Chapter 3 PPT Condensed

8/28/2022
Learning Objectives (1 of 2)
1. Define and describe fixed, variable, and mixed costs

2. Explain the use of resources and activities and their relationship to cost
behavior
Chapter 3 3. Explain how several methods of cost estimation can be used
4. Separate mixed costs into their fixed and variable components using the
Cost Behavior high-low method, the scatterplot method, and the method of least squares
Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives (2 of 2) Cost Behavior

5. Evaluate the reliability of the cost formula • Used to describe whether a cost changes when the level of output changes
6. Explain how multiple regression can be used to assess cost behavior • Fixed costs do not change as output changes
7. Define the learning curve, and discuss its impact on cost behavior • Variable costs increase in total with an increase in output and decrease in
8. Discuss the use of managerial judgment in determining cost behavior total with a decrease in output
Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Cost objects Measures of output

• Item for which managers want cost information • Activity drivers explain changes in activity costs by measuring changes in
• For manufacturing or merchandising firms, it is usually the tangible product activity output (usage)
o General categories
• For service firms, it is usually the service provided
• Unit-level drivers
• Non-unit-level drivers
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Fixed Costs (1 of 3) Fixed Costs (2 of 3)

• Costs that in total are constant within the relevant range as the level of the • JCM Audio Systems, Inc. produces speakers for home audio systems
associated driver varies o One department produces voice coils
o There are two production lines that can each make up to 100,000 voice coils per
year
o Production-line manager is paid $60,000 per year
o For production up to 100,000 units, only one manager is needed; above that (up
to 200,000 units), two managers are needed
Fixed Costs (3 of 3) EXHIBIT 3.1 – Fixed Cost Behavior

JCM Audio Systems, Inc.
Supervision Voice Coils Unit Cost

Cost Produced
$ 60,000 40,000 $1.50
60,000 80,000 0.75
60,000 100,000 0.60
120,000 120,000 1.00
120,000 160,000 0.75
120,000 200,000 0.60
The total cost of supervision remains the same within the relevant range, but
the unit cost decreases as production increases
Variable costs (1 of 2) Variable costs (2 of 2)

• Costs that, in total, vary in direct proportion to changes in an activity driver JCM Audio Systems, Inc.
• Total cost of direct materials for each level of production varies, but the unit
cost stays the same Total Direct Materials Voice Coils Produced Unit Direct Materials
Cost of Voice Coils Cost of Voice Coils
$120,000 40,000 $3
240,000 80,000 3
360,000 120,000 3
480,000 160,000 3
600,000 200,000 3
Total cost of supervision increases or decreases within the relevant range, but
the unit cost stays the same
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EXHIBIT 3.2 - Variable Cost Behavior EXHIBIT 3.3 - Nonlinearity of variable costs
EXHIBIT 3.4 - Relevant range for variable costs Mixed Costs

• Costs that have both a fixed and a variable component
• Example - JCM’s sales costs are mixed
o There are 10 sales representatives, each earning $30,000 plus receive a
commission of $5 per speaker sold that can be represented by the following
equation:
EXHIBIT 3.5 - Mixed Cost Behavior Resources, Activities, and Cost Behavior (1 of 2)
• Resources
o Economic elements that enable one to perform activities
o Activity capacity: Obtained when a firm acquires the resources needed to
perform an activity
o Practical capacity: Activity level where the activity is performed efficiently
o Unused capacity: Activity capacity that is not used completely
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Resources, Activities, and Cost Behavior (2 of 2) Step-Cost Behavior (1 of 3)
• Types of Resources • Step-cost function: Displays a constant level of cost for a range of output
o Flexible resources and then jumps to a higher level of cost at some point
• Supplied as needed and used
• Quantity of resource supplied equals the quantity demanded
• No unused capacity
o Committed resources
• Supplied in advance of usage
• A given quantity is obtained, whether or not that full amount is used
o Unused capacity is possible
EXHIBIT 3.6 – Step-cost function Step-Cost Behavior (2 of 3)
• Step-variable costs
o Follow a step-cost behavior with narrow steps
• Step-fixed costs
o Follow a step-cost behavior with wide steps
o Activity rate: Average unit cost
• Obtained by dividing the resource expenditure by the activity’s practical capacity
Step-Cost Behavior (3 of 3) EXHIBIT 3.7 - Step-fixed costs

• Relationship between resources supplied and resources used is given by
either of the following:
o Activity availability = Activity output + Unused capacity
o Cost of activity supplied = Cost of activity used + Cost of unused activity
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Activities and Mixed Cost Behavior Need for cost separation

• Activities have characteristics of both flexible and committed resources • Accounting records show only total cost and associated output of a mixed
o Example cost item
• A power department acquires long-term capacity for supplying power by investing in o Total cost should be separated into fixed and variable components
a building and equipment - Resources acquired in advance
• It acquires fuel to produce power as needed - Resources acquired as needed
Industrial Engineering Method Account Analysis Method

• Forward-looking method of determining what activities, in what amounts, are • Used to estimate costs by classifying accounts in the general ledger as:
needed to complete a process o Fixed
o Through physical observation and analysis o Variable
• Engineering studies are very precise o Mixed
• Used for manufacturing processes
• Advantage - Can be applied to new processes and designs
Quantitative methods for separating mixed costs into Quantitative methods for separating mixed costs into
fixed and variable components (1 of 2) fixed and variable components (2 of 2)
• Cost as an equation for a straight line Y = F + VX • Dependent variable: Variable whose value depends on the value of another
o Where variable
• Y = Total cost (the dependent variable) • Independent variable: Variable that measures output and explains changes
• F = Fixed cost component (the intercept parameter) in the cost
• V = Variable cost per unit (the slope parameter) • Intercept parameter: Corresponds to fixed cost
• X = Measure of output (the independent variable) • Slope parameter: Corresponds to the variable cost per unit of output
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High-Low Method (1 of 2) High-Low Method (2 of 2)

• Takes two points (the high and the low by volume of activity) and determines • Advantages
the slope and the intercept o Objective in nature
o Slope is variable rate o Simple to calculate
o Intercept is fixed cost • Disadvantages
o High and low points may be outliers that represent atypical cost-activity
relationships
o Other pairs of points may be more representative
Scatterplot Method (1 of 3) Scatterplot Method (2 of 3)

• Uses a scattergraph to visually assess the relationship between cost and • Advantages
output o Allows for visual inspection of the data
o Intercept is fixed cost o Identifies nonlinearity, outliers, and shifts in the cost relationship
o Slope is variable rate • Disadvantages
• Assesses the validity of the assumed linear relationship o Lacks objective criterion for choosing the best-fitting line
o Subjective in nature
Scatterplot Method (3 of 3) EXHIBIT 3.8 A - Scattergraph for Anderson Company’s

Materials Handling Costs
• Anderson Company had the following 10 months of data on materials
handling cost and number of moves:
Month Materials Handling Cost Number of Moves
January $2,000 100
February 3,090 125
March 2,780 175
April 1,990 200
May 7,500 500
June 5,300 300
July 4,300 250
August 6,300 400
September 5,600 475
October 6,240 425
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EXHIBIT 3.8 B - Scattergraph for Anderson Company’s EXHIBIT 3.8 C - Scattergraph for Anderson Company’s
Materials Handling Costs Materials Handling Costs
EXHIBIT 3.9 A - Scattergraph for various cost behavior EXHIBIT 3.9 B - Scattergraph for various cost behavior
patterns patterns
EXHIBIT 3.9 C - Scattergraph for various cost behavior Method of Least Squares
patterns
• Deviation: Difference between the predicted and actual costs
o Shown by the distance from the points marked in the scattergraph to the best-
fitting line
• Measure of closeness is the sum of the squared deviations of the points from
the line
o Smaller the measure, the better the line fits the points
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EXHIBIT 3.10 - Deviations of Data from a Line Using Regression Programs (1 of 2)

• Enter the data
• Choose “Data Analysis” option from the “Tools” menu
o If not available, choose "Add-ins" and select "Analysis ToolPak" to add the data
analysis tools
• Click on “Regression”
• Click on “Input Y Range” and highlight the dependent variables column
Using Regression Programs (2 of 2) Exhibit 3.11 - Spreadsheet Data for Anderson

Company’s Materials Handling Cost
• Click on “Input X Range” and highlight the independent variables column
• Choose preferred location for output
• Click “OK”
EXHIBIT 3.12 - Regression Results for Anderson Using Regression Programs

Company’s Materials Handling Cost
• Interpreting the results
o Under “Coefficients” in the bottom left of the output, find the intercept and the
slope
o Write the equation
• Y = $12.39X + $854.50
o Use the equation to make a point estimate
• At a point of 350 moves, total cost is predicted
o Y = $12.39(350) + $854.50
o Y = $5,191
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Reliability of Cost Formulas Hypothesis test of cost parameters

• Statistical assessments concerning the cost formula’s reliability • t Stat tests the hypothesis that the parameters are different from zero
o Hypothesis test of cost parameters: Indicates whether the parameters are • P-value is the level of significance achieved
different from zero
o P-value of 0.05 or less is needed for significance
o Goodness of fit: Measures the degree of association between cost and activity
output
o Confidence intervals - Provide a range of values for the actual cost with a
prespecified degree of confidence
Goodness of fit measures Coefficient of correlation(R)

• Coefficient of determination • Square root of the coefficient of determination when there is one
o Percentage of variability in the dependent variable explained by an independent independent variable
variable • Ranges between −1 and +1
o always has a value between 0 and 1.00 • Higher the magnitude, the greater the correlation
o Adjusted R Square is used because value has been adjusted for the number • Value close to zero indicates no correlation
of variables included in the equation
EXHIBIT 3.13 - Correlation Illustrated Standard Errors

• Tell how tightly the data points cluster around the regression line
• Small standard error indicates that the regression line more closely
approximates the data
o Larger standard error indicates the opposite
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Multiple Regression (1 of 4) Multiple Regression (2 of 4)

• Used whenever least squares is used to fit an equation involving two or more • Adding another independent variable might increase the explanatory power
independent variables of our model
• Linear equation is expanded to include the additional variable when there are • Performing the regression is very similar to simple regression
two explanatory variables Y = F + V1X1 + V2X2 o Input the data - Make sure the two independent variables are placed next to each
o Where other
• X1 = Number of moves o Follow the same directions, but select both independent variable columns for the
• X2 = Number of pounds moved “Input X Range”
Multiple Regression (3 of 4) EXHIBIT 3.14 - Multiple Regression Results for

Anderson Company’s Materials Handling Cost
Month Materials Number of Pounds Moved
Handling Cost Moves
January $2,000 100 6,000
February 3,090 125 15,000
March 2,780 175 7,800
April 1,990 200 600
May 7,500 500 29,000
June 5,300 300 23,000
July 4,300 250 17,000
August 6,300 400 25,000
September 5,600 475 12,000
October 6,240 425 22,400
Multiple Regression (4 of 4) Learning Curve and Nonlinear Cost Behavior (1 of 2)
• Interpreting the results • Learning curve: Shows how labor hours per unit decrease as units
o Under “Coefficients” in the bottom left of the output find the intercept and the produced increases
slope • Experience curve: Relates cost to increased efficiency, such that the more
o Write the equation often a task is performed, the lower the cost is of doing it
• Y = $507.31 + $7.84X1 + $0.11X2 • Incremental unit-time learning curve model
• Examine reliability of the new model o Decreases by a constant percentage each time the cumulative quantity of units
produced doubles
o Adjusted R Square is 99% - Significant improvement
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Learning Curve and Nonlinear Cost Behavior (2 of 2) EXHIBIT 3.15 - Spreadsheet for Cumulative Average-
Time Learning Model
• Cumulative average-time learning curve model
o States that the cumulative average time per unit decreases by a constant
percentage, or learning rate, each time the cumulative quantity of units produced
doubles
• Learning rate: Gives the percentage of time needed to make the next unit, based on
the time it took to make the previous unit
o Expressed as a percent
EXHIBIT 3.16 - Graph of Cumulative Total Hours Managerial Judgment

Required and the Cumulative Average Time per Unit
• Most widely used method in practice in determining cost behavior
• Managers may:
o Use their experiences and observations to determine fixed and variable costs
o Identify mixed costs and use experience to determine what part is fixed, thus
denoting the rest as variable
• Yields good results when the manager has a good understanding of the
processes
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8/28/2022

1. Define and describe fixed, variable, and mixed costs

Learning Objectives (2 of 2) Cost Behavior

Cost objects Measures of output

Fixed Costs (1 of 3) Fixed Costs (2 of 3)

Fixed Costs (3 of 3) EXHIBIT 3.1 – Fixed Cost Behavior

Supervision Voice Coils Unit Cost

Variable costs (1 of 2) Variable costs (2 of 2)

EXHIBIT 3.4 - Relevant range for variable costs Mixed Costs

Resources, Activities, and Cost Behavior (2 of 2) Step-Cost Behavior (1 of 3)

EXHIBIT 3.6 – Step-cost function Step-Cost Behavior (2 of 3)

Step-Cost Behavior (3 of 3) EXHIBIT 3.7 - Step-fixed costs

Activities and Mixed Cost Behavior Need for cost separation

Industrial Engineering Method Account Analysis Method

High-Low Method (1 of 2) High-Low Method (2 of 2)

Scatterplot Method (1 of 3) Scatterplot Method (2 of 3)

Scatterplot Method (3 of 3) EXHIBIT 3.8 A - Scattergraph for Anderson Company’s

EXHIBIT 3.10 - Deviations of Data from a Line Using Regression Programs (1 of 2)

Using Regression Programs (2 of 2) Exhibit 3.11 - Spreadsheet Data for Anderson

EXHIBIT 3.12 - Regression Results for Anderson Using Regression Programs

Reliability of Cost Formulas Hypothesis test of cost parameters

Goodness of fit measures Coefficient of correlation(R)

EXHIBIT 3.13 - Correlation Illustrated Standard Errors

Multiple Regression (1 of 4) Multiple Regression (2 of 4)

Multiple Regression (3 of 4) EXHIBIT 3.14 - Multiple Regression Results for

Multiple Regression (4 of 4) Learning Curve and Nonlinear Cost Behavior (1 of 2)

EXHIBIT 3.16 - Graph of Cumulative Total Hours Managerial Judgment

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