ACCT 3210 Advanced Management Accounting

Session 2 B (Ch 10)

Determining
How Costs Behave
Nonlinear Cost Functions
Learning Curve
 Class Quiz (Quick Revision on
Regression Analysis)
The new cost analyst in your accounting department has just received a computer-
generated report that contains the results of a simple regression program for cost
estimation. The summary results of the report appear as follows:

  Variable Coefficient Standard Error t-Value

Constant $74.79 $16.82 4.45

Independent variable $1,081.76 $215.67 5.02

r2 = 0.75

 Required:

a. What is the cost estimation equation according to the report?

b. What is the goodness of fit? What does it tell about the estimating equation?
 Class Quiz

Answer:

a. y = $74.79 + $1,081.76X

b. Goodness of fit is 0.75.

It measures how well the predicted values match the actual observations. In this case, the
equation passes the goodness of fit test because it is substantially above 0.30 (0.5), the
threshold of acceptance.
Learning Objectives
10.1 Explain and give examples of nonlinear cost
functions.
10.2 Understand the concept of learning curve
10.3 Distinguish the cumulative average-time learning
model from the incremental unit-time learning model.
10.4 Understand and Apply learning curve model
10.5 Be aware of data problems encountered in
estimating cost functions.
10.1 Nonlinear Cost Functions

• Cost functions - not always behave in a neat, orderly,

linear fashion
• the graph of total costs is not a straight line within the
relevant range.
Nonlinear Cost Functions, Examples

1. Economies of scale
 e.g. An Advertising Agency produces double the advertisements
for less than double the costs
2. Quantity discounts
 e.g. Unit cost of direct material decreases with volume discount
3. Step cost functions
 costs remain the same within a narrow range
 increases by discrete amounts as the level of activity increases
 E.g. increases by ‘lot sizes’ instead of units
Nonlinear Cost Functions, Examples
4. Learning curve
 labor-hours per unit decreases as more units produce
as workers learns and become better at their jobs
5. Experience curve
 Broader application of the learning curve
 Extends to other business functions e.g. marketing,
distribution and customer service.
Nonlinear Cost Functions, Illustrated
Examples of Nonlinear Cost Functions
10.2 Learning curve
 Theory & Concept - Simple
 Perform tasks of a repetitive nature, we learn, and
productivity increases.
 Can do better not only the second time but each
succeeding time until no more. Thus, the time we take to
complete subsequent tasks reduces
 So, this affects the estimation of the cost functions
 No longer linear cost function but non-linear cost function
 Other area of management accounting affected?
Learning curve
 Can the pattern of improvement be sufficiently regular to
be predictive?
 Learning curve is used as a mathematical model to
quantify the patterns of this type of ongoing improvement,
that often found in different stable processes.
 Thus, can be used to estimate cost functions, predicting
future cost due to increasing productivity
 It has evolved from experience in making airplanes some
80 years ago
Learning Curve – Learning Phase &
Steady State
10.3 Two different learning curve models

Cumulative average-time learning Model or Wright's

Model
 Original Model
 Developed by T. P. Wright in 1936

Incremental unit-time learning Model or Crawford's

Model
 Developed later by a team of researchers at Stanford
 Cumulative average-time learning model
 Examine how the cumulative average labour time per unit changes
with the production
 There is a constant percentage change in the cumulative average
time per unit when the cumulative production quantity of units
doubled
 In short, the average labour-hours to complete a unit of production
will decrease by a constant percentage each time the production
quantity is doubled.
 For example, with an 80% learning curve, when the production
quantity doubles, the average labour time for all units produced
drops to 80% of the previous one.
Cumulative Average-Time Learning Model

Cumulative Average-Time Learning Model

80% Learning Curve

Cumulative Cumulative Culumulative Cumulative

Number of Average Time Total Time: Individual Unit
Units (X) per unit(y)b; Labour-Hours for the Xth
Labour-Hours Unit: Labour-
Hours
A B C=AXB
1 100.00 100.00 100.00
2 80.00 160.00 60.00
3 70.21 210.63 50.63
4 64.00 256.00 45.37
5 59.56 297.80 41.80
6 56.17 337.02 39.22
7 53.45 374.15 37.13
8 51.20 409.60 35.45
9 49.29 443.61 34.01
10 47.65 476.50 32.89
11 46.21 508.31 31.81
12 44.93 539.16 30.85
13 43.79 569.27 30.11
14 42.76 598.64 29.37
15 41.82 627.30 28.66
16 40.96 655.36 28.06
 Cumulative average-time learning model
• Example:

• The Super Gadgets Inc. has gathered the following data on production costs of its new
Super-Gadget:

Average Unit Time

No of Units (Hours)
1 1,000
2 800
3 702
4 640
5 596
6 562
7 535
8 ?
 Discussion
 We can see that as the production quantity doubled from Unit 1 to
Unit 2,
 the cumulative average-labour hour decreased by 200, or 20% of the
Unit 1 time of 1,000 labour hours.
 Quantity doubled from Unit 2 to Unit 4, the cumulative average-
labour hours dropped by 160, which is also a 20% decrease from the
previous cumulative average-labour hours of 800 for Unit 2.
 Based on this data and the learning curve theory, Super Gadgets
predicts that the recurring unit cost for Unit 8 will be 20% less than
that of Unit 4, or 512 hours.
 Discussion
Average Unit
No of Units
Time (Hours)
1 1,000
2 800
3 702
4 640
5 596
6 562
7 535
8 512

Average Unit Time (Hours)

1,200

1,000

800

600

400

200

-
0 1 2 3 4 5 6 7 8 9
Cumulative Average-Time Learning Model
•
The Mathematical Relationship
•
Y = a Xb
•
Y = cumulative average labour time per unit or batch.
•
a = time taken to produce initial quantity.
•
X = cumulative number of units produced or, if in batches, the cumulative number of
batches.
•
 b = the learning index or coefficient, representing factor used to calculate average time to
produce units.
•
The value of b is calculated as: log (percentage learning rate (in decimal point) )/log 2.
•
log learning curve percentage (in decimal point) ÷ log 2.
•
So, for an 80% learning curve, b = log 0.8 ÷ log 2 = -.09691/.301 = -.32196 or - 0.322.
•
E.g. X = 3, a = 100; b = -3.22; y = 100 X 3 - 0.322 = 70.21 labour hours
•
The total cumulative total time when X = 3 is 70.31 x 3 = 210.63 labour hours
Incremental unit-time learning model
 By focusing on the incremental time needed to produce the last unit
when the cumulative production quantity of units doubles,
 There is a constant percentage change in the Incremental unit-time
to produce the last unit when the cumulative production quantity of
units produced doubles.
 In short, the incremental time needed to produce the last unit
decreases by a constant percentage each time the quantity of units
produced doubles.
 For example, an 80% learning curve means that when unit
production doubles, the time needed to produce the last unit is 80%
of the time needed to produce the last unit before production
doubled.
Incremental Unit-Time Learning Model

Incremental Unit-Time Learning Model

80% Learning Curve

Cumulative Individual Unit Culumulative Cumulative

Number of Time for Xth Total Time: Average Time
Units (X) Unit (y)b; Labour- Labour-Hours Per Unit: Labour-
Hours Hours
A B C D=C/A
1 100.00 100.00 100.00
2 80.00 180.00 90.00
3 70.21 250.21 83.40
4 64.00 314.21 78.55
5 59.56 373.77 74.75
6 56.17 429.94 71.66
7 53.45 483.39 69.06
8 51.20 534.59 66.82
9 49.29 583.88 64.88
10 47.65 631.53 63.15
11 46.21 677.74 61.61
12 44.93 722.67 60.22
13 43.79 766.46 58.96
14 42.76 809.22 57.80
15 41.82 851.04 56.74
16 40.96 892.00 55.75
 Incremental Unit-Time Learning Model
•
The Mathematical Relationship
•
Y = a Xb
•
Y = Time taken to produce the last single unit or batch.
•
a = time (labour hour) taken to produce initial quantity (first unit/batch).
•
X = cumulative number of units produced or, if in batches, the cumulative number of
batches.
•
 b = the learning index or coefficient, representing factor used to calculate incremental unit
time to produce units.
•
The value of b is calculated as: log (percentage learning rate (in decimal point) )/log 2.
•
log learning curve percentage (in decimal point) ÷ log 2.
•
So, for an 80% learning curve, b = log 0.8 ÷ log 2 = -.09691/.301 = -.32196 or - 0.322.
•
E.g. X = 3, a = 100; b = -3.22; y = 100 X 3 - 0.322 = 70.21 labour hours
•
The total cumulative total time when X = 3 is (100+80+70.31) = 250.21 labour hours
 Time Learning Model Comparative Plots

Exhibit 10.12 Plots for Cumulative Average-Time Learning Model and Incremental Unit-
Time Learning Model for Rayburn Corporation
10.4 Which Model is Appropriate
 If the learning rate is the same for both models (e.g. 80%)
 the cumulative average-time learning model represents a faster pace
of learning.
 Which model of learning curve to use?
 What percentage learning curve to use?
 Unique for each case;
 Based on past data for prediction
•
 10.4 Predicting Costs Using Alternative Time Learning Models

Exhibit 10.13 Predicting Costs Using Learning Curves at Rayburn Corporation

10.5 Data Collection

The ideal database for estimating cost functions:

 Sufficient reliably measured observations of the cost
driver and the related costs.
 Values spanning a wide range for the cost driver.
Pay Attention to Possible Data Problems
Before using the data to estimate Cost Functions, Pay
attention to:
1. Match the Appropriate time period for the dependent variable and
cost driver (e.g. Any time lag of Online advertising on Revenue)
2. Identify if there are any Fixed costs as if they are variable.
3. Not all observations are available or some may not be reliable
4. Extreme values of observations occur.
5. There is no clear relationship between the cost driver and the cost
pool of the dependent variable.
 Try It! 10-3

Try It! 10-3

Maude Designs manufactures various picture frames. Each new employee takes 6 hours to
make the first picture frame and 4.8 hours to make the second. The manufacturing
overhead charge per hour is $25.

a. What is the learning-curve percentage, assuming the cumulative average method?

b. What is the time needed to build 8 picture frames by a new employee using the
cumulative average-time method? You may use an index of -0.1520.

c. How much manufacturing overhead would be charged to the 8 picture frames under the
cumulative average-time approach?

d. What is the learning-curve percentage, assuming the incremental unit-time method?

e. What is the time needed to produce the 16th frame by a new employee using the
incremental unit-time method? You may use an index of -0.3219.

 
a. Unit Hours Cumulative Cumulative Average

1 6 6 6

2 4.8 10.8 5.4

Try It! 10-3 Discussion
 a. Unit Hours Cumulative Cumulative Average

1 6 6 6

2 4.8 10.8 5.4

Learning percentage = 5.4/6.0 = 0.90

 b. y = a Xb

= 6 × 8− 0.1520

= 4.37 hours

 (or) Cumulative average time for:

1 unit = 6 hours

2 units = 6 × 0.9 = 5.4 hours

4 units = 5.4 × 0.9 = 4.86 hours

8 units = 4.86 × 0.9 = 4.37 hours

Therefore, total time to build 8 units = 8 × 4.37 = 34.96 hours.

 Try It! 10-3 Discussion
c. Total time = 34.96 hours

Manufacturing overhead charge = 34.96 × $25 = $874

d. As production doubles from 1 to 2 units, the incremental time of the second unit relative
to the first is 4.8 hours/6 hours = 0.8.

 Therefore, this represents an 80% learning curve under the incremental unit-time learning
model.

e.  y = a × Xb

= 6 × 16− 0.3219

= 2.458 hours

(or) Time for:

1st unit = 6 hours

2nd unit = 6 × 0.8 = 4.8 hours

4th unit = 4.8 × 0.8 = 3.84 hours

8th unit = 3.84 × 0.8 = 3.072 hours

16th unit = 3.072 × .8 = 2.458 hours

 Application of Learning Curve
 Assume that you are a small business owner, and you need to decide whether to
assembly a relatively complex sub-assembly or contract to have it outsourced to a
manufacturer that specializes the sub-assemblies. Your employees have been
assembling the item for a short period of time and it is clear that the complexity of the
process has upped its costs to more than you had originally estimated.

 The contract manufacturer approaches you with a proposal to outsource the product
at a cost of $230 per unit delivered to your place of business. You know that the raw
materials are $100 per unit of product and the labour to assemble the product is $200
per unit.

 You realise that the raw material costs and assembly labour are variable direct costs
that will be eliminated if you choose to outsource the manufacture of the product. You
would have to lay off or terminate those employees involved in assembling the
product.

 Assume there are no fixed costs. Only the assembly supervisor will have to be
retained to supervise other products, and the subassembly requires no dedicated
equipment. Thus, the raw material, labour, and outsourcing costs are the only ones
that are relevant to the outsourcing decision.

 Question: Which Option should you choose? A. Outsourcing or B.

Perform the subassembly with your employees
Discussion – First Part
• Which Option should you choose? A. Outsourcing or B to perform the
subassembly with your employees
• Answer : Outsourcing, Why ?
• Outsourcing cost $230 per unit
• Total in-house cost - $ 300; $100 (raw materials) + $200 (labour cost)
 Further Question – Application of Learning Curve

 What about if your assembly workers will learn of more efficient ways
to assemble the units as you build more of them. Now that an 80
percent learning curve for each batch is assumed.
 If you expect number of production units will be over 8,000 units in 8
batches. Each batch processes 1,000 units. Would the
consideration of the learning effect change your initial decision?
 Please calculate the total in-sourcing cost per unit when your
company reaches the 8,000 unit level for better comparison.
 Discussion

80% learning curve example

Batch # Quantity Cumulative Cost per cumulative cost
Quantity unit
units units
1 1000 1000 200 200000
2 1000 2000 160 320000
3 1000 3000
4 1000 4000 128 512000
5 1000 5000
6 1000 6000
7 1000 7000
8 1000 8000 102.4 819200
 Discussion

In-Sourcing cost when production is 8,000 units :

Labour Cost: $ 102.4 per unit

Raw Material: $ 100 per unit
Total cost per unit $ 102.4 + $100 = $ 202.4
Which is less than $ 230 per unit in Outsourcing

So, in making decision, setting prices, preparing budgets,

and determining standard costing, the learning curve
effect should be considered.
•
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