Horngren’s Cost Accounting: A Managerial

Emphasis
Seventeenth Edition

Chapter 10
Determining How Costs
Behave
Learning Objectives
1 Describe linear cost functions and three common ways in
which they behave
2 Explain importance of causality in estimating cost functions
3 Understand various methods of cost estimation
4 Outline six steps in estimating a cost function using
quantitative analysis
5 Describe three criteria used to evaluate and choose cost
drivers
6. Explain nonlinear cost functions, in particular those arising
from learning-curve effects
7. Be aware of data problems encountered in estimating cost
functions
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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.
• 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.

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Cost Terminology
From prior chapters, we are familiar with the distinction
between variable and fixed costs. In this chapter, we
introduce mixed costs.
• Variable costs—costs that change in total in relation to
some chosen activity or output
• Fixed costs—costs that do not change in total in relation
to some chosen activity or output
• Mixed costs—costs that have both fixed and variable
components; also called semivariable costs

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Linear Cost Function

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Bridging Accounting and Statistical
Terminology
Accounting Statistics
Variable Cost Slope or Slope Coefficient
Fixed Cost Intercept or Constant
Mixed Cost Linear Cost Function

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Linear Cost Functions Illustrated
Exhibit 10.1 Examples of Linear Cost Functions

Panel A: Variable Cost Panel B: Fixed Cost Panel C: Mixed Cost

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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.
Better management decisions, cost predictions, and
estimation of cost functions can be achieved only if
managers correctly identify the factors that affect costs.

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The Cause-and-Effect Criterion (1 of 3)
• 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.

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The Cause-and-Effect Criterion (2 of 3)
• 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, or
– 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.

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The Cause-and-Effect Criterion (3 of 3)
• Economic plausibility is critical because it gives analysts
and managers confidence that the estimated relationship
will appear repeatedly in other sets of data.
• 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.

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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.
• Managers should follow the five-step decision-making
process outlined in Chapter 1 to evaluate how changes
can affect costs and product decisions.

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Cost Estimation Methods
Four Methods of Cost Estimation
1. Industrial engineering method
2. Conference method
3. Account analysis method
4. Quantitative analysis methods
– High-low method
– Regression analysis

These methods are not mutually exclusive, and often more

than one is used.

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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
• Use mandated by some government contracts

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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.

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Account Analysis Method
• This 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 method is 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.

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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

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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.

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High-Low Method
• Simplest method of quantitative analysis
• Uses only the highest and lowest observed values
• “Fits” a line to data points that can be used to predict costs
• Three steps in the high-low method to obtain the estimate
of the cost function

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Steps in the High-Low Method (1 of 3)
Step 1: Calculate the slope coefficient (the variable cost per
unit of activity).
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.
If we had high activity of 100 at cost of $2,500 and low
activity of 80 at cost of $2,100, our formula for variable cost
per unit of activity would be as follows:
( $2,500 - $2,100 ) / (100 - 80 ) or 400/20 = $20.00
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Steps in the High-Low Method (2 of 3)
Step 2: Calculate the constant (the total fixed costs).
Total cost from either the highest or lowest activity level
- (Variable Cost per unit of activity ´ Activity associated
with above total cost) = Fixed Costs
Continuing our example, let’s calculate fixed costs using both
the high and low levels of activity. Recall the our VC from the
previous slide was calculated at $20:
High: $2,500 - ( $20 ´ 100 ) = $500 fixed costs
Low: $2,100 - ( $20 ´ 80 ) = $500 fixed costs

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Steps in the High-Low Method (3 of 3)
Step 3: Summarize by writing a linear equation:
Y = Fixed Costs + (Variable cost per unit of Activity * Activity)
or Y = FC + (VC / U * X)

In our example, our equation would look like this:

Y = $500 + ( $20 * X ) .
If we wondered what total costs would be at an activity level
of 120, we’ll simply plug that number for X in our equation:
Y = $500 + ( $20 * 120 ) ; therefore,
Y = $2,900.

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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.

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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.

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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.

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Sample Regression Model Plot
Exhibit 10.6 Regression Model for Weekly Indirect Manufacturing Labor Costs
(y) and Machine-Hours (X)

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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. Three criteria are
used:
1. Economic plausibility
2. Goodness of fit
3. Significance of the independent variable
Determining the correct cost driver to estimate costs is
critical. Identifying the wrong drivers or misestimating
cost functions can lead management to incorrect and
costly decisions along a variety of dimensions.

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Cost Drivers and Activity-Based
Costing
Estimating cost drivers in an activity-based costing (ABC)
system doesn’t differ in general from what’s been discussed.
However, since A B C systems have a great number and
variety of cost drivers and cost pools, managers must
estimate many cost relationships.
They will do so using the same methods, taking special care
with the cost hierarchy. If a cost is batch-level, for example,
only batch-level cost drivers can be used.

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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 follow.

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Nonlinear Cost Functions Examples
(1 of 2)
1. Economies of scale (produce double the number of
advertisements for less than double the cost).
2. Quantity discounts (direct material costs rise but not in
direct proportion to increases in quantity due to the
nonlinear relationship caused by the quantity discounts).
3. Step cost functions resources increase in “lot-sizes,”
not individual units.

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Nonlinear Cost Functions Examples
(2 of 2)

4. 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.
5. 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.

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Nonlinear Cost Functions Illustrated
Exhibit 10.9 Examples of Nonlinear Cost Functions

Panel A: Effects of Panel B: Step Variable- Panel C: Step Fixed-

Quantity Discounts on Cost Function Cost Function
Slope Coefficient of Direct
Material Cost Function

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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.
2. The database should consider many values spanning a
wide range for the cost driver.

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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.
2. Fixed costs are allocated as if they are variable.
3. Data are either not available for all observations or are
not uniformly reliable.

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Data Problems (2 of 3)
4. Extreme values of observations occur.
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.)
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.

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