COST MANAGEMENT

Don R. Hansen

Maryanne M. Mowen

PPT 3 -1
 Chapter Three

Activity Cost
Behavior

PPT 3 -2
 Learning Objectives

 Define and describe fixed, variable, and mixed

costs.
 Explain the use of resources and activities and
their relationship to cost behavior.
 Separate mixed costs into their fixed and variable
components using the high-low method, the
scatterplot method, and the method of least
squares.

PPT 3 -3
 Learning Objectives (continued)

 Evaluate the reliability of the cost formula.

 Explain how multiple regression can be used to

assess cost behavior
 Discuss the use of managerial judgment in
determining cost behavior.

PPT 3 -4
 Cost Behavior

Fixed Cost Behavior Variable Cost Behavior

$ $
Relevant Range

Activity Activity

PPT 3 -5
 The Behavior of a Mixed Cost
Linearity Assumption
Total Costs

$Cost
Fixed Costs
Variable Costs

Number of Units Produced

Y = F + VX
PPT 3 -6
 Basic Terms

Activity capacity is the ability to perform activities.

Practical capacity is the efficient level of activity
performance.
Resources are economic inputs that are consumed in
performing activities.

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 Types of Fixed Resources

 Flexible Resources

 Committed Resources

 Discretionary Fixed Costs

PPT 3 -8
 Flexible Resources

Flexible resources are supplied as used and needed.

They are acquired from outside sources, where the terms of
acquisition do not require any long-term commitment for
any given amount of the resource.
Example: Materials and energy

PPT 3 -9
 Committed Resources

Committed resources are supplied in advance of

usage.
They are acquired by the use of either an explicit or implicit
contract to obtain a given quantity of resource, regardless of
whether the amount of the resource available is fully used
or not. Committed resources may have unused capacity.
Example: Buying or leasing a building or equipment

PPT 3 -10
 Committed Resources (continued)

Committed fixed expenses are costs incurred for the

acquisition of long-term capacity.
Example: Plant, equipment, warehouses, vehicles, and salaries of
top employees

Discretionary fixed expenses are shorter-term

committed resources.
Example: The hiring of new receiving clerks

PPT 3 -11
 Resource Relationships

The relationship between resources supplied and

resources used is expressed by the following
equation:
Resources available = Resources used + Unused capacity

PPT 3 -12
 Example

Available orders = Orders used + Orders unused

7,500 orders = 6,000 orders + 1,500 orders

Fixed engineering rate = $150,000/7,500

= $20 per change order
Variable engineering rate = $90,000/6,000
= $15 per change order

PPT 3 -13
 Example (continued)

Cost of orders supplied = Cost of orders used + Cost of unused orders

= [($20 + $15) x 6,000] + ($20 x 1,500)
= $240,000
Of course, the $240,000 is precisely equal to the $150,000 spent on engineers
and the $90,000 spent on supplies.

The $30,000 of excess engineering capacity means that a new product could
be introduced without increasing current spending on engineering.

PPT 3 -14
 Step-Variable Costs
Linearity Assumption

$Cost
Narrow Width

Number of Units Produced

PPT 3 -15
 Step-Fixed Costs

Linearity Assumption

$Cost

Wider Width

Number of Units Produced

PPT 3 -16
Methods for Measuring the Fixed and
Variable Components of a Mixed Cost

 The High-Low Method

 Scatterplot Method

 The Method of Least Squares

PPT 3 -17
 High-Low Method: An Example

Month Utility Costs Units Produced

January $2,000 200
February 2,500 400
March 4,500 600
April 5,000 800
May 7,500 1,000

PPT 3 -18
The High-Low Method (continued)

Y = F + VX

Variable Cost Rate (V)= (Y2 - Y1)/(X2 - X1)

V = ($7,500-$2,000)/(1,000-200)
V = $5,500/800
V = $6.875 per unit

PPT 3 -19
 The High-Low Method (continued)

Y = F + VX
$7,500 = F + $6.875 (1,000)
F = $7,500 - $6,875
F = $625

The cost formula using the high-low method is:

Y = $625 + $6.875 (X)

PPT 3 -20
 Utility Scatterplot Method
Cost
$8,000

Important: Cost function is only

.
relevant within relevant range
6,000
.
. Analyst can fit line
4,000 . based on his or her
experience
.
2,000

200 400 600 800 1,000

0 Units Produced
PPT 3 -21
 Nonlinear Relationship

Activity
Cost

* *
*

*
*

0 Activity Output

PPT 3 -22
 Upward Shift in Cost Relationship

Activity
Cost

* *
*

*
*
*

0 Activity Output

PPT 3 -23
 Presence of Outliers

Activity
Cost
*
*
*

*
*
*

0 Activity Output

PPT 3 -24
 Least Squares

Constant 250
Std Err of Y Est 299.304749934466
R squared 0.944300518134715
No. of Observations 5
Degrees of Freedom 3

X Coefficient(s) 6.75
Std Err of Coef. 0.9464847243

PPT 3 -25
 Least Squares (continued)

The results gives rise to the following equation:

Utility Costs = $250 + ($6.75 x # of units produced)

R2 = .944, or 94.4 percent of the variation in setup costs is explained by the number
of setup hours variable.

PPT 3 -26
 Least Squares (continued)

Using Confidence Intervals:

Given:
*T-value for sample size of 5 at 95% confidence level is 3.182 (two-tale
test and 3 degrees of freedom)
*Standard error of estimate for this sample at the 95% confidence level
is 598.6

The confidence interval for 300 units is:

TC = $250 + 6.75 (300) + (3.192 x $598.6)
= $2275 + $1911

PPT 3 -27
 Multiple Regression

TC = b0 + b1X1 + b2X2 + . . .

b0 = the fixed cost or intercept

bi = the variable rate for the ith independent variable

Xi = the ith independent variable

PPT 3 -28
 Multiple Regression (continued)

Utility
Month MHrs Summer Cost
January 1,340 0 $1,688
February 1,298 0 1,636
March 1,376 0 1,734
April 1,405 0 1,770
May 1,500 1 2,390
June 1,432 1 2,304
July 1,322 1 2,166
August 1,416 1 2,284
September 1,370 1 1,730
October 1,580 0 1,991
November 1,460 0 1,840
December 1,455 0 1,833
PPT 3 -29
 Multiple Regression (continued)

Constant 243.1115
Std Err of Y Est 55.5083
R squared 0.9672
No. of Observations 12
Degrees of Freedom 9

X Coefficient(s) 1.0972 510.4907

Std Err of Coef. 0.2102 32.5490

PPT 3 -30
 Multiple Regression (continued)

The results gives rise to the following equation:

Utilities cost = $243.11 + $1.097(MH) + $510.49(Summer)

R2 = 0.967, or 96.7 percent of the variation in utilities cost is

explained by the machine hours and summer variables.

PPT 3 -31
Cost Behavior and Managerial
Judgment

Some Tips
 Use past experience
 Try to confirm results with operating personal
 Use common sense to confirm statistical studies

PPT 3 -32
End of Chapter 3

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