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Chapter 10 - Determining How Costs Behave

Chapter 10 - Determining How Costs Behave - Chapter 10...

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Chapter 10 – Determining How Costs Behave I. General Issues in Estimating Cost Functions a. Cost Function: i. Mathematical description of how a cost changes with changes in the level of an activity relating to that cost 1. Preparing setups for production runs, operating machines, etc b. Basic Assumptions and Examples of Cost Functions: i. Two assumptions: 1. Variations in the level of a single activity (the cost driver) explain the variations in the related total cost 2. Cost behavior is approximated by a linear cost function within the relevant range a. Relevant range: i. Range of the activity in which there is a relationship between total cost and the level of activity ii. Slope Coefficient: 1. Amount by which total cost changes when a one-unit change occurs in the level of activity iii. Constant: 1. Fixed cost of an equation a. Also the y-intercept iv. Linear Cost Function: 1. y = a + bX c. Brief Review of Cost Classification: i. Three Criteria for Classifying a Cost into its Variable and Fixed Components: 1. Choice of Cost Object:
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a. A particular cost item could be variable with respect to one cost object and fixed with respect to another cost object 2. Time Horizon: a. Whether a cost is variable or fixed with respect to a particular activity depends on the time horizon being considered i. Longer the time, more likely its variable 3. Relevant Range: a. Managers should never forget that variable and fixed cost-behavior patterns are valid for linear cost functions only within the given relevant range II. The Cause-and-Effect Criterion in Choosing Cost Drivers a. Most important issue in estimating a cost function is determining whether a cause-and-effect relationship exists between the level of an activity and the costs related to that level of activity i.
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