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Cost Behavior

# Cost Behavior

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Analytical study of cost behavior. Helpful for students and practitioners alike.
Analytical study of cost behavior. Helpful for students and practitioners alike.

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07/17/2013

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10-1
CHAPTER 10DETERMINING HOW COSTS BEHAVE10-1
The two assumptions are:1.Variations in the total costs of a cost object are explained by variations in a single cost driver.2.A linear cost function adequately approximates cost behavior within the relevant range of thecost driver. A linear cost function is a cost function where, within the relevant range, thegraph of total costs versus a single cost driver forms a straight line.
10-2
Three alternative linear cost functions are:1.Variable cost function––a cost function in which total costs change in proportion to thechanges in the level of activity in the relevant range.2.Fixed cost function––a cost function in which total costs do not change with changes in thelevel of activity in the relevant range.3.Mixed cost function––a cost function that has both variable and fixed elements. Total costschange but not in proportion to the changes in the level of activity in the relevant range.
10-3

A linear cost function is a cost function where, within the relevant range, the graph of total costs versus the level of a single activity is a straight line. An example of a linear cost functionis a cost function for use of a telephone line where the terms are a fixed charge of \$10,000 per yearplus a \$2 per minute charge for phone use. A nonlinear cost function is a cost function where,within the relevant range, the graph of total costs versus the level of a single activity is not astraight line. Examples include economies of scale in advertising where an agency can double thenumber of advertisements for less than twice the costs, step-function costs, and learning-curve-based costs.
10-4
No. High correlation merely indicates that the two variables move together in the dataexamined. It is essential to also consider economic plausibility before making inferences aboutcause and effect. Without any economic plausibility for a relationship, it is less likely that a highlevel of correlation observed in one set of data will be similarly found in other sets of data.
10-5
Four approaches to estimating a cost function are:1.Industrial engineering method.2.Conference method.3.Account analysis method.4.Quantitative analysis of current or past cost relationships.
10-6
The conference method develops cost estimates on the basis of analysis and opinionsgathered from various departments of an organization (purchasing, process engineering,manufacturing, employee relations, etc.). Advantages of the conference method include:1.The speed with which cost estimates can be developed.2.The pooling of knowledge from experts across functional areas.3.The improved credibility of the cost function to all personnel.

10-2
10-7
The account analysis method estimates cost functions by classifying cost accounts in theledger as variable, fixed, or mixed with respect to the identified level of activity. Typically,managers use qualitative, rather than quantitative, analysis when making these cost-classificationdecisions.
10-8
The six steps are:1.Choose the dependent variable (the variable to be predicted, which is some type of cost).2.Identify the cost driver(s) (independent variables).3.Collect data on the dependent variable and the cost driver(s).4.Plot the data.5.Estimate the cost function.6.Evaluate the estimated cost function.Step 3 typically is the most difficult for a cost analyst.
10-9
Causality in a cost function runs from the cost driver to the dependent variable. Thus,choosing the highest observation and the lowest observation of the cost driver is appropriate in thehigh-low method.
10-10
Criteria important when choosing among alternative cost functions are:1.Economic plausibility.2.Goodness of fit.3.Slope of the regression line.
10-11
A learning curve is a function that shows how labor-hours per unit decline as units of output are increased. Two models used to capture different forms of learning are:1.Cumulative average-time learning model. The cumulative average time per unit declines by aconstant percentage each time the cumulative quantity of units produced is doubled.2.Incremental unit-time learning model. The incremental unit time (the time needed to producethe last unit) declines by a constant percentage each time the cumulative quantity of unitsproduced is doubled.
10-12
Frequently encountered problems when collecting cost data on variables included in a costfunction are:1.The time period used to measure the dependent variable is not properly matched with the timeperiod used to measure the cost driver(s).2.Fixed costs are allocated as if they are variable.3.Data are either not available for all observations or are not uniformly reliable.4.Extreme values of observations occur.5.A homogeneous relationship between the individual cost items in the dependent variable andthe cost driver(s) does not exist.6.The relationship between cost and the cost driver is not stationary.7.Inflation has occurred in a dependent variable, a cost driver, or both.

10-3
10-13
Four key assumptions examined in specification analysis are:1.Linearity between the dependent variable and the independent variable within the relevantrange.2.Constant variance of residuals for all values of the independent variable.3.Residuals are independent of each other.4.Residuals are normally distributed.
10-14
No. A cost driver is any factor whose change causes a change in the total cost of arelated cost object. A cause-and-effect relationship underlies selection of a cost driver. Some usersof regression analysis include numerous independent variables in a regression model in an attemptto maximize goodness of fit, irrespective of the economic plausibility of the independent variablesincluded. Some of the independent variables included may not be cost drivers.
10-15
No. Multicollinearity exists when two or more independent variables are highly correlatedwith each other.
10-16
(10 min.)
Estimating a cost function
1.Slope coefficient=Difference in costsDifference in machine-hours
=
\$3,900 – \$3,0007,000 – 4,000
=
\$9003,000
=
\$0.30 per machine-hourConstant= Total cost (Slope coefficient
×
Quantity of cost driver)= \$3,900 (\$0.30
×
7,000) = \$1,800= \$3,000 (\$0.30
×
4,000) = \$1,800The cost function based on the two observations is:Maintenance costs = \$1,800 + \$0.30 (machine-hours)2.The cost function in requirement 1 is an estimate of how costs behave within the relevantrange, not at cost levels outside the relevant range. If there are no months with zero machine-hoursrepresented in the maintenance account, data in that account cannot be used to estimate the fixedcosts at the zero machine-hours level. Rather, the constant component of the cost functionprovides the best available starting point for a straight line that approximates how a cost behaveswithin the relevant range.