Cost Management

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Accounting 321 Class 2 Cost Estimation CVP
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Cost Estimation
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Strategic Management
Accurate costs estimates are required--

• to facilitate strategic positioning analysis
• to facilitate value chain analysis
• to facilitate target costing and life cycle
  costing

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Use the right Cost Driver
Cost to be Estimated
Potential Cost Drivers
Fuel expense for auto Heating expense for
building Maintenance cost in a manufacturing
plant Product design cost

• Miles driven
• Temperature to be maintained
• Machine hours, labor hours
• Number of design elements, design changes

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TheSix Steps

• What is the cost object and the purpose of the
  analysis?
• Define the Cost to be Estimated
• Identify the Cost Drivers
• Collect Data
• Graph it
• Test results/ Forecast outcomes

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Cost Estimation Methods

• account classification
• visual fit
• the high-low method
• work measurement
• regression analysis

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Visual Fit
Ben Garcia, the management accountant, is
estimating various plant costs. He
is particularly interested in maintenance cost.
Ben graphs the data on maintenance cost.
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Visual Fit
Maintenance Cost
Ben graphs the data.
Maintenance Cost
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Visual Fit
Based on quick view of the data, Ben
concludes that maintenance cost will be 23,200
in 19X8. However, there are potential errors

• The scale of the graph may affect the viewers
  ability to estimate costs accurately.
• Studies have shown that users of both tabular and
  graphical reports make significant perception
  errors.

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High-Low Method
Maintenance Cost
Ben enters the data into a graph.
Total Operating Hours
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High-Low Method
Maintenance Cost
Next, he selects two points--the high and the low
cost. Or perhaps two representative outcomes
Total Operating Hours
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High-Low Method
Y a (b x H)
The high-low estimate is represented as follows
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High-Low Method
Y a (b x H)
The high-low estimate is represented as follows
the value of the estimated maintenance cost
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High-Low Method
Y a (b x H)
The high-low estimate is represented as follows
a fixed quantity that represents the value of Y
when H zero
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High-Low Method
Y a (b x H)
The high-low estimate is represented as follows
the slope of the line
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High-Low Method
Y a (b x H)
The high-low estimate is represented as follows
the cost driver, the number of hours of operation
for the plant
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High-Low Method
High Maintenance Cost - Low Maintenance
Cost High Operating Hours - Low Maintenance
Hours
b
First, b is calculated.
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High-Low Method
High Maintenance Cost - Low Maintenance
Cost High Operating Hours - Low Maintenance
Hours
b
23,175 - 22,510
3,500 - 3,325
b
b 3.80 per hour
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High-Low Method
a Y - (b x H)
a 23,175 - (3.80 x 3,500) a 9,875
The 19X8 estimation for total maintenance cost
using high-low is
Y 9,875 (3.80 x H)
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High-Low Method
If 3,600 operating hours are expected in 19X8,
the estimated maintenance cost (Y) is 23,555.
Y 9,875 (3.80 x 3,600) Y 23,555
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Work Measurement
Kupper Insurance Company analyzes the time it
takes to process a claim. The mean processing
time is 18 minutes, while 95 of the claims
require between 10 and 25 minutes.
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Work Measurement
Because of this study, Kupper is able--

• to estimate cost more effectively.
• to evaluate the processing clerks more
  effectively and fairly - benchmark.

Work measurement should be an on-going activity.
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Regression Analysis

• Regression analysis is a statistical method for
  obtaining the unique equation that best fits a
  set of data points.

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Regression Analysis
Regression analysis is a statistical method for
obtain the unique equation that best fits a set
of data points.

• Least squares regression is widely viewed as one
  of the most effective methods for estimating
  costs.

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Regression Analysis
the value of the dependent variable, the cost to
be estimated
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Regression Analysis
Y a bX e
a fixed quantity, also called the intercept or
constant term, which represents the value of Y
when X is zero
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Regression Analysis
Y a bX e
the unit variable cost, also called the
coefficient of the independent variable, that is,
the increase in Y (cost) for each unit increase
in X (cost driver)
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Regression Analysis
Y a bX e
the value for the independent variable, the cost
driver for the cost to be estimated there may be
one or more cost drivers
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Regression Analysis
Y a bX e
the regression error term, which is the distance
between the regression line and the data point
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Regression Analysis
Month Supplies Expense (Y) Production Level
(X) 1 250 50 units 2 310 100 units 3 325 150
units 4 ? 125 units
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Regression Analysis
400 350 300 250 200
e 15
e 7.5
Supplies Expense
e 7.5
50 100
150
Units of Output
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Regression Analysis
400 350 300 250 200
e 15
e 7.5
Supplies Expense
e 7.5
220
Fixed Cost
50 100
150
Units of Output
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Regression Analysis
Y a bX e Y 220 (.75 x 125) Y
313.75
Estimated value for supplies expense in Month 4
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Regression Analysis
400 350 300 250 200
Outlier
50 100
150 200
proper line, excluding the outlier improper line,
influenced by outlier
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Regression Analysis
400 350 300 250 200
50 100
150 200
Regression with low R-squared
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Regression Analysis
400 350 300 250 200
50 100
150 200
Regression with high R-squared
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Data Accuracy

• Selecting the time period
• Mismatched time period
• Length of the time period
• Nonlinearity problems
• Trend and/or seasonality
• Outliers
• Data shift

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Cost-Volume-Profit Analysis
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CVP Applications
CVP has many applications

• setting prices for products and services
• introducing a new product or service
• replacing a piece of equipment
• deciding whether a given product or service
  should be made within the firm or purchased
  outside the firm
• performing strategic what if? analyses

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CVP Applications
Profit Revenues - Total Costs
or
Revenues Fixed Costs Variable Costs
Profits
expanded
Units sold x Price Fixed Cost Units sold x
Variable Cost Profit
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CVP Applications
Q units sold v unit variable cost f
total fixed cost p unit selling price N
operating profit
The C-V-P Model p x Q f (v x Q) N
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Contribution Margin

• The unit contribution margin is the difference
  between unit sales price and unit variable cost,
  and is a measure of the increase in profit for a
  unit increase in sales.

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Contribution Margin
The unit contribution margin is the difference
between unit sales price and unit variable cost,
and is a measure of the increase in profit for a
unit increase in sales.

• The total contribution margin is the unit
  contribution margin multiplied by the number of
  units sold.

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Data for Household Furnishing, Inc.

Per
Monthly Annual
Unit

• Fixed cost 5,000 60,000
• Desired operating profit 4,000 48,000
• Price 18,750 225,000 75
• Variable cost 8,750 105,000 35
• Planned production 250 units 3,000 units
• Planned Sales 250 units 3,000 units

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Contribution Income Statement
Contribution Income Statement
Household Furnishings, Inc.

• CHANGE
• 15,000
• 7,000
• 8,000
• -0-
• 8,000

19X2 195,000 91,000 104,000
60,000 44,000
19X1 Sales 180,000 Variable Costs
84,000 Contribution Margin 96,000 Fixed
Costs 60,000 Profit
36,000
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CVP Analysis for Breakeven Planning

• the equation method
• the contribution margin method
• the contribution margin ratio method

These are each special cases of the CVP model
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The Equation Method
HFI Break-Even in Units
75 x Q 5,000 35 x Q
Selling price per table
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The Equation Method
HFI Break-Even in Units
75 x Q 5,000 35 x Q
Fixed Cost
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The Equation Method
HFI Break-Even in Units
75 x Q 5,000 35 x Q
Variable Cost
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The Equation Method
HFI Break-Even in Units
75 x Q 5,000 35 x Q (75 - 35) x Q
5,000 Q 5,000/40
Q 125 units
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The Equation Method
HFI Break-Even in Y Sales Dollars
Y (v/p) x Y f N
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The Equation Method
HFI Break-Even in Dollars
Y (v/p) x Y f N
210,000/450,000
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The Equation Method
HFI Break-Even in Dollars
Y .4667 x Y f N
210,000/450,000
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The Equation Method
HFI Break-Even in Dollars
Y .4667 x Y f N Y .4667 x Y 5,000 Y
9,375 note .4667 is the Variable Cost ratio
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The Equation Method
HFI Break-Even in Dollars
Y .4667 x Y f N Y .4667 x Y 5,000 Y
9,375
Proof 125 tables x 75 9,375
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The Contribution Margin Method
HFI Break-Even in Units
f p -v
Q
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The Contribution Margin Method
HFI Break-Even in Units
f p -v
Q
5,000 75 - 35
Q
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The Contribution Margin Method
HFI Break-Even in Units
f p -v
Q
5,000 75 - 35
Q
Q 125 units per month
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The CVP Graph
Total Revenue
Total Revenue
Cost or Revenue
Profits
Total Cost
Cost or Revenue
Total Cost
5000 0
Q 125 Breakeven Point
Losses
Output Volume
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The Contribution Margin Method
HFI Break-Even in Dollars
f (p - v)/p
p x Q
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The Contribution Margin Method
HFI Break-Even in Dollars
f (p - v)/p
p x Q
5,000 (75 - 35)/75
p x Q
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The Contribution Margin Method
HFI Break-Even in Dollars
f (p - v)/p
p x Q
5,000 (75 - 35)/75
p x Q
p x Q 9,375 per month
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CVP Application Target Costing
Management of HFI is considering a new piece of
equipment that will reduce variable cost, but
increase fixed costs by 2,250 per month.
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Target Costing
(f N) Q
p - v
restated to solve for v
(f N) Q
v p -
(87,000 48,000) 2,700
v 75 -
v 25
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Target Costing example 2
Management of HFI finds that 1,000 of the
5,000 monthly fixed costs is sales salaries, and
that 7.50 of the 35 variable cost is
sales commissions. If salaries are increased to
1,450, how much would sales commission rate need
to be decreased to keep profits the same?
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Target Costing
Fixed costs will increase by 450 per month and
variable costs will decrease.
v r x 75 27.50
Original 35 - 7.50 (10 of 75)
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Target Costing
Fixed costs will increase by 450 per month and
variable costs will decrease.
v r x 75 27.50 f 5,000 450
5,450
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Target Costing
(f N) Q
v p -
Substituting for v and f
65,400 48,000 2,700
r x 75 27.50 75 -
r .0733
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Target Costing
(f - N) Q
v p -
Managers would have to reduce the commission rate
from 10 to 7.33 to keep profits the same if the
salespeoples salaries are increased by 450.
Substituting for v and f
65,400 - 48,000 2,700
r x 75 27.50 75 -
r .0733
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Including Income Taxes in CVP Analysis

N (1 - t )

f p - v
Q
60,000 48,000/(1 - .2) 75 - 35
Q
Q 3,000 units per year
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Sensitivity Analysis of CVP Results
Margin of Safety
Margin of Safety
Planned Sales - Breakeven Sales
Margin of Safety
3,000 units - 1,500 units
Margin of Safety
Margin of Safety
1,500 units
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Fully Automated High Fixed Cost
Profits _at_ 75,000 units 25,000 x 10
250,000
Total Revenue
Total Revenue
1.5m .5m
Losses _at_ 25,000 units - 25,000 x 10 -
250,000
Total Cost
Total Cost
Cost or Revenue
Fixed cost/yr. 500,000 Variable cost/
unit 2 Price 12 Contribution margin 10
25,000 50,000
75,000
Output in Units
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Labor Intensive Low Fixed Cost
Profits _at_ 75,000 units 25,000 x 3
75,000
Total Revenue
Total Revenue
1.5m .5m
Total Revenue
Total Revenue
Total Cost
Total Cost
Losses _at_ 25,000 units - 25,000 x 3 -
75,000
1.0m
Cost or Revenue
Fixed cost/yr. 150,000 Variable cost/
unit 9 Price 12 Contribution margin 3
.l5m
25,000 50,000
75,000
Output in Units
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CVP Analysis with Step-Fixed Cost Behavior
Revenues, Total Costs
Total Revenue
There is no breakeven below the 10,000 unit level
of output.
280,000 100,000
Cost or Revenue
Losses
10,000 20,000
25,000 30,000
Output in Units