Chapter 10

Determining How Costs Behave

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Cost

Monetary measure of resources given up to attain an objective (such as

acquiring a good or delivering a service)
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Cost Classifications

Cost behavior
• means how a cost
will react to changes
in the level of
business activity.
Cost Behavior
• Cost reactions to changes in activity:
▫ Variable
▫ Fixed
▫ Mixed
▫ Step

Relevant Range—normal operating range

Alternative Operating/Capacity Levels

■ Capacity measure of volume or some other

activity base
■ Alternative measures
❑ Theoretical

❑ Practical

❑ Normal

❑ Expected

■ Choice of capacity level affects product cost

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Theoretical Capacity
•All production factors are operating
perfectly
•Disregards
▫Machinery breakdown
▫Holiday downtime
•Results in
▫Significant underapplied overhead
▫Lowest product cost
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Practical Capacity
• Theoretical capacity reduced by ongoing, regular
operating interruptions (holidays, downtime, and
start-up time)
• Usually results in
▫ Underapplied overhead
▫ Low product cost

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Normal Capacity
• Considers
▫ Historical production level
▫ Estimated future production level
▫ Cyclical fluctuations
• Attainable level of activity
• When normal capacity is greater than
expected capacity, may result in
▫ Underapplied overhead
▫ Higher product cost

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Expected Capacity
• Anticipated activity level for the upcoming period
based on projected product demand
• Determined during the budget process
• Should closely reflect actual costs
• Results in
▫ Immaterial overapplied or underapplied overhead
▫ Highest product cost

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Alternative
AlternativeCapacity
CapacityLevels
Level
■ Theoretical lowest product cost
■ Practical low product cost
■ Normal higher product cost *
■ Expected highest product cost
*assuming normal exceeds expected capacity

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Cost Behavior
• Fixed costs—remain unchanged in total
regardless of changes in the relevant range of
activity or volume.
• Variable costs—changes in total in proportion
to changes in the related level of activity or
volume.
• Mixed costs—costs that have both fixed and
variable components; also called semivariable
costs.
• Costs are fixed or variable only with respect to a
specific activity or a given time period.
Cost Reaction to Changes in Activity
•Variable cost •Fixed Cost

$
$

# of Units # of Units
Within the
relevant range
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website for classroom use.
1-13

Total Variable Cost

Your total texting bill is based on how
many texts you send.
Total Texting Bill

Number of Texts Sent

1-14

Variable Cost Per Unit

The cost per text sent is constant at
5 cents per text.

Cost Per Text Sent

Number of Texts Sent
1-15

Total Fixed Cost

Your monthly contract fee for your cell phone is fixed for
the number of monthly minutes in your contract. The
monthly contract fee does not change based on the
number of calls you make.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
1-16

Fixed Cost Per Unit

Within the monthly contract allotment, the average
fixed cost per cell phone call made decreases as
more calls are made.

Monthly Cell Phone

Contract Fee

Number of Minutes Used

Within Monthly Plan
 Total and Unit Cost Behavior
Total Cost Unit Cost

Varies in direct Remains constant

Variable
proportion to throughout the
Cost
changes in activity relevant range
More output = More cost

Varies inversely
Fixed Remains constant with changes in
Cost throughout activity throughout
the relevant range
the relevant range More output = lower cost
per unit

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 Cost Reaction to Changes in Activity
•Variable cost •Fixed Cost
$ $
Total Total

# of Units # of Units

Unit $ Unit $
Within the
# of Units relevant range # of Units
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1-19

Quick Check ✔
Which of the following costs would be variable
with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be
more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
1-20

Quick Check ✔
Which of the following costs would be variable
with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be
more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Multiple Classification of Costs
• Costs may be classified as:
▫ Direct/Indirect, and
▫ Variable/Fixed
• These multiple classifications give rise to
important cost combinations:
▫ Direct and variable
▫ Direct and fixed
▫ Indirect and variable
▫ Indirect and fixed
Multiple Classification of Costs,
Visualized
Mixed Costs
• Costs that have both a fixed and a variable component
• Example - JCM’s sales costs are mixed
o There are 10 sales representatives, each earning $30,000 plus receive a
commission of $5 per speaker sold that can be represented by the following
equation:

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Step-Cost Behavior (1 of 3)

• Step-cost function: Displays a constant level of cost for a range of

output and then jumps to a higher level of cost at some point

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be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Step-Cost Behavior (2 of 3)

• Step-variable costs
o Follow a step-cost behavior with narrow steps
• Step-fixed costs
o Follow a step-cost behavior with wide steps
o Activity rate: Average unit cost
• Obtained by dividing the resource expenditure by the activity’s practical capacity

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Step-Cost Behavior
• Relationship between resources supplied and resources used is
given by either of the following:
o Activity availability = Activity output + Unused capacity
o Cost of activity supplied = Cost of activity used + Cost of unused
activity

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Cost Reaction to Changes in Activity
•Step Cost (fixed) •Mixed Cost

variable
$ $
fixed
# of Units # of Units

Within the
relevant range
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 Determining Cost Behavior
• Cost Predictor • Cost Driver
▫ Activity accompanied ▫ Activity that has a
by consistent, direct cause-effect
observable changes in relationship on cost
a cost item
▫ Predicts but may not ▫ Directly causes the
cause the cost to cost to change
change

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Activities that cause costs to be
incurred are called COST DRIVERS:

2-29
Measures of output
• Activity drivers explain changes in activity costs by measuring changes in
activity output (usage)
o General categories
• Unit-level drivers
• Non-unit-level drivers

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Product Cost Behavior

• Direct Material Variable

• Direct Labor Variable

• Overhead Variable, fixed, or mixed

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Need for cost separation of Fixed
Costs and Variable Costs
•Accounting records show only total cost
and associated output of a mixed cost
item
o Total cost should be separated into fixed and
variable components because some fixed
costs are sunk cost which will be irrelevant to
the decision-making.

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be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Analyzing Mixed Costs
A mixed cost contains both
a variable and fixed component

variable
Mixed Cost $
fixed
# of Units
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Cost Function, Defined
• A cost function is a mathematical description of how a
cost changes with changes in the level of an activity
relating to that cost.
• Cost functions can be plotted on a graph by measuring
the level of an activity on the horizontal axis (called
the x-axis). (ex. number of batches produced or number
of machine-hours used)
• The amount of total costs corresponding to—or
dependent on—the levels of that activity are measured
on the vertical axis (called the y-axis).
Cost Function, Defined
• 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,
and
◼ Cost behavior is approximated by a linear cost function
within the relevant range.
▫ Relevant range is the range of the activity in which there is a
relationship between total cost and the level of activity.
▫ Linear Cost Function, total cost versus the level of a single
activity related to that cost is a straight line within the relevant
range.
Linear Cost Function

Total cost
y = a + bX
The dependent
variable: Measure of output
the cost that is The independent
being predicted variable: the cost driver
activity base to which y is
related

The slope of
The intercept: the line:
fixed costs variable cost
fixed portion of total cost per unit

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 Quantitative methods for separating mixed costs into
fixed and variable components
• Dependent variable: Variable whose value depends on the value of another
variable
• Independent variable: Variable that measures output and explains changes in
the cost
• Constant/Intercept: Corresponds to fixed cost. It is the component of the total
cost that does not vary with changes in the level of the activity.
• slope coefficient: Corresponds to the variable cost per unit of output. The
amount by which total cost changes when a one-unit change occurs in the level
of activity.
• mixed cost / semivariable cost: is a cost that has both fixed and variable
elements.
ACCOUNTING STATISTICS
Variable Cost Slope or Slope Coefficient
Fixed Cost Intercept or Constant
Mixed Cost Linear Cost Function
th
Hansen/Mowen, Cornerstones of Cost Management, 4 Edition. © 2018 Cengage. All Rights Reserved. May not
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Linear Cost Functions, Illustrated
Exhibit 10.1 Examples of Linear Cost Functions
Exercise 10-29 Linear cost approximation
Terry Lawler, managing director of the Little Rock Reviewers Company, is
examining how overhead costs behave with changes in monthly professional
labor-hours billed to clients. Assume the following historical data:

1. Compute the linear cost function, relating total overhead costs to

professional labor-hours, using the representative observations of 4,000
and 7,500 hours.
2. What would be the predicted total overhead costs for (a) 5,000 hours and
(b) 8,500 hours using the cost function estimated in requirement 1?

Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exercise 10-29 Linear cost approximation
Terry Lawler, managing director of the Little Rock Reviewers Company, is examining how
overhead costs behave with changes in monthly professional labor-hours billed to clients.
Assume the following historical data:

1. Compute the linear cost function, relating total overhead costs to professional
labor-hours, using the representative observations of 4,000 and 7,500 hours.
Solution: Slope coefficient (b) = Difference in cost / Difference in labor-hours
= ($521,000– $395,000)/(7,500 – 4,000)
= $36.00

Constant (a) = $521,000 – ($36.00 × 7,500) = $251,000

Cost function = $251,000 + ($36.00 professional labor-hours)

Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exercise 10-29 Linear cost approximation
Terry Lawler, managing director of the Little Rock Reviewers Company, is
examining how overhead costs behave with changes in monthly professional
labor-hours billed to clients. Assume the following historical data:

2. What would be the predicted total overhead costs for (a) 5,000 hours and
(b) 8,500 hours using the cost function estimated in requirement 1?
(a) 5,000 hours = $251,000 + ($36.0 x 5000) = 431,000
(b) (b) 8,500 hours = $251,000 + ($36.0 x 8,500) = 557,000

Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Review of 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. Outside the relevant range,
variable and fixed cost-behavior patterns change,
causing costs to become nonlinear (nonlinear means
the plot of the relationship on a graph is not a straight
line).
Identifying Cost Drivers
• Managers use cost estimation to measure a
relationship based on data from past costs and
the related level of an activity.
• Managers are interested in estimating past cost
functions primarily because they can help them
make more accurate cost predictions, or
forecasts, of future costs.
• 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 (1 of 2)

• The most important issue in estimating a cost function is

determining whether a cause-and-effect relationship
exists between the level of an activity and the costs
related to it.
• Without a cause-and-effect relationship, managers will
be less confident about their ability to estimate or predict
costs.
• When a cause-and-effect relationship exists between
a change in the level of an activity and a change in
the level of total costs, we refer to the activity measure
as a cost driver.
The Cause-and-Effect Criterion (2 of 2)

• 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

• Identifying cost drivers also gives managers insights into

ways to reduce costs and the confidence that reducing
the quantity of the cost drivers will lead to a decrease in
costs.
Cost Drivers and the
Decision-Making Process
• To correctly identify cost drivers in order to make
decisions, managers should always use a long time
horizon.
• Costs may be fixed in the short run (during which time
they have no cost driver), but they are usually variable
and have a cost driver in the long run.
Cost Estimation Methods
FOUR METHODS OF COST ESTIMATION ARE:
1. Industrial engineering method
2. Conference method
3. Account analysis method
4. Quantitative analysis methods
1. High-low method
2. Regression analysis
These method are not mutually exclusive and often more
than one is used.
Industrial Engineering Method
• Estimates cost functions by analyzing the relationship
between inputs and outputs in physical terms.
• Includes time-and-motion studies.
• Very thorough and detailed when there is a physical
relationship between inputs and outputs, but also costly
and time-consuming.
• Also called the work-measurement method.
• Some government contracts mandate its use.
Conference Method
• Estimates cost functions on the basis of analysis and
opinions about costs and their drivers gathered from
various departments of a company.
• Pools expert knowledge, increasing credibility.
• Because opinions are being used, the accuracy of the
cost estimates depends largely on the care and skill of
the people providing the inputs.
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.
• Widely used because it is reasonably accurate,
cost-effective, and easy to use.
• 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.
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.
Six Steps in 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.
• Three steps in the high-low method to obtain the
estimate of the cost function.
High-Low Method (1 of 2)

• Takes two points (the high and the low by volume of

activity) and determines the slope and the intercept
o Slope is variable rate
o Intercept is fixed cost
• Advantages
o Objective in nature
o Simple to calculate
• Disadvantages
o High and low points may be outliers that represent atypical
cost-activity relationships
o Other pairs of points may be more representative

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 Using the High–Low Method
Machine
Hours Cost
High 9,000 $3,500
Low 4,600 2,180
Difference 4,400 $1,320
$1,320
= $0.30/unit Variable cost per unit
4,400
3,500 = a + ($0.30)(9,000)
a = 800 Fixed cost
Y = $800 + $0.30X (X = machine hours)
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for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
 Fixed costs
a. per unit remain the same regardless of total output
b. remain the same within the relevant range of output
c. increase in steps as the amount of the cost driver volume
increases
d. have both fixed and variable components in them
e. none of the above.
 Fixed costs
a. per unit remain the same regardless of total output
b. remain the same within the relevant range of output
c. increase in steps as the amount of the cost driver volume
increases
d. have both fixed and variable components in them
e. none of the above.
You have a situation where total costs amount to $6,000
when labor hours total is 400, and $5,000 when labor
hours total is 300. Using the high-low method, what would
be the total cost when labor hours amount to 450 hours?
a. $4500
b. $5500
c. $6500
d. $7500
e. none of the above
You have a situation where total costs amount to $6,000
when labor hours total is 400, and $5,000 when labor
hours total is 300. Using the high-low method, what would
be the total cost when labor hours amount to 450 hours?
a. $4500
b. $5500
c. $6500
d. $7500
e. none of the above
b = ($6000 – 5000) / (400 – 300) labor hours = 1000/100 = $ 10 per labor hours
Compute for a: 6000 = a + $10 (400) = 6000 = a + 4000 = $2,000

Y = $2,000 + 10X
= $2,000 + 10 (450 hours)
= $6,500
Problem 10-36 High-low method
Farm Fresh, a cooperative of organic family-owned farms outside of New South Wales, Australia, has
recently started a fresh produce club to provide support to the group’s member farms and to promote
the benefits of eating organic, locally produced food to the nearby suburban community. Families pay
a seasonal membership fee of $75 and place their orders a week in advance for a price of $35 per
order. In turn, Farm Fresh delivers fresh-picked seasonal local produce to several neighborhood
distribution points. Seven hundred families joined the club for the first season, but the number of
orders varied from week to week.
Sam Baker has run the produce club for the first 10-week season. Before becoming a farmer, Sam
had been a business major in college, and he remembers a few things about cost analysis. In
planning for next year, he wants to know how many orders will be needed each week for the club to
break even, but first he must estimate the club’s fixed and variable costs. He has collected the
following data over the club’s first 10 weeks of operation:

Estimate the cost equation using the high-low method

Problem 10-36 High-low method
Scatterplot Method (1 of 3)

• Uses a scatter graph to visually assess the relationship

between cost and output
o Intercept is fixed cost
o Slope is variable rate
• Assesses the validity of the assumed linear relationship
• Advantages
o Allows for visual inspection of the data
o Identifies nonlinearity, outliers, and shifts in the cost relationship
• Disadvantages
o Lacks objective criterion for choosing the best-fitting line
o Subjective in nature

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be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
EXHIBIT 3.8 A - Scattergraph for Anderson Company’s
Materials Handling Costs

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be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
EXHIBIT 3.8 B - Scattergraph for Anderson Company’s
Materials Handling Costs

Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Regression Analysis Method
▫ Regression analysis is a statistical method that
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.
Types Of Regression Analysis
• Simple regression estimates the relationship
between the dependent variable and ONE
independent variable
• Multiple regression estimates the relationship
between the dependent variable and TWO OR
MORE independent variables.
Regression analysis is widely used because it
helps managers understand why costs behave as
they do and what managers can do to influence
them.
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.
Sample Regression Model Plot
Exhibit 10.6 Regression Model for Weekly Indirect Manufacturing Labor Costs and
Machine-Hours for Elegant Rugs
Evaluating and Choosing Cost
Drivers (1 of 2)
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 - both cost drivers are
economically plausible (likely to be true or valid)
2. Goodness of fit - the vertical differences between the
actual costs and predicted costs are much smaller.
3. Significance of the independent variable – a flat or
slightly sloped regression line indicates a weak
relationship between the cost driver and costs.
Evaluating and Choosing Cost
Drivers (2 of 2)
QUESTION: Why is choosing the correct cost driver to
estimate costs important?
ANSWER: Identifying the wrong drivers or misestimating
cost functions can lead management to incorrect and costly
decisions along a variety of dimensions.
Problem 10-36 Regression Analysis
Farm Fresh, a cooperative of organic family-owned farms outside of New South Wales, Australia, has
recently started a fresh produce club to provide support to the group’s member farms and to promote
the benefits of eating organic, locally produced food to the nearby suburban community. Families pay
a seasonal membership fee of $75 and place their orders a week in advance for a price of $35 per
order. In turn, Farm Fresh delivers fresh-picked seasonal local produce to several neighborhood
distribution points. Seven hundred families joined the club for the first season, but the number of
orders varied from week to week.
Sam Baker has run the produce club for the first 10-week season. Before becoming a farmer, Sam
had been a business major in college, and he remembers a few things about cost analysis. In
planning for next year, he wants to know how many orders will be needed each week for the club to
break even, but first he must estimate the club’s fixed and variable costs. He has collected the
following data over the club’s first 10 weeks of operation:

Estimate the cost equation using the Regression Analysis

Weekly total costs = $10,048 + $28.91 × (Number of Orders per week)
Problem 10-36 Regression Analysis

Did Farm Fresh break even this season? Remember that each of the families
paid a seasonal membership fee of $75.
Problem 10-36 Regression Analysis

Assume that 850 families join the club next year and that prices and costs do not
change. How many orders, on average, must Farm Fresh receive each week to
break even?
Nonlinear Cost Functions, Defined
• Cost functions are not always linear.
• A nonlinear cost function is a cost function for which the
graph of total costs is not a straight line within the relevant
range.
• Some examples of nonlinear cost functions are:
• 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.
Nonlinear Cost Functions, Illustrated
Exhibit 10.9 Examples of Nonlinear Cost Functions
Two Learning Curve Models
• 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.
• The learning curve function is defined as follows:
Y = aXb
• where:
Y = the cumulative average time (or cost) per unit.
X = the cumulative number of units produced.
a = time (or cost) required to produce the first unit.
b = slope of the function when plotted on log-log paper.
= log of the learning-curve % in decimal form / log of 2.
Sample Cumulative Average—Time Model
Sample Incremental Unit—Time Learning Model
Time Learning Model Comparative Plots
Exhibit 10.12 Plots for Cumulative Average-Time Learning Model and Incremental
Unit-Time Learning Model for Rayburn Corporation
It takes this worker 10 minutes to assemble a toy.
With a learning curve of 70% as production
doubles, compute for the:

Cumulative average-time learning model

• Cumulative Average Time per unit (y)
• Cumulative Total Time when X = 3
• Individual unit time for Xth unit

Incremental unit-time learning model

• Individual unit time for Xth unit (y)
• Cumulative Total Time when X = 3
• Cumulative Average Time per unit
It takes this worker 10 minutes to assemble a toy. With a
learning curve of 70% as production doubles, the average
time needed to make 3 units would be:
Y = aXb
Y = 10 (3 units) b
Y = 10 (3 units) -0.5145
= 5.68180 minutes
b = log 0.70 / log 2
= -0.5145
Cumulative average-time learning model
• Cumulative Average Time per unit (y) = 5.68180 minutes
• Cumulative Total Time when X = 3 is 17.045 minutes (5.68180
minutes x 3 units)
• Individual unit time for Xth unit = 17.045 – (7 mins x 2 units)
= 3.045 mins.
1 unit = 10 minutes
2 units = (10 mins x .7) 7 minutes
It takes this worker 10 minutes to assemble a toy. With a
learning curve of 70% as production doubles, the average time
needed to make 3 units would be:
Y = aXb
Y = 10 (3 units) b
Y = 10 (3 units) -0.5145
= 5.68180 minutes
b = log 0.70 / log 2
= -0.5145
Incremental unit-time learning model
• Individual unit time for Xth unit (y) = 5.68180 minutes
1 unit = 10 minutes
2 units = (10 mins x .7) 7 minutes
• Cumulative Total Time when X = 3 is 22.6818 minutes (10+ 7 mins +
5.68180 mins)
• Cumulative Average Time per unit = 7.5606 mins (22.6818 min/3)
 Data Collection and
Adjustment Issues
The ideal database for estimating cost functions quantitatively
has two characteristics:
1. The database should contain numerous reliably measured
observations of the cost driver and the related costs.
Errors in measuring the costs and the cost driver are
serious may result in inaccurate estimates of the effect of
the cost driver on costs.
2. The database should consider many values spanning a
wide range for the cost driver. Using only a few values of
the cost driver that are grouped closely together causes
managers to consider too small a segment of the relevant
range and reduces the accuracy of the estimates
obtained.
 Data Problems (1 of 3)

Managers should ask about these problems and assess how

they have been resolved before they rely on cost estimates
generated from the data.
1. The time period for measuring the dependent variable
does not properly match the period for measuring the cost
driver. This problem often arises when a company does
not keep accounting records on the accrual basis.
2. Fixed costs are allocated as if they are variable. The costs
appear to be variable, but that is related to the allocation
methods used, not the actual behavior of the costs.
3. Data are either not available for all observations or are not
uniformly reliable. Missing cost observations often arise
because they have not been recorded or classified
correctly
Data Problems (2 of 3)

4. Extreme values of observations occur. These values

arise from (a) errors in recording costs, (b)
nonrepresentative periods or (c) observations outside
the relevant range.
5. There is no homogeneous relationship between the
cost driver and the individual cost items in the
dependent variable-cost pool. (A homogeneous
relationship exists when each activity whose costs are
included in the dependent variable has the same cost
driver.)
Data Problems (3 of 3)

6. The relationship between the cost driver and the cost is

not stationary. This can occur when the underlying
process that generated the observations has not
remained stable over time.
7. Inflation has affected the costs, the cost driver, or both.
Inflation cause costs to change even when there is no
change in the level of the cost driver.
Absorption vs. Variable Costing
Absorption or Full Costing Variable or Direct Costing
• External use • Internal use
• GAAP • Not GAAP
• Classify by Function • Classify by Behavior
▫ Cost of goods sold ▫ Variable
▫ Selling expense ▫ Fixed
▫ Administrative
expense

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
 Absorption vs. Variable Costing
Absorption or Full Variable or Direct
■ Product costs ■ Product costs

❑ Direct material ❑ Direct material

❑ Direct labor ❑ Direct labor

❑ Variable mfg. overhead ❑ Variable mfg. overhead

❑ Fixed mfg. overhead ■ Period costs

■ Period costs ❑ Fixed mfg. overhead

❑ Selling ❑ Selling

❑ General ❑ General

❑ Administrative ❑ Administrative

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
Differences Between Absorption and
Variable Costing
Absorption Costing Variable Costing
• Fixed manufacturing • Fixed manufacturing
overhead is a product overhead is a period
cost cost
• Variable operating
expenses are
subtracted from product
contribution margin to
equal contribution
margin
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
5-91

Overview of Absorption and

Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses
Income Statement
Absorption Costing
Product Costs
Sales Direct Material
Less: Cost of Goods Sold Direct Labor
Gross Profit Fixed and
Variable
Less: Operating Expenses
Mfg. Overhead
Net Income
Period Costs
Selling, General,
Administrative
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
 Variable Costing or Contribution
Margin Income Statement
Sales Direct
Material
Less: Variable Cost of Goods Sold
Direct Labor
Product Contribution Margin
Variable Mfg.
Less: Variable Operating Expenses Overhead
Contribution Margin
Selling,
Selling
Less: Fixed Mfg. Overhead
General,
General
Less: Fixed Operating Expenses Administrati
Net Income on
ve

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
Exercise 10-29 Linear cost approximation
Terry Lawler, managing director of the Little Rock Reviewers Company, is
examining how overhead costs behave with changes in monthly professional
labor-hours billed to clients. Assume the following historical data:

Cost function = $251,000 + ($36.00 professional labor-hours)

Lawler had a chance to accept a special job that would have boosted
professional labor-hours from 4,000 to 5,000 hours. Suppose Lawler, guided
by the linear cost function, rejected this job because it would have brought a
total increase in contribution margin of $31,000, before deducting the
predicted increase in total overhead cost, $36,000. What is the total
contribution margin actually forgone?

Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exercise 10-29 Linear cost approximation
Cost function = $251,000 + ($36.00 professional labor-hours)
Lawler had a chance to accept a special job that would have boosted
professional labor-hours from 4,000 to 5,000 hours. Suppose Lawler, guided
by the linear cost function, rejected this job because it would have brought a
total increase in contribution margin of $31,000, before deducting the
predicted increase in total overhead cost, $36,000. What is the total
contribution margin actually forgone?
Solution:

Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Difference in Income
Absorption vs. Variable
• No change in inventory level
▫ Absorption Income = Variable Income
• Increase in inventory level
▫ Absorption Income > Variable Income
▫ Phantom Profits
• Decrease in inventory level
▫ Absorption Income < Variable Income

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
5-97

Quick Check ✔
Which method will produce the highest values
for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
5-98

Quick Check ✔
Which method will produce the highest values
for work in process and finished goods
inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends.
5-99

Unit Cost Computations

Harvey Company produces a single product
with the following information available:
5-100

Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses are

always treated as period expenses and
deducted from revenue as incurred.
5-101

Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional information
for Harvey Company.
• 20,000 units were sold during the year at a price of
$30 each.
• There is no beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
5-102

Absorption Costing
5-103

Variable Costing
Variable
manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
5-104

Extended Comparison of Income

Data Here is information about the operation
of Harvey Company for the second year.
5-105

Unit Cost Computations

Since there was no change in the variable costs

per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
5-106

Absorption Costing

These are the 25,000 units

produced in the current period.
5-107

Variable
Variable Costing manufacturing
costs only.

All fixed
manufacturing
overhead is
expensed.
5-108

Comparing Absorption and

Variable Costing: Year 1
Let’s compare the methods.
5-109

Comparing Absorption and

Variable Costing: Year 1
We can reconcile the difference between absorption
and variable net operating income as follows:

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
units
5-110

Comparing Absorption and

Variable Costing: Year 2
We can reconcile the difference between absorption
and variable net operating income as follows:

Fixed mfg. overhead $150,000

= = $6.00 per unit
Units produced 25,000
units
5-111

Comparing Absorption and

Variable Costing: Years 1 and 2
5-112

Summary of Key Insights

NOI = net operating income

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for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
Controllable and
Uncontrollable Costs
A cost that can be significantly influenced
by a manager is a controllable cost.

2-114
1-115

Differential Costs and Revenues

Costs and revenues that differ
among alternatives.
Example: You have a job paying $1,500 per month in
your hometown. You have a job offer in a
neighboring city that pays $2,000 per month. The
commuting cost to the city is $300 per month.

Differential revenue is: Differential cost is:

$2,000 – $1,500 = $500 $300

Net Differential Benefit is:

$200
Opportunity Cost

The potential benefit that is

given up when one
alternative is selected
over another.
▫ Example: If you were
not attending college,
you could be earning
$20,000 per year.
Your opportunity cost
of attending college for one
year is $20,000.
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 are not
differential costs and should not be considered in
decisions.
▫ Example: You bought an automobile that cost
$12,000 two years ago. The $12,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $12,000 cost.

2-117
Differential Costs
Costs that differ between alternatives.

Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.

What is your differential cost?

$300 - $50 = $250

2-118
Marginal Costs and Average Costs

The extra cost

The total cost to
incurred to
produce a quantity
produce
divided by the
one additional
quantity produced.
unit.

Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.

2-119
1-120

Quick Check ✔
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the cost of the train ticket relevant in this
decision? In other words, should the cost of the
train ticket affect the decision of whether you
drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not
relevant.
1-121

Quick Check ✔
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the cost of the train ticket relevant in this
decision? In other words, should the cost of the
train ticket affect the decision of whether you
drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not
relevant.
1-122

Quick Check ✔
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the annual cost of licensing your car relevant
in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
1-123

Quick Check ✔
Suppose you are trying to decide whether to
drive or take the train to Portland to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the annual cost of licensing your car relevant
in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
1-124

Quick Check ✔
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
1-125

Quick Check ✔
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
1-126

Cost Classifications for Decision

Making
Every decision involves a choice
between at least two alternatives.
Only those costs and
benefits that differ
between alternatives
are relevant to the
decision. All other costs
and benefits can and
should be ignored.
Costs and Benefits of Information

Costs Benefits

More information does not mean more

benefits if information overload results.

2-127
Managerial Judgment
• Most widely used method in practice in determining cost behavior
• Managers may:
o Use their experiences and observations to determine fixed and variable costs
o Identify mixed costs and use experience to determine what part is fixed, thus
denoting the rest as variable
• Yields good results when the manager has a good understanding of the
processes

Hansen/Mowen, Cornerstones of Cost Management, 4th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
End of Chapter 3

2-129
1-130

Acknowledgements & PowerPoint

Sources
Cost Management Accounting & Control
- Hansen, Mowen, Guan
Introduction to Management Accounting
- Horgreen, Sundeen, Starton
Cost Accounting: Foundations and Evolutions
- Kinney, Raiborn
Financial and Managerial Accounting
- Williams, Haka, Bettner

© 2012 Pearson Education. All rights reserved.

 Chapter 1
Managerial Accounting and Cost
Concepts

PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 2

Basic Cost
Management Concepts
and Accounting for Mass
Customization Operations

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.