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Case tutorial 1: Cost EstimationCase information
Noelle Narvekar is the management accountant of a company producing and selling bags of N&Ns.
The company sells bags of 500 grams for a unit P of €5.
The daily Q of activity and costs of production recorded in February 2019 are presented in Table 1.
The correlations between these variables are presented in Table 2.
In addition, Noelle plotted the evolution of daily costs over the month of February. This evolution is
displayed in Figure 1.
, 1. What are the criteria to select a cost driver? Which measures of activity would you
recommend here, and why?
Two criteria should ideally be met to select a cost driver among various measures of activity:
A causal relationship between the measure of activity and the corresponding costs;
A high correlation between the measure of activity and the corresponding costs.
In this case, both criteria are met for the number of bags produced because:
The more bags are produced, the more materials and labour are used;
The highest correlation is observed between number of bags and TC . This indicates that
bags is the cost driver for TC .
In this case, labour hours is also a cost driver, but not the best one. Therefore, we consider labour
costs as a component of TC .
2. What kind of cost behaviours are mixed in the TC s recorded? Give some concrete
examples of costs having such behaviours.
Cost behaviour is connected to the Q of activity. Costs can be classified based on their behaviour, i.e.
based on whether, and to what extent, they are proportional to the Q of activity.
Mixed costs are typically composed of three kinds of costs:
VC ; VC s are proportional to the Q of activity.
Capacity FC ; capacity FC are used to maintain a capacity of production and not varying
over the period.
, Discretionary FC . Discretionary FC vary at managers’ discretion, but not proportionally to
the Q of activity (e.g. marketing expenses, R&D expenses, employee trainings costs).
3. Looking at Figure 2 and thinking about the underlying technology, do you think that the
same linear cost equation can be used to predict costs for a volume ranging from 1.000 to
16.000 bags? Why?
In this question, we have to wonder if the same cost equation can be used. To know if the same cost
equation can be used, we have to look at the plotted data.
In this case, we cannot use the same cost equation because Vc and FC are not constant over the
range of activity. In this case we get the best fit if we draw two lines and therefore we have two
linear cost equation. A linear cost equation is always for a specific range.
FC is the starting point of the line. It is not needed to lengthen the line so that it intercept
the y-axis.
TC are shown on the y-axis.
The slope is Vc .
We can conclude that the lines differs in terms of steepness. This indicates different cost structures.
The cost structure is man-made: a management tool. The managers’ goal when defining a cost
structure is to minimize costs. To know when the costs are minimal, we have to have knowledge
about the indifference point. The indifference point will be explained later.
Cost estimation consists of building a linear cost function for a specified range of activity:
TC=(Q ∙ Vc)+ FC for Q ∈ [ Q MIN , Q MAX ]
A cost equation is built for the period over which the units and costs are reported. In this case, the
equation is based on daily data, so the cost equation predicts daily costs. If we find negative
estimates, the cost equation does not make an economic sense because costs cannot be negative
and is therefore invalid. Negative estimates are outliers, so you have to remove them. Or define a
more relevant range.
Figure 2 shows a scatter plot ofTC for the number of bags produced each day in February. The x-axis
is the amount of bags produced (Q of activity) and the y-axis is TC .
, 4. Define the concept of relevant range and explain why it is useful for cost estimation. What
relevant range would you recommend here?
The relevant range is the range of activity (Q s of cost driver) for which a specific linear cost equation
is valid, and thus provides accurate predictions over which Vc and FC can be assumed to be
constant. The relevant range is useful because it is necessary to build a meaningful cost equation.
As we can see in Figure 2, the intercept and slope changes when the organization produces around
8.000 bags. So, it seems that two relevant ranges should be defined:
A low range of activity from 1.000 bags to 7.999 bags;
A high range of activity from 8.000 bags to 16.000 bags.
5. Using the high-low method, build a daily cost equation for the following ranges of activity:
1.000 to 16.000 bags;
1.000 to 7.999 bags;
8.000 to 16.000 bags.
The high-low method is a cost estimation technique. The high-low method is about finding the slope
and the intercept of the line going through the point corresponding to the highest and lowest
volumes. We have to do the following steps to proceed the high-low method:
1. Identify the highest and lowest volumes of activity;
2. Compute Vc ; Vc is the additional cost incurred for one additional unit of cost driver:
TC highest Q −TC lowest Q
Vc=
Qhighest −Qlowest
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