Welcome to Unit 2.

In this unit we will be discussing cost behaviour, cost drivers and

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In unit 1, we discussed an overview of management accounting and looked at the
various changes occurring in the 21st century and how management accounting
respond to these changes. Furthermore, we discussed the components of
management accounting system and looked at some of the basic concepts and
terminologies in management accounting, which you were introduced to in AF102.

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The overall focus of this unit is on the relation between cost behaviour, cost
estimation and cost prediction. While discussing this relation, we will be discussing
cost drivers as well as cost behaviour patterns. We will also be discussing various
ways of estimating costs and using cost behaviour in predicting future cost. Towards
the end of the unit, we will be discussing some of the practical issues in estimating
cost.

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After studying this unit, you should be able to achieve the following LOs. These LOs
are also provided in the study organizer so please take sometime to go over them
while studying the unit and when you have completed the unit, revisit these LOs
again to see if you can be able to do what is being required by these LOs.

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This exhibit shows the relationship between cost behaviour, cost estimation and cost
prediction. In determining cost behaviour a management accountant will estimate
the cost behaviour through a process of cost estimation. One way of doing this is
through consideration of historical data. Once the cost behaviour is estimated, it will
be used to predict future cost.

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Cost driver is an important factor when it comes to estimating cost behaviour. It is
defined as any activity that gives rise to cost. Therefore the activity is an independent
variable, while the cost in the dependent variable. So in controlling the cost driver,
will control the cost. The conventional costing system assumes that cost is driven by
volume-based cost drivers. Example of volume based cost driver is the unit of
production (or sales). On the other hand, a contemporary costing system assumes
that cost is driven by both the volume-based and non-volume based cost drivers. A
good example of a non-volume cost driver is the number of setups.

One of the contemporary costing system, which we will study in this course is the
Activity-based costing system. In ABC, there are four hierarchies of cost – unit, batch,
product and facility. This will be further elaborated in unit 5.
In choosing a cost driver, it can either be input based (e.g. kilogram of raw material)
or output based (e.g. no of units produced); more detailed (more than one cost
drivers) or it can short-term (e.g. fixed cost does not change with level of production)
or long-term (e.g. fixed cost changes with level of production). Selection of cost
drivers – whether input or output; more detailed or less detailed, short or long term –
must be based on cost and benefit analysis. Furthermore, cost drivers used to
estimate cost might not be the same cost driver to manage cost. Cost drivers used for
cost management is known as the root cause cost driver.

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There are five cost behaviour patterns. Variable cost is a cost that changes in total in
direct proportion to the changes in the activity level. Fixed cost is a cost that does not
change in total as the activity level changes. Step-fixed cost is a cost that remains
fixed over a wide range of activity levels, but jumps to a different amount for levels
outside that range. Semi-variable cost is a cost that has fixed and variable
components. And curvilinear cost is a cost that shows a cost behaviour described by a
curved line.

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The three methods to estimate cost are managerial judgment, where the managers
use their judgment to estimate cost; engineering approach, where the study of the
process on how a task is done results in the occurrence of cost; and quantitative
method uses past data to estimate cost. Two quantitative methods are the high-low
method, which uses two sets of data; the highest point and the lowest point to
estimate cost. The point of reference to identify the highest and the lowest point is
the level of activity NOT the cost. The cost must correspond to the level of activities.

With regards to regression analysis, it uses Microsoft excel to derive the cost function
from all the data set.

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Whether we use high-low method or regression analysis, the cost function that is
derived from the analysis of the data set is in the form of Y = a + bx, where Y is the
dependent variable, the variable that is estimated; ‘a’ variable represents the fixed
costs; ‘b’ variable represents the variable cost per unit of activity and ‘x’ is the
independent variable that drives the ‘Y’ variable. It is the activity level or the cost
driver.

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The cost function is as good as the data set, which means that collection of data
requires careful attention to avoid the following data collection problems. Missing
data occurs when source documents are misplaced or not recorded. Outliers are
observations out of the ordinary circumstance therefore it may be eliminated from
the analysis. Mismatch time periods occurs when the dependent and independent
variables are collected on different time frames. All data must be on the same time
frame; eg. Weekly, monthly or yearly. Trade-offs in choosing time periods. This
involves the number of observations and their reliability in predicting future cost.
Deriving an accurate cost function requires more observations, which implies that the
time period will be more into the past. This will make the cost function more
unreliable in predicting future cost. Allocated fixed costs are expressed as per unit
therefore it must be interpreted carefully. During periods of inflation, historical cost
data may not reflect future cost behaviour. This requires appropriate adjustment to
the data set.

Learning curve effect – as labor gains more experience over time in producing a new
product, the labour time per unit decreases. Hence labour cost will reduce.

Costs and benefits of accurate cost information – In choosing the simpler or

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In summary, cost drivers are factors that incur costs therefore to control costs, the
driver has to be controlled. In predicting cost, cost behaviour patterns were also
discussed as they assist managers in analyzing the effect on cost. To estimate cost
functions, managerial judgement, engineering approach and quantitative methods
were discussed. Furthermore, when estimating cost functions, managers must be
aware of some practical issues that must be taken into consideration.

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