Chapter2 -cost_estimation_umy_sep2011


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Chapter2 -cost_estimation_umy_sep2011

  1. 1. Chapter Two Cost Behaviour, Cost Estimation, and Product Costing Jul 2006 MAF 1
  2. 2. Chapter Outline       Introduction Classification of costs Determining product and service costs Cost estimation methods Data collection problems Conclusion Jul 2006 MAF 2
  3. 3. What Do We Mean By a Cost? A Cost is the measure of resources given up to achieve a particular purpose. Jul 2006 MAF 3
  4. 4. Why Do We Need the information? To assist managers in planning, controlling and decision making e.g. Naza Motors need to decide on the selling price of the Naza Sutera – require the total production costs of the model Jul 2006 MAF 4
  5. 5. Cost Objects  A cost object is something for which a company wants to know the cost. It may be a product, service, customer, department and so on, for which costs are measured and assigned.  E.g. To know the cost of its Bachelor of Accounting programme, then the Bachelor of Accounting programme is the cost object.  All costs related to the Bachelor of Accounting programme are accumulated and assigned to the cost object, such as the cost of the salaries of lecturers teaching in the programme, the cost of printing brochures on the programme, the cost of salaries of administrative staff servicing the programme, and so on. Jul 2006 MAF 5
  6. 6. Cost terms and classifications Fixed and Variable Direct vs Indirect Product vs Period Manufacturing vs Non-manufacturing Opportunity cost Sunk cost Prime costs Conversion costs Jul 2006 MAF 6
  7. 7. Cost Classifications Cost behavior means how a cost will react to changes in the level of business activity.   Jul 2006 MAF Total variable costs change when activity changes. Total fixed costs remain unchanged when activity changes. 7
  8. 8. Variable Costs (a)total (b) per unit Paper Costs Paper Costs No. of students (a) Jul 2006 MAF No. of students (b) 8
  9. 9. Fixed Costs (a) Total (b) Per unit Professor’s salary (RM) Professor’s salary (RM) No. of students (a) Jul 2006 MAF No. of students (b) 9
  10. 10. Cost Classifications Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Total variable cost changes as activity level changes. Variable cost per unit remains the same over wide ranges of activity. Total fixed cost remains the same even when the activity level changes. Fixed cost per unit goes down as activity level goes up. Fixed Jul 2006 MAF 10
  11. 11. Semi variable  Some costs are neither fixed nor variable but a little bit of both.  A semivariable cost is partly fixed and partly variable Jul 2006 MAF . Consider the following electric utility example. 11
  12. 12. Total Utility Cost Semivariable(mixed) Cost Slope is variable cost per unit of activity. Variable Utility Charge Fixed Monthly Utility Charge Activity (Kilowatt Hours) Jul 2006 MAF 12
  13. 13. Semi fixed or step fixed costs  Within a given time period and within specific activity level, they are fixed, but that eventually increase or decrease by a constant amount at various critical activity levels Supervisor’s Salary Jul 2006 MAF Output 13
  14. 14. Step-variable Cost Total Cost Nearly variable but increases in small steps instead of continously. e.g. part time employees called upon for relatively small increments of time such as few hours (delivery truck drivers of a bakery ) Activity (Hours) Jul 2006 MAF 14
  15. 15. Product Costs, and Period Costs Product costs are costs associated with goods for sale until the time period during which the products are sold, at which time the costs become expenses. e.g. costs of raw materials Period costs are costs that are expensed during the time period in which they are incurred. Includes all non manufacturing costs e.g. salary of clerks Jul 2006 MAF 15
  16. 16. Cost Classifications on Financial Statements – Income Statement Product Costs Cost of goods sold Jul 2006 MAF Period Costs Operating expenses 16
  17. 17. Direct and Indirect Costs Direct costs Indirect costs  Costs that can be easily and conveniently traced to a product or department.  Costs that must be allocated in order to be assigned to a product or department.  example: cost of paint in the paint department of an automobile assembly plant.  example: cost of national advertising for an airline is indirect to a particular flight. Jul 2006 MAF 17
  18. 18. Manufacturing Costs Direct Labor Direct Material Manufacturing Overhead The Product Jul 2006 MAF 18
  19. 19. Manufacturing Companies There are 3 major categories of manufacturing costs: Direct Materials resources that can be feasibly observed being used to make a specific product. Jul 2006 MAF Direct Labor The cost of paying employees who convert direct materials into finished product. Manufacturing Overhead Indirect material Indirect labor Other overhead 19
  20. 20. Direct Material Cost of raw material that is used to make, and can be conveniently traced, to the finished product. Example: Steel used to manufacture the automobile. Jul 2006 MAF 20
  21. 21. Direct Labor Cost of salaries, wages, and fringe benefits for personnel who work directly on manufactured products. Example: Wages paid to an automobile assembly worker. Jul 2006 MAF 21
  22. 22. Committed Costs Fixed costs that have been incurred to provide facilities to enable firms to produce its products. e.g.: space, equipment, factory buildings Jul 2006 MAF 22
  23. 23. Discretionary costs Costs that are decided by management Sometimes called “managed costs” e.g.: advertising, repairs, research and development expenses May be changed when company is experiencing a difficult time Jul 2006 MAF 23
  24. 24. Opportunity Cost The potential benefit that is given up when one alternative is selected over another.  Jul 2006 MAF Example: If you were not attending college, you could be earning $60,000 per year. Your opportunity cost of attending college for one year is $60,000. 24
  25. 25. Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future are sunk costs. Sunk costs should not be considered in decisions.  Example: You bought an automobile that cost $72,000 two years ago. The $72,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $72,000 cost. Jul 2006 MAF 25
  26. 26. Cost estimation, cost behaviour and cost prediction Cost estimation Cost behavior Cost prediction Process of determining cost behavior, often focusing on historical data. Relationship between cost and activity. Using knowledge of cost behavior to forecast level of cost at a particular activity. Focus is on the future. Jul 2006 MAF 26
  27. 27. Assumptions in Cost-Behavior Estimation Changes in total costs can be explained by changes in the level of a single activity. Cost behavior can adequately be approximated by a linear function of the activity level within the relevant range. Using equation TC = TFC + TVC TC = TFC + VC per unit x Q (Q = activity level) Jul 2006 MAF 27
  28. 28. Cost Estimation Methods Account classification method  Conference method  Industrial engineering method  Visual fit method  High low method  Least squares regression method  Multiple regression  Jul 2006 MAF 28
  29. 29. Cost Estimation Approaches These methods differ in terms of: The costs of undertaking the analysis  The assumptions they make  The accuracy of the estimated cost  Jul 2006 MAF 29
  30. 30. Account classification method Estimates cost by classifying cost accounts in the subsidiary ledger as variable, fixed or mixed with respect to the identified level of activity  Use qualitative analysis when making cost classifications  Jul 2006 MAF 30
  31. 31. Account Classification Method Example Account Indirect Labor Indirect Material Depreciation Property Taxes Insurance Utilities Maintenance Totals Jul 2006 MAF Overhead Total Cost $ 450 700 1,000 200 300 400 600 $ 3,650 Costs for 1,000 Units Variable Fixed Cost Cost $ 450 700 1,000 200 300 350 50 500 100 $ 2,000 $ 1,650 31
  32. 32. Conference Method  Estimates cost functions on the basis of ANALYSIS and OPINIONS about costs and their drivers gathered from various departments of a company (e.g. purchasing dept, process engineering, production dept and so on) Jul 2006 MAF 32
  33. 33. Industrial Engineering Method   Also known as work measurement method Estimates cost functions by analyzing the relationship between inputs and outputs in physical terms  e.g. carpet manufacturer use INPUTS – cotton, wool, dyes, direct labor, machine time, power to produce OUTPUT- square yards of carpet  TIME AND MOTION STUDY may conclude that to produce 10 square yards require 1 hour of direct labor Jul 2006 MAF 33
  34. 34. Quantitative Analysis Method Uses a formal mathematical method to fit cost functions to past data observations  Visual fit method  High low method – the simplest method  Regression analysis – simple and multiple regression  Jul 2006 MAF 34
  35. 35. Visual-Fit Method Total Cost in 1,000’s of Dollars Plot the data points on a graph (total cost vs. activity). 20 10 * * * * * ** * ** 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Jul 2006 MAF 35
  36. 36. Visual-Fit Method Total Cost in 1,000’s of Dollars Draw a line through the plotted data points so that about equal numbers of points fall above and below the line 20 10 * * * * * ** * ** 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Jul 2006 MAF 36
  37. 37. Visual-Fit Method Total Cost in 1,000’s of Dollars Total variable cost = Total cost – Total fixed cost Total variable cost = $16,000 – $10,000 = $6,000 Unit variable cost = $6,000 ÷ 3,000 units = $2 Estimated fixed cost = $10,000 20 * ** * Vertical distance ** is total cost, * * * * 10 approximately $16,000. 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Jul 2006 MAF 37
  38. 38. The High-Low Method MiraCo recorded the following production activity and maintenance costs for two months: High activity level Low activity level Change Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600 Using these two levels of activity, compute:  the variable cost per unit.  the total fixed cost. Jul 2006 MAF 38
  39. 39. The High-Low Method High activity level Low activity level Change Jul 2006 MAF Units 9,000 5,000 4,000 Cost $ 9,700 6,100 $ 3,600 39
  40. 40. The High-Low Method Question 1 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. b. c. d. Jul 2006 MAF $.08 per unit $.10 per unit $.12 per unit $.125 per unit 40
  41. 41. The High-Low Method Question 2 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. b. c. d. Jul 2006 MAF $ 2,000 $ 4,000 $10,000 $12,000 41
  42. 42. Least-Squares Regression Method  Statistics courses and computer courses deal with detailed regression computations using computer spreadsheet software.  Accountants and managers must be able to interpret and use regression estimates. Jul 2006 MAF 42
  43. 43. Regression Analysis The regression equation and regression line are derived using the least-squares technique. The objective of least-squares is to develop estimates of the parameters a and b. Jul 2006 MAF 43
  44. 44. Least-Squares Regression Method Regression is a statistical procedure used to determine the relationship between variables such as activity and cost. Total Cost The objective of the regression method is the general cost equation: Y = a + bX in cost terms TC = F + VX Jul 2006 MAF Activity 44
  45. 45. Data collection problems      Missing data Outliers Allocated and discretionary costs Inflation Mismatched time periods All cost-estimation methods are based on simplifying assumptions so that the benefits of use outweigh the costs of data collection and manipulation. Jul 2006 MAF 45
  46. 46. End of Chapter 2 Jul 2006 MAF 46