Chapter 3 Cost behaviour, cost drivers and cost estimation Copyright ª 2006 McGraw­Hill Australia Pty Ltd 3­ 1 What are cost behaviour, cost estimation and cost prediction? • Cost behaviour – The relationship between a cost and the level of activity or cost driver • Cost estimation – The process of determining the cost behaviour of a particular cost item • Cost prediction – Using knowledge of cost behaviour to forecast the level of cost at a particular level of activity Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-2 Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-3 Cost drivers • A cost driver – An activity or factor that drives or causes costs – The higher the correlation between the cost and the cost driver, the more accurate is the description and understanding of cost behaviours – Cost allocation base is commonly used instead of cost driver, as the causal relationship may not always exist – Conventional understandings of cost behaviour regard costs as variable or fixed, based on the level of production volume – Volume-based cost drivers include units produced, direct labour hours, direct labour cost and machine hours continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-4 Cost drivers • Contemporary viewpoints recognise that there are a range of possible cost drivers other than production volume (non-volume cost drivers) • Activity-based approaches classify costs and cost drivers into four levels: – Unit – Batch – Product – Facility continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-5 Cost drivers • Unit level costs – Relate to activities that are performed for each unit produced – Use conventional volume-based cost drivers • Batch level costs – Relate to activities performed for a group of product units • Product (or product-sustaining) level – Relate to activities performed for specific products or product groups • Facility level – Costs incurred to run the business continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-6 Cost drivers • Selecting the best cost drivers – Input or outputs? One input cost driver is the weight of material One output driver is the number of units of production Cost–benefit principles will determine the choice – How detailed should the analysis be? As the number of cost categories increases, the accuracy of the resulting information should increase Again, cost–benefit criteria are important – Long or short term? Cost behaviour and cost drivers can change over time Depends on the purpose of the cost prediction continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-7 Cost drivers • Cost drivers for cost estimation or cost management? – Cost drivers that are used to predict costs may differ from those used to manage costs – Effective cost management requires the identification of root cause cost drivers The basic costs that cause a cost to be incurred The true causes of costs continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-8 Cost drivers • In choosing cost drivers, the costs and benefits of each driver must be assessed – Reasons for analysing cost behaviour – Timeframes for analysing the cost behaviour – Availability of data on cost drivers – Any other uses for the cost behaviour information Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-9 Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-10 Cost behaviour patterns • Cost behaviour – The relationship between a cost and the level of activity • Cost behaviour patterns – Variable costs – Fixed costs – Step-fixed costs – Semivariable costs – Curvilinear costs continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 3-11 Cost behaviour patterns • Variable costs – A change, in total, that is in direct proportion to a change in the level of activity – The variable cost is the slope of the cost line in the following cost function: Y = a + bX Where Y = total cost a = fixed cost component (the intercept on the vertical axis) b = variable cost per unit of activity (the slope of the line)