Cost Behavior & Cost Behavior & Cost EstimationCost Estimation

Costs behave in three waysCosts behave in three ways 1. Fixed costs 1. Fixed costs 2. Variable costs2. Variable costs 3. Semi-variable costs3. Semi-variable costs Cost estimation is finding a Cost estimation is finding a

relationship between cost relationship between cost behavior and the cost driver.behavior and the cost driver.

Cost behaviorCost behavior Costs can be variable, fixed or semi Costs can be variable, fixed or semi

variable.variable. Variable costs Variable costs are costs are costs that vary in direct proportion to that vary in direct proportion to change in the cost drive. Direct change in the cost drive. Direct labor is a good example only if labor is a good example only if workers are paid by piece. workers are paid by piece. FixedFixed costscosts are costs that that remain the are costs that that remain the same despite change in the cost same despite change in the cost drive e.g. Depreciation, rent and drive e.g. Depreciation, rent and insurance.insurance.

Fixed costs are Fixed costs are committedcommitted, i.e. they , i.e. they result from previous actions result from previous actions (depreciation). Or they can be (depreciation). Or they can be discretionarydiscretionary because mgt uses its because mgt uses its professional judgment to decide on the professional judgment to decide on the amount of cost.amount of cost.

SemiSemi--variablevariable costscosts are costs that are costs that behave partly as fixed and partly as behave partly as fixed and partly as variable. e.g. indirect labor costs and variable. e.g. indirect labor costs and indirect material.indirect material.

Any cost can be defined in terms of this Any cost can be defined in terms of this functionfunction

Y= a + bxY= a + bx Where y is the total cost, a is constant that Where y is the total cost, a is constant that

does not change with the activity level, b is a does not change with the activity level, b is a variable cost and x is the activity volumevariable cost and x is the activity volume . .

Cost estimation methodsCost estimation methodsThe low- high method: this method requires The low- high method: this method requires

that we know the highest and lowest activity that we know the highest and lowest activity level. This is the most commonlevel. This is the most common..

Example :Example : Bobs Company has budgeted factory costs Bobs Company has budgeted factory costs

for four values of operation.for four values of operation.Machine hoursMachine hours

50005000 60006000 70007000 80008000

In-labor 2100In-labor 2100 24002400 27002700 30003000 Insurance 600Insurance 600 600600 600600 600600 Depreciat1000 1200Depreciat1000 1200 14001400 16001600 UtilitiesUtilities 2000200023002300 26002600 29002900

Required: Required: 1. Indicate the behavior of the four 1. Indicate the behavior of the four

costscosts 2. using the low-high method 2. using the low-high method

determine the cost estimating formula determine the cost estimating formula for each of the four costs.for each of the four costs.

In order to check whether the cost is In order to check whether the cost is variable or not you will need to check if variable or not you will need to check if it varies directly with the number of it varies directly with the number of units of productionunits of production

Indirect labor is a semi-variable cost Indirect labor is a semi-variable cost as the rate changes but not as the rate changes but not proportionally 2100/ 5000, 2400/6000, proportionally 2100/ 5000, 2400/6000, 2700/ 7000 and 3000/ 8000.2700/ 7000 and 3000/ 8000.

Insurance is a fixed cost because it Insurance is a fixed cost because it does not change with production.does not change with production.

Depreciation is a variable cost and Depreciation is a variable cost and that changes directly with production. that changes directly with production. (0.2) is the rate.(0.2) is the rate.

Utilities are semi-variable as the rate Utilities are semi-variable as the rate changes but not proportionally with changes but not proportionally with production. production.

Indirect labor Indirect labor Highest no of hrs= 8000 Highest no of hrs= 8000 highest cost highest cost

=3000 =3000 Lowest no of hrs= Lowest no of hrs= 50005000 lowest cost = lowest cost =

21002100 Difference 3000Difference 3000

900900 Variable cost rate = 900/ 3000 = $0.3Variable cost rate = 900/ 3000 = $0.3 Fixed cost = 3000 – 0.3(8000) = $600Fixed cost = 3000 – 0.3(8000) = $600 The function is The function is TC (indirect labor) = 600+ 0.3(x)TC (indirect labor) = 600+ 0.3(x)

InsuranceInsurance Highest no of hrs= 8000 Highest no of hrs= 8000 highest cost = highest cost =

600 600 Lowest no of hrs= Lowest no of hrs= 50005000lowest cost = lowest cost = 600600 Difference Difference 3000 3000 0 0 Variable cost rate = 0/ 3000 = $0Variable cost rate = 0/ 3000 = $0 Fixed cost = $600 – 0(8000) = $600Fixed cost = $600 – 0(8000) = $600 The function is The function is TC (Insurance) = $600TC (Insurance) = $600

DepreciationDepreciation Highest no of hrs= 8000 highest cost = Highest no of hrs= 8000 highest cost =

1600 1600 Lowest no of hrs= Lowest no of hrs= 50005000 lowest cost = lowest cost = 10001000 Difference Difference 3000 3000

600600 Variable cost rate = 600/ 3000 = $0.2Variable cost rate = 600/ 3000 = $0.2 Fixed cost = 1600– 0.2(8000) = 0Fixed cost = 1600– 0.2(8000) = 0 The function isThe function is TC (Deprecation) = 0.2(x)TC (Deprecation) = 0.2(x)

Utilities Utilities Highest no of hours= 8000 highest cost = Highest no of hours= 8000 highest cost =

2900 2900 Lowest no of hours= Lowest no of hours= 5000 5000 lowest cost = lowest cost =

20002000 Difference Difference 3000 3000

900900 Variable cost rate = 900/ 3000 = $0.3Variable cost rate = 900/ 3000 = $0.3 Fixed cost = 2900 – 0.3(8000) = $500Fixed cost = 2900 – 0.3(8000) = $500 The function is The function is TC (utilities) = 500+ TC (utilities) = 500+

0.3(x)0.3(x)

Faisal Company has budgeted factory Faisal Company has budgeted factory costs for three values of operation.costs for three values of operation.

Machine hoursMachine hours

1000 20001000 2000 3000300040004000

In.mat 1100In.mat 1100 21002100 31003100 41004100 Rent 700 700Rent 700 700 700 700 700700 DeprecDeprec 500500 10001000 15001500 20002000

Required: Required: Indicate the behavior of the costsIndicate the behavior of the costs Use the low-high method to Use the low-high method to

determine the cost estimating determine the cost estimating formula for each of the three formula for each of the three costs.costs.