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 Explain the role of Resource Usage models in understanding

cost behaviour

 Discuss cost behaviour for costs and be able to separate costs

into different cost categories (i.e. fixed and variable costs).
Including the least squares method.

Cost Behaviour & Cost

Estimation Methods

 Determining how cost will change with output for planning,  Recall cost behaviour patterns :
controlling and decision-making activities.
Fixed Cost Variable Cost Mixed Cost
Description: in total, are constant in total, vary in direct have both a fixed and a
 Most of planning, control and decision-making activities of within the relevant range proportion to changes in
variable component
management depend on reliable estimates of costs and as activity output activity output
changes
distinguishing between fixed and variable costs, at different
activity levels. Examples: factory rent direct materials lease payment of Tk.1,000
per month plus Tk.10 per
machine hour used
 To estimate future cost, it is important to understand how cost Per unit: changes as activity level remains constant per
behave. changes. If activity unit of activity
increase PUC decrease
and if activity falls then
PUC increase
 Cost behaviour is based on assumption that future costs will
Formula: Total variable cost = Total mixed cost =
behave the same as it has in the past Variable cost per unit × Fixed costs + Variable costs
◦ Not always a good assumption Units of activity

◦ Need to exercise judgement

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 Mixed Cost – Difficult in classifying costs into fixed and

variable
• If assume all fixed – overstates fixed costs
• If assume all variable – overstates variable costs per unit and
understates fixed cost.
• Therefore must separate into components (F & V) to understand
how the cost will behave when volume changes

 Mixed cost can be analyzed by-

◦ looking at how cost behavior over time.
◦ evaluating each cost in terms of production methods, material
requirements, labor usage and overhead.

 The total mixed cost line can be expressed with the equation
Y = a + b(x)

 It deals with where and how resources are used

 Implications of Activity-based resources usage model:

 Types of resources use-

◦ Improve managerial control
◦ Flexible resources
 by paying more attention to controlling resource usage and
◦ Committed resources (can be two types- committed fixed spending in changed situation
expenses, and discretionary fixed expenses).
 ABC resources usage model allows managers to access the
changes in resources supply and demand resulting from
 Conventional/Traditional and Activity based are resources any new decision, such as new product mix; adding new
usage models customized product etc.

 Q- Is there any difference between Conventional/ ◦ Improve managerial decision making

Traditional and Activity based resources usage model ?  e.g. what to do with excess capacity; whether to make or
◦ Think in terms of – buy a part, to accept or reject a special orders, and to keep
 overhead cost identification and allocations techniques or drop product lines.
under both system and benefits & limitations of each.

 Flexible and Committed resources and there characteristics

 The relationship can be expressed in equation in both physical
Flexible Resources Committed Resources term and financial term.
Definition: Resources are acquired from outside Resources are acquired by either
sources, and the organization is free explicit or implicit contract to obtain When relationship express in Physical term-
to buy only the quantity of the a given quantity of resources, regard- Resources available = Resources used + Unused resources
resource needed. less of whether the quantity of the (capacity)
resource available is fully used or not.
Unused capacity: No; Yes;
Resource supplied = Resource usage Resource supplied  Resource usage When relationship express in financial term-
and demand Cost of resources available for use= Cost of resources used +
Cost of unused resources
Examples: materials equipment
Or
Cost behavior: usually variable Cautiously treated as fixed expenses.
Discretionary fixed expenses are Cost of resources available for use= (Unit cost x resources
incurred for short-term capacity. used) + (P.U. Fixed cost x unused resources)

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 Analysis Approaches
 Say , A company hired three production engineers at
Tk.90,000 each
◦ Account analysis
◦ Engineering Approach
 Each engineer is capable of processing 3,000 orders
 Cost Estimation Methods
 Tk.120,000 was spent on supplies (which are flexible ◦ The scatter plot method;
resource) for the engineering activity ◦ The high-low method; and
◦ Least squares regression methods
 There were 8,000 orders processed by the engineers ◦ Management estimates – managers uses experience to
state a cost equation
 Q. i) Show the relationship between resources available
and resources used in physical term.
ii) Calculated the cost of order supplied?

 The analyst examine each item of expense for a particular
period and then classify it as a wholly fixed, wholly variable or a
semi-variable cost.
 A single average unit cost figure is selected for the items that
are categorized as variable, whereas a single total cost for the
period is used for the items that are categorized as fixed.
 For semi-variable items, analyst agree on a cost function that
appears to best describe the cost behaviour.
Drawbacks
 very subjective (involves individual judgements). Therefore, cost
estimates lack the precision necessary when they are to be used
in making decisions.
 Based on the use of engineering analyses of technological
relationships between inputs and outputs
◦ E.g. methods study, work sampling and time and motion
studies.
 Is appropriate when there is a physical relationship between
costs and the cost driver.
◦ E.g. direct materials, labour and machine time, because
these items can be directly observed and measured.
 Drawbacks
◦ Is not generally appropriate for estimating costs that are
difficult to associate directly with individual units of outputs,
such as overhead costs.
◦ Methods study, work sampling and time and motion study
techniques can be expensive to apply in practice.

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 Cost estimation is the process of determining the relative fixed

Organisation cost Possible cost drivers
and variable components of expected total cost at various
activity level
Hospital Surgeries Staffing requirements
Procedure types (e.g.
 To effectively estimate cost, managers must understand which heart or cosmetic
surgery)
activities drives costs. Patient condition
Pizza delivery service Vehicle fuel Vehicle age
 It is important to clearly Identifying cost drivers because- Vehicle type
◦ cost structure differ across industries Miles driven

◦ due to dissimilarities in business processes among industries, Lawn mower manufacturer Product warranties No. of defects
No. of parts
cost drives also differ
Retailer Store rent Property size
Property age
 Therefore, factors that affect costs in one industry may not be location
the same in another Accounting, consulting, law Salaries Experience
firm Education
Certifications (CA, CPA
licensed attorney)

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 A quick and easy way to isolate the components of a expected

total cost at various activity levels
◦ The scatter graph/plot method;
 This method involve plotting on a graph the total cost data
◦ The high-low method; and (represented on the vertical axis – Y) for each activity (recorded
on the horizontal axis – X) to see the relationship between cost
◦ Least squares regression methods and the activity level.

 Drawing a straight line through the middle of the plotted points

◦ Management estimates – managers uses experience to
state a cost equation
by visual approximation.
◦ The point where the straight line cuts the vertical axis
represents the fixed cost.
◦ The unit variable cost is found by observing the differences (in
costs and activity levels) between any two points on the
straight line.

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 The purpose of this method is -  Advantages –

◦ to see whether or not an assumed linear relationship is ◦ Allows to see the relationship between activity cost and
reasonable, and activity usage
◦ also identify any points that do not fit the general pattern of ◦ Identify unusual occurrence
behaviour (i.e. outliers).
 Disadvantage-
◦ lacks objectivity criterion for choosing the best fitting line.
 The line chosen should be the one that appears to best fit the ◦ quality of cost formula depends on the quality of subjective
points. judgment of the analysts.
◦ Best fit means the line to which the data points are closest.

 It use only highest and lowest observed values of the cost Assume the following hours of maintenance work and the
drivers within the relevant range. total maintenance costs for six months.

 Steps to calculate the cost function under this method-

◦ Step 1: identify the highest level of activity and its related total cost
and the lowest level of activity with its related total cost
◦ Step 2: compare the change in costs that result from the two levels
to determine variable cost per unit of activity

High Cost – Low Cost

b=
High Units – Low Units

◦ Step 3: Using either the high cost or low cost, estimate the total
fixed cost (a) by subtracting the VC portion from the total cost.
◦ Sept 4: Determine the cost formula

The variable cost per hour

of maintenance is equal to
the change in cost divided
by the change in hours.
Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)

Total Fixed Cost = $9,800 – $6,400
$2,400
300 = $8.00/hour Total Fixed Cost = $3,400
The Cost Equation for Maintenance

Y = $3,400 + $8.00X

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 If sales salaries and commissions are $10,000 when 80,000

 Advantage: units are sold and $14,000 when 120,000 units are sold, what
◦ Objectivity is the variable portion of sales salaries and commission?
◦ Allows a manage to get a quick fix by estimating a cost a. $0.08 per unit
relationship using only two data point b. $0.10 per unit
c. $0.12 per unit
 Disadvantage: d. $0.125 per unit
◦ Ignores all cost observations other than the observations for
the lowest and highest activity levels.  If sales salaries and commissions are $10,000 when 80,000
units are sold and $14,000 when 120,000 units are sold, what
◦ The high –low points may be outliers (extreme observations is the fixed portion of sales salaries and commissions?
which arise from abnormal events) a. $2,000
b. $4,000
◦ May not reflect true cost relationship in case of special c. $10,000
agreement or contract
d. $12,000

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 This method is a more sophisticated approach to estimate costs.

 A regression equation:
 LSRM determines mathematically the regression line of best fit.
◦ identifies an estimated relationship between a dependent
 It is a more objective and precise approach to estimating the (i.e. cost) and one or more independent variables (i.e. an
regression line than the scatter graph method (the later fits the activity measure or cost driver) based on past observations.
regression line by visual inspection).

 Simple regression:
Unlike the high-low method.
this method uses all of the ◦ when the regression equation includes a dependent variable
data points to estimate and only one independent variable.
cost. The goal of this method is
to fit a straight line to the  Multiple regression:
data that minimizes the ◦ when the regression equation includes a dependent variable
sum of the squared errors. and two or more independent variables.
The regression errors are the vertical deviations from the data
points to the regression line.

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 Types of Relationships between dependent (Y) and independent

(X) variables:

 Direct vs. Inverse

◦ Direct – where X and Y increase together
◦ Inverse –where X and Y have opposite directions

 Linear vs. Curvilinear

◦ Linear – where straight line best describes the relationship
between X and Y
◦ Curvilinear –where curved line best describes the relationship
between X and Y

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 To see how reliable potential cost drivers are in predicting the
dependent variable.
 Three tests of reliability can be applied:
◦ The coefficient of determination,
◦ The standard error of the estimate, and
◦ The standard error of the coefficient
 The Coefficient of Determination (r2)
 r2, that is a measure of the goodness of fit of the regression
line to the data points.
 It measures the extent, or strength, of the association between
two variables (X,Y).
 It indicates how much of the fluctuation in the dependent
variable is produced by its relationship with the independent
variable (s).
 r2 varies from 0% to 100%, and the higher the percentage the
better. An r2 of 1.00 indicates that 100% of the variation in the
dependent variable is explained by the independent variable
(s). And if an r2 value is 85% then it means that 85% of the
variation in the dependent variable is explained by the
variations in the independent variable(s) and remaining 15% is
explain by other omitted variables.
 Conversely, an r2 of 0.0 indicates that none of the variation in
the dependent variable is explained by the independent
variable (s).

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Correlation Analysis

Coefficient of Correlation – is square root of coefficient of Negative Correlation

determination (i.e. r2 ).
r approaches -1
•It reveals the direction of the relationship in addition to the
strength of the relationship.
•Since square root can be negative, the value of the coefficient
of correlation can range from -1 and +1.
Hours of Safety Industrial Hours of
Positive Correlation Industrial
Training Accidents Safety
Accidents
Training
r approaches +1 No Correlation
r~0

Machine Utilities Hair

Accounting Hair Accounting
Machine Utilities Grade
Hours Costs Length Grade Length
Hours Costs

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 Q. How do we know what to use to predict cost?

◦ Look for statistically strong relationship
 Must be logical
 Look for relationship between variables as these can
confuse the relationship
◦ Interpret a correlation analysis
 Closer to 1 the stronger the relationship

Sales Advert. Outlets Hits

Sales 1
Advert. 0.411256 1
Outlets 0.213344 0.010491 1
Hits 0.913775 0.06123 0.200803 1

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