Mgmt.

201 - Managerial Accounting – Week #5

Cost Behavior

Cost Estimation

Professor Thoman
Fall 2010

Overview of Chapter 6 – Cost behavior and estimation

In Chapter 6 we will:

I. Learn terms that describe cost behavior

Review the meaning of variable costs, fixed costs, and the relevant
range.
Both graph and represent algebraically the costs.
Learn new cost terms: step fixed costs, discretionary costs and mixed
costs.

II. Discuss cost estimation techniques and use the estimates to predict future
costs and earnings.
Account-classification method
Visual fit method
High Lo method (terrible method)
Least-squares method

III. Discuss the learning curve.

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I. Variable versus fixed costs
Definitions:
Activity A measure of an organization’s output of goods or services
• bushels of wheat produced
• pairs of Dockers
• tons of ore mined
• number of Chevy Blazers
Variable Costs Given a relevant range of activity, costs that automatically change
with the activity level; accountants usually assume that variable
costs vary proportionately with the activity level.
Fixed Costs Given a relevant range of activity, costs that do not vary with the
level of activity

Variable costs for manufacture of textbook Fixed costs for manufacture of textbook:

Must always specify an activity before one can determine if a cost is variable or
fixed with respect to that activity. Must also specify a time frame—with more time,
more items become variable. In past chapters we have been assuming a long time
frame so that all of the ABC or traditional costs of the product are variable.
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Graphs of variable and fixed costs:

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I. Other cost behavior terms

Definitions:

Mixed or semi-variable Costs that have both a fixed and variable component.
costs

Definitions:
Step or step-fixed costs Costs that are fixed over a range of output levels.

Discretionary fixed costs Costs that are fixed but the level at which they are fixed
depends upon managerial discretion.

BOTTOM LINE: COSTS CAN BE DIVIDED INTO VARIABLE COSTS AND

SOME KIND OF FIXED COSTS (NOT VARIABLE). WE WILL FIND THIS IS A
USEFUL CLASSIFICATION FOR MANY PURPOSES
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I. Contracts that use both fixed and variable costs.

The Pacific Corporation operates car rental agencies at more than 20 airports. Customers
can choose from one of three contracts for car rentals of one day or less:

Contract 1: $50 for the day

Contract 2: $30 for the day plus $0.20 per mile traveled
Contract 3: $1 per mile traveled

If a customer needed the car for 2 days and expected to drive 100 miles, which contract is
the cheapest?

Equation for Contract 1: Equation for Contract 2: Equation for Contract 3:

Graphs for the 3 contracts as a function of the number of miles driven, if renting the car
for 2 days:

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II. Cost Estimation

What are the cost estimation techniques that are actually used to separate variable
and fixed costs?

! Account-classification method or Account analysis

! Visual fit method

! High Lo method (terrible method)

! Least-squares method

Account-classification method or Account analysis

An analyst looks at each item in the organization’s ledger accounts and classifies each
cost as variable, fixed or mixed. Mixed costs must be separated into their fixed and
variable components; then total fixed costs and variable costs per unit are estimated.

The State Department of Taxation processes and audits income-tax returns for state
residents. The state tax commissioner has recently begun a program to estimate the costs
of running the department. The independent variable used in the program is the number
of returns processed. The analysis revealed that the following variable costs are incurred
in auditing a typical tax return.

Time spent by tax professional, 20 hours at $25 per hour $ 500

Time spent by clerical employees, 10 hours at $12 per hour 120
Telephone charges, $10 per audit 10
Computer time, $50 per audit 50
Postage, $2 per audit 2
Total cost per audit $ 682

In addition, the department incurs $10,000 of fixed costs each month that are associated
with the process of auditing returns.

How could this be used?

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II. Account analysis

Lorenzo operates a car wash. Incoming cars are put on an automatic conveyor belt. Cars
are washed as the conveyor belt carries them from the start station to the finish station.
After a car moves off the conveyor belt, it is dried manually. Workers then clean and
vacuum the inside of the car. Lorenzo serviced 80,000 cars in 2009. Lorenzo reports the
following costs for 2009.

Account Description Costs

Car wash labor $ 260,000
Soap, cloth, and supplies 42,000
Water 38,000
Electric power to move conveyor belt 72,000
Depreciation 64,000
Salaries 46,000

1. Classify each account as variable or fixed with respect to the number of cars washed.
Explain.
2. Suppose Lorenzo washed 90,000 cars in 2009. Use the cost classification you
developed in requirement 1 to estimate Lorenzo’s total costs in 2009. Depreciation is
computed on a straight-line basis.

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II. Visual fit
Visual fit method

The analyst plots the cost data—activity on the horizontal axis and the cost on the vertical
axis. Looking only at the relevant range, the analyst visual fits a good line to the data.
From the graph the fixed costs and the variable cost per unit can be estimated.

Nantucket Marine Supply is a wholesaler for a large variety of boating and fishing
equipment. The company’s controller, Alan Denney, has recently completed a cost study
of the firm’s material handling department. The activity measure used in the study was
hundreds of pounds of equipment loaded or unloaded at the company’s loading dock.
Denney completed the following data:

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Units of Activity Material-

Month (hundreds of pounds of equipment handing
loaded or unloaded) costs
January 1,800 $ 11,700
February 1,600 11,300
March 1,300 11,250
April 1,000 10,200
May 2,200 11,100
June 2,400 12,550
July 2,000 12,000
August 1,800 11,400
September 2,600 12,120
October 1,100 11,050
November 1,200 11,350
December 1,400 11,350

1. Visually fit a line to the above data.

2. Estimate the variable and fixed components of the department’s cost behavior
pattern using the visually fit cost line.
3. Predict the company’s material-handling costs for a month when 2,250 units of
activity are recorded.

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II. Least squares regression analysis
Least squares regression method:

Statistical techniques can objectively fit a line to the data. With the least squares method,
the line is positioned to minimize the sum of the squared deviations between the cost line
and the data points.

Bob Jones owns a catering company that prepares food and beverages for banquets and
parties. For a standard party the cost on a per-person basis is:

Food and beverages $15

Labor (0.5 hour X $10 per hour) 5
Overhead (0.5 hour X $14 per hour) 7
Total cost per person $27

Jones is quite certain about his estimates of the food, beverages, and labor costs but is
not as comfortable with the overhead estimate. The overhead estimate was based on
the actual data for the past 12 months, which are presented here. These data indicate
that overhead costs vary with the direct labor-hours used. The $14 estimated was
determined by dividing total overhead costs for the 12 months by total labor-hours.

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Month Labor-Hours Overhead Costs

January 2,500 $ 55,000
February 2,700 59,000
March 3,000 60,000
April 4,200 64,000
May 7,500 77,000
June 5,500 71,000
July 6,500 74,000
August 4,500 67,000
September 7,000 75,000
October 4,500 68,000
November 3,100 62,000
December 6,500 73,000
Total 57,500 $805,000

Jones has recently become aware of regression analysis. He estimated the following
regression equation with overhead costs as the dependent variable and labor-hours as
the independent variable:

Y = $48,271 + $3.93X

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II. Least squares regression analysis

Brickman Apparel produces equipment for the extreme-sports market. It has four peak
periods, each lasting two months, for manufacturing the merchandise suited for spring,
summer, fall, and winter. In the off-peak periods, Brickman schedules equipment
maintenance and runs advertising to generate demand for its upcoming seasonal
merchandise. Brickman’s controller, Sascha Green, wants to understand the drivers of
equipment maintenance costs and the effect of advertising expenditures on sales. A
regression analysis of two years of monthly data yield the following relationships:

Maintenance costs = $21,000 – ($2.20 per machine-hour X Number of machine-hours)

Sales revenue = $310,000 – ($1.80 X advertising expenditure)

Upon examining the results, Green comments, “So, all I have to do to reduce
maintenance costs is run my machines longer?! And, clearly our advertising function is
broken: The more we spend on advertising, the lower our sales revenue.”

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III. Learning or experience curve

In many production processes, production efficiency increases with experience. As labor

time declines, labor cost declines as well. When estimating cost behavior one needs to
take this relationship into account.

Global Defense manufactures radar systems. It has just completed the manufacture of its
first newly designed system, RS-32. Manufacturing data for the RS-32 follow:

Direct material cost $80,000 Per unit of RS-32

Direct manufacturing labor time for first unit 3,000 Direct labor-hours
Learning curve for manufacturing labor time per 90% Cumulate average time
radar system
Direct manufacturing labor cost $25 Per direct labor hour
Variable manufacturing overhead cost $15 Per direct labor hour

Calculate the total variable costs of producing 2,4, and 8 units.

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