Chapter 3
Cost behaviour, cost drivers and cost
estimation
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-1
What are cost behaviour, cost estimation
and cost prediction?
•
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 forecast the level of
cost at a particular level of activity
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-2
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-3
Cost drivers
•
A cost driver
– An activity or factor that drives or causes costs
– The higher the correlation between the cost and the cost
driver, the more accurate is the description and
understanding of cost behaviours
– Cost allocation base is commonly used instead of cost
driver, as the causal relationship may not always exist
– Conventional understandings of cost behaviour regard
costs as variable or fixed, based on the level of
production volume
– Volume-based cost drivers include units produced, direct
labour hours, direct labour cost and machine hours
continued
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-4
Cost drivers
•
•
Contemporary viewpoints recognise that there are
a range of possible cost drivers other than
production volume (non-volume cost drivers)
Activity-based approaches classify costs and cost
drivers into four levels:
–
–
–
–
Unit
Batch
Product
Facility
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-5
Cost drivers
•
Unit level costs
– Relate to activities that are performed for each unit
produced
– Use 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-6
Cost drivers
•
Selecting the best cost drivers
– Input or outputs?

One input cost driver is the weight of material
 One output driver is the number of units of production
 Cost–benefit principles will determine the choice
– How detailed should the analysis be?

As the number of cost categories increases, the accuracy of
the resulting information should increase
 Again, cost–benefit criteria are important
– Long or short term?

Cost behaviour and cost drivers can change over time
 Depends on the purpose of the cost prediction
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-7
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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-8
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
Any other uses for the cost behaviour information
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-9
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-10
Cost behaviour patterns
•
Cost behaviour
– The relationship between a cost and the level of activity
•
Cost behaviour patterns
–
–
–
–
–
Variable costs
Fixed costs
Step-fixed costs
Semivariable costs
Curvilinear costs
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-11
Cost behaviour patterns
•
Variable costs
– A change, in total, that is in direct proportion to a change
in the level of 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-12
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-13
Cost behaviour patterns
•
Fixed costs
– Remain unchanged, in total, despite changes in the level
of activity
– 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-14
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-15
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
•
Semivariable cost
– Has both fixed and variable components
•
Curvilinear cost
– Has a curved cost line, but is often approximated as a
semivariable cost function
– At lower levels of activity, there is decreasing marginal
cost
– At higher levels of activity, there is increasing marginal
cost
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-16
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-17
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-18
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-19
Cost behaviour patterns
•
An engineered cost
– Bears a defined physical relationship to the level of output
– If we know the level of activity, we can predict the total
cost
•
A committed cost
– Results from an organisation’s basic structure and
facilities, and is difficult to change in the short term
•
A discretionary cost
– Results from a management decision to spend a particular
amount of money for some purpose, and can be easily
changed
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-20
Cost behaviour patterns
•
Cost structures are shifting towards a decreasing
proportion of costs that vary with production. This
is due to the following:
– As production becomes more automated, there is less
reliance on labour and more reliance on equipment; this
does not vary with production output
– Some employee enterprise agreements lead to a more
stable labour force with fixed salaries

Wages do not vary with production activity levels
 More difficult to change the number of staff employed as
activity levels change
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-21
Cost estimation
•
Approaches to cost estimation
– Managerial judgment
– Engineering approach
– Quantitative analysis
•
Using managerial judgment to estimate costs
– Using experience and knowledge rather than formal
analysis to predict future costs
– The account classification method involves managers
using their judgment to classify costs as exhibiting certain
behaviours
– Reliability of cost estimates dependent on the ability of
the manager
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-22
Cost estimation
•
The engineering approach to estimating costs
– Studying processes that result in the incurrence of a cost
– Focuses 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
– These techniques are expensive and time-consuming
– Useful when there is no reliable past data on which to
base cost estimates
– Most cost effective when there is a direct relationship
between inputs and outputs
– Activity-based approaches extend task analysis to the
study of indirect activities and costs
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-23
Cost estimation
•
Estimating costs using quantitative analysis
– Formal analysis of past data to identify the relationship
between cost and activities
– A scatter diagram 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-24
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
– More accurate method than high–low method as it makes
use of all data and has statistical properties that allows us
to make predictions and draw inferences
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-25
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—does the regression line make
sense?
• Goodness of fit—how well does the line fit the data points?
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PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-26
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-27
Practical issues in cost estimation
•
Data collection problems
– Missing data
– Outliers—extreme observations of activity or costs
– Mismatched time periods for dependent and independent
variables
– Trade-offs in choosing the time period—the number of
observations compared to the reliability of past data
points as predictors of future cost behaviour
– Allocated fixed costs may be misleading
– Inflation may cause past cost data to be less relevant
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-28
Practical issues in cost estimation
•
Effect of learning on cost behaviour
– In estimating labour costs for relatively new products or
processes, labour times per unit may decrease at varying
rates
•
Activity-based approaches allow us to consider
more complex cost behaviour patterns
– Costs are assigned to activities
– Unit, batch and product level costs are assumed to vary
in proportion to their cost drivers
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-29
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 enough
for the firm’s needs
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-30
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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
3-31