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    Week 4 - Cont. Week 3 Slides - Updated

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    This document discusses cost estimation methods, specifically linear cost functions. It defines key terms like dependent variable, independent variable, intercept, and slope. The document compares qualitative and quantitative cost estimation approaches. It then explains the high-low method and regression analysis for quantitative analysis. Managers can use these techniques to understand cost behavior and help predict and manage costs.

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    Week 4 - Cont. Week 3 Slides - Updated

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    Sin Tung
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    This document discusses cost estimation methods, specifically linear cost functions. It defines key terms like dependent variable, independent variable, intercept, and slope. The document compares qualitative and quantitative cost estimation approaches. It then explains the high-low method and regression analysis for quantitative analysis. Managers can use these techniques to understand cost behavior and help predict and manage costs.

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    This document discusses cost estimation methods, specifically linear cost functions. It defines key terms like dependent variable, independent variable, intercept, and slope. The document compares qualitative and quantitative cost estimation approaches. It then explains the high-low method and regression analysis for quantitative analysis. Managers can use these techniques to understand cost behavior and help predict and manage costs.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    82 views43 pages

    Week 4 - Cont. Week 3 Slides - Updated

    Uploaded by

    Sin Tung
    This document discusses cost estimation methods, specifically linear cost functions. It defines key terms like dependent variable, independent variable, intercept, and slope. The document compares qualitative and quantitative cost estimation approaches. It then explains the high-low method and regression analysis for quantitative analysis. Managers can use these techniques to understand cost behavior and help predict and manage costs.

    Copyright:

    © All Rights Reserved
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    of 43

    Advanced Management Accounting

    Week 3
    Cost Estimation Methods

    Instructor: Zhihong Wang, PhD


    Understand Linear Cost Function
    Cost Function
    Managers often estimate cost functions based on two
    assumptions:

    ¡ Variations in the level of a single activity (the cost driver)


    explain the variations in the related total costs
    ¡ Cost behavior is approximated by a linear cost function
    within the relevant range.
    Linear Cost Function

    y = a + bX
    The dependent The independent
    variable: variable:
    the cost that is the cost driver
    being predicted

    The slope of
    The intercept: the line:
    fixed costs variable cost
    per unit
    Linear Cost Functions
    In-class Exercise
    Bridging Accounting and Statistical
    Terminology

    ACCOUNTING STATISTICS

    Variable Cost Slope or Slope Coefficient

    Fixed Cost Intercept or Constant

    Mixed Cost Linear Cost Function


    In-class Exercise

    The cost function y = 2,700 + 8X ________.

    1) has a slope coefficient of 2,700


    2) has an intercept of 8
    3) is a straight line
    4) represents a fixed cost
    Factors Affect Cost Classification
    1. Choice of cost object—different objects may result in
    different classification of the same cost.
    2. Time horizon—the longer the period, the more likely the
    cost will be variable.
    3. Relevant range—behavior is predictable only within this
    band of activity.
    Better management decisions, cost predictions and
    estimation of cost functions can be achieved only if
    managers correctly identify the factors that affect costs.
    The Cause-and-Effect Criterion
    • A cause-and-effect relationship might arise as a result of:
    ¡ A physical relationship between the level of activity and
    the costs
    ¡ A contractual agreement
    ¡ Knowledge of operations
    Only a cause-and-effect relationship—not merely
    correlation—establishes an economically plausible
    relationship between the level of an activity and its costs.
    Qualitative-Based Analysis
    Account Analysis Method
    • Estimates cost functions by classifying various cost
    accounts as variable, fixed, or mixed in respect to the
    identified level of activity.
    • Typically, managers use qualitative rather than quantitative
    analysis when making these cost-classification decisions.
    • The accuracy of the account analysis method depends on
    the accuracy of the qualitative judgments that managers
    and management accountants make about which costs are
    fixed and which are variable.
    In-class Exercise
    Quantitative Analysis

    - High Low Method


    - Regression Analysis
    Quantitative Analysis
    • Uses a formal mathematical method to fit cost functions to
    past data observations.
    • Advantage: results are objective.
    • Advantage: most rigorous approach to estimate costs.
    • Challenge: requires more detailed information about
    costs, cost drivers, and cost functions and is therefore
    more time-consuming.
    Estimating a Cost Function Using Quantitative Analysis

    1. Choose the dependent variable (the cost to be


    predicted and managed)
    2. Identify the independent variable (the level of activity
    or cost driver)
    3. Collect data on the dependent variable and the cost
    driver.
    4. Plot the data to observe the general relationship.
    5. Estimate the cost function using two common forms of
    quantitative analysis: the high-low method or regression
    analysis.
    6. Evaluate the cost driver of the estimated cost function.
    High-Low Method
    • Simplest method of quantitative analysis.
    • Uses only the highest and lowest observed values.
    • “Fits” a line to data points which can be used to predict
    costs.
    High-Low Method
    Assuming that we had a cost function y=a+bx. We also had
    the highest activity of 100 at cost of $2,500 and the lowest
    activity of 80 at cost of $2,100.
    We obtain two cost equations below:
    (1) 2,500=a+b*100
    (2) 2,100=a+b*80
    Steps in the High-low Method
    Calculate the slope coefficient (the variable cost per unit of
    activity: “b”).
    Slope coefficient = Difference between costs associated
    with highest and lowest observations of the cost driver /
    Difference between highest and lowest observations of
    the cost driver.
    Equation (1) - (2):
    ($2,500 - $2,100) / (100 – 80) or 400 / 20 = $20.00
    Steps in the High-Low Method
    The second step is to calculate the constant (the total fixed
    costs:”a”).
    Total cost from either the highest or lowest activity level –
    (Variable Cost per unit of activity X Activity associated with
    above total cost) = Fixed Costs
    Substitute the actual slop coefficient for “b” in the equation:
    High: $2,500 – ($20 x 100) = $500 fixed costs
    Low: $2,100 – ($20 x 80) = $500 fixed costs
    Steps in the High-Low Method
    The third and final step in the high-low method is to
    summarize by writing a linear equation:
    Y = $500 + ($20 * X)
    If we wondered what costs would be at a 120 level of activity,
    we’ll simply plug that number for X in our equation:
    Y = $500 + ($20 * 120) or
    Y = $2,900
    In-class Exercise
    In-class Exercise

    For Heavy Manufacturing Company, labor-hours are 40,000 and wages


    $144,000 at the high point of the relevant range, and labor-hours are 24,000
    and wages $96,000 at the low point of the relevant range.

    What is the slope coefficient?


    1) $3.75
    2) $3.00
    3) $3.60
    4) $4.00
    Regression Analysis Method
    • Regression analysis measures the average amount of
    change in the dependent variable associated with a unit
    change in one or more independent variables.

    • Regression analysis is more accurate than the high-low


    method because the regression equation estimates
    costs using information from ALL observations whereas
    the high-low method uses only TWO observations.

    • Load the Analysis ToolPak in Excel - Office


    Support (microsoft.com)
    Types Of Regression Analysis
    • Simple regression estimates the relationship
    between the dependent variable and ONE
    independent variable (y=a+bx+e)
    • Multiple regression estimates the relationship
    between the dependent variable and TWO OR
    MORE independent variables
    (y=a+b1X1+b2X2+…+e)

    Regression analysis is widely used because it helps managers


    understand why costs behave as they do and what managers can
    do to influence them.
    Sample Regression Model Plot
    Regression Model for Weekly Indirect Manufacturing Labor Costs and Machine-Hours
    Regression Analysis: Terminology
    • Goodness of fit indicates the strength of the
    relationship between the cost driver and costs.
    • Residual term measures the difference between
    actual cost and estimated cost for each
    observation.
    • The smaller the residual term, the better is the fit
    between the actual cost observations and
    estimated costs.
    In-class Exercise

    Could you estimate the cost function using a simple regression analysis?
    Evaluating and Choosing Cost Drivers
    How does a company determine the best cost driver when
    estimating a cost function? An understanding of both
    operations and cost accounting is helpful.
    Here are the three criteria used:
    1. Economic plausibility
    2. Goodness of fit
    3. Significance of the independent variable
    In-class Exercise
    A company is trying to determine the best cost driver of its indirect labor
    costs. The cost driver candidates are Machine hours and irect labor
    hours.
    Using the dataset below, which is included in the Excel file for this class,
    perform a simple regression analysis to determine the best cost driver.
    Machine Direct Labor Indirect Labor
    Week Hours Hours Costs
    1 68 30 1,190
    2 88 35 1,211
    3 62 36 1,004
    4 72 20 917
    5 60 47 770
    6 96 45 1,456
    7 78 44 1,180
    8 46 38 710
    9 82 70 1,316
    10 94 30 1,032
    11 68 29 752
    12 48 38 963
    Total 862 462 12,501
    In-class Exercise
    Using the dataset below, which is also included in the Excel file for this
    class, to perform a multiple regression analysis to determine the cost
    driver hierarchies.
    Number of Machine Direct Labor Indirect Labor
    Week Batches Hours Hours Hours
    1 12 68 30 1,190
    2 15 88 35 1,211
    3 13 62 36 1,004
    4 11 72 20 917
    5 10 60 47 770
    6 12 96 45 1,456
    7 17 78 44 1,180
    8 7 46 38 710
    9 14 82 70 1,316
    10 12 94 30 1,032
    11 7 68 29 752
    12 14 48 38 963
    Total 144 862 462 12,501
    Multicollinearity
    Multicollinearity exists when two or more independent
    variables are highly correlated with each other.
    A coefficient of correlation between independent vari-ables
    greater than 0.70 indicates multicollinearity.
    Multicollinearity increases the standard errors of the
    coefficients of the individual variables. That is, variables that
    are economically and statistically significant will appear not
    to be significantly different from zero.
    Try to perform a correlation analysis in Excel.
    Nonlinear Cost Functions

    Learning Curve
    Learning Curve and Experience curve
    • Learning curve—a function that measures how labor-hours
    per unit decline as units of production increase because
    workers are learning and becoming better at their jobs.
    • Experience curve—measures the decline in the cost per
    unit of various business functions as the amount of these
    activities increases. It is a broader application of the
    learning curve that extends to other business functions in
    the value chain such as marketing, distribution and
    customer service.
    Types of Learning Curves
    • Cumulative average-time learning model—cumulative
    average time per unit declines by a constant percentage
    each time the cumulative quantity of units produced
    doubles.
    • Incremental unit-time learning model—incremental time
    needed to produce the last unit declines by a constant
    percentage each time the cumulative quantity of units
    produced doubles.
    Cumulative Average—Time Model

    • Assume that it takes a person 10 hours to complete the


    first unit and the second one only requires 8 hours to
    complete.
    Learning curve=Cum. Ave/Previous Cum. Ave.
    =(18/2)/(10/1)
    =0.9
    • Each time production quantity doubles, the cumulative
    average time per unit will be 90% of the previous
    cumulative average time per unit.
    Cumulative Average—Time Model

    • Assume that it takes a person 10 hours to complete the


    first unit and the second one only requires 8 hours to
    complete. Draw the table to present the learning curve:

    # Unit Avg Time per Unit Total Time

    1 10 hours 10 hours

    2 10*0.9=9 18

    4 9*0.9=8.1 32.4

    8 8.1*0.9=7.29 58.4
    Cumulative Average—Time Model

    • How do we get the numbers mathematically?


    • Y=aXb

    Y: cumulative avg time per unit


    X: cumulative number of units produced
    a: time required to produce the first unit
    b: learning curve factor =ln(learning curve)/ln(2)

    Could you try to use an excel sheet to produce a complete


    learning curve table?
    Incremental Unit—Time Model

    • Assume that the incremental unit-time learning curve is


    90%, this means that, when the quantity of units produced
    is doubled from X to 2X, the time to produce the 2Xth unit is
    90% of the time needed to produce the Xth unit.
    • Mathematical relationship:
    • Y=aXb
    Y=Time for the last single unit
    X: cumulative number of units produced
    a: time required to produce the first unit
    b: learning curve factor =ln(learning curve)/ln(2)

    •
    In-class Exercise

    To complete the first setup on a new machine took an employee 320


    minutes. Using an 70% cumulative average-time learning curve indicates
    that the second setup on the new machine is expected to take ________.

    A) 112 minutes
    B) 128 minutes
    C) 272 minutes
    D) 224 minutes
    In-class Exercise

    To complete the first setup on a new machine took an employee 200


    minutes. Using an 64% incremental unit-time learning model indicates that
    the second setup on the new machine is expected to take ________.

    A) 128.0 minutes
    B) 312.5 minutes
    C) 328.0 minutes
    D) 72.0 minutes
    How to use Learning Curve?

    • Pricing decisions
    • Performance evaluation standards
    • Cost estimation and control
    # Unit Cul. avg Total Cumulative Average
    hours per hours labor cost (50 labor cost
    Unit per hour) per unit
    1 10 hours 10 hours 500 500
    2 10*0.9=9 18 900 450
    4 9*0.9=8.1 32.4 1620 405
    8 8.1*0.9=7.29 58.4 2920 365

    Discussion: Does learning curve generate other benefits?


    In-class Exercise

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