Cost Analysis and Estimation

COST CONCEPT AND ESTIMATIONQUIZ: GroupWhat is the cost object?What are the direct cost?What are the indirect cost?Cost object: aluminum foilDirect cost: materials: aluminum block, titanium silica, Indirect cost: MH operator, QC operator, power, maintenance cost, machine depreciation, liquid coolant

Cost object: skateboardDirect cost: materials: board, direct laborIndirect cost: MH operator, QC operator, power, maintenance cost, machine depreciation, support material: ink, coat: epoxy, screw

Cost TermsCost Driver:

Manufacturing Cost:

Sales and General Administrative Costs:

Direct and Indirect Costs:

Controllable and Uncontrollable Costs:

Product/Period Cost:Any activity or event that causes costs to be incurred.Direct material (DM), direct labor (DL), and manufacturing overhead (MOH).

All costs associated with running the business, excluding production costs.Costs that can either be traced (direct) or not traced (indirect) to a specific department in the organization.

Costs used to describe the extent of a managers influence on cost.

Refers to the timing which costs become expenses.

Economic TermsOpportunity Cost:

Sunk Cost:

Differential and Incremental Cost:

Marginal Cost:

Average Cost per Unit:Benefit lost because the choice of one action precludes another action.

Costs that have already been incurred and can not be altered by current or future decisions.

Difference in the costs incurred under two alternative actions.

Cost associated with producing one additional unit.

Total cost for the quantity produced, divided by the number of units produced. Cost Classifications

Assigning Costs to a Cost ObjectDirect costs are easily traced to the cost object.Determining the costs that should attach to a cost object is called cost assignment.Cost AssignmentIndirectCostsCostObjectDirectCostsIndirect costs are not easily traced to the cost object, and must be allocated.cost tracingcost allocationThe cost assignment text box is automated.The first click begins the sequence to define direct costs.The second click begins the sequence to define indirect costs.

Examples: a Candy Manufacturer

9Cost BehaviorFixed Costs: costs that remain constant regardless of the quantity of product produced.

Variable Costs: costs that increase linearly and proportionately as production volume increases.

Profit = (Sales Revenue-Variable Cost) - Fixed Cost

Total Contribution MarginBehavior of Total (Linear) CostsTotal Fixed Costs$Cost Driver$Cost DriverTotal CostsIf costs are linear, then total costs graphically look like this. Total fixed costs do not change as the cost driver increases. Higher total fixed costs are higher above the x axis. The first click completes the top graph and brings in the first text box, which disappears on the next click.The second click brings in all of the elements on the rest of the slide in an automated sequence.Behavior of Total (Linear) CostsTotal Variable Costs$Cost Driver$Cost DriverTotal CostsIf costs are linear, then total costs graphically look like this. Total variable costs increase as the cost driver increases.A steeper slope represents higher variable costs per unit of the cost driver.The first click brings in all of the elements on the rest of the slide in an automated sequence.Total Versus Per-unit (Average) Cost BehaviorIf total variable costs look like this . . . . . . then variable costs per unit look like this.$Cost DriverTotal Variable Costs$/unitCost DriverPer-Unit Variable Costsmslope = $m/unitThe top part of the slide is automated.The first click brings in the rest of the elements on the slide in an automated sequence.Total Versus Per-Unit (Average) Cost BehaviorIf total fixed costs look like this . . . . . . then fixed costs per unit look like this.$Cost DriverTotal Fixed Costs$/unitCost DriverPer-Unit Fixed CostsThe first click brings in the rest of the elements on the slide in an automated sequence.

Mixed Costs/ Semi Variable CostMixed costs are costs that have both a fixed and a variable component. For example, overhead for a company may consist of a fixed supervisor salary plus the cost of supplies that vary with the quantity of output produced. The formula and graph depiction for a mixed cost is as follows:Total cost = Total fixed cost + Total variable cost

VolumeMixed costs are costs that have both a fixed and a variable component. For example, this slide shows an example of overhead for a company that may consist of a fixed supervisor salary plus the cost of supplies that vary with the quantity of output produced. The formula for a mixed cost is: Total cost = Total fixed cost + Total variable cost

15Methods for Separating Mixed Costs

Three methods of separating a mixed cost into its fixed and variable components are commonly used:the high-low methodthe scattergraph methodthe method of least squaresEach method requires the simplifying assumption of a linear cost relationship. Three methods of separating a mixed cost into its fixed and variable components are commonly used:the high-low methodthe scattergraph methodthe method of least squaresEach method requires the simplifying assumption of a linear cost relationship.

16Recall the expression of cost as an equation for a straight line is: Total cost = Fixed cost + (Variable rate x Output)The dependent variable is a variable whose value depends on the value of another variable. In the previous equation, total cost is the dependent variable; it is the cost we are trying to predict. The independent variable is a variable that measures output and explains changes in the cost or other dependent variable. A good independent variable is one that causes or is closely associated with the dependent variable. Therefore, many managers refer to an independent variable as a cost driver. The intercept corresponds to fixed cost.The slope of the cost line corresponds to the variable rate. Recall the expression of cost as an equation for a straight line is: Total cost = Fixed cost + (Variable rate X Output). The dependent variable is a variable whose value depends on the value of another variable. In the previous equation, total cost is the dependent variable; it is the cost we are trying to predict. The independent variable is a variable that measures output and explains changes in the cost or other dependent variable. A good independent variable is one that causes or is closely associated with the dependent variable. Therefore, many managers refer to an independent variable as a cost driver. The intercept corresponds to fixed cost. The slope of the cost line corresponds to the variable rate. 17The High-Low MethodGiven two points, the slope and the intercept can be determined. The high-low method is method of separating mixed costs into fixed and variable components by using just the high and low data points.

Given two points related to a cost function, the slope and the intercept can be determined. The high-low method is a method of separating mixed costs into fixed and variable components by using just the high and low data points. To demonstrate, we will use data from materials handling costs at Anderson Company. The plant manager believes that the number of material moves is a good activity driver for the activity.

18The High-Low MethodFour steps must be taken in the high-low method:Step 1: Find the high point and the low point for a given data set.Step 2: Using the high and low point, calculate the variable rate.Variable rate = (High point cost - Low point cost) (High point output - Low point output)Step 3: Calculate the fixed cost using the variable rate (from Step 2) and either the high point or low point.Fixed cost = Total cost at high point - (Variable rate x Output at high point)Step 4: Form the cost formula for materials handling based on the high-low method.3Four steps must be taken in the high-low method.Step 1: Find the high point and the low point for a given data set. The high point is defined as the point with the highest activity or output level. The low point is defined as the point with the lowest activity or output level. It is important to note that the high and low points are identified by looking at the activity levels and not the costs. In some cases, the highest (or lowest) activity level might also be associated with the highest (or lowest) cost, whereas in other cases it is not. Therefore, regardless of cost, the managerial accountant must be careful to use the activity level in identifying the high and low data points for the analysis. For Anderson, the high output occurred in May, with 500 material moves and total cost of $7,500. The low output was in January with 100 material moves and total cost of $2,000.Step 2: Using the high and low points, calculate the variable rate. To perform this calculation, we recognize that the variable rate, or slope, is the change in the total cost divided by the change in output. For Anderson, the variable rate is: [($7,500 2,000) (500 100) = $13.75]Step 3: Calculate the fixed cost using the variable rate (from Step 2) and either the high point or low point using the following formulas.Fixed cost = Total cost at high point - (Variable rate x Output at high point) ORFixed cost = Total cost at low point - (Variable rate x Output at low point)For Andersons high point, this fixed cost is [Fixed cost = $7,500 ($13.75 X 500) = $625]Step 4: Form the cost formula for materials handling based on the high-low method. For Anderson, this equation is: Total cost = $625 + ($13.75 X Number of moves)

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Solution:Step 1Find the high and low points: The high number of machine hours is in March, and the low number ofmachine hours is in June. (Hint: Did you notice that the high cost of $4,200 was for August? Yet August is not the high point because its number of machine hours is not the highest activity level. Remember, the high point is associated with the highest activitylevel; the low point is associated with the lowest activity level.)Now lets look at CORNERSTONE 3-2 and gain additional practice on how to use the high-low method to calculate fixed cost and the variable rate when constructing a cost formula.20

Notice on CORNERSTONE 3-2 that the total electricity cost formula could be used for managerial decision making and predicting future month costs, as long as management could estimate the number of machine hours to be used.

21Scattergraph MethodThe scattergraph method is a way to see the cost relationship by plotting the data points on a graph. The first step in applying the scattergraph method is to plot the data points so that the relationship can be seen.The scattergraph method is a way to see the cost relationship by plotting the data points on a graph. The first step in applying the scattergraph method is to plot the data points (shown in frame A in this slide) so that the relationship between materials handling costs and activity output can be seen. 22First, remember that our two points are (100, $2,000) and (0, $800). Next, use these two points to compute the variable rate (the slope):

Variable rate = ($2,000 - $800) $100 - 0 = $1,200/100 = $12 Thus the variable rate is $12 per material move.Fixed rate= $2,000 ($12 * 100) = $800 The fixed cost and variable rate for materials handling cost have now been identified.The cost formula for the materials handling activity can be expressed as:Total cost = $800 + ($12 x Number of moves)

This gives us the straight line shown in Frame C in the slide. We can use the high-low method to determine the variable rate of $12 per material move. The fixed cost and variable rate for materials handling cost have now been identified. The cost formula for the materials handling activity can be expressed as: Total cost = $800 + ($12 X Number of moves)

23The Method of Least SquaresThe method of least squares (regression) is a statistical way to find the best-fitting line through a set of data points. Basically, the best-fitting line is the one in which the data points are closer to the line than to any other line.

The method of least squares (regression) is a statistical way to find the best-fitting line through a set of data points. One advantage of the method of least squares is that for a given set of data, it will always produce the same cost formula. Basically, the best-fitting line is the one in which the data points are closer to the line than to any other line. 24YXii=+abSimple Linear Regression ModelShows linear relationship between dependent & explanatory variablesExample: Sales & advertising (not time)Dependent (response) variableIndependent (explanatory) variable

Slope

Y-intercept^2574Linear Regression EquationsEquation:

Slope:

Y-Intercept:

2676

Now lets look at CORNERSTONE 3-5 and how see how to use the regression method to calculate fixed cost and the variable rate and to construct a cost formula for budgeted cost.

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Notice that the regression method in CORNERSTONE 3-5 uses the same basic linear costing model that we used previously with the results of the high-low and scattergraph methods.

28Comparison of MethodsKnowing how costs change in relation to changes in output is essential to planning, controlling, and decision making. Each of the methods for separating mixed costs into fixed and variable components help managers understand cost behavior and consequently make good business decisions.Knowing how costs change in relation to changes in output is essential to planning, controlling, and decision making. Each of the methods for separating mixed costs into fixed and variable components help managers understand cost behavior and consequently make good business decisions. 29

30This exhibit provides an overview of each of these methods, along with the advantages and disadvantages of each.Task high low method Calculate the cost formula for the maintenance below:MonthMaintenance cost Number of activity(Y)(X)Januari6.900.00046Februari7.500.00061Maret6.400.00040April7.200.00055Mei8.100.00063Juni8.800.00070Juli6.800.00052Agustus7.090.00046September6.500.00042Oktober6.900.00047November8.500.00065Desember6.700.00043ANSWERVar rate= (Rp 8.800.000-6.400.000)/(70-40)= Rp 80.000 per activityFixed cost= Rp 8.800.000 (Rp 80.000 x 70)= Rp. 3.200.000Cost formula = Total maintenance cost = Rp. 3.200.000 + (Rp 80.000 X activity)

HAVE A NICE DAY

Sheet1$Output

Sheet1$Output