ADVANCED MANAGEMENT ACCOUNTING

ACC60804
TUTORIAL 1 (SOLUTIONS)

1. Explain what is meant by the term ‘cost function’.

- The term cost function refers to a regression equation that describes the
relationship between a dependent variable (DV) and one or more independent
variables (IV). In addition, is a mathematical representation that describes how
a company’s total costs change as its production or output level changes.
- Fundamental concept used to analyze and predict costs within a business.
- Cost functions are normally estimated from past cost data and activity levels. Cost
estimation begins with measuring past relationships between total costs and the
potential drivers of those costs.

2. Under what circumstances can the engineering method be used to estimate

costs?
- The engineering method is a cost estimation technique commonly used in various
industries, particularly in manufacturing and construction, to estimate costs based
on a detailed analysis of the engineering and technical specifications of a
project or product. This method is most appropriate and effective under the
following circumstances:

(a) Well-Defined Projects or Products: The engineering method is best suited

for projects or products with well-defined and detailed technical specifications. It
is particularly useful when there is a clear understanding of what needs to be
built or produced.

(b) Custom or Unique Projects: It is often employed for custom or one-of-a-kind

projects where there are no historical cost data or industry benchmarks
available for reference. Each project is unique, and cost estimation must be
done from the ground up.

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(c) Highly Specialized or Complex Projects: When the project involves
specialized or complex engineering, such as aerospace, civil engineering, or
advanced manufacturing, the engineering method is valuable for accurately
capturing the intricacies of the work involved.

(d) Availability of Skilled Engineers: It requires a team of skilled engineers or

technical experts who can analyze the project's requirements, specifications,
and engineering drawings in detail. These experts can break down the project
into its constituent elements and estimate the costs associated with each.

(e) High Accuracy Requirements: In situations where precision and accuracy are
paramount, such as in critical infrastructure projects or industries with stringent
quality standards, the engineering method is preferred because it allows for a
thorough examination of all cost elements.

(f) Regulatory Compliance: Certain industries, like pharmaceuticals or nuclear

energy, have strict regulatory requirements. The engineering method helps
ensure that all compliance-related costs are accounted for in the estimation.

(g) Risk Assessment: The engineering method allows for a detailed risk
assessment, as it considers various technical aspects and potential challenges
that may affect the project's cost. It helps in identifying and quantifying risks
associated with the project.

While the engineering method provides a detailed and accurate cost estimate, it
can be time-consuming and resource-intensive. Therefore, it is typically used in
situations where the benefits of precision outweigh the costs associated with the
detailed analysis required. In contrast, for simpler or repetitive projects with
historical cost data available, other methods like parametric estimation or analog
estimation may be more practical and cost-effective.

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3) Describe the high–low method.
- The high-low method is a simple cost estimation technique used in management
accounting to estimate fixed and variable costs within a given cost dataset.
- The high-low method is a method of analyzing cost behavior that consists of
selecting the periods of highest and lowest activity levels and comparing the
changes in costs that result from the two levels to separate fixed and variable
costs.
- The variable cost per unit is derived by dividing the difference in cost between
the two levels by the differences in activity. Fixed costs are computed by
deducting the derived variable cost from the total cost at either the lowest or
highest output level.

4) What is the major limitation of the high–low method?

Assumes Linearity: The high-low method assumes that the relationship between
costs and activity levels is linear, which may not always be the case.

Relies on Two Data Points: The accuracy of the estimates depends on the selection
of the high and low data points, and outliers in the data can skew results. The method
ignores all cost observations other than the observations for the lowest and highest
activity levels. Unfortunately, cost observations at the extreme ranges of activity levels
are not always typical of normal operating conditions and therefore may reflect
abnormal rather than normal cost relationships.

Not Suitable for Non-linear Costs: It may not work well for costs that exhibit
nonlinear behavior, such as step-fixed costs or costs with multiple cost drivers.

While the high-low method is a basic and quick cost estimation technique, it should be
used with caution and in situations where a simple estimate is sufficient, or when more
detailed data or analysis methods are not readily available.

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5) Describe how the scattergraph method is used to analyze costs into their fixed
and variable elements.

The scattergraph method involves plotting on a graph the total cost for each
observed activity level. The total cost is represented on the vertical (Y axis) and the
activity levels are recorded on the horizontal (X axis). A straight line is drawn
through the middle of the scatter of points so that the distances of observations below
the line are equal to the distances above the line. The variable cost per unit is
derived from the straight line by dividing the difference in cost by the difference in
activity. The intercept gives the estimated fixed cost.

6) Describe the least-squares method. Why is this method better than the high–low
and scattergraph methods?
- also known as linear regression analysis, is a statistical technique used in cost
estimation and data analysis to determine the relationship between two variables,
typically a cost and an activity level. It is a more sophisticated and statistically
sound method compared to the high-low and scattergraph methods.

Why the Least-Squares Method Is Better Than High-Low and Scattergraph

Methods:

Statistical Validity: The least-squares method is based on statistical analysis and

provides a more robust and statistically valid estimate of cost behavior. In contrast,
the high-low method and scattergraph method rely on simplifications and are less
statistically rigorous.

Accuracy: By considering all data points, the least-squares method provides a more
accurate representation of the relationship between cost and activity, whereas the
high-low method relies on just two data points, which can be less representative.

Flexibility: The least-squares method is versatile and can be used to estimate costs
at various activity levels, while the high-low method is limited to high and low points.

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 7) A hospital’s records show that the cost of carrying out health checks in the last five
accounting periods has been as follows:

Period No. of patients seen Total costs (RM)

1 650 17,125
2 740 17,800
3 1,260 18,650
4 990 17,980
5 1,150 18,360

Using the high–low method and ignoring inflation, calculate the estimated cost
of carrying out health checks on 850 patients in period 6.

y = a + bx

HC – LC
b (variable cost per unit) =
HA - LA

18,650 – 17,125
b (variable cost per unit) =
1,260 – 650

b (variable cost per unit) = RM2.50

a (Fixed cost) = 18,650 – (2.5 x 1,260)

= 15,500

y = 15,500 + 2.5x
y = 15,500 + 2.5(850)
y = 15,500 + 2,125
y = RM17,625

Step 1: select highest & lowest figures. Find b (use formula)

Step 2: Find variable cost per unit
Step 3: Find fixed cost. [Total cost – (VC per unit x no f units]
Step 4: Find Y = aX + b
Step 6: Find Y

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 8) High-low method
(a) Calculate the estimated total costs for an output of 205,000 units.

HC – LC
b (variable cost per unit) =
HA - LA

2,840k – 2,420k
b (variable cost per unit) =
190k – 160k

b (variable cost per unit) = RM14.00

a (Fixed cost) = 2,840k – (14x190k)

= 180,000

y = 180,000 + 14x
y = 180,000 + 14(205,000)
y = RM3,050,000

(b) A step-fixed cost, also known as a step-cost or a semi-variable cost, is a type of cost
that remains constant within a certain range of activity or production levels, but it
changes abruptly or steps up to a new higher level when activity exceeds a specific
threshold or step point.

The company has now established that there is a stepped increase in fixed
costs of RM30,000 when output reaches 180,000 units. Calculate the estimated
total costs for an output of 175,000 units.

Outputs (units Total costs (RM)

160,000 2,420,000
175,000 ?
180,000 TC ( including 30,000)
185,000 2,775,000
190,000 2,840,000

Answer:

Cost before stepped increase for the highest output level (190,000 units)
= RM2,840,000 - RM30,000 = RM2,810,000

Variable cost per unit = (RM2,810,000 - RM2,420,000) / (190,000 – 160,000)

= RM390,000 / 30,000
= RM13

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 Fixed costs at 190,000 units (including step FC) = RM2,840,000 – (190,000 x RM13)
= RM370,000

Fixed cost at 190,000 units (excluding step FC) = RM370,000 – RM30,000) =

RM340,000

Total costs at 175,000 units = (175,000 x RM13) + RM340,000

= RM2,615,000

9) Calculate the budgeted total costs for an output level of 45,000 units.

Outputs (units) Total costs (RM)

24,000 304,000
30,000 352,000
35,000 392,000
38,000 TC=FC+VC (FC=+30k)
40,000 TC = FC + VC (-VC5%)
41,000 (-VC5%)

45,000 ?

HC - LC 392,000 – 304,000
b (variable cost per unit) = HA - LA = 35,000 – 24,000

b (variable cost per unit) = RM8

a (Fixed cost) = 392k – (8x35k)

= 112,000

Fixed costs will increase by RM30,000 for output levels above 38,000 units.

Thus, Fixed cost @ 45,000 units = 112,000 + 30,000 = 142,000

b (Variable cost per unit @ 45,000 units) = 8 x 95% = 7.6

Total cost (y) @ 45,000 units:

y = 142,000 + (7.6 x 45,000)
y = RM484,000

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10)

Some major reservations to consider when evaluating this prediction:

Historical Data Accuracy: One of the primary concerns would be the accuracy and
reliability of historical data used to make this prediction. If the data used for analysis is
incomplete, outdated, or not representative of the current situation, it can lead to
inaccurate predictions.

Assumption of Linearity: Maintenance costs may not increase linearly with production
volume. There might be economies of scale or other nonlinear factors at play. It's
essential to understand the underlying assumptions of the prediction model.

Change in Technology or Equipment: Changes in technology or equipment used in

production can significantly affect maintenance costs. If there have been recent upgrades
or changes in machinery, it might not be reflected in the historical data used for the
prediction.
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Maintenance Quality: The quality of maintenance performed can vary over time. If there
have been changes in the skill level or training of maintenance personnel, it could
influence costs.

External Market Conditions: The prediction may not consider external market conditions,
such as changes in demand for the product, which can impact production volume and
maintenance costs.