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CHAPTER

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ETERMINING HOW COSTS BEHAVE

LEARNING

OBJECTIVES

1. Explain the two assumptions frequently used in cost-behavior estimation 2. Describe linear cost functions and three common ways in which they behave 3. Understand various methods of cost estimation 4. Outline six steps in estimating a cost function using quantitative analysis 5. Describe three criteria used to evaluate and choose cost drivers 6. Explain and give examples of nonlinear cost functions 7. Distinguish the cumulative average-time learning model from the incremental unittime learning model 8. Be aware of data problems encountered in estimating cost functions

What is the value of looking at the past? Perhaps it is to recall fond memories or to extend your knowledge of historical events. Maybe your return to the past is done to better understand and predict the future. When an organization looks at the past, it’s typically done to analyze the results of decisions made so that, in the future, the best outcomes are repeated and the mistakes avoided. When Elegant Rugs’ general manager, Wendy Stevens, called her management accountant, Julio Colon, into her office, she had both the past and the future on her mind. Wendy: Julio, I’ve been thinking about our manufacturing operations and some of our recent successes. The new contemporary designs have been a huge success for the company. Yet I know that we can’t expect to repeat our success without an understanding of how we got there. I’d like to see how we can use actual costs to predict costs in the future. Can you help me with this? Julio: Sure. We have a number of techniques at our disposal, all of which require that we separate fixed costs from variable costs. Some of them are pretty simple to use, such as the industrial engineering method, the conference method, and the account analysis method. But they’re not as accurate as some other approaches. I know how you like precision, so I’d recommend we use a more sophisticated method—regression analysis. Wendy: Ah yes! I recall using this technique in business school, although I’ll admit it’s been a while since I’ve used regression analysis. Can you give me a quick refresher? Julio: All right. Predicting costs, such as direct materials and direct labor, is fairly easy. The challenge is in determining manufacturing overhead costs for our different carpet types. To do this, we first need to identify the cost drivers of different overhead costs. We then use regression analysis and past data to estimate the relationship between the amount of the cost driver and overhead cost. This helps us predict the cost per unit of the cost driver and overhead costs for the different styles of carpets. Wendy: I can see the benefits of predicting costs. With our upcoming introduction of new styles of carpet, we’ll be able to determine which ones will likely be the most profitable. We should also be able to predict how our costs will decrease as we learn through experience how to make the new styles more efficiently. Thanks, Julio. Let’s meet again next week to review your regression results.

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anagers must understand how costs behave to make strategic decisions and operating decisions. For example, managers at Sony must determine which alternative product design for the new line of Plasma televisions is most profitable. Managers at GE might consider whether a component part for its new line of dishwashers should be made or bought. At Bank of America, managers might want to explore the effect a 5% increase in customers is expected to have on operating income. The management team at Gap, Inc., would want to learn why the variable overhead...
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