Week 10 (Cost Estimation)

What are variable costs?

Change in total in direct proportion to changes in activity

• Increase as activity increases

• Equals zero dollars when activity is zero

• Y=bX

What are fixed costs?

Do not change in response to a change in activity volume

• No change as activity increases or decreases

• No response to short-run changes in activity cost drivers

• Y=a

What are mixed costs?

Contain a fixed & variable cost element; sometimes called semi-variable costs

• Increase in a linear fashion when activity increases

• Positive in amount when activity is zero

• Y=a+bX

What is contribution margin?

Revenue - variable expenses

What is contribution margin ratio?

Contribution margin/ revenue

What is total cost behavior?

Total fixed costs + (variable costs per unit * number of units)

What is relevant range?

• A portion of a range of activity associated with fixed cost of current or expected capacity

• A normal range of activity in which a company expects to operate, where fixed costs remain linear (total cost remains the same)

  • Economic’s total cost function, referred to as curvilinear

  • Accountant’s linear approximation of total cost function

What is cost estimation?

• Determination of the relationship b/w an activity & total cots

• An important part of cost management

• Identifying variable or fixed costs

What is the purpose of cost estimation?

Forecasting future costs

What are the methods of estimating fixed & variable cost components?

• High-low method

• Scatter diagrams

• Least-squares regression analysis

What is high-low cost estimation?

• Utilizes data from 2 time periods

  • A high activity period & a low activity period

What are scatter diagrams?

• A graph of past activity & cost data, with individual observations represented by dots

• When used alone to estimate costs, professional judgement is required

What is least-squares regression?

• Also known as simple regression (one variable)

• A mathematical technique to fit a cost-estimating equation to observed data

• Minimizes vertical squared difference b/w estimated & actual costs at each data point

• Minimizes the sum of all squared vertical deviations b/w individual observations & cost-estimating line

What’s the advantage of least-squares?

• Superior to the high-low & scatter diagram methods

  • B/c it uses all data points, &

  • Does not rely on subjective judgement

• Statistical measures are available to determine how well the equation fits the line

  • Coefficient of determination

    • Measures the percent of variation in dependent variable that the independent variable explains

    • Also called R-squared (R²)

What are the cautions in developing cost estimate equations?

• Managers are responsible for making decisions

  • Mathematical models do not make decisions; they are tools to aid decision making

• Not all data are based on normal operating conditions

• Nonlinear relationships may exist

• Results should make sense

What is operating leverage?

• A measure of the extent to which fixed costs are being used in an organization

• Operating leverage is greatest in companies that have a high proportion of fixed costs in relation to variable costs

• A small percentage change in revenue produces a large percentage change in profits

What is risk & reward assessment?

• Risk refers to the possibility of sacrifices may exceed benefits

• Risk may be reduced by converting fixed costs into variable costs

• Shifting cost structure from fixed to variable enables a company to avoid fixed cost risk

  • The risk of incurring this loss is estimated by shifting to variable cost structure (loss of $35,000 if no tickets sold)

• Shifting cost structure from fixed to variable also reduces potential for profits

  • Variable costs do not offer operating leverage whereas fixed costs do

  • Operating leverage allows a company to magnify the effect of a % increase in sales onto a % increase in profit

What is cost estimation?

Process of determining cost behavior, often focusing on historical data

What is cost behavior?

Relationship b/w cost & activity

What is cost prediction?

Using knowledge of cost behavior to forecast level of cost of a particular activity. Focus is on the future

What is the break-even point?

Point in volume of activity where the organization’s revenues & expenses are equal

What is the margin of safety?

• The difference b/w budgeted sales revenue & break-even sales revenue

• The amount by which sales can drop before losses begin to be incurred