3
Cost behaviour, cost drivers and cost
estimation
Basic concepts
• Cost behaviour
– The relationship between a cost and the level of
activity or cost driver
• Cost estimation
– The process of determining the cost behaviour of
a particular cost item
• Cost prediction
– Using knowledge of cost behaviour to focus the
level of cost at a particular level of activity
2
3
Cost drivers
• A cost driver
– An activity or factor that causes costs to be
incurred
– The higher the correlation between the cost and
cost driver, the more accurate is the description
and understanding of cost behaviours
• Conventional understandings of cost
behaviour regarded costs as variable or fixed,
based on the level of production volume continued
4
Cost drivers
• Contemporary viewpoints recognise that there
are a range of possible costs divers other than
production volume (non-volume cost drivers)
• Activity-based approaches classify costs and
cost drivers into four levels:
– Unit
– Batch
– Product, and
– Facility
continued
5
Cost drivers
• Unit level costs
– Relate to activities that are performed for each unit
produced
– Uses conventional volume-based cost drivers
• Batch level costs
– Relate to activities performed for a group of product
units
• Product (or product-sustaining) level
– Relate to activities performed for specific products or
product groups
• Facility level
– Costs incurred to run the business
continued
6
Cost drivers
• Selecting the best cost drivers
– Input or outputs?
An example of an input cost driver is the weight of
material, and an output driver is the number of units of
production
Cost benefit principles will determine the choice
– How detailed should the analysis be?
– Long or short term?
Cost behaviour and cost drivers can change over time
Depends on the purpose of the cost prediction
continued
7
Cost drivers
• Cost drivers for cost estimation or cost
management?
– Cost drivers that are used to predict costs, may
differ from those used to manage costs
– Effective cost management requires the
identification of root cause cost drivers
The basic costs that cause a cost to be incurred
The true causes of costs
continued
8
Cost drivers
• In choosing cost drivers the costs and benefits
of each driver must be assessed:
– Reasons for analysing cost behaviour
– Timeframes for analysing the cost behaviour
– Availability of data on cost drivers, and
– Any other uses for the cost behaviour information
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10
Cost behaviour patterns
• Cost behaviour patterns
– Variable costs
– Fixed costs
– Step-fixed costs
– Semi-variable costs
– Curvilinear costs
continued
11
Cost behaviour patterns
• Variable costs
– Change in total in direct proportion to a change in
activity
– The variable cost is the slope of the cost line in the
following cost function:
Y = a + bX
Where Y = total cost
a = fixed cost component (the intercept on the vertical axis)
b = variable cost per unit of activity (the slope of the line)
X = the level of activity
continued
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13
Cost behaviour patterns
• Fixed costs
– Remains unchanged in total as the level of activity
varies
– As activity increases, total fixed costs do not
change, but unit fixed cost declines
– Contemporary approaches to cost analysis
recognise that there are cost drivers for some of
these “fixed” costs, and very few costs remain
fixed
continued
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15
Cost behaviour patterns
• Step-fixed costs
– Remain fixed over a wide range of activity levels
but jump to a different amount for levels outside
that range
• Semi-variable cost
– Has both fixed and variable components
• Curvilinear cost
– Has a curved cost line, but is often approximated
as a semi-variable cost function
continued
16
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Cost behaviour patterns
• Cost structures are shifting towards a
decreasing proportion of costs that vary with
production due to:
– Labour being replaced by equipment, which does
not vary with production output
– Production wages moving towards fixed salaries
that do not vary with production activity levels
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Cost estimation
• Approaches to cost estimation
– Managerial judgement
– Engineering approach, and
– Quantitative analysis
• Using managerial judgment to estimate costs
– The account classification method involves
managers using their judgement to classify costs
as exhibiting certain behaviours
continued
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Cost estimation
• The engineering approach to estimating costs
– Studying processes that result in the incurrence of
a cost
– Focus on the relationships that should exist
between inputs and outputs
– Using time and motion studies (or task analysis)
where employees are observed as they undertake
work tasks
– Activity-based approaches extend task analysis to
the study of indirect activities and costs
continued
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Cost estimation
• Estimating costs using quantitative analysis
– A scatter plot can be useful in allowing us to plot
the data points to visualise the relationship
between cost and the level of activity
– The high-low method involves taking the two
observations with the highest and lowest level of
activity to calculate the cost function
– Regression analysis is a statistical technique that
uses all observations to determine the cost
function
continued
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Cost estimation
• Regression analysis
– Allows us to estimate the line of best fit by making
the deviations between the cost line and the data
points as small as possible
– Simple regression involves estimating the
relationship between the dependent variable (Y)
and one independent variable (X)
Y = a + bX
continued
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Cost estimation
• Regression analysis
– Multiple regression allows us to include two or
more independent variables, that is, cost drivers
Y = a + b1X1 + b2X2
– The regression line can be evaluated using several
criteria:
Economic plausibility
Goodness of fit
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Practical issues in cost estimation
• Data collection problems
1. Missing data
2. Outliers
3. Mismatched time periods for dependent and
independent variables
4. Trade-offs in choosing the number of
observations and the reliability of past data
points as predictors of future cost behaviour
5. Allocated fixed costs
continued
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6. Inflation
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Practical issues in cost estimation
• Effect of learning on cost behaviour
– In estimating labour costs for relatively new
product or processes, labour times per unit may
decrease at varying rates
• Activity-based approaches allows us to
consider more complex cost behaviour
patterns
– Costs are assigned to activities
continued
– Unit, batch and product level costs are assumed
to
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Practical issues in cost estimation
• The accuracy of cost functions
– Sometimes approximate estimates are used to
estimate cost functions within firms
– Why is the case?
Limited time and knowledge to undertake quantitative
techniques
The data required to estimate reliable cost functions
may not exist
A low priority may be given to determining accurate
cost behaviour and cost estimation
Subjective cost estimates may be considered good continued
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2003needs
McGraw-Hill Australia
enough for the
firm’s
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Practical issues in cost estimation
• All cost functions are based on simplifying
assumptions, such as:
– Cost behaviour depends on a single activity
– Cost behaviours are linear within a relevant range
• Costs and benefits of producing accurate cost
information need to be assessed
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