CHAPTER ONE NATURE AND PURPOSE OF COST ACCOUNTING > OBJECTIVES After studying this chapter, you should be able to: + Define cost accounting * Distinguish between cost accounting and other accounting subjects such as financial accounting and management accounting based on various aspects + Define the various cost accounting terminologies + Explain the role of a cost accounting department in an organization + Explain the design and operation of a Cost and Management Accounting system + Explain the relationship between nature of business enterprise and cost accounting * Distinguish between qualitative and quantitative information + Explain the features of an effective cost center framework > INTRODUCTION The purpose of this chapter is to introduce the basic concepts of cost accounting, terminologies and distinguish cost accounting from financial accounting. It is aimed at making it clear on what cost accounting is all about and introduce some of the terminologies used in the chapters that follow. First, we will discuss the nature of cost accounting and budgeting and then introduce the key cost accounting terminologies, which will act as the base for other discussions. > DEFINITION OF KEY TERMS Cost: Cost is simply a quantification or measurement of the economic sacrifice made to achieve agiven objective. Itis, therefore, a measurement of the amount of resources sacrificed in attaining a specified goal Cost object or cost unit: This is an activity for which a separate measure of cost is desired. Cost Accountant: He/she is a member of the accounting department responsible for collecting product costs and preparing accurate and timely reports to evaluate and control company operations. STUDY TEXTCreamed RED Te) Cost Analysis: This is an activity that uses engineering, time and motion studies, timekeeper's records and planning schedules from production supervisors. Cost center: This may be defined as any point at which costs are gathered in order to control cost, fix responsibility and enable costs to be recharged on an equitable basis >» EXAM CONTEXT You must be prepared to answer questions touching on definition of cost accounting terminologies and distinguish cost accounting from other disciplines of accounting such as management and tax accounting. Questions normally set from this section are theoretical and thus you need to understand the theory to be able to answer them well > INDUSTRY CONTEXT The applicability of this topic comes in handy when holding discussions with other managers in a firm or during meetings. You need to understand the cost accounting terminologies and how it relates to other disciplines for effective relay of the messages intended for managers of other fields. Pa hanes DEFINITION OF COST ACCOUNTING In general, cost accounting is a field of accounting that measures, records and reports information about costs. It involves the comprehensive set of principles, methods and techniques to determine an appropriate analysis of costs to suit the various parts of organizational structure within the enterprise. There is, however, no watertight definition for cost accounting. Various authorities and scholars have gone ahead to give their definitions. Some of the definitions include: “That part of management accounting, which establishes budgets and standard costs and actual costs of operations, processes, departments or products and the analysis of variances, profitability or social use of funds.” (Chartered Institute of Management Accountants - CIMA). “That which identities, defines, measures, reports and analyzes the various elements of direct and indirect costs associated with producing and marketing goods and services. Cost accounting also measures performance, product quality and productivity.” (Letricia Gayle Rayburn)MULAN LU Stel S0) ere ste oe NUT) “A systematic process of collecting, summarizing and recording data regarding the various resources and activities in a firm so as to calculate the basis of production costs used in financial accounting or making other relevant decisions in a firm." (Homgren. cq) Cost accounting is broad and extends beyond calculating production costs for inventory valuation, which government-reporting requirements largely dictate. However, accountants do not allow external reporting requirements to determine how they measure and control internal organization's activities. In fact, the focus of cost accounting is shifting from inventory valuation for financial reporting to costing for decision-making, The main objective of cost accounting is communicating financial information to management for planning, evaluating and controlling performance, and to assist management to make decisions that are more informed. Its data are used by managers to guide their decisions From the definitions above, we can generally say that cost accounting is concerned + Cost planning and cost control of activities of operations since it aims at improving efficiency by controlling and reducing costs = Resource alllocation decisions, for instance, production, pricing and product costing + Performance measurement and evaluation of managerial performance; this is done through variance analysis, comparing actual output with the standard or budgeted output. + Formulation of overall strategies and long range plans; Cost accounting will be useful in forecasting Cost accounting aims at providing useful information to decision makers to enable them make better decisions. It helps them in preparing various statements such as cash budgets and performance reports, cost data collection and application of costs to products and services. 1 _ Cost Accounting Terms a) Cost A cost is simply a quantification or measurement of the economic sacrifice made to achieve a given objective. It is, therefore, a measurement of the amount of resources sacrificed in attaining a specified goal. For a product, cost represents the monetary measurement of resources used such as materials, labor and overheads. Fora service, cost is the monetary sacrifice made to provide the service. Accountants generally use cost with other descriptive terms, for example, historical, product, prime, labour or material. Each of these terms defines some characteristic of the cost measurement process or an aspect of the object being measured, aah ee aPa ane as by a) °) Cream eCoredURED Te) Cost object or cost unit This is an activity for which a separate measure of costs is desired. Examples include cost of providing a service to a client or cost of manufacturing a specific product or undertaking a specific assignment, and cost of running an organizational segment. In other words, a cost object/cost unit is the quantitative unit of the product or service in relation to which costs are ascertained. It is determined by the nature of the business enterprise. Cost accountant Heishe is a member of the accounting department responsible for collecting product costs and preparing accurate and timely reports to evaluate and control company operations. He/she assembles, classifies and summarizes financial and economic data on the production and pricing of goods and services. Some of the roles that he plays in the various aspects of the organization include: Material cost control: this includes tracing materials issued to departments, reporting of the cost of material wasted (variance analysis) and provision of information about ordering and holding costs of stocks. Labour cost control: this includes time keeping and payroll operation, establishing of standard labour cost for various products, monitoring productivity of labour and analysis of hours worked Overhead cost planning and control: understanding the cost behavior of cost items, identifying the expenditure on overheads by various departments and establishing the absorption rate guides. Operational efficiency: this includes ensuring that maximum output is achieved at minimum cost. Cost analysis This is an activity that uses engineering, time and motion studies, timekeeper's records and planning schedules from production supervisors. Cost analysis techniques. include break-even analysis, comparative cost analysis, capital expenditure analysis and budgeting techniques. After determining what is actually happening, accountants should identify available alternatives. Professional judgment is then needed to apply and interpret the results of each costing technique. Cost benefit approach This is the primary criterion for choosing among alternative accounting approaches. In a company, there is a direct relationship between the amount of time and the funds that management is willing to spend on cost analysis and the degree of reliability desired. Ifa company wants detailed records with a high degree of accuracy, managers should provide additional time and money for compiling and maintaining cost information. Managers should only use cost analysis and control techniques when anticipated benefits in helping achieve management goals exceed the cost. Responsibility center This is a part of the organization in which a manager who has a budget is made responsible for the plans and the resulting information on the performance of the plans.UTI OD aU Stel So) sete lste oe NUT) Responsibility accounting is the use of budgeting with standard costing. Responsibility center makes it necessary for the organization to be organized with clear statements of the responsibilities of each manager who has a budget. The process of responsibility center enables management by exception principle to be practised. This is where a subordinate is given a clearly defined role with the requisite authority and resources to carry out that part of the overall plan assigned, and if activities do not proceed according to plan, the variations are reported to a higher authority. There are various types of responsibility centers, namely, cost center, revenue center, profit center and investment center, among others SSO OTTO SEM TE TS EM TEM OTST HOTTEST STE incurred for the production of goods and services. Cost centers accumulate costs directly incurred and apportioned in order to ascertain the total cost of a department or center for a particular period. Cost centers ascertain costs and relate to cost units for control purposes. They help in ascertaining the total cost incurred in each center, determining whether the cost centers are working efficiently, controlling costs effectively, allocating costs to appropriate departments or cost units and, planning the activities of a particular department and improving their performance. ROLE OF COST ACCOUNTING IN MANAGEMENT OS CCH Cree ee ecm ee en ene cae a ana way Cost accounting is utilized for a number of purposes, some of which are briefly described in the following points: a) Accounting for costs This may be seen as a record keeping or score-keeping role. Information must be gathered and analyzed in a manner which will help in planning, controlling and decision making b) Planning and budgeting This involves the quantification of plans for future operations of the enterprise; such plans may be for the long or short term, for the enterprise as a whole or for the individual aspects of the enterprise. c) Control of operations of the enterprise Control may be assisted by the comparison of actual cost information with that included in the plan. Any differences between planned and actual events can be investigated and corrective action implemented as appropriate ah ee asCreamed RED Te) d) Decision making Cost accounting information assists in the making of decisions about future operations of the enterprise; such decisions making may be assisted by the information from cost techniques and cost-volume-profit analysis. e) Resource allocation decisions For example product pricing in determining whether to accept or reject jobs. This is based on cost and revenue implications of the relevant decisions f) Performance evaluation Cost accounting information is used to measure and evaluate actual performance so as to make a decision of the degree of optimality or efficiency of resource utilization. SCOPE OF COST ACCOUNTING As part of their jobs, cost accountants interpret results, report them to management and provide analyses that assist decision-making in the following departments: a) Manufacturing Cost accountants work closely with production personnel to measure and report manufacturing costs. The efficiency of the production departments in scheduling and transforming materials into finished units is evaluated for improvements. Pa hanes b) Engineering Cost accountants and engineers translate specifications for new products into estimated costs; by comparing estimated costs with projected sales prices, they help management decide whether manufacturing a product will be profitable ©) Systems design Cost accountants are becoming more involved in designing computer integrated manufacturing (CIM) systems and databases corresponding to cost accounting needs. The idea is for cost accountants, engineers and system designers to develop a flexible production process responding swifly to market needs d) Treasury The treasurer uses budgets and related accounting reports developed by cost accountants to forecast cash and working capital requirements. Detailed cash reports indicate where there are excess funds to invest or where cash deficits exist and need to be financed. e) Financial accounting Cost accountants work closely with financial accountants who use cost information in valuing inventory for external reporting and income determination purposes.MUTA OD aU Stel So sete lste oe) f) Marketing Marketing involves the cost accountant during the product innovation stage, the manufacturing planning stage and the sales process. The marketing department develops sales forecast to facilitate preparing a products manufacturing schedule. Cost estimates, competition, supply, demand, environmental influences and the state of technology determines the sales price that the product will be offered and will command in the market. 9) Personnel Personnel department administers the wage rate and pay methods used in calculating each employees pay. This department maintains adequate labour records for legal and cost analysis purposes. Atthis point, it cannot be over-emphasized that cost accounting is simply an information system designed to produce information to assist the management of an organization in planning and controlling the organization's activities. It also assists the management to make informed decisions so as to enable the organization to operate at maximum effectiveness and efficiency. ROLE OF C' ACCOUNTING DEPARTMENT The cost accounting departments responsible for keeping cost accounting records. This includes gathering, compiling and communicating a variety of information regarding an organization's cost activities. For the records kept to be of proper use for the managerial functions, they should STUDY TEXT + analyze production, administration, selling and distribution costs in such a way as to help management reach decisions required. = be used to produce periodic performance statements or control reports which are necessary to the management for control purposes. + the cost accounting system should be capable of analyzing © past costs for profit measurement and stock valuation purposes. © future costs of planning and decision making Information obtained may be non-mutually exclusive in nature. This means that information gathered as part of the management information system may be used in two or more subsystems for differing purposes. An example of this information is with regard to the amount and location of work in progress: (work in progress refers to partly completed units of products where a product passes through a number of operations and processes before being passed into finished goods store or to the customer). Work in progress information may be used by: a) Production planning department; in order to monitor the progress of parts of an order through the production process and to instigate action to speed up the completion of slow moving parts of an order.Pa hanes Creamed RED Te) b) Quality control department; in comparing one batch of product with another in highlighting the incidences of process losses and their location ¢) Cost management department; in the quantification and valuation of actual losses as compared to the level originally allowed for in the business plan d) Financial accounting department; in the valuation of work in progress for balance sheet purposes and for purposes of determining the cost of sales in the income statement tutorial not ! Business Management involves planning, organizing, staffing, directing and controlling an organization's activities so as to mest a specified objective, usually profit maximization. The function of managing a business’ activities is entrusted to the managers of the business. For the managers to maximize profits, they must minimize the entire business’ costs. They, therefore, need to track all costs as they are incurred and recovered via the organization's activities. To get this information as it happens (LIVE), they need an effective an efficient ‘information system’ referred to as cost accounting. It will, therefore, be appreciated that if an organization's cost .ccounting information system fails, managers cannot manage it efficiently and effectively COST ACCOUNTING AND OTHER ACCOUNTING SUBJECTS Accounting can be described as a specialized information system that is used for purposes of decision making by the management of the organization and other users such as tax authorities, investors, creditors and the public. Accounting is broadly divided into Financial Accounting and Management Accounting Cost accounting and Management accounting distinguished CIMA defines management accounting as “provision of information required by the management for such purposes as formulation of policies, planning and controlling the activities of the enterprise, decision making on the alternative courses of action, disclosure to those external to the entity (shareholders and others), disclosure to employees and safeguarding assets. Cost accounting and management accounting have basically the same functions. Management accounting is part of accounting that relates to the provision of financial information to people and managers within the organization to aid in the execution of management functions: planning, organizing, controlling, evaluation of performance and decision making such as make/ buy decisions. It involves professional skills and knowledge. In particular, it involves preparationVU TAN OL aU Stel S0] sete ste oe NUT) and presentation of information to all levels of management in the organization. The information generated by management accounting is, therefore, for internal uses and is not guided by any standards or legal requirements. Management Accounting, unlike financial accounting, is proactive i.e. it is future-oriented. In a nutshell, cost accounting enables a business to, not only find out what various jobs or processes have cost, but also what they should have cost. It indicates where losses are occurring before the work is finished and therefore corrective action can be undertaken. However, there is a very slim distinction between Cost accounting and Management accounting, In fact, cost accounting is part of management accounting Cost accounting and Financial accounting distinguished esc eee eee aU MRE Re eee UR Se MOS RU mR Starting with their definition to the mode of accounting, regulation and information used. Financial Accounting is concemed with provision of information to parties outside the organization. This is the analysis, classification and recording of financial transactions and the ascertainment of how such information will be reported to the various users. It involves the development of general-purpose financial statements largely for external reporting. It requires that costs should be matched with revenues in order to calculate the profits for the period under consideration. These statements are developed in accordance with standards imposed by the public (through the professional accounting bodies such as the Institute of Certified Public Accountants of Kenya (ICPAK) and the International Accounting Standards Board (IASB) as well as the requirements of the Companies Act Chapter 486. Cost accounting and financial accounting are distinguishable in various aspects. The major differences between the two branches of accounting are a) Generally accepted accounting principles There are a number of accounting standards that are followed in producing accounting information. Financial statements must be prepared in accordance with the Generally Accepted Accounting Principles applicable in the industry in which the firm operates. The statements produced are intended for use by external users. Such users require assurance that the information they are receiving has been prepared with some common set of ground rules. Otherwise, there could exist an opportunity of fraud or misinterpretation which would destroy their confidence in the financial statements. However, in cost accounting, managers are not governed by any standards or principles. They use a number of techniques, which include budgeting, standard costing, marginal costing and cost-volume-profit analysis. They set their own ground rules. b) Statutory requirement Financial accounting is mandatory. Itis governed by the Companies Act Cap 486, which requires that a number of accounting records be kept and made available, for instance, STUDY TEXTPa hae as d) Creare RED Te) a summary of cash flows. For limited companies, audited financial statements must be produced, which in the opinion of the auditor, portray a true and fair view. Cost and management accounting is not mandatory. It is entirely optional. Information prepared by the managers may or may not be produced depending on the managers’ intention. In addition, managers may or may fail to create a cost accounting department Focus on segments of the organization Financial accounting focuses on the organization as a whole. It is primarily concemed with the reporting of business activities for the company as a whole. On the contrary, cost accounting focuses less on the whole and more on the parts, or segments of the company. It lays emphasis on segments of the business while conducting analysis; examination of job, process, product or service. Examples of segments include departments, product lines and company divisions. Emphasis on non-monetary measures Non-monetary measures are used in the interpretation of accounting statements, for example, expressing gross profit as a percentage of sales revenue to obtain the markup. Thus, monetary base is predominant in financial accounting. However, in cost accounting, there will be greater use of non-monetary measures. Managers lay more emphasis on non-monetary measures. These include areas like materials requirement and labour input, material losses, machine efficiency, e.t.c. Futuristic cost accounting versus historical financial accounting Cost accounting is futuristic in that it focuses on the future thus necessitating managers to have a strong future orientation. Managers concentrate more on planning, as it is the key to success, Without proper plans, most of the activities of the company may be bound to fail. Nevertheless, historical information is crucial in the planning process. Managers analyze historical information and use it in the planning process. Use of historical information in forecasting poses a great challenge since managers cannot simply assume that the future will be simply a reflection of the past. Changes taking place, however, demand managers planning framework be built in large part of estimated data that may or may not be a reflection of past experience. In financial accounting, there is the statutory requirement for provision of historical data from which accounting statements may be prepared. Such statements may be used in the forecasting of fulure trends for use by potential investors or investment analysts. Precision and accuracy of information provided Financial accounting lays more emphasis on precision and accuracy of data to the nearest cent except in subjective areas such as determination of depreciation and other allowances. (On the contrary, in cost accounting, accuracy of information will tend to vary with the circumstances. For instance, Management Reports may summarize figures to the nearest thousand shilling whereas the material cost per unit of a product may be expressed to four decimal places. At times, cost accounting recognizes the need for good estimates and approximations rather than for numbers, which are accurate to the last, penny. When information is needed, speed becomes more important than9) h) ) MULAN LU Stel S0) ere ste oe NUT) precision. The faster the information is obtained, the faster the problems are attended to and resolved. Thus, the manager is often willing to trade off some accuracy for information that is immediately available. Is accounting a means to an end or an end in itself? Financial accounting is an end in itself in so far as it fulfils the statutory requirements in relation to accounting records and the publication of financial accounting statements. It is also a means to an end in that it provides an overview of the business, which may be interpreted by the various users of accounting information, which the Companies Act seeks to protect. Cost and management accounting is a means to an end. It may be used to assist management in future planning, control and decision-making required for the efficient implementation of the objectives of the enterprise and the strategies, which will best lead to achievement of these objects. To what extent does the discipline draw from other disciplines? Cost and Management accounting draw heavily from other disciplines for instance finance, statistics, operation research and organizational behavior. This forms a strong interdisciplinary network, Cost accounting extends beyond the boundaries of traditional accounting, The extemal sources give managerial accounting a strong interdisciplinary flavor. For what use is information generated intended? Cost accounting system provides information to be used intemally in an organization, That means much of the information that a manager needs would be confusing or valueless to external stakeholders, The manager uses information derived from the cost and management accounting system to direct day-to-day operations, plan the future, solve problems and make decisions, On the other hand, financial accounting provides information for external use, Users of financial accounting information include stockbrokers, the government, potential and existing investors and customers. What are the pertinent qualities of the information generated from the system? Financial accounting data are expected to be objectively determined and verifiable since they are intended for external use. The manager is more concerned about receiving relevant and flexible information than completely objective and verifiable information. In cost accounting, relevance and objectivity may be viewed as a matter of secondary importance. In summary, the comparison and contrast can be summarized in the table below: Cost and management accounting Financial accounting Financial Accounting is highly regulated and is governed by the Generally Accepted Accounting Principles. Cost accounting is not govemed by any principles or concepts. Cost accounting is not mandatory, the Financial management is a statutory management may practice it or not requirement. It is mandatory. STUDY TEXTPoe hae as Cream Cored RED Te) Cost accounting looks at segments of the 3, organization and the organization as a whole. Cost accounting is futuristic; it places more emphasis on the future. Cost accounting places less emphasis 5. on precision and more emphasis on non- monetary data Cost accounting draws heavily from other 6. disciplines such as economics, finance, statistics and operation research. Cost and management accounting 7. _ provides data for internal use by management. g Cost accounting emphasizes the relevance and flexibility of data, Financial accounting looks at the organization as a whole. It is less. concerned with segmental performance. Financial accounting is historical in that it reports what has already taken place. Financial accounting places more emphasis on monetary data and precision Financial accounting draws little if any from other disciplines. It is governed by the statutes and the Generally Accepted Accounting Principles Financial accounting provides data for external uses. Financial accounting emphasizes more on objectivity and verifiabilty of data, SELECTION OF AN IDEAL ACCOUNTING SYSTEM A system is a set of interdependent parts, which together form a unitary whole that performs certain functions. Anumber of sub systems make up the whole. In this context of an organization, a management information system may be seen as the overall system with a number of sub- systems including the cost and management accounting system that provide the information to management for purposes of planning, organizing, directing and controlling the organization's activities so as to achieve corporate goals, including profit maximization Anumber of features and factors must be taken into account when designing a cost and management accounting system. These are: a) Preliminary investigations must be made before a system is installed, This helps to disclose weaknesses and inefficiencies. b) For accuracy of cost records, a system of material cost, labour cost and production overheads cost is essential ©) Nature of the business enterprise must be put into consideration when designing the cost accounting system. The system developed should be practical and must suit the business. d) The system should be cost effective in that the benefits derived from the system must be greater than the cost of running it.UTA OL aU Stel S0) sere lste Neo NUT) The following factors must be taken into account before finalizing the cost accounting system design a) The system must be designed in such away as to meet the managerialinformationneeds. There should be no duplication in reporting. Only relevant management information should be provided. Information is relevant if it has an impact on the decision made by the management. The factory layout and production sequence. This is important for the identification of the sequence of production i.e. the starting and the ending points. Control exercised over production; the cost data must focus on specific areas of control so that the responsibility of any variances between the actual and the standard costs can be identified with an individual manager or department. Nature of raw materials used affect the system adopted. This is because it affects the recording and issuance of raw materials and the method of pricing The deployment of workers, who may work as a team or as individuals. This affects the method of remuneration and the analysis of time worked. For instance, where employees work as a team, there may be group bonus awards, which do not exist in situations where employees work individually. Key personnel and office staff; their cooperation is vital for the success of the system. In addition, the system needs to be simple and easy to understand to enhance acceptability Relative size of cost element; it is only reasonable to analyze cost elements with a significant value. Cost elements of insignificant value may be left out of the analysis depending on the composition of the cost items Need for uniformity; a business needs to observe the industrial norms and thus follow the industrial practices as regards the accounting. Ifthe business, for instance, belongs to a trade association, it will need to follow the association's recommendation on cost accounting principles and in order to facilitate comparison of its data with that of other businesses in the industry. The cost benefit analysis should be carried out and itis only reasonable to run a system whose benefits are more than the costs incurred in terms of money, time spent in designing, installing, testing, running and maintaining the cost accounting system. The system should be capable of adapting to changing conditions. It should be logical and simple. Flexibility is vital to any accounting system bearing in mind that the ‘organization exists in an open system. Itis only a subsystem of a larger system. Periodical upgrade of the system is crucial to avoid the danger of going obsolete as the world is rapidly changing. ah ee asPoe hanes Sm NCL Te} THE RELATIONSHIP BETWEEN THE NATURE OF THE BUSINESS ENTERPRISE AND COST ACCOUNTING ators Cost accounting method used depends on the nature of the business besides other factors. The relationship between cost accounting and the nature of the business stems from the fact that the accumulation of costs into cost centers is fully dependent on the nature of the business enterprise. What is a cost center in one business enterprise may not be a cost center in another business enterprise. The business enterprise may be such that: (a) Individual orders are received from customers for work which is undertaken according to the specific requests of the customer (specific order costing). (b) Output is the result of a series of continuous operations or processes (process costing) () Aservice is provided to the customer (operation/service costing). The costing and management accounting system is designed and operated such that costs can be identified and accumulated for each unit of output. The costs are then accumulated for the various cost centers and further analysis done to produce useful information for planning, controlling, decision-making and performance evaluation. A Cost Center Framework/Approach in Cost Accounting Cost accounting is based on the concept or framework of cost centers, i.e. all the costs incurred during the production process have to be identified and accumulated around certain points of the production process, referred to as cost centers. A cost center may be defined as ‘any point at which costs are gathered in order to control cost, fix responsibility and enable costs to be recharged on an equitable basis. Each cost will be the responsibility of one management member and will have costs charged to it and also costs recharged from it if such costs are incurred for purposes of offering a service to other cost centers.a COST CLASSIFICATIONmC MALT} STUDY TEXTCHAPTER TWO COST CLASSIFICATION > OBJECTIVES After studying this chapter, you should be able to: + Define cost classification and understand the basis of cost classification, especially the cost objectives + Classify a specific cost as either manufacturing or non-manufacturing and whether direct or indirect. + Understand the behavioral classification of costs and be able to classify various costs according to their behavior, either variable or fixed, and draw cost graphs for the various costs + Understand the controllable and non-controllable costs and their relevance in cost decision making + Classify costs according to their functions. + Explain the difference between product and period costs. > INTRODUCTION ah ee a This chapters aimed atintroducing the mostimportant concepts applicable inalllthe otherchapters. We look at the various cost classifications based on the various basis of classification, > DEFINITION OF KEY TERMS Prime cost: this is a summation of all direct costs incurred in production. It comprises direct material and direct labour costs and direct expenses. Variable cost: a cost that changes in direct proportion to changes in the level of activity. Fixed cost: a cost that does not change with the level of output - also called autonomous cost Direct costs: are costs that can be traced specifically and identified to the end product of the production process without any extra cost or inconvenienceCreare RED Te) Pa hae as Indirect costs: are costs that will not be directly attributable to a specific product. They are regarded as overheads. Marginal cost: it represents the additional cost of producing an extra unit of output, >» EXAM CONTEXT This topic is normally examined because it is the basis on which flexible budgets, among other statements, are prepared. It provides the ground on which to understand various costing techniques. The examiner may not set questions directly from this topic but from topics that borrow significantly from cost classification topic. > INDUSTRY CONTEXT Cost classification is important as management accountants apply it when preparing budgets and carrying out sensitivity analysis. The above are just but a few applications. Fast forwar Costs are classified for various purposes or reasons, There is an objective for each classification. A cost can fall into more than one classification based on the objective, Cost classification may be defined as ‘the arrangement of cost items in a logical sequence having regard to their nature and purpose to be fulfilled’, Costs are classified according to the cost objectives. Cost objective is the activity for which a separate measure of cost is desired, They include, cost stock valuation, cost for decision-making and cost for control purposes. The table below shows a summary of cost classifications given cost objectives: Cost objective Possible classification 1. | Stock valuation | * Manufacturing and non-manufacturing costs : Period and product costs : Direct and indirect costs 2. | Decision making | + Cost behavior: Variable, fixed, semi variable, : Relevance: opportunity, sunk cost, historical cost, standard costs 3. | Control purposes | + Controllable and non-controllable . Avoidable and non avoidablefete me CT aloo MANUFACTURING AND NON-MANUFACTURING COSTS: Manufacturing costs These are the costs incurred to produce a product. Remember that a product refers to both goods and services. The elements of manufacturing costs are: direct material costs, direct labour costs; and overhead costs, The elements make up the total cost of a product, as shown below: Note; direct expenses are expenses incurred for a particular job, project or service e.g. royalties, franchise, hire of special equipment, materials, labour, e.t.c. they are traceable to that specific job. These costs are discussed further in the following sections. 1 (a) Material costs: Material refers to all the physical inputs into the production process. They do not only refer to purely unprocessed materials or natural resources but refers to any material input in the manufacturing process. Finished goods for one company can be raw materials for another for instance, packed wheat flour is a finished good for the milling industry but a raw material to the banking industry. Raw materials can be classified as direct or indirect Direct materials are those materials that can be easily traced to a product without any extra cost or inconvenience. Examples include leather and sole for a shoe making industry. Direct expenses are expenses incurred for a particular job, project or service e.g. + Royalties + Franchise + Hire of special equipment Indirect materials are materials that become an integral part of the finished product but may be traceable into the product only at great cost or inconvenience. Examples include glue and thread for a shoe making industry. STUDY TEXTCrema Cored RED Te) An analysis of the various materials input into a production process is as follows Raw material Components and subassemblies Consumable materials Maintenance materials @ (b) Labour Labour is the physical and mental human input in a production process. Labour costs can be divided into direct labour costs and indirect labour costs. Direct labour cost refers to wages paid to workers who are directly involved in the production of each item produced. Such labour cost can be physically traced to the creation of product without undue cost. The cost can be readily identified with specific product or unit. For instance, wages Paid to factory supervisors, forklift truck drivers, factory store room clerks, etc. Pah ane as Indirect labor costs refer to the wages paid to workers whose efforts cannot be readily identified with specific product units or batches e.g. laborers paid to maintain all the premises utilized for production of goods and services. @ (c) Overhead costs They are also called indirect production costs. They include all costs of manufacturing except direct materials and direct labour. They are incurred for the benefit of all products thus the amount of overhead allocated can only be an estimate. They include indirect materials, indirect labour and other indirect expenses that cannot be traced directly to a product. They are at times referred to as factory burden, factory overheads or manufacturing expense. Non-manufacturing costs are costs incurred by all activities that support the production of goods and services. They are administration costs, selling costs and distribution costs. These are explained as follows: (a) (b) Production costs: these are costs incurred in the manufacturing process. They include material costs, labour costs and overhead costs as discussed above, Administrations cost: |s the sum of costs associated with the overall management of the enterprise, which cannot be readily identified with one of the major functional areas e.g. salary of the factory manager would be seen as a production cost but the salary of the personnel officer will be viewed as administrative cost since the personnel function does work for all other functions of the enterprise,(c) (a) (e) (f) (ele e CT aloo Selling Cost: this is the sum of costs associated with the securing of orders from customers. Included in this area will be items such as the salaries paid to the salesmen. and expenditure on advertising. Distribution costs: these are costs associated with warehousing the products and their delivery to customers. They are incurred in getting the finished product to customers for instance, depreciation of the distribution van Finance costs: These are costs incurred to secure funds to finance the organization's, activities. These include interests on loans and overdrafts, dividends to shareholders, interests on debentures etc Research and development costs: These are costs that are incurred to invent new products or to modify the existing ones, as well as costs incurred to acquire more information on such products. Cece ke curs Definition Cost behavior means how costs will respond or react to changes in the activity level. i.e. as we increas .e output or sales, are the costs rising, dropping or remaining the same. Cost Behavior can be used to produce various classifications of costs such as: @ Variable costs These are costs that increase or decrease, in total, in direct proportion to changes in the total level of activity or number of units produced i.e. that portion of the cost of an activity that change with the level of output. Examples of variable costs include wages paid to casual employees paid on an hourly basis and fuel cost based on mileage. Cost Variable costs secosts scactivity Level Activity Level Acosts ‘Activity level STUDY TEXTPam hana as Cremer RED Te) With variable costs, the cost level is zero when production is zero. The cost increases in proportion to the increase in the activity level because variable cost per unit of activity level is constant, thus the variable cost function is represented by a straight line from the origin. The gradient of the function indicates the variable cost per unit. For a cost to be variable, there should be an activity base which drives it. This activity base is a measure of effort that operates as a casual factor in the incurrence of variable costs. Thus to control these costs, cost accountants should be well acquainted with the various cost drivers (activity bases) within the organization Semi variable costs These are costs with both a fixed and variable cost component. The fixed component is that Portion which is constant irrespective of the level of activity. They are variable within certain activity levels but are fixed within other activity levels, as shown below: examples include salesmen salaries (salary plus commission, telephone charges, water bills, etc. To illustrate variable cost Total costs Variable cost Fixed Cost Aativly Level To illustrate unit variable cost Costs # unit variable {________, 0fete me CT aloo @ Fixed Costs These are costs that do not change with the level of output. They are also called autonomous costs, as they remain the same irrespective of the activity level as shown below. To illustrate total fixed costs A Costs Fixed cost {__y ° Activity To illustrate unit fixed cost a Unit Cost Fixed cost Pah nee as $$$» Activity Level The classification of cost into fixed and variable costs would only hold within a relevant range beyond which all costs are variable, The relevant range is the activity limits within which the cost behavior can be predicted. @ Semi Fixed Costs or stepped costs ‘These are costs which are constant within a certain production band but eventually increase at some critical point by a constant amount to another fixed level once the output band changes. This is a clear illustration of how fixed costs behave in the long run. For instance, managers’ salaries are increased from time to time. Each time there is an increase, the costs increase by the amount added at that critical point.Cremer RED Te) Pa ane as To illustrate somi variable costs Costs 4 Variable ‘componen ap fo Output Activity love! Fixed Component ° @ Curvilinear Curvilinear cost functions exist where costs do not vary in direct proportion to the level of activity thus giving a non linear funtion. (i) Convex cost function Convex direct costs are said to occur where each and extra unit of output causes a less than proportionate increase in cost. This is especially the case where economies of scale are in operation. For instance, the more you buy, the more quantity discounts you secure, Though there is an increase in total material cost, the unit material cost continues to decrease for each and every additional material unit purchased. The cost function will appear as follows: To illustrate convex cost function Cost Concave cost function Concave cost functions exist where an increase in activity level causes a more than proportionate increase in costs. For instance, where the rate of variability increases between two points e.g. wages paid under a bonus scheme. The cost function will be as shown on the opposite page;fete me CT aloo To illustrate concave cost function Cost | Activity Assuming that bonus is awarded at an increasing rate on the following basis Output Bonus per unit Oto 100 500 101 to 200 1000 201 to 300 1500 Note that the labour cost is increasing at a more than proportionate increase in output. When the relationship is plotted on a graph, a concave cost function will be derived. DIRECT COSTS AND INDIRECT COSTS Direct costs are costs that can be traced specifically and identified to the end product of the production process without any extra cost or inconvenience. Direct costs consist of costs that can be directly attributed to a specific output, product or level of activity. Direct costs include direct raw materials and direct labour also called prime costs in aggregate, PRIME COST = Direct Material Cost + Direct Labour Cost + Direct expenses Indirect costs are costs that will not be directly attributable to a specific product. They are regarded as overheads. Identification of overheads to specific products is done through cost allocation and apportionment. They include supervisors’ salaries, rent, electricity, depreciation of building ete. In order to trace a cost, it must first be possible, ie. practical, to measure the service or supply and then determine the related cost. Note that it is not the nature of the cost but its traceability that determines whether the cost is direct or indirect. STUDY TEXTSTUDY TEXT Crema Cored RED Te) Classification according to controllability Controllable cost: Refers to the cost, which can be influenced by the actions of a person in whom authority for such control is vested. Cost is said to be controllable at a particular level of management if that level has the power to authorize its incurrence. In other words, controllable costs are costs that are reasonably subject to regulations by the manager with whose responsibility those costs are being identified. For instance, a decision to hire more personnel to an organization at affordable rates can be controlled. Non controllable cost: is a cost which cannot be influenced by a person in whom authority for such control is vested. They are costs, which cannot be adjusted without affecting the long- term objective of the firm. For example if the trade union demands an increase in wages, the increment is a non controllable cost. Similarly, the depreciation of a building is a non-controllable cost to a manager as he does not have authority over depreciation In decision making, only controllable costs are relevant because they can be changed by the decision maker. There is little or nothing that the decision maker can do about the non-controllable costs thus they are irrelevant in decision making. g Classification according to normality Normal costs: these are costs that are expected to be incurred given a specific level of production. They may also be referred to as standard costs. Abnormal costs: abnormal costs are costs above the normal costs given a specific level of activity. For instance, abnormal costs may be incurred in production where the prices of materials, have significantly and adversely varied from the standard. @ Classification according to Historical costs: these are costs that were incurred ata given time in the past. They are irrelevant for decision making. An example is acquisition cost of an asset Predetermined costs: these are estimated costs that have been estimated for purposes of decision making. An example of such costs include overheads which are absorbed on a given predetermined overhead absorption rate, They are not always accurate. Classification based on identification with inventory Under this classification, costs are classified according to the function they perform in an organization, Costs can functionally be classified as:(a) (b) (a) (b) (c) (a) {e) (f) (9) (hy fete me CT aloo Product costs: are all the costs incurred in production of units during a time period e.g. raw material costs, direct labour costs and production overheads. Such costs are capitalized and expensed (charged to the profit and loss account) only when the manufacturer sells inventory. These costs may be carried from one period to the other. Period costs: these are costs mainly incurred in the ordinary running of the business enterprise. They include costs like electricity bill paid, salaries and allowances and rent payments. They are referred to as period costs since they are expensed in the period they are incurred fication for decision making Sunk costs: these are costs, which have already been incurred. They cannot be changed by any decision made after incurrence. Such costs are irrelevant for decision making. For example, cost of a delivery van already acquired by the organization shall be irrelevant as it cannot be changed by any course of action taken by management. Marginal cost: is the additional cost of producing an extra unit of output. Opportunity cost: is defined as the cost of the next best foregone alternative or the potential benefit that is lost by taking one course of action and giving up the other. For instance, by deciding to take on a leave and forego wages, the opportunity cost of the decision shall be the foregone wages. ferential cost/incremental cost: these are costs that differ among alternatives. They are costs relevant for decision making. They may be either variable or fixed. For instance, if taking up a different business apartment amounts to an extra Shs.2,000 rent expense, the differential (incremental) cost of the decision shall be the Sh.2,000. Imputed cost Is an expense not incurred directly, but actually borne. For example, a person who ‘owns a home debt-free has an imputed rent expense equal to the amount of interest that could be eamed on the proceeds from the sale of the home if the home were sold Replacement cost ‘The amount it would cost to replace an asset at current prices. If the cost of replacing an asset in its current physical condition is lower than the cost of replacing the asset so, as to obtain the level of services enjoyed when the asset was bought, then the asset is, in poor condition and the firm would probably not want to replace it Standard cost ‘A management tool used to estimate the overall cost of production, assuming normal operations. Budgeted cost This is the cost estimated to be incurred and used for budgeting purposes. It is a cost included in the budget representing cost expected, Most of the times, budgeted cost will be derived from standard cost. STUDY TEXTCrema Cored RED Te) CHAPTER SUMMARY Costs can be broadly categorized into two: Manufacturing costs and Non manufacturing costs Manufacturing costs comprise direct materials, direct labour and manufacturing overheads. The total of manufacturing overheads and direct labour gives conversion cost. The total of direct materials and direct labour gives Prime cost. Non manufacturing costs comprise selling and administrative and selling expenses. This chapter primarily focuses on classification of costs. The following table will help analyze the various objectives of classification and categories, which fall under them. . x rf ss Cost obje Possible classification rs a 1. | Stock valuation | + Manufacturing and non-manufacturing costs Fa + Period and product costs a : Direct and indirect costs 2. | Decision making | + Cost behavior: Variable, fixed, semi variable, + Relevance: opportunity, sunk cost, historical cost, standard costs 3. | Control purposes | + Controllable and non-controllable + Avoidable and non avoidable i) Manufacturing cost; cost incurred to produce a product. It comprises of material cost, labour cost and overhead cost ji) Non-Manufacturing costs are costs incurred by all activities that support the production of goods and services. They are administration costs, selling costs and distribution costs. Period costs are costs mainly incurred in the ordinary running of the business enterprise. They include examples like electricity bill paid, salaries and allowances and rent payments, They are referred to as period costs since they are expensed in the period they are incurred.a 3 COST ESTIMATIONEm CCLRC) Pee nee aeCHAPTER THREE COST ESTIMATION >» OBJECTIVES After studying this chapter, you should be able to: + Define cost estimation and understand the relationship between cost classification and estimation and why cost estimation is important. + Explain the various methods of cost estimation, their advantages and disadvantages and conclude on which method is the best under what circumstances + Predict costs using the high low method and visual fit method + Understand regression analysis and be able to predict costs through linear regression + Determine the degree of association between the dependent and independent variables by computing coefficient of determination > INTRODUCTION Cost estimation is a measurement of past costs for the purpose of predicting future costs for decision-making purposes. This chapter will primarily aim at using past data to predict future costs. Various methods of cost estimation, their advantages and limitations will be discussed. The methods of cost estimation include, High Low Activity method, account analysis, engineering analysis, visual fit (scatter graph) method, simple linear regression analysis and learning curve theory. > DEFINITION OF KEY TERMS Cost driver is any activity that causes a cost to be incurred e.g. labor hours, level of output, ete. Correlation is the degree of association between variables Coefficient of determination measures how much of the variation in the dependent variable is explained by the variation in the independent variable STUDY TEXTCrema Coed RED Te) Regression li best fit is a line fitted to an array of plotted points; may also be referred to as line of > EXAM CONTEXT Exam questions from this chapter are likely to be a mixture of calculations and discussions. You may be required to discuss the advantages and limitations of a particular cost estimation method or compare two or more cost estimation methods. For calculations, the examiner will normally focus on practical questions applicable in the industry. You, therefore, need to understand the theory comprehensively and practise to solve questions set on the various cost estimation methods. > INDUSTRY CONTEXT Cost estimation may be used to predict the relationship between a specific cost and a factor affecting the cost. The strength of the relationship, correlation, will be significant in deciding the cost determining factor. Practically in the industry, costs are normally driven by more than one factor. Therefore, the single factor cost estimation models discussed here will act as a base of comprehending the multifactor models. INTRODUCTION Cost estimation may be defined as a study which attempts to predict the relationship between costs and the activity level or cost driver’ that causes those costs based on an analysis of historical costs. In other words, cost estimation occurs when an individual attempts to measure historical costs in order to predict future costs. STUDY TEXT To achieve the measurement, it is necessary to separate cost into their fixed and variable cost elements. Semi variable costs can be separated into their fixed and variable components using scatter diagram approach, high-low method or regression analysis. In this topic, we shall deal with linear cost relationships and equations. A linear equation is an expression of the relationship between variables, the independent and the dependent variables. The cost estimating function for linear relationships is Y=a+bX Analyzed as Total cost = Fixed cost + Variable costSeen Y represents the dependent variable or the total cost a represents fixed cost component of the total cost (Constant amount) bX represents the variable costs component of the total cost b represents the unit variable cost (this is the gradient of the equation) Xx represents independent variable or the output level This is the usual straight line equation you have been encountering in elementary mathematics. q PURPOSE OF ESTIMATION Itassists in estimating the future expenditure (cost prediction) as the expenditure will depend on the cost of the respective activities Itassists in determining the net benefits anticipated in a specific activity based on the relationship between projected costs and projected revenue (profit prediction). Cost estimation is useful in the execution of managerial functions: business planning, cost control, performance evaluation and decision making STUDY TEXT Dy) q METHODS OF COST ESTIMATION Petri s een Pann oct a eae CR LCM eI expertise and the level of desired accuracy. We will consider following cost estimation methods commonly u (a) High Low Activity method ized, namely: (b) Account Analysis (c)_ Engineering Analysis (d) Visual Fit (Scatter graph) method (e) Simple linear regression analysis (f) Learning curve theoryCram LCL Tc} High-Low method Here, cost estimation is based on the relationship between past cost and past level of activity. Variable cost is based on the relationship between costs at the highest level of activity and the lowest level of activity. The difference in cost between high and low activity level is taken to be the total variable cost from which the unit variable cost can be computed by dividing it by the change in output level. This is indicated below: Total Variable Cost = Cost at - Cost at low activity level Therefore, Unit variable cost= Variable Costs. = Cost at high level activity - Cost at low level activity Output units Units at high level activity - Units at low level activity The variable cost per unit so calculated forms the ‘b’ of the straight line equation mentioned earlier. By substituting’ b’ into the equation, we can obtain ‘a’, the fixed cost. >>> Illustration I Based on performance, you have been provided with the following information regarding ABC Ltd for the year ended 31 December 2004: aa hae as Labour hours (Activity evel) Service costs (Shs) 450,000 400 155,000 350 153,000 600 192,000 310 145,000 200,000 d Req Develop a total cost function based on the above data using the high-low method Solut Labour hours Service costs (Shs) Highest activity level 800 200,000 Lowest activity level 300 150,000Seen Unit variable cost= Variable Costs = Cost at high level activity - Cost at low level activity Output units Units at high level activity - Units at low level activity Variable cost per Unit = Shs.200,000 - Shs.150,000 800hrs - 300 hrs = Shs.50,000 500hrs = Shs.100 per hr Therefore, b = 100 To get the fixed cost a, substitute ‘b’ into the straight line equation as follows: When labour hours (X) = 800, service cost (total cost, Y) = shs.200,000 Therefore, from the Straight Line equation, Y =a + bX 200,000 = a + (100) 800 200,000 = a + 80,000 200,000 - 80,000 120,000 a a Therefore, fixed costs = Shs.120,000 NB: Even if we used the 2" set of labour hours and service costs, were would still get he same answer i.e. When labour hours (X) = 300, service cost (total cost, Y) = Shs. 150,000. Therefore, 50,000 a + 100(300) 150,000 - 30,000 Shs.120,000 » 0 Therefore, the cost equation is: Y = 120,000 + 100x aa a ee aPoa ane ae Cram LCL RAI Tc} This equation can be used to estimate or predict the total costs: For example, when the activity level is, say, at 1000 labour hours, then the total cost would be: y = 120,000 + 1000(100) 120,000 + 100,000 ‘Shs.220,000 >>> Illustration Il Evans, the Managing Director of Mambo Company, has asked for information about the cost behavior of manufacturing overhead costs. Specifically, he wants to know how much overhead cost is fixed and how much is variable. The following data are the only records available. Month Machine-hours: Overhead Costs February 1,700 ‘Shs.20,500 March 2,800 Shs.22,250 April 1,000 Shs.19,950 May 2,500 Shs.21,500 June 3,500 Shs.23,950 Required: Using the high-low method, determine the overhead cost equation. Use machine-hours as your cost driver Solution: Note that in most cases, you are required to identify the cost driver. For instance, in our case, the cost driver is the machine hours and not overhead cost. Overhead cost cannot be a cost driver. It is a cost by itself. Unit variable cost= Variable Costs Cost at high level activity - Cost at low level activity Output units Units at high level activity - Units at low level activity Variable cost per unit = Shs.23,950 - Shs.19,950 3,500hrs - 1000hrs = Shs.4000 2,500hrs = Shs.1.6 per hr Therefore, b = 1.6Sean To get the fixed cost a, substitute ‘b’ into the straight line equation as follows: When machine hours (Y) = Shs.1,000, Overhead cost (total cost, Y) = shs.19,950 Therefore from the Straight Line equation, Y = a + bX 19,950 = a + (1.6)1000 19,950 = a + 1,600 a = 19,950 - 1,600 a = 18,350 Therefore fixed costs = shs.18,350 Therefore, the cost equation is Y = 18,350 + 1.6X High low method of cost estimation is easy to use and is liked by many as it is handy when a quick rough estimate is required. However, it does not consider all observations and thus outlier cases may distort the model. Itis only suitable with a single predictor and, in addition, It assumes that the relationship between the X and Y variables is linear and exists. The probable error of estimation can not be measured Account analysis (inspection of accounts) Using account analysis, the accountant examines and classifies each ledger account as variable, fixed or mixed. Mixed accounts are broken down into their variable and fixed components. They base these classifications on experience, inspection of cost behavior for several past periods or intuitive feelings of the manager. >>> Illustration Management has estimated Shs.1,090 variable costs, Shs.1,430 fixed costs to make 100 units using 500 machine hours. Since machine hours drives variable costs in our example, the variable cost stated as 2.18(1090/500) Then we get the total cost equation as Y = 1,430 + 2.18X Where, Y = total cost number of machine hours ah eeeae hae as Cremer RED Te) For 550 machine hours Total cost, Y = 1,430 + 2.18(550) 1,430 + 1,199 Shs.2,629 This analysis should determine whether any factors apart from output machine hours are influencing total cost. i Advantages and disadvantages of accounts analysis (inspection) method The accounts analysis method is easy to use and useful when a quick cost forecast is required. However, it assumes that what occurred in the past will be reflected in the future. This calls for further analysis, The model's reliability and validity cannot be determined as we cannot measure the size of probable error in forecasts made i.e. it lacks statistical vigor. The method is highly subjective as different managers will classify some costs differently. Engineering method This method is based on a detailed study of each operation where careful specification is made for materials, labour and equipment necessary to produce a product. It involves identifying the level of input required of an activity in form of raw material and labour while total cost is based on the cost of each input. This approach is applicable where no past data exists. Disadvantage: The main setback of the approach is that it requires a complex analysis of all the constituents of an activity and the requirements of an activity in terms of costs detailed into materials, labour, overheads and time. Visual fit (scatter graph method) Cost estimation is based on past data regarding the dependent variable and the cost driver. The past data on cost levels and the output levels is plotted on a graph (called a scatter graph) and a line of best fit is drawn as shown in the diagram. A line of best fit is a line drawn so as to cover the most points possible on a scatter graph. It can also be defined as ‘a straight line used as a best approximation of a summary of all the points in a scatter-plot’. Its intersection with the vertical axis indicates the fixed cost while the gradient indicates the variable cost per unit. This method takes into account all observations and is easy to apply. However, it cannot be used with two or more independent variables and is subjective to some extent as different lines of best fit may be drawn by different analystsose (See the diagram in the illustration below) I >>> Illustration IV Assume a firm has total costs of 8m, 4m and 1m respectively when the output units are 400,000, 200,000 and 0 respectively. Estimate its cost equation using the visual fit method. Direct Variable cost (otal cost) x, X% 200,000 400,000 Independent variable (Guputteved = a a freee cost =X, = lm = Not Change inY _Y, = ° * eran Change in X X ax” Variable cost per Unit a = o Change in cost 8m-4m eo TT _ ing) Change in activity level ~ 400,000 - 200,000 Variable cost per Unit = +. Total cost equation, Y = Im+20X On the basis of the existing data, fixed cost is Shs 1m and the variable cost per unit is 20. On the basis of the developed model, estimates can be made regarding future cost. When the activity level is 600,000 units, total cost will be estimated as: TC = Im+ 20(600,000) =1m+ 12m=13mPa ane as Pam NCL Te} REGRESSION ANALYSIS eer CCE ESO RR ec Soe the data available and establishes the relationship and the degree of relationship between the Nese) Regression analysis has a mathematical base of all regression lines that could be drawn to represent the data. The least square regression line of Y on X is that line for which the sum of squares of vertical deviations of all the points from the line is least. It involves estimating the cost function using past data or the dependent and the independent variables. The dependent variable will constitute the relevant cost, which may be service, variable cost, overhead cost, etc. The independent variable will be the cost drivers where the cost drivers will be labour hours, units of labour or raw materials, units of output, etc, In regression analysis, a regression model of the form Y = a + bX for a simple regression is obtained. This formal model measures the average amount of deviation of the dependent variable that is associated with unit changes in the amount of the independent variable. For a multiple regression, a regression model of the form Y = a+ b,X, +b, X,+....... + ,X, is obtained Where ais fixed cost, X,, X,, Xn are cost drivers X,, X,, X,up to Xn _ b, b, b, are changes in cost with the change in value of cost driver i.e. variable cost per unit of change in X,, X, Y is the dependant variable (total cost) Note that a simple regression produces a cost function of the form Y = a + bX so that we only have only one variable cost per unit (b) and only one independent variable (cost driver) x. However, a multiple regression produces a cost function of the form Y=a +b,X, +b, X, +. b,X, so that we have several variable costs per unit (b,,b, b,) and several independent variables (yy Xoy X) The general formulas used to compute a and b are as listed below. The equations are solved simultaneously to obtain the values. @ y-m+bSx Gi) Yvx= aYxHH yxSeen tA table, such as the one below, will help you summarize the data and easily obtain the figures for the computation of a and b values. Independent | Dependent x xY viable (x) _| variable (Y) 1 x 7 xr x % 2 xz Xe Ye n Xa in Xe Xa Ya a =X rY =X! zxY_ | Assumptions of the regression analysis (a) There exists a cause and effect relationship between the variables. That is, a change in the independent variable causes a change in the dependent variable. ah nea (b) There is good evidence of correlation. In this case, linearity of costs exists. Correlation is the degree of relationship between variables which seek to determine how well linear or other equations, explain or describe, the relationship between variables ()_ The historical data used covers a large level of activity level (d) Only one independent variable or activity base affects costs. This is in the case of simple regression analysis where only one independent variable exists. >>> Illustration The following data relates to MAKB Company limited for the half year period just ended Month. ‘Output (Units) Total Cost (Shs) January 40 5,100 February 45 5.450 March 50 6,050 April 40 5,400 May 60 6,850 June 55 6,250 Required: Determine the business fixed and variable costs for its manufacturing overheads and thus write down the cost equation in the form of Y=a + bX.