From the very beginning (especially from the academic point of view) we have been studying that the cost functions approximately shows linear relationship.

Is it really simple to predict the costs? In fact costs are not easy to predict, since they behave differently under different circumstances. In this article we will be observing how the cost will change with the change in level of production/other factors.

The determination of how cost will response with output level (production level) or other measurable factors of activity could be an important matter for decision-making, planning and control. The preparation of budgets, the production of performance reports, the calculation of standard costs and the provision of relevant costs for pricing and other decisions all depend on reliable estimates of costs.                                                                                                

I don’t think that the management (or accountants) whosoever may be would easily predict the costs of any product/segment without the basic knowledge of this portion.

Now let’s continue the discussion,

Cost function is a mathematical relation that describes cost pattern regarding how cost changes with

cost driver. Simply, cost driver can be defined as any factor whose change will cause a change in the total cost of an activity. Cost functions are normally estimated from past cost data and activity levels. Cost estimation begins with measuring past relationships between total costs and the potential drivers of those costs. The objective is to use past cost behavior patterns as an aid to predicting future costs. Any expected changes of circumstances in the future will require past data to be adjusted in line with future expectations.

E.g.: Direct labor, hours, machine hours, units of output and number of production run set-ups…

Broadly, cost driver may be divided into 2 categories:

Resource Cost Driver:

It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.

Activity Cost Driver:

It is a measure of the frequency and intensity of demand placed on activities by cost objects. It is used to assign activity costs to cost objects.

A cost object is any item for which cost measurement is required, for example, a product or a customer Service, Project, Brand category, Department, Programme etc.

Basic assumptions that we take for estimation cost functions.

1) Variations in the total costs of a cost-object are explained by variations in a single cost driver.

2) Cost behavior is adequately approximated by a linear cost function of the cost driver within the relevant range. [However in practical life we may rarely this assumption applied due to the economies of scale, but it’s a popular assumption for academic purpose]

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niraj thapaThe above article is contributed by Niraj Thapa (ICAI Reg. No. : FRO0004147), a CA Final Student currently doing Article ship in a Delhi based Firm. For any queries and suggestions you may reach him at:  tniraj20@hotmail.com, (Mob. No: +91-7503500777).

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