. Outside that range discounts may be obtained or lost and transport charges may change per unit. In the chapter the example of curvilinear electricity costs in Tasty Bread demonstrates that efficiencies of scale may only apply up to a particular level and then unit costs can begin to increase again.

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3.11 The cost analyst should respond by pointing out that in most cases a cost behaviour pattern should be limited to the relevant range of activity. When the firm’s electricity cost was shown as a semivariable cost, it is likely that only some portion in the middle of the graph would fall within the relevant range. Within the relevant range, the firm’s electricity cost can be approximated reasonably closely by a semivariable cost behaviour pattern. However, outside that range (including an activity level of zero) the semivariable cost behaviour pattern should not be used as an approximation of the cost. 3.12 1

Monthly cost of a multiyear contract to maintain a national highway: committed cost. (Once the highway has been built, it must be maintained. The transportation authorities are largely committed to spending the necessary funds to maintain the highway adequately.)

2

Cost of ingredients used to produce strawberry yoghurt: engineered cost.

3

Cost of advertising for a credit card company: discretionary cost.

4

Depreciation on a courier company’s fleet of delivery trucks: committed cost.

5

Cost of charitable donations that are budgeted as 1 per cent of sales revenue: discretionary cost.

6

Product research and development costs at a leading travel goods manufacturer: discretionary cost.

3.13 There are a number of issues to draw out in a discussion about the variability of direct labour, as seen in the ‘Real life’ case. 

Historically direct labour was a variable cost. As discussed in this chapter, there are different contractual obligations (in different employment agreements and in the current regulatory environment) that can make the cost of direct labour behave more like a fixed cost than a variable cost.



Some firms have a basic workforce that can be supplemented by hourly or daily paid workers on an ‘on-call’ basis. This effectively makes direct labour behave as a variable cost.



Even when all workers are on contracted incomes, there is an argument that moving workers from working on one product to another effectively makes the direct labour cost of those products a variable cost.

3.14 The account classification method of cost estimation involves identifying costs as being of a particular type and analysing their past behaviour to understand the expected cost in the future. For example, a manager may identify the costs that will not change with changing production levels (the fixed costs), and separately address the costs that change with the levels of production (both variable costs and semivariable costs). This way the estimation of costs is based on expected cost behaviour, especially in relation to levels of activity such as production volumes.

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3.15 Some of the possible reasons that approximations are used in estimating cost functions include the following: 

lack of accounting time or lack of knowledge about cost estimation techniques



lack of data



low priority may be given to determining accurate cost functions



the resultant cost functions may be regarded as ‘accurate enough’ for the firm’s needs.

3.16 The chief drawback of the high-low method of cost estimation is that it uses only two data points, and ignores all other observations. The rest of the data are ignored. An outlier can cause a significant problem when the high-low method is used, if one of the two data points happens to be an outlier. In other words, if the high activity level happens to be associated with a cost that is not representative of the data, the resulting cost line may also not be representative of the cost behaviour pattern. 3.17 Regression analysis is a statistical method that measures the average amount of change in the dependent variable that is associated with a unit change in one or more independent variables. Simple regression analysis estimates the relationship between the dependent variable and a single independent variable, while multiple regression estimates the relationship between the dependent variable and multiple independent variables. Multiple regression can help management determine more accurate cost estimates because it is able to recognise the effects of two or more factors that influence total costs, and therefore is more economically plausible. Two cost drivers that could form part of a multiple regression equation to estimate the cost function of a university’s salary costs of full-time academic staff are: a.

management and administrative roles held by academic staff that have responsibility allowances attached to them

b.

travel and subsistence allowances for academic staff delivering lectures on multiple campuses of the university.

3.18 A particular least squares regression line may be evaluated on the basis of criteria such as economic plausibility and the goodness of fit. The coefficient of determination, represented by the R2 statistic, is used to evaluate the goodness of fit of the regression line. It indicates the extent to which the pattern of variability of the dependent variable imitates the pattern of variability of the independent variable. The more closely they vary (or move together), the greater the fit between the two variables. This indicates the degree to which the change in the dependent variable can be explained by the change in the independent variable. The proportion of change in the dependent variable that can be explained by the change in the independent variable is what we measure with the coefficient of determination ( R2). The higher the R2, the better the fit.

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3.19 Types of problems often encountered when collecting data for cost estimation include: 

missing data due to misplaced documents or failure to record a transaction



outliers (unusual circumstances), which need to be detected and eliminated from the data set



mismatched time periods between dependent and independent variables



trade-offs in choosing the length of the time period



recording of allocated and discretionary costs as ‘per unit’ data



inflation, which may affect the currency of historic data.

3.20 A learning curve reflects how production efficiency increases with increased production. An experience curve shows how product costs, including costs from across the value chain, decrease with increased production. Learning and experience curves are extensively used by firms in production planning and cost forecasting. Research has shown that when a task is performed over and over there is efficiency in production; for example, a doubling of production quantities over a period often reduces the average labour time taken in production by about 20 per cent. An improvement in performance is seen as a result of learning and experience.

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SOLUTIONS TO EXERCISES

EXERCISE 3.21 (15 minutes) Cost drivers: service firm A number of different answers are possible here.

Cost

Cost driver

Cost behaviour

Branch manager’s salary

Number of customer enquiries

In practice, fixed for a wide range of activity, usually one per branch

Number of staff Number of staff hours worked (full-time and casual) Full-time customer service staff salaries

Number of customer enquiries /quotes Number of bookings

In practice, step-fixed as it is contractually fixed for a wide range of activity, until an additional fulltime staff member is required

Number of staff Number of full-time staff hours worked Casual customer service staff wages

Number of customers

Variable, casual labour

Number of journeys quoted Number of flight, accommodation and car bookings made Number of hours worked

Computer expenses

Number of bookings processed Number of desks Number of hours worked

Step-fixed, each computer can only process a given number of enquiries and bookings before an additional computer is required

Number of customers' quotes provided Telephone expenses

Number of bookings processed Number of desks/telephones Number of hours worked

A wide range of contracts are available. In practice, this may be fixed for a wide range of activity before additional charges are made

Number of customers' quotes provided

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EXERCISE 3.22 (15 minutes) Variable and fixed costs; graphical and tabular analyses: manufacturer 1

Graph of raw materials cost:

Total raw material costs

$1 800 000

$1 200 000

$600 000

10 000

20 000

30 000

Balls Produced

2 Production level (balls)

Unit cost

Total cost

10 000

$60 per ball

$ 600 000

20 000

$60 per ball

$1 200 000

30 000

$60 per ball

$1 800 000

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3

Graph of fixed production costs:

Total Fixed cost

$80 000

$60 000

$40 000

$20 000

10 000

20 000

30 000

Balls Produced

4 Production level (balls)

Unit cost

Total cost

10 000

$7.50

$75 000

20 000

$3.75

$75 000

30 000

$2.50

$75 000*

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EXERCISE 3.23 (40 minutes) Graphing cost behaviour patterns: hospital 1

Cost of food:

2

Cost of salaries and on-costs for administrative staff:

3

Laboratory costs:

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4

Cost of cleaning:

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5

Nursing costs:

EXERCISE 3.24 (15 minutes) Approximating a curvilinear cost: service firm 1

2

Actual

Estimated

(a)

10 000 km

$2000

$4200

(b)

30 000 km

4300

4500

(c)

60 000 km

6000

6000

(d)

90 000 km

8000

7500

(a) The approximation is very accurate in the range of 50 000 to 70 000 km per month. (b) The approximation is less accurate in the extremes of the longer range of 70 000 to 100 000 km per month.

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EXERCISE 3.25 (15 minutes) Account classification method; manufacturer. 1

(a)

Fixed; does not change for different levels of production.

(b)

Variable: varies proportionately with the number of kilograms sausages produced.

(c)

Variable: varies proportionately with the number of kilograms of sausages produced

(d)

Fixed: does not change for different levels of production.

(e)

Semivariable (or mixed): includes a fixed element ($4000 per month) and a variable element ($0.20 per kilogram of sausages produced).

Production cost per month = $33 000* + $2.00X †

2

*33 000 = $19 000 + $10 000 + $4 000 †

$2.00 = $1.10 + $0.70 + $0.20

EXERCISE 3.26 (15 minutes) Estimating cost behaviour; high–low method: manufacturer 1

Variable cost per number of machine hours =

$ 36150−$ 33150 =$ 0 . 10 61500−31500

Total cost at 61 500 machine hours Variable cost at...