Cost Accounting (14th Edition)

The Cause-and-Effect Criterion
The most important issue in estimating a cost function is determining whether a causeand-effect
relationship exists between the level of an activity and the costs related to that
level of activity. Without a cause-and-effect relationship, managers will be less confident
about their ability to estimate or predict costs. Recall from Chapter 2 that when a causeand-effect
relationship exists between a change in the level of an activity and a change in
the level of total costs, we refer to the activity measure as a cost driver. We use the terms
level of activity and level of cost driver interchangeably when estimating cost functions.
Understanding the drivers of costs is crucially important for managing costs. The causeand-effect
relationship might arise as a result of the following:
A physical relationship between the level of activity and costs. An example is when
units of production are used as the activity that affects direct material costs.
Producing more units requires more direct materials, which results in higher total
direct material costs.
A contractual arrangement. In alternative 1 of the Cannon Services example
described earlier, number of minutes used is specified in the contract as the level of
activity that affects the telephone line costs.
Knowledge of operations. An example is when number of parts is used as the activity
measure of ordering costs. A product with many parts will incur higher ordering costs
than a product with few parts.
Managers must be careful not to interpret a high correlation, or connection, in the relationship
between two variables to mean that either variable causes the other. Consider direct material
costs and labor costs. For a given product mix, producing more units generally results in
higher material costs and higher labor costs. Material costs and labor costs are highly correlated,
but neither causes the other. Using labor costs to predict material costs is problematic.
Some products require more labor costs relative to material costs, while other products
require more material costs relative to labor costs. If the product mix changes toward more
labor-intensive products, then labor costs will increase while material costs will decrease.
Labor costs are a poor predictor of material costs. By contrast, factors that drive material costs
such as product mix, product designs, and manufacturing processes, would have more accurately
predicted the changes in material costs.
Only a cause-and-effect relationship—not merely correlation—establishes an economically
plausible relationship between the level of an activity and its costs. Economic
plausibility is critical because it gives analysts and managers confidence that the estimated
relationship will appear again and again in other sets of data from the same situation.
Identifying cost drivers also gives managers insights into ways to reduce costs and the
confidence that reducing the quantity of the cost drivers will lead to a decrease in costs.
To identify cost drivers on the basis of data gathered over time, always use a long time
horizon. Why? Because costs may be fixed in the short run (during which time they have
no cost driver), but they are usually variable and have a cost driver in the long run.
Cost Drivers and the Decision-Making Process
Consider Elegant Rugs, which uses state-of-the-art automated weaving machines to produce
carpets for homes and offices. Management has made many changes in manufacturing
processes and wants to introduce new styles of carpets. It would like to evaluate how
these changes have affected costs and what styles of carpets it should introduce. It follows
the five-step decision-making process outlined in Chapter 1.
Step 1: Identify the problem and uncertainties. The changes in the manufacturing
process were specifically targeted at reducing indirect manufacturing labor costs, and
management wants to know whether costs such as supervision, maintenance, and quality
control did, in fact, decrease. One option is to simply compare indirect manufacturing
labor costs before and after the process change. The problem with this approach is that
the volume of activity before and after the process change was very different so costs need
to be compared after taking into account the change in activity volume.
IDENTIFYING COST DRIVERS 345