Cost Behavior, Activity Analysis, and Cost Estimation - Report Example

Note: I will send presentation in a few hours. Thanks! Financial and Managerial Accounting Cost behavior, Activity Analysis, and Cost Estimation Student name : ID number : Professor name : Submission date : Table of Contents Contents Contents 2 Executive Summary This project assessed the importance of three related planning and decision-making tools. These activity-based management tools include cost behavior, activity analysis, and cost estimation. Cost behavior is general affected by activity drivers while activity analysis detects non-value-added activities that add cost without customer value. Cost reduction can be achieved through activity elimination, selection, reduction, and sharing. Cost estimation is generally predicting future cost but only useful when similar past cost behavior exists otherwise production output beyond established relevant range will not yield realistic cost. Organizations wanted to become more competitive and ensure sustainability must reduce cost and maximize utilization of resources using these activity-based management tools. 1. Introduction Knowledge of how cost change as activity output changes is critical to planning, controlling, and decision making as poor understanding of cost behavior can lead to disastrous decisions. Similarly, knowledge of activity analysis and cost estimation can help organizations become more competitive and sustainable as it can provide managers with the opportunity to evaluate the processes they use to produce goods and services and eliminate unnecessary activities that add costs and estimate future cost using past cost behavior. 2. Cost Behavior, Activity Analysis, and Cost Estimation 2.1 Cost Behavior Cost behavior describes the changes in the cost whenever the level of activity driver changes. A “fixed cost” is a type of cost behavior that does not change or constant as opposed to “variable cost” that often vary in direct proportion to changes in an activity driver . Mixed cost and stepped cost on the other hand are costs having both fixed and variable cost behavior patterns as shown in Figure 1 and 2 respectively. Fixed cost are costs that “in total” are constant within the relevant range until the level of influencing activity driver change while variable costs vary based on the quantity of work being done . Examples of fixed costs are rent, insurance, executive salaries while direct material, direct labor, and variable overheads are considered variable costs . A “driver” in this context is a factor that causes a change in cost or activity . For example, production output is an activity driver that affects variable cost such as the total cost of materials used in the process. The total cost of material as shown in the example below will change relative to the amount produced while the unit cost remains the same. Table 1- Example of variable cost behavior In contrast, fixed cost behave differently as it is in certain period dependent on “relevant range” or the span of activity in which a certain company plan to operate . Within this relevant range (commonly a one-year period), both total fixed cost and per unit variable are assumed constant until the activity exceeds this range due to factors such as change in plant capacity, labor requirements, and other production-related activities as shown below . Table 2 - Fixed cost behavior within and beyond relevant range In the above table, the company assumed cost of supervision is $54,000 to process between 1 to 10,000 pieces of a particular product. The company also assumed that beyond this relevant range or 12,000 and more, the cost of supervision should be double or $108,000 thus cost of supervision remains constant within their respective relevant change. However, as the level of activity driver (number of products produced) change, the unit cost of the product change. Notice how the unit cost of supervision change from $9.00 when 12,000 products are produced to $5.40 when 20,000 products are produced. In principle, the total cost remains constant regardless of activity level while cost per unit decrease as the activity level increases. In contrast, the cost per unit increase as the activity level decreases . Figure 1 demonstrates portions of total sales revenue with mixed, variable, and fixed cost while Figure 2 show the difference between fixed cost (with straight orange line) and stepped cost with increasing cost pattern based on relevant range. Figure 1- Mixed cost behavior Figure 2 - Difference between fixed cost and stepped cost 2.2 Activity Analysis 2.2.1 Definition and Principle In accounting, activity analysis allows organizations producing goods and services to identify and eliminate activities that have no value and add unnecessary cost to the product systematically. It has four important steps and these include charting of activities, classification of activities, elimination non-value-added activities, improvement or replacement of value-added activities with more efficient one . These steps in other words requires evaluating the activities that the organization performs such as what activities are done, how many people performed these activities, the time and resources used, and the values of those activities . Activity analysis is closely associated with process-value analysis, which is fundamental to activity-based management, and is concerned with driver analysis or the search of root causes of activity cost, activity analysis or identification and assessment of value content, and performance measurement . According to , cost reduction is commonly achieved through activity analysis as identification and elimination of non-value added costs resulting from unnecessary activities and efficiencies in necessary activities improve performance and maximize use of company resources. For instance, if a certain department’s core responsibility is to procure materials then asking them to distribute these materials to parties concern is a non-value-added activity as it is “indirectly” related to their core responsibility. Reducing or eliminating this type of activity therefore can help the department concentrate and use majority of their resources on activities “directly” related to purchasing . 2.2.2 Value-Added Activities In activity analysis, it is critical to understand clearly, which activities are adding value and required in business. For instance, some activities are value-added by mandate such as activities required to comply with government regulations thus cannot be eliminated although unnecessary. Other activities are discretionary in nature and classified as value-added provided they are activities that produce a change of state, associated activities cannot achieve similar effect, and required so that other activities can be performed . In building construction for instance, a number of steel rods are cut to specified length, group together, and use as steel reinforcement for beam and columns. The cutting of steel rods is valued-added as it is not only causes a change of state but because no other activity can create this change and such activity enable creation of steel reinforcement. Similarly, purchasing of materials and varnishing a wooden chair are value-added activities as it results to the creation of a product and customer satisfaction respectively . As primary component of activity-based management, activity analysis is a process where activities are studied based on their worth thus value-added activities are worthy of time and resources . Value-added activities can be assessed in terms of customer willingness to pay for this activity (ex. a varnished chair against a cheaper chair with splinters). The table below demonstrates a simple activity analysis where value-added and non-value activities are identified. Table 3- Sample Activities with indentified value-added activities Quality Control Activities Activity Cost ($) Classification Design engineering 55,000 Value-added Disposing of rejected materials 160,000 Non-value-added Finished goods inspection 140,000 Value-added Materials inspection 70,000 Value-added Preventive maintenance 80,000 Value-added Processing returned materials 150,000 Non-value-added Disposing of scrap 195,000 Non-value-added Assessing vendor quality 45,000 Value-added Rework 380,000 Non-value-added Warranty work 225,000 Non-value-added Total activity cost 1,5000,000 Note how internal and external failure costs are classified as non-value-added while prevention and appraisal cost as value-added. In summarizing the cost of above activities, it is clear that 74% of this organization’s quality control activities are non-value added thus improvements in these areas are necessary. Classification Amount Percent Value-added 390,000 26% Non-value-added 1,110,000 74% Total 1,500,000 100% 2.2.3 Non-value-Added Activities As opposed to value-added activities, non-value-added activities as shown in Table 3 seem to consume majority of the total activity cost. Considering customer’s perception of value, non-value-added activities can be either nonessential (those activities perceived by customers as no value) or essential such as payroll, maintenance and others. However, essential or not, non-value-added activities should be evaluated and pass the highest level of scrutiny as they add cost and time to the products and services offered but no value . Non-value-added activities can be identified by its failure to satisfy the first two conditions set for value-added-activities discussed earlier. For instance, if cutting steel bars is value-added then inspecting cut bars for correct length is non-value-added as it can only detect the state rather than change it. Similarly, reworking goods generally change the state of from non-conforming to conforming state but this activity is non-value-added as it repeats work or doing something achievable by preceding activities . As shown in Table 3, rework is costing $380,000, which is much larger than value-added activities such as preventive maintenance or finished goods inspection. Non-value-added activities often result to non-valued added cost or the cost of activity itself thus activity analysis is often intended to eliminate waste or the causes of the costs. In manufacturing, scheduling, moving, waiting, inspecting, and storing are activities often considered wasteful and unnecessary because none of them adds any value for the customer. For instance, inspection is definitely not necessary if manufacturing of goods is done accordingly. Identification of non-value-added activities result to cost reduction initiatives, an activity management intended to ensure timely delivery products at the lowest cost possible . 2.2.4 Cost Reduction and Activity Elimination As mentioned earlier, cost reduction is mostly intended for non-value-added activities and this include activity elimination, selection, reduction, and sharing . Activity elimination according to , eliminate the need to perform a certain activity and the most effective to reduce cost and increase resource utilization by reducing fixed activity costs. Activity selection on the other hand is only applicable to activities that can be done more efficiently or with a better alternative in terms of costs. In activity reduction, an activity is not eliminated or replaced with better alternative but rather improve so that time and efforts devoted to perform such activity is reduced. Similarly, activity sharing as the name implies allows design alternatives for products so that they can share activities and provide economies of scale. Table 4 - Cost reduction technique and possibilities How to reduce cost Possible process design changes Possible product design changes Activity elimination Eliminate material-handling activities Outsource subassembly production Activity selection Separate high-volume from low-volume products Choose an insertion process Activity reduction Reduce set up time Activity sharing Centralize functions Use common components 2.3 Cost Estimation (Graphical, High-Low, and Statistical Method using Regression) Cost estimation is a process associated with cost behavior where past relationships between total costs and potential cost drivers are measured. The purpose is to predict future costs using past cost behavior . Cost estimation allows an organization to plan the current and future activities and it can be done using three methods – graphical (scatter diagram) , high-low (algebraic), and the regression method . 2.3.1 Graphical Method (Scatter Diagram) Figure 3- Scatter Diagram The scatter diagram demonstrates the actual costs incurred from different levels of activity. The dots represent the total actual maintenance costs per month for a parcel company delivery trucks. A month’s activity for one city is represented by each dot. For instance, the dot in far left represent the actual maintenance cost of $38,000 for 30,000 miles a month while $42,000 for 40,000 miles and so on. The inclined line represent the most likely pattern of dots starting from $25,000 at 0 miles and estimated to pass $57,000 at 80,000 miles on the horizontal axis. This information suggest that the variable cost portion of the mixed costs with around $0.40 per mile or 57,000 minus 25,000 divided by 80,000 miles minus 0 miles. The truck maintenance cost therefore should be around $25,000 per month plus 40 cents for every mile onwards. 2.3.2 High-Low Method In High-Low Method, the elements of mixed costs can be identified by using the highest and lowest points. As shown in Figure 3, the lowest point is $38,000 at 30,000 miles while the highest is at $60,000 for 80,000 miles drive. Therefore, the amount of variable cost per mile can be computed by dividing the change in cost by the change in units which is $60,000-38,0000 / 50,000 miles = $0.44 per mile. Similarly, the fixed portion may be computed by subtracting the variable cost at the level of output or $80,000 x 0.44 from the total cost at 80,000 miles or $60,000. The fixed cost at all levels of mileage within the relevant ranges is about $24,800. The scatter diagram is more precise compared to this method because these two points may not be representing the data as a whole. For this reason, some analyst use two or more method while some use statistical method such as regression analysis for accuracy . 2.3.3 Statistical Method (Regression Analysis) Regression analysis is statistical cost estimation where the relation between costs and activities is estimated by creating an equation relating independent variables or “X” to dependent variables or “Y”. Similar to the other two cost estimation methods, regression analysis uses data from the past in establishing cost and activities relationship. The first step is to establish a logical relation between cost and activities which in essence are independent variables analyst perceived correlate with the dependent variable cost . As opposed to High-Low, regression analysis uses all the available data points in estimated intercept and slope of a cost equation . In regression, the “best straight-line “ is fitted to the data as shown in the figure below. Figure 4- Regression estimate of production cost Compared to High-Low, the regression line fits the available data better and likely to yield more accurate future cost prediction, as it is more consistent. The cost estimation equation on this regression result is presented below : Total cost= fixed cost + (variable cost per unit x activity level in units) Thus; Total cost = $93,619 + ($90.83 x activity level in units) If production level of 1,500 units then; Total cost = $93,619 of fixed cost + ($90.83 x 1,500) = $229, 864 However, since the highest prior level of production was 3,000 units, fixed cost and variable cost for production level above this point is outside the relevant range and may not be useful, as the activity level have not yet been encountered in the past. 3. Conclusion Cost behavior, activity analysis, and cost estimation are important planning and decision making tools. It helps to identify changes in cost due to activity drivers, improve value-added activities and eliminate non-value-added ones, and predict future cost using past cost behavior. As opposed to scatter diagram and High-Low, statistical method such as regression analysis is more accurate in predicting future cost but limited to cost behavior that has been previously encountered. 4. Recommendation Organizations wanted to maintain competitiveness and future sustainability should take advantage systematic planning and decision-making tools such as cost behavior, activity analysis, and cost estimation. In particular, evaluate and eliminate activities that add cost but no value to customer, improve value-added activities, reduce cost and increase resource utilization, and determine future cost using the most accurate cost estimation method. 5. References Albrecht, W. S., Stice, K., Stice, J. D., & Swain, M. R. (2010). Accounting: Concepts and Applications: South-Western/Cengage Learning. 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