Lecture 2: Cost Behaviors, Drivers and

Estimation

ACC2706
Managerial Accounting
Semester I, AY 2022/23

1
 Learning Objectives & References

Learning Objectives
1. Cost drivers
2. Cost behavior patterns
3. Cost estimation and cost prediction
4. Big data, data analytics and visualisation

References
Chapter 3
(*Regression analyses for cost estimation will be covered, but not
required for the exam.)

2
 1. Cost drivers

• A cost driver is an activity or factor that causes costs to be

incurred.

• Prior to the 1980s, cost behaviour estimates assumed that

production volume was the only cost driver (i.e., volume-
based cost driver). Volume-based cost drivers include units
produced, direct labour hours, direct labour cost and
machine hours.

• More recent viewpoints recognise that there are cost drivers

other than production volume, i.e., non-volume cost drivers.

3
 Types of cost drivers

Activity-based approaches classify costs and cost drivers into four

levels and not all cost drivers are volume-based cost drivers:
• Unit level costs
• Use conventional production volume-based cost drivers.
• Batch level costs
• Relate to activities performed for a group of product units, such
as a batch or a delivery load (e.g., setup cost by batch)
• Product (or product-sustaining) level costs
• Relate to activities performed for specific products or product
groups (e.g., product design cost)
• Facility level costs
• Non-specific costs which cannot be attributed to unit, batch or
product levels but are attributable to the manufacturing facility
(e.g., facility rental and facility manager salary)
4
Example - Bakery (Breadtalk)

5
 Selecting the best cost drivers-considerations

1. How detailed should the analysis be?

Increasing the number of cost drivers will increase the
accuracy of the information but would be more costly.

2. Timeframe for the analysis – long term or short term?

Cost behaviours and cost drivers can change over time.

3. What resources are needed to gather the data?

The costs and benefits of selecting each cost driver must
be assessed.

(cont.)
6
 Selecting the best cost drivers
4. What are the purposes ?
• For cost prediction or cost management.

• Cost drivers that are used to predict costs may differ from
cost management (part 3 of lecture notes).

• Cost management is the identification of root cause cost

drivers and managing them.
• Cost Management: 'How to reduce the number of batches’ to
manage machine setup cost.
• Solutions: Combine batches, increase batch size, reduce product
diversity – Lego
(https://www.channelnewsasia.com/watch/inside-storm/lego-
group-1598121)

7
 2. Cost behaviour patterns

• Cost behaviour
➢The relationship between a cost and the level of
activity (or cost driver).

• Cost behaviour patterns include:

➢Variable costs
➢Fixed costs
➢Step-fixed costs
➢Semi-variable costs
➢Step-variable costs
➢Curvilinear costs

8
 • Video on automation of Bread factory
Shifting cost
structures in • Observe the direct materials, type of workers
modern business involved and the different value-chain activities
involved in the multi-step production of bread.
environments
 The Bread Factory (Gardenia)

DL
DM • What are KGB’s fixed and variable costs?
• Machine operators
• Flour
• Sugar
MOH
• Baking Powder
• Machine depreciation
• Vegetable Oil
• Factory Rental
• Salt
• Quality Checks
• Butter
• Factory Supervisors
• Milk
• Machinery Tools
• Packaging material
• Machine lubricants
 Shifting cost structures in modern business
environments
Less production costs now vary directly with production
volume as:
−Automation has led to less reliance on direct labour and
more reliance on equipment (more fixed cost).
−Some employee wage agreements specify fixed salaries.
− A stable workforce (more difficult to vary the number of
staff as activity level changes).

Hence, a larger fixed cost component in total cost

structure.

11
 Variable costs

• Variable costs change in direct proportion to changes in the level

of activity.

• Variable cost per unit remains constant

• The variable cost per unit is the slope of the cost line in the
following cost function:
Y = a + bX
Y : Total Cost
a: Fixed cost
b: Slope or variable cost per unit of X
X: cost driver

12
Variable cost: direct material cost for
wholemeal rolls (Gardenia)

13
 Fixed costs

• Fixed costs remain unchanged in total but fixed cost per unit
changes.
• Fixed cost per unit does not reflect the way that fixed costs
actually behave.
• Contemporary approaches (for example, activity-based
costing) track these costs to activities to find a cost driver.

• Step-fixed costs
• Remain fixed over a wide range of activity levels but
change outside that range.

14
Fixed cost: premises cost (Gardenia)

15
Step-fixed cost: shop mangers’ salaries,
(Gardenia)

16
 Other cost behaviour patterns

• Step-variable cost
• Increases in small steps instead of continuously, that usually
include inputs that are purchased and used in relatively small
increments. E.g., batch packaging material.

• Semi-variable (or mixed) cost

• Has both fixed and variable components.

• Curvilinear cost
• Has a curved cost line.
• Activity levels impact the marginal cost.
• Often semi-variable cost pattern is used to approximate
curvilinear cost.
17
Semi-variable cost: cost of operating delivery
trucks (Gardenia)

18
 Step-variable cost behaviour patterns

Some costs are nearly

variable but they
increase in small steps
instead of
continuously, that
usually include inputs
that are purchased
and used in relatively
small increments. E.g.,
batch packaging
material.
Curvilinear cost: electricity cost (Gardenia)

20
Approximating the Variable Cost Function

21
 Cost behaviour and the relevant range

• The relevant range is the range of activity over

which a particular cost behaviour pattern is
assumed to be valid.

• Outside the relevant range the cost behaviour

pattern may not hold.

• For example, the linearity behaviour of cost versus

activity level can be observed within the relevant
range of output of 1,000 to 10,000 units.

22
 Quick Check ✓
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.

23
 Engineered, committed and discretionary
costs
Classifications of costs for budgeting and planning purposes
• Engineered costs
– When level of activity is known, total cost can be
predicted.

• Committed costs
−Cost of organisation’s basic structure and facilities.
− Difficult to change in the short-term.

• Discretionary costs
− Subjected to the discretion of the management.
− Can be changed in the short-term.
24
 Real World Application of Cost Behaviours
- Wal-Mart and flexible hours
Wal-Mart implemented a computerized system that analyzes
data of the working hours and shifts of 1.3 million employees:
- The objective is to move these workers from fixed shifts to flexible
shifts based on the number of customers in the store.
- This helps the company reduce costs and improve customer
service by closely matching the number of sales associates to the
number of customers at different times.
- The cost of sales associates should be considered a variable cost
as the cost object is the number of customers. In contrast, if sales
associates are scheduled to fixed schedules, then the cost would
best be considered a fixed cost.
- By converting a fixed cost to a variable cost, Wal-Mart has
improved its ability to manage the cost.

25
 3. What are cost estimation, cost behaviour
and cost prediction?
• Cost estimation
• The process of determining the cost behaviour of a
particular cost item.

• Cost behaviour
• The relationship between a cost and the level of activity
or cost driver.

• Cost prediction
• Application of cost behaviour to forecast the level of cost
at a set level of activity for planning and control purposes.

26
 3. Cost Estimation
Three approaches to cost estimation:

A. Managerial judgment: Uses experience and knowledge of

the manager to estimates future costs by examining past
costs and identifying factors that might affect costs in the
future.

B. Engineering method: Uses time and motion studies (a.k.a.

task analysis or work measurement) for estimating cost
behaviour. Observation and task analysis of the steps
performed provide data on time needed for each step,
employees required and materials to perform the steps.
(cont.)
27
 3. Cost Estimation

C. Quantitative Analysis of historical data to identify relationships

between costs and activities
• Methods include:
–A scatter diagram plots the data points and eyeballing to detect
a linear relationship.
–The high–low method involves taking the two observations
with the highest and lowest level of activity to calculate the
cost function.
–Regression analysis uses a range of data points to estimate the
relationship between cost and cost drivers.

• Cost formula can be used to predict cost at any activity level

within the relevant range. The relevant range of activity should
be specified for each method.

28
Scatter Diagram Plot

29
 Scatter Diagram Plot
Draw a line through the data points with about an equal
number of points above and below the line. Ensure straight line
passes at least one data point.

Based on the
scatter diagram,
the cost for 1,000
batches would be
about $6,500.

The relevant range is 700-1200

batches, which means that the
scatter diagram provides no info
about the cost relationship
30
outside this range of activity.
 High-Low Method

$7,035-$5,100
Variable Cost = = $4.50/batch
1,180-750

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $5,100 – ($4.50 × 750)
Total Fixed Cost = $1,725

The Cost Equation for Electricity

The high-low method always
uses the highest and lowest
activity level (not the cost) as
the 2 base points to derive the
mixed cost formula.
Y = $1,725 + $4.50X
X : Number of batches produced per
month
Y: Electricity cost for the month
31
 Quick Check ✓
Liner Manufacturing makes a product called ANA-1. The relevant range of
operations is between 2 500 units and 10 000 units of ANA-1 per month. Per
unit costs at two activity levels are as follows: 5 000 units at $14.50 per unit;
7 500 units at $13.00 per unit. Determine the cost formula that expresses
the behaviour of ANA-1’s total costs:

A. Y = $22,500 + $10X

B. Y = $20,000 + $13X

C. Y = $45,000 + $4X

D. Y = $40,000 + $9X

E. None of the above

32
 Regression analysis

• Estimates the relationship between a dependent variable

‘Y’(cost) and independent variables ‘X’ (cost driver).
• Utilises all of the data points to determine the line of best
fit.
• A simple regression line may be represented by the
equation
Y = a + bX
• More accurate than high-low method as it uses all the data
points to determine the line of best fit statistically.
(cont.)

33
 Regression analysis

• Multiple regression
–Estimates a linear relationship between one dependent
variable and two or more independent variables
Y = a + b1X1 + b2X2
• The regression line can be evaluated by:
–How well the line fits the data points.
–Using excel regression, the closer the coefficient of
determination (R2) to 1 means the better the fit.
– R2 above 0.8 is considered a good fit.

34
Least squares regression method:
electricity cost

R2 is 0.949

35
 Practical issues in cost estimation

• Collection of data may be problematic due to

• Missing data, outliers and impact of inflation.

• The learning curve effect may influence cost behaviour.

• Labour time per unit decreases as the labour force gains
experience in manufacturing a new product.

• Some businesses do not use objective technique for cost

behaviour analysis because:
• Limited time and knowledge.
• Data required to estimate reliable cost functions may not
exist.
• Costs of producing more accurate cost estimates need to be
assessed against likely benefits.
36
 Real World Application of Cost Estimation
• The construction industry uses cost estimation extensively,
and in many cases a project cost is estimated directly based
on projected labor-hours, materials, and other elements of
the project.

• Alternatively, the construction cost for a project can be

estimated based upon the actual costs incurred for similar
projects already completed.

In this approach, the management accountant identifies the

several key cost drivers of construction cost, which might be
square feet of space and other similar measures of activity.
A regression is then used to develop a cost estimation
equation to predict project cost based upon the cost drivers. 37
4. Characteristics and potential uses of big data

38

Big Data, data analytics and
data visualisation
Big Data
• Massive data available
due to digitisation and
new tracking and storage
technologies.
• Increasing importance of
using big data for
analytics to draw out
information about
external customers,
government agencies,
markets and
competitors, to improve
decision-making and for
managing internal
operations and
resources.
39
 Data analytics
• Process of examining data sets to draw conclusions about
Data the information they contain, with the aid of specialised
analytics systems and computer software.
and data
visua- Data visualisation
lisation • Presentation of data in a graphical or pictorial format to
help managers discern patterns, trends, relationships and
other complex scenarios embedded in the data.
40
 Summary

• Understanding cost behaviour enables cost prediction for

planning and control.
• Conventional cost drivers are volume-based, but non-
volume related cost drivers are becoming more recognised.
• Costs can be estimated using managerial judgment,
engineering methods and quantitative techniques.
• Cost estimation is fraught with a range of practical
difficulties, and the choice of technique involves a cost-
benefit trade-off.
• Data analytics and data visualisation have become
increasingly important tools in managerial decision making.
41
 Lecture Suppl. Question 1
Pleasant View Hospital of British Columbia has just hired a new chief
administrator who is anxious to employ sound management and planning
techniques in the business affairs of the hospital. Utilities costs are very high in
the department due to a CAT scanner with the following data on utilities costs
and use of the scanner since the first month of the year. The number of scans as
per the data collected is considered by the management as the relevant range
for cost prediction.
1. Using the high-low method,
estimate a cost formula for utilities.
Express the formula in the form Y = a
+ bX. (The variable rate should be
stated in terms of cost per scan.)

2. What is the utilities cost would you

expect the hospital to incur at an
operating level of
a) 115 scans per month?
b) 180 scans per month?
 Lecture Suppl. Question 2

A number of graphs
displaying cost behavior
patterns are shown. The
vertical axis on each graph
represents total cost, and the
horizontal axis represents
level of activity (volume).

For each of the following

situations, identify the graph
that BEST illustrates the cost
behavior pattern involved.
Any graph may be used more
than once.

43
 Lecture Suppl. Question 2
a. Cost of one type of raw material used in production
b. Electricity bill—a flat fixed charge, plus a variable cost after a
certain number of kilowatt-hours are used.
c. City water bill, which is computed as follows:
First 1,000,000 gallons or less $ 1,000 flat fee
Next 10,000 gallons $ 0.003 per gallon used
Next 10,000 gallons $ 0.006 per gallon used
Next 10,000 gallons $ 0.009 per gallon used
d. Depreciation of equipment, where the amount is computed by the straight-line method.
e. Rent on a factory building donated by the city, where the agreement calls for a fixed fee
payment unless 200,000 labor-hours or more are worked, in which case no rent need be
paid.
f. Salaries of a few maintenance workers, where one maintenance worker is needed for every
1,000 hours of machine—hours or less (that is, 0 to 1,000 hours requires one maintenance
worker, 1,001 to 2,000 hours requires two maintenance workers, etc.).
g. Rent on a factory building donated by the county, where the agreement calls for rent of
$100,000 less $1 for each direct labor—hour worked in excess of 200,000 hours, but a
minimum rental payment of $20,000 must be paid.
h. Use of a machine under a lease, where a minimum charge of $1,000 is paid for up to 400
hours of machine time. After 400 hours of machine time, an additional charge of $2 per hour
is paid up to a maximum charge of $2,000 per period. 44