Cost estimation and cost behaviour

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1 Cost estimation and cost behaviour Solutions to Chapter 24 questions Question (a) The first stage is to convert all costs to a 2002 basis. The calculations are as follows: ( 000) ( 000) ( 000) ( 000) Raw materials Skilled labour 242(1.2) 4 344(1.2) 3 461(1.2) 2 477(1.2) Unskilled labour Factory overheads 168(1.15) 3 (1.2) 206(1.15) 2 (1.2) 246(1.15)(1.2) 265(1.2) Power 25(1.1)(1.25) 3 33(1.25) 3 47(1.25) 2 44(1.25) Raw materials Skilled labour Unskilled labour Factory overheads Power Total (2002 prices) Output (units) The equation Υ a bx is calculated from the above schedule of total production costs (2002 prices) and output. The calculations are as follows: Output Total cost in units (000) ( 000) x y x 2 xy Σx 750 Σy 3869 Σx Σxy We now solve the following simultaneous equations: Σy Na bσx Σxy Σxa bσx 2 Therefore a 750b (1) a b (2) Multiply equation (1) by 190 ( /750) and equation (2) by 1. Then equation (1) becomes Subtract equation (2) from equation (3): a b (3) 2970 = 10a a COST ESTIMATION AND COST BEHAVIOUR

2 Substitute for a in equation (1): x b b b 3.57 The relationship between total production costs and volume for 2002 is: y x where y total production costs (at 2002 price) and x output level. (b) See pages in Chapter 24 for the answer to this question. (c) General company overheads will still continue whether or not product LT is produced. Therefore the output of LT will not affect general production overheads. Consequently, the regression equation should not be calculated from cost data that includes general company overheads. General company overheads will not increase with increments in output of product LT. Hence short-term decisions and cost control should focus on those costs that are relevant to production of LTs. Common and unavoidable general fixed costs are not relevant to the production of LT, and should not be included in the regression equation. (a) (b) (c) = = = minutes The cumulative average time taken to produce 1000 units is minutes and the time taken to produce a total of 1000 units will therefore be minutes (i.e hours). Standard cost of 1000 units: Materials ( 28/ ) Processing cost ( hours at 25) = = = minutes Therefore the estimated time taken to produce 5000 units is minutes ( minutes) = = = minutes Therefore the estimated time taken to produce 6000 units is minutes ( minutes) so the 1000 units has taken an additional hours ( minutes minutes) giving a standard variable processing cost of 1718 (68.73 hours 25). Adding the direct material cost of gives a total standard variable cost of Revised learning curve effect: = = = minutes Question COST ESTIMATION AND COST BEHAVIOUR 193

3 The estimated total time to produce 1000 units in April is hours ( minutes/60) giving a total standard variable processing cost of 822 (32.89 hours 25). The standard direct material cost will remain unchanged at giving a total standard cost of Original budgeted profit Sales Variable costs Contribution Fixed costs Profit Actual profit Sales (900 62) Production costs: Direct materials Variable processing Fixed costs Closing stock (100 units at revised standard cost of per unit) Profit Variance calculations Processing usage/efficiency variance (original standard of 2625 revised standard of 822) 1803F Selling price variance ( 62 actual price 60 budgeted price) 900 units 1800F Sales volume (900 actual volume 1000 budgeted volume) revised stand. contrib. margin a 2970A Direct material cost (standard cost of Actual cost of ) 2396A Variable processing expenditure (Flexed budget of 2425 minutes 25/60 actual cost) 60A Variable processing efficiency ( minutes revised standard 1000 units actual time of minutes) stand. rate ( 25 per hour) 188A Fixed cost expenditure (Budgeted cost of Actual cost of ) 4840A Total variances 6851A Notes a revised standard contribution margin = 60 selling price revised variable cost ( /1000) = Reconciliation statement Original budgeted profit 7901 Less net variances as shown above 6851A Actual profit 1050 (d) If budgets and standards are set without considering the learning effect, meaningless standards are likely to be set that are easy to attain. Therefore favourable variances would be reported that are not due to operational efficiency. Where learning effects are expected, management should create an environment where improvements are expected. 194 COST ESTIMATION AND COST BEHAVIOUR

4 (a) (i) The learning curve is expressed as: yx ax b The exponent b is defined as the ratio of the logarithm of the learning curve improvement rate divided by the logarithm of 2. For an 80% learning curve: For an output of 14 units: b log 0.8/log y hours per unit Time taken for 14 units hrs Actual hours 240 It would therefore appear that an 80% learning effect is a reasonable assumption. (ii) For an output of 50 units: y hours per unit Hours required for 50 units: = hrs For an output of 30 units: y hours per unit Hours required for 30 units hours The time required for the additional 20 units hours ( ) (iii) Estimated cost for an order of 30 units Direct materials (30 30) Direct labour (401.4 hrs 6) Variable overhead (401.4 hrs 0.50) Fixed overhead ( ) a The above product cost has been calculated on an absorption costing basis in accordance with the current standard absorption costing system. Question Note a Fixed overhead for the period 6000 Direct labour hours for the period 1200 (75% 40 hrs 10 employees 4 weeks) Fixed overhead hourly rate 5 ( 6000/1200) Where the learning effect is present, unit product costs and labour hours will not be constant per unit of output. Significant variations in product costs and labour hours per unit of output are likely to occur at lower output levels. It is therefore necessary to estimate the extent of the learning effect for standard settings, budgeting and selling price quotations. Failure to take into account the presence of the learning effect can result in significant errors in cost estimates and planned labour requirements. If standards are not adjusted, they will cease to represent meaningful targets and lead to the reporting of erroneous favourable variances. (b) The statement refers to the fact that, with modern technology, there is a dramatic decrease in the direct labour content of most goods and services. Recent studies suggest that direct labour represents less than 10% of manufacturing cost and that COST ESTIMATION AND COST BEHAVIOUR 195

5 overheads are more closely related to machine hours than direct labour hours. With modern technology, output tends to be determined by machine speeds rather than changes in labour efficiency. Consequently, the presence of the learning effect as workers become more familiar with new operating procedures is of considerably less importance. The question implies that the learning curve is being replaced by an experience curve. The experience curve relates to the fact that output and efficiency are determined by manufacturing technologists such as engineers and production planners. As these groups of individuals gain experience from a range of applications of the new technology, efficiency improves and costs are minimized. It is therefore claimed that the experience curve has replaced the learning curve. However, the experience curve is extremely difficult to determine, and its impact is likely to take place over a much longer time period. It is therefore extremely difficult to capture the experience effect within short-term standard setting, budgeting and cost estimation activities. 196 COST ESTIMATION AND COST BEHAVIOUR

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