COST MANAGEMENT

PGPEM 2020-22
Cost Behavior and Cost Estimation
Chapter 6 (Hilton)
 Learning Objectives
2

During the session we will discuss and understand:

 How costs behave as the level of activity changes

 The concepts of fixed, variable and step-function

costs
 How to combine cost behavior information with

revenue information to develop a profit graph

 The concept of contribution

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 For short-term planning-Classification by
behavior
3

 Managers often need to predict how a cost will react to

change in the level of activity within the relevant range
 For example, what will be the increase in the company’s
total electricity bill for a 5% increase in sales
 Most common cost classifications are variable costs,
fixed costs, mixed costs and step-function costs
 Applications:
 Budgeting
 Cost-Volume-Profit analysis (profit planning)

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 Variable costs
4

 A variable cost varies, in total, in direct proportion

to changes in the level of activity- for example the
cost of a flash IC installed in a mobile phone
increases with the number of mobile phones
manufactured.
 However, when expressed on a per unit basis,
variable cost is constant. For example, Cost of
Flash IC per mobile phone.

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 Variable Costs
5

 Total variable costs increase in proportion to

increases in unit level cost drivers.

Total
variable
costs (Y)

0
0 Total activity (X)

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 The Activity Base (Cost Driver)
6

Units Machine
produced hours

A measure of what
causes the
incurrence of a
variable cost

Miles Labor
driven As the level of the activity
base increases , the total VC
hours
increases proportionately
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 Fixed costs
7

 A fixed cost is constant within the relevant range-

for example, the lease rental for a mobile phone
assembling plant does not change with the number
of mobile phones assembled.
 Expressed on a per unit basis, fixed cost is
inversely related to activity- the contracted lease
rental per mobile phone assembled decreases as
more mobile phones are assembled.

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 Fixed Costs
8

 Total fixed costs do not respond to changes in unit

level cost drivers within a period.

Total
fixed
costs (Y)

0
0 Total activity (X)

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 Fixed Costs and the Relevant Range
9

90
Rent Cost in Thousands of

The
The relevant
relevant range
range
Relevant of
of activity
activity for
for aa fixed
fixed
60 cost
cost is
is the
the range
range of of
Dollars

Range activity
activity over
over which
which
the
the graph
graph ofof the
the
cost
cost is
is flat.
flat.
30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)
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 Cost Classifications for Predicting Cost
Behavior
10

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 Basic Cost Behavior Patterns

Cost
Concepts - 11

 Total mixed costs contain fixed and variable cost

elements. They increase, but not in direct proportion
to increases in unit level cost drivers.

Total mixed
costs (Y) Sometimes called
semi-variable
costs

0
0 Total activity (X)
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 Mixed Costs
(also called semivariable costs)
12

Consider
Consider the
the example
example of
of utility
utility cost.
cost.

Y
Total Utility Cost

o s t
c
i xed
al m
Tot
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
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 Mixed Costs
13

Y
Total Utility Cost

ost
c
i xed
a l m
To t
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
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 Mixed Costs – An Example
14

If your fixed monthly utility charge is $40, your

variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is
the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
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 Basic Cost Behavior Patterns

Cost
Concepts - 15

 Total step costs are constant over a range of activity

for a unit level cost driver but moves to a different
amount at different ranges.

Total step
costs (Y)

0
0 Total activity (X)
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 Total cost behavior with a single unit level
Cost
cost driver
Concepts - 16

Variable
Variablecosts
costsare
are
Slope, b = Y layered
layeredon
ontop
topofoffixed
fixed
X
costs.
costs.

Total costs Y = a
Total + bX
costs
(Y) Variable costs (b)

Fixed costs (a)

0
0 Value of independent variable (X)
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 Cost estimation methods
17

The purpose of understanding cost behavior is to

make estimates of costs that can be used for
budgeting and decision making.
Methods of estimation:
 Account analysis

 Scattergraphs

 High Low method

 Regression analysis

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 Account analysis
18

 Each account is classified as fixed or variable

depending on the analyst’s prior knowledge about
how the cost behaves.
 Analyst can further refine the estimate by using his
judgment to break up mixed cost into fixed and
variable components
 Limitation of this method is that it is subjective.

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 Scattergraph Plots – An Example
19

Assume the following hours of maintenance work and the total maintenance costs for six months.

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 The Scattergraph Method
20

Plot the data points on a graph (Total Cost Y vs. Activity X).
Y Scattergraph Method
$10,000

$9,500
Total Maintenance Cost

$9,000

$8,500

$8,000

$7,500

$7,000
400 500 600 700 800 900 X
Hours of Lata
Maintenance
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 Scattergraph method
21

 Most methods which are used to estimate costs

assume that costs are linear.
 A scattergraph is useful in assessing whether
this assumption is reasonable.
 Also helps in identifying outliers.

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 The High-Low Method – An Example
22

The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $6.00/hour
400
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 The High-Low Method – An Example
23

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700Lata Chakravarthy IIMB PGP 2020-22
 The High-Low Method – An Example
24

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
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 Least-Squares Regression Method
25

A method used to analyze mixed costs if a

scattergraph plot reveals an approximately linear
relationship between the X and Y variables.

This method uses all of the

data points to estimate
the fixed and variable
cost components of a
mixed cost. The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared
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 Least-Squares Regression Method
26

 Excel spreadsheet can be used to

fit a regression line through the
data points.
 The cost analysis objective is the
same: Y = a + bX

Least-squares regression also provides a statistic,

called the R22, which is a measure of the goodness
of fit of the regression line to the data points.
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 Self Evaluation
27

 Which of the following would likely be a

suitable cost driver for the amount of direct
materials used? 
A. The number of units sold.
B. The number of direct labor hours worked.
C. The number of machine hours worked.
D. The number of units produced.
E. The number of employees working in the
factory.

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 Self Evaluation
28

 The choices below depict five costs of a company and

a possible driver for each cost. Which of these
choices likely contains an inappropriate cost driver? 
A. Petrol consumed: number of miles driven.
B. Manufacturing overhead incurred in a heavily
automated facility: direct labor hours.
C. Sales commissions: gross sales revenue.
D. Building maintenance cost: building square
footage.
E. Human resources department cost: number of
employees.
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 Self Evaluation
29

 Variable costs are costs that: 

A. vary inversely with changes in activity.
B. vary directly with changes in activity.
C. remain constant as activity changes.
D. decrease on a per-unit basis as activity
increases.
E. increase on a per-unit basis as activity
increases.

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 Self Evaluation
30

Identifying Cost drivers

Below is a list of potential cost drivers for a manufacturing
company which makes several products. It uses just-in-time (JIT)
production system so as to minimize finished goods storage time.
The products manufactured vary in size from small to large.
 Number of set-ups

 Set-up time

 Square feet

 Cubic feet

 Cubic feet weeks

 (Cont’d in next page)

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 Self Evaluation
31

(Cont’d from previous page)

For each situation described below (activity and related
resource), identify the best cost driver from the list.
1. To produce a product, production mechanics must set up
machinery. It takes about the same time to set up a
production run irrespective of the product to be produced.
What is the best cost driver for mechanic wages?
2. If it were to take longer time to set up the machinery for
complex products than for simple products, what should
be the cost driver for mechanic wages?
(Cont’d)

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 Self Evaluation
32

(Cont’d from previous page)

3. The company stores the finished goods in a warehouse.
What cost driver should the company use for
warehouse occupancy costs (depreciation and
insurance)?
4. What driver should the company use for warehouse
occupancy costs if it did not use a JIT system (i.e., the
company maintains inventories), and upon inspection
one of the products had a thick layer of dust on it?

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 Practice Problems
33

 6-37, 6-43, 6-46

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