CHAPTER 10 SYSTEMS DESIGN: ACTIVITY-BASED COSTING AND MANAGEMENT ACTIVITY-BASED COSTING “The mos dificult tsk in computing assure unit cost Vis in determining the proper amount of overhead esto assign co each job unit of produto service resivity Today, accountants reoagize that manafictring and providing services are rele activities, Thus, they diet ataton to the cost ofthese setts. The civ. tsed mange syn ns rece consumption othe eis 8 ‘company perf and ost the activist products oF customers. Activity ‘sed management ures actvty-baed costag (also called transaction-nsed costing to measure and contol hese relationships Activity: bead costing (ABC) bs been developed in response tothe manager's need for more accirate product coats 6 make them more loilly computitv. AIC helps managers identify nore clearly theosts involved in manufacturing ‘product proving a service and thereby provides more xccurate wait cost Information on whic wo base pricing and othe decisions Activig-based costing (ABO) is coming method that i designed 0 provide ‘managers with com information for sates and otber decisions that potentially affect capacity and therefore “fixed” cor, ABC is ordinarily used as a Sopplement to, cher thin as & replacement forthe company's usual costing Most organization tht se atvy-boted costing ve evo costing systems ~ the official costing system ta i ved for preparing external financial reports land the aciviy-bsed costing yaton tat sed for internal decision making and for managing tvs, ig Actviy-Based Costing end Manaement _ 397 ‘Advantages and Limitations of ABC ‘Activity-basd costing provides several benefis tothe manager, namely 1. More accurate product costs 2, Beer dta for decision making 3. Tighter cost contol ABC has ako sever! limitations. the chief of which i the difficulty and high ‘oss involved with gathering data relating wo activity centers and cost drivers. Design of an Activity-Based Costing System “The steps o activities required in designing’ ABC sytem are 1. Progess Value Analysis (PVA) 2. Mentfying Activity Centers 3. Assigning Costs Activity Cemers 4. Seleting Cont Drivers ‘Step 1. Process Value Analysis involves the flowing sep, 4) Analyze stivtes required to make the prodoct of perform the Service. This canbe done through he preparation of lowchar. Aetiling each in the manufacturing process from the receiving esi il np i eae a This requires walking tough an operation and document every activi Snel at well ws theme inilved. Ansty {is any event or tamuction that cout driver = that, eases the incorence of cost nan organization, 1b) Casi cach activity as vlucauded or non-value-adde. ©) Meaty ways to either edace or eliminate the non-val added‘Systoms Design: Aetrigy Based Costing and Management 399 chp i ital ap ges eee ola oe aan en tee ee Gee re ae ee oun pale) Pee pee eee “The goal sto rode or eliminate the nonae added stvites. Sep 2 dentitying Activity Cotes ‘An activity center can be defined part ofthe production process for which management wants a seperate repoting of the cost of the setivity involved. Generally the levels of activites canbe elssifed int fur a follows: |. Unitlevel activites, which ave performed cach time a unit is produced; 2. ath-tvel activites, which ar performed cach tie ebatch of ‘ds is handled or processed, 2. Prodactlevel aetites, which are performed as needed to ‘suppor the production ofeach different pe of product nd 4. Facilp-lerel atte which simply sustain fail’ general manufturing process. Step 3 Assign Cost o Acsiviy Cantars Assign costs tothe activity centers where they are accumulate ‘while waiting tobe applied o products. Cost tat are traceable to ‘he setivgy center should be assigned directly to activity centers, Other costs shared by two oF more activity centers should be assigned according to some cost river that conto tho wsiliation of the coats invlved ‘Step 4 Select Cost Drivers This involve assigning costs from the activi center to the prt using appropiate cost drivers. When selecting a com driver, oe rast conser the following factors 1. The ease of obtaining daa relating to the cost driver 2 The degree to which the cost driver messues actual consumption by products ofthe activity involved Figure 10. shows examples of Activity Centers, Cost Drivers, and Traseable Cont Figure 104 "ay Goes Coat one Taceas Go Neciesrated xis, sce he owe Sqrecmay ong’ Uberous trance conte Lbeemsachiien, Sn er including rge bens Depreciation of generale ‘machines sn caper ossacai salar overt ‘aC coaoren Tron Gove Purchase com proswoshg Number far rosea’ Circa corte Producion ona Nmber ef mati recsit. Stppie snauned precneeng Pounds ofmelealnended Lab se conte Exupren ees ember of sets {ie col ohne mater ‘veer ncn Hour ofaship be Dypresaton tofice setup isynapecten Noms tmapectons Sra mater nea Hours ofirepeckr ime ""eaupment400 _Chaper 10 ‘eke ons Coe Orws Tracane casa Poreineny Joust tesing wie Fane Sdnmitaron cons M Newoeretpettpes Purscaryig cont Prod So Housefdeoun te Prof engrorng costs NinBe' ot engwernp Daag con ‘changers IV, Facttyeve Atte oa one Troan cnate crne ure Pan manager ares tisenowre Pont dopeencn Nemberoferpoyees Proper mee rca ‘food courd Fone sums Hee ronna ime ‘otn Enos ray ot ~The sont of come of nao aces may e acoabe in par se ety eve ano Dot te’ eat caress taunt ee produc eval ara Bach eve! Peco! ‘SGricon ana arin oy bo Such an ty ustrative Problem 10.1. Manuticturing Applications of Actvity-based Conting Luzon Company manufactures 4,000 units of Prodvct X and 20,000 units of Product each year. The company currently uses direct labor hours 9 assign averhead cons o products, Product X requires 25 DLH and Product B requires 2.0 DLN to produce Presently, Luzon Company uses plantwide overhead allocation rte. Using this method, the ni product os Product — Product B Direct materi 36.00 30.00 Direct abor 1750 4.00 Manufacturing ovetead 25 DLHx PIS/DLH, 45.00 20DLH x PIR/DLH 36.00 “otal nit produc cost ix aon toms Design: Actviy-Based Costing anc Management 401 “Management at Luzon believes that overheed costs are actually caused by the Following ive sctiviies atv, Traceable Cost Machine setups 7255,000, Quai inspections 160,000, Prodveton orders s.000 Mechino-bours worked 314000 Material exits 0.000 Total eao00 “The following transaction dat have been compiled by the management of Laon Acsiviy Total — Product A Product B Machine setups soo 3,000 "3,000 ‘Quality inspections 5000 S000 3.000 Protion oners 00200400 ‘Machine-hours worked 40000 12,000 28,000, Material recep 7013060 ‘These data canbe used to develop overhead nes fr each of the ive astivities Aettey Cons Product A Prodct Machine sere 7255000 "5000 P SI.DOpersetup (Qaiyiapeeione 160000 8.000 20.00 perinapection Production orders 81000" 60013500 per onder Machinetous worked 314.000 40000785 per hour Mater recep 90.000 73012000 per esi “The activity based overhead rates that were just akulted canbe wed 0 asign ‘overhead costs to Luzon’ we produ, Product A Aetity ‘ABC Rote Tronsactions Amount Machine setups Psi0o 3,000" P3000 Quality inspections 2000 5000 10,000 Production orders 13500 200 27,000 Machineshours worked 785 12,000 94200 Matra eceips| 12000 150 18000 “Tonal overheaasigned 392,200 umber of units produced =.000 (Overhead por unit BsRos402_Chepror 10_ Product B Activity ‘ABC Rote Transactions Amount Machine seine Psi00 2,000. P102,000 Quality inspections 20.00 3,000 60,000, Prodiction orders 135.00 ‘400 54,000, Machineshous worked 78528000 219,800, Materia eceips| 12000 ‘600 72.000 “Total overhead assigned 507,800 [Nomber of ents pda = 20,000 Overhead pr unit bas ‘Now compare the unit product costs ting the old costing system and our ABC system, Casting Meth! Product — Product B Activiy-based costing PIsiss P6039 ‘Od costing system 9850 $0.00 Iustrative Problem 10.2. Activity-based Costing Application 10 ‘Merchandising Company Essence, Ic specializes in te distribution of soap products. Essence buys fiom manufacrers and resell each ofthe diffrent markets: General supermarket chins 1b. Drugstore chains Small convenience stores Dante Cruz the new controller of Essence, reported the following data for September 2018: General ‘Smelt Supermartet —Drgstore Convenience ‘Chains Chains ‘Stores ‘Average revenue pe deiner 30:900 10,500 isso ‘Average cont of gods sold pe delivery 30,000 10,000 Pi.s00 Number of delivers 120 300) 1900 “Systems Design: Activ Baved Costing aml Management 403. For many years, Essence has used gross magia percentage (Revenue - Cost of s00ds sold) » Revene] to evaluate the relative profisbility of ie different troupings of customers (distribution outs), Cuz recently aftended 4 seminar on sctivig-baced costing and decides 10 oneder using iat Essence, Cri meets with all the key managers and many Staf members. People generally agree thi there are five Key activity areas Essence: Activity Area Customer purchase order processing Purchase orders by customers Coat Driver 1 2, Lineitem ordering Line items per porebase der 3. Store delivery Store dalivenes| 4 Cartons shipped wo stores Cartons shipped 10 @ stor’ per delivery S. Shelfstocking at cusomer stores Hous of sel stocking Each customer purchase order consists of one or moe line items. A in item represents single prodect (such as Oil of Olay soap). Each sore delivery fatal delivery of one oc more cartons of product to a customer. Each product delivered in one or more separte cartons, Eesonoe ea eae cartone directly ‘onto display shelves ina sore. Currently, there is nochange for his sevice, and ‘otal eistemers use Estence for this stv ‘Te September 2018 operating cots other than cost of goods sd) of Essence sre P301,080. These operating costs re assigned tothe five atvty areas, The ots in cach area andthe amount ofthe cost driver nite ted in that area for Septemberareas follows: Total Units of Cost Total Costs in Driver Used in Activity Ara Soplember 2018 _ September 20 T, Castomer purchase order processing 30,000 2,000 orders 2, Line-item ordering 63.840 21,280 line tems 3. Store delivery ‘7.001420 ‘sore 4. Cartons sipped to stores 176,000, 5. ShelEstoeking at customer stores 0.240, P5o1,080= a ‘Systems Design: AetiviwBased Costing and Management 405 tes bac ir Sapenbesielnte en ine ‘The gross margin of Esenee, Ine wa 496% (PA3BOD0 = PRE,000, The Genet Sma Cpetig cme mario aes ns as SSE 6920 PERO), Beeps Dense Coma Ginter Retrt2 Te preter ach “Total number of orders 0 360 am |. Customer parchase order processing, P80,000 + 7.000 = PAD per order vragen ine ems 2 theta gemiag mow = 3.50 © Pa reineen torent “ 2 10 5 Sec i= 1409 = beter Tudlnmberofsoredsneies 3 3001.00, 4 Comoatypsinates Patno7a000 rere oes mmber cars $ Sovaeite restos > open ‘ppd prscrcelney 300 » 6 Avera manera eet} i any betcha ir Se ‘betcing per store “ a Goer Smal Sein 30 Y eee ” Crome Chie pa 1 Comer cien TT Compt te Seb 2018 rome pert och tee ne sie i Garson mers Wha thc opning cone of sss? 7 CaLeaiuae ee 2 Campa te Some 2018 per nt cos irate otc ofthe Fe Porgonteosin sy sr Seo sim samo e500 ong he oping income of ach dba mah September 3. Saye < case ie the reals, (F302 120, 300, 1000) 500 15.000 50,000 2OTE wing tsb eosin infra Comment on ee 1 ee ‘ac nw i ae svabe we sce noma? poor aerate 4, Dante trhaeng Cur woul ice In apie ie a Setter oe ane ois oping cos of 0180 a thine acy a 5. gotancne ect 3200x065 soc a Toxo 44@ gm le ee as 28 a Resumen ee isa “Ts ae oyeatilg crm tent Sparta gure Comet a = Ce Ce Oa toed oe a raping coo rismiow ret a Peart oon Gecotimos ou’ Samnind amoung Lindon eonote — raonine iso Pisiozon wasnt Semi ak : Comoteetsot "Sipoow “Sootem "Lama "tao Capea ies ‘Grossmann Tosow 150000 ~“1ann00 ~3eao0 ceumen am gine _ Sty cent rom ane 80m ee ate ee *2as10« 20,1050 x30; 19020) ope ee (P0000 10; (0000x301 801000) ten 131% 25% a3‘Sjstems Design: Activiy-Based Costing and Management 407 $06 _Chaper 10 ne 5 ‘The rnking of the hee mares ar: in rea Margin ng Orang Ince 1. SmallComenene Storer 909% 1. Drugstore Chas 250% 2 Dru Cais 40% 2 General Sopomaet Chains 131% 5. Gone Supermarket Chee 29/5 3, Small Convenience Stores 03796 ‘The activi: hued ans fens hhh bo the Small Coverence Stores ws ‘lige umouor of Essence snes per eve peso har the oe Wo Mark ‘Terai of he opeaing costo even across he he orks = General Supermarket Chas ———LINE_—_(P 59.240 2 3.708.0) Drugstore Chins 220m (P9240 P3,150000 Small Covenence Stes 7% (Pr72600 + P1.380.000) This ya lai tsaton of te mann that “al revenbe pesos ae ot cet ca” ogre: Probl th may be encountered inasiging css | Choosing the appropiate cnt ives fr each area. The ase ves a cost Shiver ech Chosen activity aren Homers ety avec ine er ‘Minamoto ves woul aco, For example nt llstere elves are Tana ey to ke, dopacing on putng sally, acosxiy of Oe omg spce tothe delery poi lela, nt al exons are oly ery t ler = ir weg oF Thelybelage component ae ‘Bos hat can ary ars ean pe 1b Developing reliable deta bate onthe chase cont ever. or same he, ‘Sich atthe numberof eres and the mber of le Hens, hs inlroation aly wold be sien machine edie frm aa high eel of accuracy. Unies the deivey percnnd have tan-belé comptes at they te in Syucatic ay, ets of seleocking tie ae lly to be url ‘Advance informacion echacog ket wll ever poles in thse over Deciding howto handle cot that may he common acres several acs Fee example, (3) sre delivery and (8) eatons shipped to sores avs the ‘Strmon cot fhe sane ep. Some oraz way seat (3) ae primary ‘Sev and atte To 4) only tacremesal cst. Silay, (1) order roceting (2) ne em ondeing may hve comon eos, Choice ofthe tne period to compute cot rates ares driver. Cruces thier mies om only bss (September 2018). He may want o eon ting Longe tine pevods tat muy be les feed by saxon o random ‘acne comand Behavior acrs re kl ob a chalerge Ce. Ne mrt hoe e who sili fn Sal Convio tres acout that hy have ‘re ess ofa han previ tou ustrative Problem 10.3, Actvity-based Costing Application to Trading Company “Foods R Us" Supermarkets found that its ABC analysis provided important insights. extends the analysis to cover thee more prodct lines - breads & ‘pastries, jules, and ffozen delights. Tho revenues, cast of goods sol, store ‘Suppor costs ad activity area usage ofthe tne product ines i fellow Brats & ‘Frosen Pastries sucess Financia data Revenues 57,000 P63.000 2,000 (Cost of goods sold 38000 47.000 35000 ‘Store support 11400 14,100 10,500, Activity are usage (cost diver) ‘Ordering (purchase orders) 20 2s b Delivery (elvis) 98 36 28 ‘Shelfstockng (hours) 13 166 4 (Customer support ems sold) 15,500 20,500 7.900 “There reno bot retums for any ofthese thre poet nes, Reouinen: 1. Use dhe previous costing system (support cot allocated to products st the rate of 30% of cost of goods sold) 10 compute a proctine profit reper for "Foods R Us" 2. Use the ABC system (ordering at P1OD per purchase order, delivery at P80 per delivery, shelfstacking at F20 per hour, and custome support at PO20 er em sold) Yo compute productline profitability report for “Foods R. Ue 3, What new insights does the ABC stom in requirement 2 provide to “Fonds Us" manager?”408 Chapter 10 Soluion: “Pood R Us" Supermarkets Reuiemsa “he revi costing sytem paste lowing: Broads Pauriss —hkes Revenses P20 63.00 3500 47000 Lisa 4.100 Zeeao0 ZéLo0 Exon Eon Operating income +Reveies 33% 3.0% ewuiconen.2 ‘The ABC system ports he following: Brscte& Patristics evens PS1om 66.000 Cons ‘Cet of gee sid sooo 47000 ‘Ordering 3002500, Stelfsocking 30 3.20 Cistomer ppt 3.i00_3100 "Foul eas Ss S900 COpersting eae iam 2am Operating income + Reveoues 24056 5.08% “Tete civics re ed on he allowing: ‘Onerng Delvery Shetetiking Caste appr Bronte & Cou losin Rte Pastries 100 pr puree ore 30 HO pr dlery 8 20 jes hour sh Pb per tem soit 15.500 P00 35.000 2.50% Frasen Delgh 35000 1300 ces 6 2nst0 ‘29000 Tat 20000 300 12980 7860 90% Datghs 3 % FY 7500 iy-Baved Costing and 409 ‘Systeme Design: Ati ‘Therarkings of reds in ems of ei poiahity ae: Previous Costin Sytem 400 Stem 1, ris peace 13538 Fromndelghs "2.93% 2 Fromndeliphs 1250 uke ‘508 3 Ios saa Breads pases 246 “The pcentagervene, COGS, and att cots fer ach ot are: Breads Prosen Poavier er Deir Total: Reverses Sees 08 ono coos Me 373816 tano0 ati rae Oring au 3678920000 Detvery @s 2m 1728 ea Shel stocking 80 4s aat “ten Custmersippon 353146717990 Requirenen 3, “The beads & pases te drops sical in prftabiliy when the ABC i we Alou conse 31.57% o COGS, ue a pherYo otal recources nach Acca, epi the high cost deliver acy aren In com, ze ligt draws much lover of taal eouces sed in cach activi ae than 6 ‘eft COCS. Hence, under ABC, fen delights much mors pofiabe Foods R Us” Sapematets may mato explore way oneness of fazer Be Cost Eximation 448 ‘Regression Analysis Method Regression analysis uses ll eailabe data estimate the cos function, tsa Statistical method that measures the average amount of change inthe dependent ‘variable (costs) that is associated with nmi change of an or more independent variables (cost drives such as number of unite produced, machine hour, ef) ‘Simple regression anys estimates the relationship betwen the dependent variable and one independent variable; while multple regresion malls ‘timate the relationship between the dependent variable and mulile independent varlales, Multiple regresion is ued when the dependent vere +» (iy cost is caused by more than one factor. Although adding more factors ot ‘varies make the computation more comple, the principles involved are the sme as inthe simple reayession analysis Simple regression analysis asee the following estimated cost faction or ution Yeatox hile mle regression analysis uses the following equation: YaatbXit bX te wher: y coast be predicted dependent variable} X.Xi.Xoj = independent variables om which the predicon is tobe based Fixed cos simated coeficens ofthe regression model ‘residual term that inlads the net foc of ether factors notin the model and measurement ears inthe dependent and independent variables ‘Least-squares Regression Method bbb A statistical technique whch soften usd in separating mixed costs ino thee Fixed and variable components is lar-squares regression. Basialy, ine of regression is determined by solving two simultaneoes linear equtios which are based on the condition that he sum of doviations above the line equals the sum of deviations below the line446 Chepeer 11 i “The equation forthe determination ofa saight ine is Y= atox “The two linear equations tat are used to solve for a and b are: Equation (1) EY Equation (2) EXY Where Y= Touaeost a= Fhedeost b= Varinble costa X= measie of activity (¢g hours, units) N= numberof observations = Greok leer signifying summation ‘Using the data in lstrative Problem I Predictors, lc), determine the variable cos tte and te ied cost under the Least squares regression method. Solution: Predictors, Tne (Least-squares regression method) x r x 2» Po ‘me o 0 a 3m FA n ‘vo x ° = ° “o ° to rH ‘o 2 ita 2 “ut xa ry 1601 eutan (1) 1000 = 100 + 3500 Ewan) 29800 = she} 1430 “To etm one uo (nd solve fb py Eaton | by 35 (la common itn and speach nm Eouation 3 om Eaton 2: (Cast Estimation _447 qution@) 38400 = 3500+ 14,5008 uation @) [yenion 1x35) 35000 = 3500 = 12.2506 ‘sa0= 22505 Vorole contre = ERO4 Tosole fora (Fined cos subi he ake of bo Eatin 1. Tham, 10 + 350,200) 108 26 0 o = Eo Seattergraph or Visual ‘This isa rough guide for cost estimation whic plot the coe agsinst past activity levels. These activities are refered to as predictors (X) of independent variables, oF the rihthand-side of a regression equation, The cost to be ‘timated may be alle the dependent variables, (Y) or the lefthand sie of the regression equation. The line is drawn, insofar as it posible by visual ment, 50 thatthe distances ofthe observation above the linear equal to the stances’ of the observations low the lie repression represents the dt a8 The sep involved inthe se of Seaterpraph are a follows 1. Ona grph, plo actual costs (on vertical axis) dering the pera under study against the volume loves (on horizontal ax). 2. The Tne of best fit is then drawn by visual inspection ofthe pled ins, the line representing the tron shown by the majority of the pois. 53. Tie fined cost is estimated by extending the left end ofthe line tothe esta ax 4 The variable cos rate or slope of he cost ie is determin by dividing the ilferece between any two level of activites by the differen coats comesponding tothe stme lve of ectivities Using the data in tustrative Problem I (Predictors ne.) determine the variable ‘os rate and the fixed coat under the Seaterraph metho,448 Chopter 11 gb te Aare Solution; Predictors, ne, onder he Seatergraph method) ae cee 0 NN m0 ( 10 |-———_y ” © os ° Say Tw! - 5 9 : @ 0 20 0 x 3 ww HouRs Pu10—P70 Vat conte oy = PUO=FID - ee = raperbowr Fina cost 0) P90 which wee he tn of epson eins. Coxe Estimation 449 Strengths and Weaknesses of Cost Estimation Methods Eich of the methods discussed have advantages and disudvanages, When ‘deciding which w use in practice, the cost of eich method must be compared ith the benefis. The strengths and weaknesses of these methods are Sumnained follows Mad Seg Wess [Account Ansys Provides dealed expen Sbjeave alysis fh cot tevin each account lngnerng Method Basson sus of what No pray wt faurecoss suid be wien he py elton rar tan wa pcos Between ipa and outs ase been inet Highow Maid ‘Simple ap Uses nly vo dts points ‘which my ot rode Scateyaph Method User al he bsvations of The iting ofthe let he cat a, erations sajetve Rett ee t0 Ditto do whee tndentnd an apply. several ndopendet ‘rales ae tobe ed Leatsqures Regression Usesllofthecbsnadons The regression mods Method feet oa, reo tht several ‘Thelin esti Fito eanely tt rpons fe oaervata bested ete eae o ‘Nimo othe ondnet bv ortofte int te hervatins i pov Relive ety tose wit sexes ‘opted alee450 _ Chapter 11 2 : Correlation Analysis Inthe process of estimating and controling costs, management must evaluate ‘ncther or not the factor selected fr estimating cost behavior i suitable fr that purpose. Costs mayor may nt reset with changes in he factor selected for cost analysis. The degree of correlation between the level of stvity and costs may be measured by te “coeicient of determination”, most frequently designate as ‘To comput for this the equation is ae -__ (esintdcdine n deviin manedfom of ae i ‘Tandard deviation messed from he average ofa Ga 4. Esinated condor stndard devin mesure rom thee frees: Ve Tine of egesion cost ober of eso ia x Sanda devition mesure fm vege ofall at: V Be Sverags cost numberof ems ofa y ¥ Ir expressed as «percentage wil be rolatvely high, the correlation is good. It means hat the costs follow the factor selected Using the data in Illustrative Problem I (Predictors, ne), evalu the degre of Corrlation between the direct Iabor hours and suppliers cot by solving for Por ‘fein of determination, as stimaion 451 Por. gase wae Renee i pene 0007 23 Conctston: There i apparent a vr high degre of cnelaton Between ours of peated supe cts Compassion of Exim! Coons Send Deviion Mestre fom the ne of Conn ona Peon fines aed tomegtoc® Doors “Smee : i 5 mp paw dom ne ® 0 tem (3m ae @ ‘3 ‘sos (My to S % aoe ose = > Se (sam coe ° io vio fgg) ou = 8 tio “oad eae io o ‘om ae rt = 0 Ee a a woo cna iia © P2R6D + (P204x No. of Hour) [sited Condon! Sundar Deviation =A52_Chapter 11 Schedule I. Compution of std ovinonmeasued fom average ofa dt eine ewalCon Avg Coa” Devons "Sed oe ¥ rr ae tn Pleo 350 via i ° co He ito so fd GS 8 2 &® e ° te i se o i a uo to 0 00 i to » 0 captan eee " santas winin = fg - ‘Coat behavior models are correlational rather than causal n a eausl model, X {eau in Y, while corelational mode, eccurtenees or movements in Y ae {Svocited with occureoces or movements in X mot inort sen etinting cst son (eno) into dtrming Tene cider lansip exe fetwern the cot ver (X) and Haan cane an tes ratosip might we sre way 1. A pliscalcelationship exists between costs and the eos driver. “Example: To prodace more wits of product requires more materials which es in higher materials costs. 2 Causeand-effec the vee fom a contractual arrangement. ample: Under the metered system, the mumber of phone-minutes ted the cout driver of the telephone fine cost. Cost Estimation 453 3. Logic and knowledge of operations can establish cause-and-effect, Example: When the member of component ports is wed ara cost diver (of design cats, « complex product design with mamy component parts will incur higher design costs than «simple product with fow component parts. A high correlation or connection between two variables may not mean that ther ‘vatable causes theater. high correlation Between two variables, X and Y, ‘may not necessarily imply cause-and-effect bt may merely indice thatthe variables move together. Its posible that X may cause Y; X and Y may interact; both may be affected by hid variable Z oa correlation may be due to chance. No conclsions sbout cause-and-eflest may be warranted by high ‘corelatons. For example, higher matecals costs and higher labor costs ae caused by higher production. Materials costs and tabor cost ae highly corelated but either eases the other. A vital aspect of cost estimation is establishing economic plausibility. Only a true causo-andeffect relations conomically. plausible relationship between costs and. their cont drivers, Economic plausibility gives the analget confidence. tht the estimated relationship wil epeately appear ner smiles of dat. ‘The Learning Carve Theory ‘One assumption ia estimating cost bobavior i tha the cost ofeach input isa Tinear function of the quantity signed. However, the relationship between ‘costs and independent variables ie not vay liner ‘As 2 worker performs n certain tsk, a systematic, noniner reatonship has teen found. ‘The learning curve theory, alto caled the improvement curve ‘theory is based onthe proposition hat as workers gain experiance in task, they needless time io complete the job and productivity increases, Case studies have shown that lerning often follows a patter: asthe cumulative ‘umber of units manufactures is doubled the cumulative average time that i ‘ukes to make a unit is advised by a constant perentage. I the rate of reduction 120%, the leaming curve is refered to as an 80% curve, The leaning curve is ‘8 power function, and if ploted on double logaithmie paper will appear ms a Ssaight line.