CHAPTER 3

Activity Cost Behavior

LEARNING OBJECTIVES
After studying this chapter, you should be able to: 1. Define and describe fixed, variable, and mixed costs. 2. Explain the use of the resources and activities and their relationship to cost behavior. 3. Separate mixed costs into their fixed and variable components using the high lo! method, the scatterplot method, and the method of least s"uares. 4. Evaluate the reliability of the cost formula. 5. Explain ho! multiple regression can be used to assess cost behavior. 6. Define the learning curve, and discuss its impact on cost behavior. 7. Discuss the use of managerial #udgment in determining cost behavior.

C H A P T E R S U M M A RY
$his chapter introduces cost behavior as the !ay in !hich a cost changes in relation to changes in activity output. $he resource usage model helps one better understand the cost behavior. %t emphasi&es that the committed resources may have excess capacity because they are fre"uently fixed. $here are three methods of separating mixed costs presented in the chapter !ith their strengths and !ea'nesses. $he method of least s"uares produces the line that best fits the data points and is therefore recommended over the high lo! and scatterplot methods. $he least s"uares method has the advantage of offering methods to assess the reliability of cost e"uations. $he learning curve is discussed to better describe a nonlinear relationship bet!een labor hours and output. $he chapter concludes by describing ho! managers use their #udgment alone or in con#unction !ith the cost behavior analytical methods.

CHAPTER REVIEW
(no!ledge of cost behavior allo!s you to assess changes in costs that result from changes in activities. Cost accountants use this 'no!ledge to assess the effects of decisions that change activities. I. Basics of Cost Behavior A. B. )earning *b#ective +,

Cost behavior is the !ay a cost changes in relation to changes in the levels of activity usage. $he types of cost behavior include variable costs, fixed costs, and mixed costs.

39

40
Summary of ariab!e a"# $i%e# Cost Behavior
Cost -ariable .ixed I" &ota! $otal variable cost changes as activity level changes. $otal fixed cost remains the same even !hen the activity level changes. 'er ("it

Chapter3

-ariable cost per unit remains the same over !ide ranges of activity. .ixed cost per unit goes do!n as activity level goes up.

Review textbook Exhibit 3-1, which graphically illustrates fixed cost behavior. Review textbook Exhibit 3-2, which graphically illustrates variable cost behavior. )i%e# costs are costs that have both a fixed and a variable component. Review textbook Exhibit 3-5, which graphically illustrates C. )inearity Assumption A linear cost function is used to approximate the underlying cost function !ithin a relevant range because it is less time consuming and less expensive to estimate. A re!eva"t ra"*e is the range of activity for !hich the assumed cost relationship is valid. Review textbook Exhibit 3-!, which graphically illustrates li"ear cost fu"ctio" approxi atio" withi" the releva"t ra"ge. D. $ime /ori&on ,. $he longer the time period, the more li'ely that a cost !ill be a variable cost. %n the !o"* ru", all costs are variable. 0. $he short ru" is a period of time in !hich at least one cost is fixed. 1. $!o factors determine !hat is long run and !hat is short run: 2anagement #udgment $ypes of decisions that management faces 3short term and long term decisions4 5. 6nderstanding of the nature of long run and short run cost behavior provides insights to activities and the resources needed to enable an activity to be performed. II. +esources, -ctivities, a"# Cost Behavior A. %ntroduction ,. 7esources are the economic elements that are consumed in performing activities. 0. 8hen a firm ac"uires the resources needed to perform an activity, it is obtaining activity capacity. Activity capacity is the ability to perform activities. a. 'ractica! capacity is the level at !hich the activity is performed efficiently. b. ("use# capacity occurs !hen the activity capacity ac"uired is not used.
("use# capacity . -ctivity capacity / Capacity use#

ixed cost behavior.

)earning *b#ective +0

B.

.lexible 7esources

Activity Cost Behavior

41

$!e%ib!e resources are ac"uired from outside sources !ith no long term commitments. $hey are supplied as used and needed. ,. $here is no unused capacity for this category of resources 37esource supplied 9 7esource usage4. 0. .lexible resources are generally treated as a variable cost. C. Committed 7esources Committe# resources are ac"uired by the use of either an explicit or implicit contract to obtain a given "uantity of resource. $hey are supplied in advance of usage, regard less of !hether the resources ac"uired are fully used or not. Ac"uisition of committed resources include: ,. Committe# fi%e# e%pe"ses are the costs incurred to provide long term activity capacity. $hey are "ot sub#ect to change in the short run. Examples: Ac"uiring ultiperiod service capacities by hiring employees. :urchasing a long lived asset or entering a long term contract 3buildings and e"uipment, either purchased or leased4. 0. 0iscretio"ary fi%e# e%pe"ses are the costs incurred for the ac"uisition of short term activity capacity. $hey are independent of actual activity usage, but the levels of usage can be changed "uic'ly. Example: Salaries of employees, because !or'ers may not be laid off if there is a short term drop in production. D. %mplications for Control and Decision 2a'ing ,. *perational control information systems encourage managers to pay more attention to controlling resource usage and spending and to eliminate excess capacity. 0. 2anagers need to calculate and evaluate the changes in supply and demand of resources resulting from different decisions. E. Step Cost Behavior A step1cost fu"ctio" displays a constant level of cost for a range of activity output and then #umps to a higher level of cost at some point, !here it remains for a similar range of activity. ,. Step1variab!e costs are costs that follo! a step cost behavior !ith narro! steps 3resources must be purchased in small chun's4. Step variable costs can be approximated !ith a strictly variable cost assumption. 0. Step1fi%e# costs are costs that follo! a step cost behavior !ith !ide steps 3resources are ac"uired at large "uantities4. 2any so called fixed costs are best described by a step cost function because they are fixed over the normal operating range of a firm 3relevant range4. 2any committed resources, such as engineers; salaries, follo! a step cost function.

42

Chapter3 1. A contemporary cost management system informs users of the relationship bet!een resources supplied and resources used as follo!s:
-ctivity avai!abi!ity . -ctivity output 2 ("use# capacity

-ctivity rate is the average unit cost obtained by dividing the resource expenditure by the activity;s practical capacity. $he activity rate is used to calculate the cost of the activity used 3resource usage4 and the cost of unused activity as follo!s:
Cost of activity use# . -ctivity rate 3 -ctua! activity output Cost of u"use# activity . -ctivity rate 3 ("use# activity

$hus,
Cost of activity supp!ie# . Cost of activity use# 2 Cost of u"use# activity

<ote that a traditional cost management system typically provides information only about the cost of the resources supplied. .. Activities and 2ixed Cost Behavior ,. 2ixed costs have a fixed and a variable component. 0. $he accounting records often reveal the total cost of an activity and a measure of activity output. $hus, it is necessary to separate the total costs into their fixed and variable components. III. )etho#s for Separati"* )i%e# Costs i"to $i%e# a"# ariab!e Compo"e"ts A. %ntroduction )earning *b#ective +1

,. $he expression of the mixed cost as a linear e"uation is:

Y . F 2 VX

$otal activity cost 3# 4 is the #epe"#e"t variab!e because its value depends on the value of another variable. 2easure of activity output 3$ 4 is the i"#epe"#e"t variab!e because it measures activity output and explains changes in the activity cost. $here may be more than one independent variable. $he choice of an independent variable is related to its economic plausibility. $he i"tercept parameter corresponds to fixed activity cost 3% 4 or total fixed cost. =raphically, the intercept parameter is the point at !hich the mixed cost line intercepts the cost 3vertical4 axis. $he s!ope parameter corresponds to the variable cost per unit of activity 3& 4. =raphically, this represents the slope of the mixed cost line. 0. $here are three !idely used methods of separating mixed costs into their fixed and variable components: the high lo! method, the scatterplot method, and the method of least s"uares. B. $he /igh )o! 2ethod $he hi*h1!o4 metho# uses t!o points to determine the e"uation of the cost line. ,. $!o activity points, the highest and the lo!est, and their corresponding costs are used to determine the cost formula. 0. $he parameters for the cost formula 3 % and & 4 are computed using the follo!ing e"uations:

Activity Cost Behavior

43
ariab!e cost per u"it of activity . Cha"*e i" cost 5 Cha"*e i" activity V . 6Y2 / Y17 5 6X2 / X17 $i%e# activity cost . &ota! cost / &ota! variab!e cost F . Y2 / V X2or F . Y1 / V X1

1. Advantages of the high lo! method: *b#ectivity>Any t!o people using a particular set of data !ill come up !ith the same ans!er. ?uic' estimation>*nly t!o points of data are needed. 5. Disadvantage of the high lo! method: $he high and lo! points may not be representative of the cost activity relationship. C. $he Scatterplot 2ethod %n the scatterp!ot metho#, data points are plotted so that the relationship bet!een the dependent variable and the independent variable can be seen. ,. A scatter*raph is a visual portrait of the relationship bet!een cost and activity. $otal activity cost 3material handling cost4 is the vertical axis. $he activity driver or output measure 3number of moves4 is the hori&ontal axis. Review textbook Exhibit 3-', which shows a" exa ple of plotti"g a scattergraph. 0. A scattergraph allo!s the users to: Determine !hether a relationship bet!een the dependent variable and the independent variable exists. Assess the validity of the assumed linear relationship. %dentify outliers 3i.e., points that do not fit the general pattern of behavior4. 1. Comparison of the high lo! method and the scatterplot method: a. $he main advantage of the high lo! method is that it directs the manager as to !hich t!o points to select to compute the linear cost formula. $hus, the high lo! method removes sub#ectivity from the estimation process. b. $he advantage of the scatterplot method over the high lo! method is that it allo!s the users to inspect the data visually. Review textbook Exhibit 3-(, which illustrates cost behavior situatio"s "ot appropriate for the high-low ethod. )si"g a scattergraph to i"spect data visually would be adva"tageous. ore

D.

$he 2ethod of )east S"uares $he metho# of !east s8uares produces a best-fitti"g line that is closer to the data points than any other line.

44

Chapter3 ,. 2athematically, closer is defined as the line !ith the smallest sum of the s"uared deviations. 0eviatio" is defined as the difference bet!een the predicted and actual cost. 0. $he method of least s"uares uses the sum of s"uared deviations to identify the best fitting line because: S"uaring the deviations eliminates the canceling effect of positive and negative deviations. S"uaring the deviations also assesses a larger @penaltyA to data points that have a large deviation. 2any small deviations are better than a fe! large deviations. Since the measure of closeness is the sum of the s"uared deviation of points from the line, the smaller the measure, the better the line fits the data points. E. 6sing the 7egression :rograms ,. Spreadsheet pac'ages such as 2icrosoft Excel, )otus , 0 1, and ?uattro :ro , have regression routines that !ill perform the least s"uares computations. .or example, in Excel pull do!n the @$oolsA menu and choose @Add inA to activate the @Data Analysis $oolpac'.A 7eopen the @$oolsA menu to choose @Data AnalysisA and then clic' on @7egression.A Specify the dependent variable data range in the # !indo! and the independent variable data range in the $ !indo! !ithin the 7egression dialog box. Review textbook Exhibit 3-12, which shows regressio" output produced by Excel. 0. 6se the coefficients of the intercept and the $ variable reported at the bottom of the regression output to construct the cost formula.

I .

+e!iabi!ity of Cost $ormu!as

)earning *b#ective +5

7egression output is useful to assess the reliability of the estimated cost formula because it provides the results of hypothesis testing of cost parameters, goodness of fit, and confidence intervals. $hese tests help the manager determine !hether there is a strong association bet!een an activity cost and an activity driver. Strong test results provide evidence to the manager about the correctness of the driver selection. A. /ypothesis $est of :arameters $he hypothesis test of cost parameters indicates !hether the parameters are different from &ero. ,. $he t statistic is used to test the hypothesis that the cost parameters are statistically different from &ero. 0. $he reported : value sho!s the level of statistical significance achieved by the t statistic. %f the reported : value is less than the specified degree of confidence 3for exam ple, B.BC4, the independent variable is a significant explanatory variable.

Excel is a registered trademar' of 2icrosoft Corporation. )otus and , 0 1 are registered trademar's of the )otus Development Corporation. ?uattro :ro is a registered trademar' of <ovell, %nc. Any further reference to Excel, )otus , 0 1, or ?uattro :ro refers to this footnote.

Activity Cost Behavior

45

%f the reported : value is greater than the specified degree of confidence 3for example, B.BC4, the independent variable is not a significant explanatory variable. B. =oodness of .it 2easures 9oo#"ess of fit measures the degree of association bet!een cost and activity output. 2easures of goodness of fit include the coefficient of determination and the coefficient of correlation. ,. $he coefficie"t of #etermi"atio" measures the percentage of variability in the dependent variable that is explained by the independent variable. $he coefficient of determination is labeled as 7 S"uare 3R24 in regression output. R2 al!ays ranges bet!een B and ,.BB. $he higher the percentage of cost variability explained, the better the fit. 0. $he coefficie"t of corre!atio" is the s"uare root of the coefficient of determination. %t provides information on the direction of the relationship bet!een cost and activity, because the value of the coefficient of correlation can range bet!een D, and E,. 8hen a positive correlation exists, as activity increases, costs also increase. 8hen a negative correlation exists, as activity increases, costs decrease. Review textbook Exhibit 3-13, which illustrates various correlatio"s a"d the associated correlatio" coefficie"ts. C. Confidence %ntervals A co"fi#e"ce i"terva! provides a range of values for the actual cost !ith a prespecified degree of confidence. ,. $he confidence interval of the predicted costs is used to measure the discrepancy bet!een the actual cost and the predicted cost using the least s"uares cost e"uation. $he predicted cost can be expected to be different from the actual cost because: $he cost e"uation may have omitted a relevant activity driver. A sample !as used to estimate the relationship. 0. $he standard error 3 *e4 in the regression statistics and a t statistic is re"uired to construct the confidence interval for the predicted cost.
Co"fi#e"ce i"terva! . 're#icte# cost : t 3 Sta"#ar# error

!here Standard error is the measure of dispersion found in the data. t statistic is a specified degree of confidence that describes the li'elihood that the prediction interval !ill contain the actual costs. $he value of the t statistic depends on the follo!ing: Degree of freedom 9 " + p !here " 9 <umber of data points used to calculate the cost formula p 9 <umber of parameters in the cost e"uation

46 Confidence level Review textbook Exhibit 3-1!, which provides a table of selected t values. 1. %mplications of the confidence interval include the follo!ing: $he !ider the confidence interval, the less useful the cost e"uation.

Chapter3

$he !idth of the confidence interval can be reduced by using more data points. 8ith a larger sample, both the standard error and the t statistic !ill decrease. . )u!tip!e +e*ressio" )earning *b#ective +C

)u!tip!e re*ressio" uses least s"uares to fit an e"uation involving t!o or more explanatory variables. $he hypothesis test of the parameters no! is a test of !hether or not the independent variable should be included in the e"uation. $he @ad#usted 7 S"uareA is used as the goodness of fit measure. $he t statistic for each regression coefficient is calculated, and the achieved level of statistical significance 3the reported p value4 is tested in the same !ay as those in simple regression. Calculate the confidence interval in the same !ay as those in simple regression. Review textbook Exhibit 3-15, which shows a sa ple ultiple regressio" a"alysis output.

I.

&he ;ear"i"* Curve a"# <o"!i"ear Cost Behavior

)earning *b#ective +F

$he !ear"i"* curve describes the mathematical or graphic representation of ho! the labor hours !or'ed per unit decrease as the volume produced increases in a nonlinear fashion. $he !ear"i"* rate, expressed as a percent, gives the percentage of time needed to ma'e the next unit, based on the time it too' to ma'e the previous unit. $he use of the learning curve concept helps management to be more accurate in budgeting and performance evaluation for processes in !hich learning occurs. $he learning curve can be applied to the service industry and to the manufacturing industry using the follo!ing models: A. Cumulative Average $ime )earning Curve $he cumu!ative avera*e1time !ear"i"* curve model states that the cumulative average time per unit decreases by a constant learning rate each time the cumulative "uantity of units produced doubles. Review textbook Exhibit 3-1,, which gives the data for a cu ulative average-ti e lear"i"g curve with a" '- perce"t lear"i"g rate a"d 1-- direct labor hours for the first u"it. .ote that the bold rows give the cu ulative average ti e a"d cu ulative total ti e accordi"g to the doubli"g for ula.

Activity Cost Behavior

47

Calculate the amounts for units that are not doubles of the original amount using the follo!ing formula: Y = pXq 8here: # 9 Cumulative average time per unit $ 9 Cumulative number of units produced p 9 $ime in labor hours re"uired to produce the first unit / 9 7ate of learning 9 ln 3percent learning4 G ln 0 Review textbook Exhibit 3-10, which shows the graph of both the cu ulative average ti e per u"it a"d the cu ulative total hours re/uired. B. %ncremental 6nit $ime )earning Curve $he i"creme"ta! u"it1time !ear"i"* curve mo#e! describes that the incremental time per unit decreases by a constant learning rate each time the cumulative "uantity of units produced doubles. Review textbook Exhibit 3-1', which gives data for a" i"cre e"tal u"it-ti e lear"i"g curve with a" '- perce"t lear"i"g rate a"d 1-- direct labor hours for the first ti e. Calculate the amounts for units that are not doubles of the original amount using the follo!ing formula: m = pXq 8here: 9 $ime needed to produce the last unit $ 9 Cumulative number of units produced p 9 $ime in labor hours re"uired to produce the first unit / 9 7ate of learning 9 ln 3percent learning4 G ln 0 C. $he difference bet!een the cumulative average time learning curve model and the incremental unit time learning curve model is in the underlying assumptions of the t!o models. ,. $he cumulative average time learning curve model assumes that the decrease in learning applies to all the units in bet!een the original observation and the doubled observation, not #ust to the incremental unit. 0. $he incremental unit time learning curve model assumes that the decrease in learning applies only to the incremental unit, not to all the units in bet!een the original observation and the doubled observation. 1. %n general, the incremental unit time learning curve model does not decrease as rapidly as the cumulative average time learning curve model.

4= II. )a"a*eria! >u#*me"t )earning *b#ective +I

Chapter3

2anagers may use their experience and past observations of cost relationships to determine fixed and variable costs. $his is the most !idely used method in practiceH its appeal is simplicity. 2anagers may use their experience and #udgment to refine the statistical estimates. .or example, experienced managers might @eyeballA the data and thro! out several points as outliers, excluding them from the computations.

Activity Cost Behavior

49

KEY TERMS TEST

S?& @1
From the list that follows, select the term that best completes each statement and write it in the space provided.

activity capacity activity rate committed fixed expenses cost behavior cost of resource usage cumulative average time learning curve model discretionary fixed expenses fixed costs flexible resources learning curve

long run mixed costs practical capacity relevant range resources supplied in advance of usage short run step cost function step fixed cost step variable cost unused capacity variable costs

1. %f the cost remains constant over !ide ranges of activity usage, it is a3n4 JJJJJJJJ JJJJJJJJJJJJJJJJJJJJJ H if the ranges are relatively narro!, it is a3n4 JJJJJJJJ JJJJJJJJJJJJJJJJJJJJJ. 2. $he ability to perform activities is called JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. 3. $he JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ states that the cumulative average time per unit decreases by a constant learning rate each time the cumulative "uantity of units produced doubles. 4. $he efficient level of activity performance is the JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. 5. $he period of time in !hich all costs are variable is the JJJJJJJJJJJJJJJJJJH the period of time in !hich at least one cost is fixed is the JJJJJJJJJJJJJJJJJJ. 6. $he activity rate multiplied by actual activity usage is the formula for JJJJJJJJJJJJJ JJJJJJJJJJJJJJJJJJJJJJJ. 7. $he JJJJJJJJJJJJJJJJJJJJJJ is the average unit cost. =. Costs incurred for the ac"uisition of short term capacity or services JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. are

9. JJJJJJJJJJJJJJJJJJJJJJJ is the !ay in !hich a cost changes in relation to changes in activity usage. 10. $he difference bet!een the ac"uired activity capacity and the actual activity usage is the JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. 11. Costs incurred for the ac"uisition of long term JJJJJJJJJJJJJJJJJJJJJ JJJJJJJJJJJJJJJJJJJJJJJJ. activity capacity are

50

Chapter3

12. 8hen the cost function is defined for ranges of activity usage, it is a3n4 JJJJJJJJJJJJJJJ JJJJJJJJJJJJJJ. 13. JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ are resources ac"uired from outside sources !ith no re"uirement of any long term commitment, !hile JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ JJJJJJJJJJJJJJJJJJJJJJJJJJJJ are ac"uired through either an explicit or implicit contract to obtain a given "uantity of resource, !hether fully used or not. 14. JJJJJJJJJJJJJJJJJJJJJJJJJ vary i" total in direct proportion to changes in an activity driver. 15. JJJJJJJJJJJJJJJJJJJJJJJJJ have both a fixed and a variable component. 16. JJJJJJJJJJJJJJJJJJJJJJJJJ are i" total constant !ithin the relevant range as the level of the activity driver varies. 17. $he assumed cost relationship is valid only for the JJJJJJJJJJJJJJJJJJJJJJJJJJ. 1=. $he JJJJJJJJJJJJ describes the mathematical or graphic representation of ho! the labor hours !or'ed per unit decrease as the volume produced increases in a nonlinear fashion.

S?& @2
From the list that follows, select the term that best completes each statement and write it in the space provided.

activity output coefficient of correlation coefficient of determination committed resources confidence interval dependent variable deviation flexible resources goodness of fit high lo! method hypothesis test of cost parameters

independent variable intercept parameter incremental unit time learning curve learning rate method of least s"uares multiple regression nonunit level drivers scattergraph scatterplot method slope parameter unit level drivers

1. JJJJJJJJJJJJJJJJJJ is the difference bet!een the predicted value and the actual cost. 2. $he JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ is a measure of the relationship bet!een t!o variables, including the direction of the relationship. 3. $he plot of cost versus activity is a3n4 JJJJJJJJJJJJJJJJJJJJJ. 4. $he JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ is used JJJJJJJJJJJJJJJJJ JJJJJJJJJJJJJ. to predict the

5. $he JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ is the percentage of total variability in the dependent variable that is explained by the independent variable.

Activity Cost Behavior

51

6. $he JJJJJJJJJJJJJJJJJJJJJJJJJJJ is the degree of association bet!een cost and activity. 7. $!o methods that fit a line to data using only t!o points are the JJJJJJJJJJJJJJJJJ JJJJJJJJJJJJJ and the JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. =. A3n4 JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ provides a range of predicted values rather than a single point estimate. 9. $he fixed cost is estimated by the JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ, !hile the variable cost per unit of activity usage is estimated by the JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. 10. $he statistical method of finding the e"uation of the line that best fits the set of data is the JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. %f t!o or more variables are used, it is called JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ. 11. $he JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJmodel states that the incremental time per unit decreases by a constant learning rate each time the cumulative "uantity of units produced doubles. 12. $he percentage of time needed to ma'e the next unit, based on the time it too' to ma'e the previous unit, is called JJJJJJJJJJJJ.

M U LT I P L E - C H O I C E Q U I Z
Complete each of the following statements by circling the letter of the best answer.

1. $he amount of activity capacity used in producing the organi&ation;s output is: a. practical capacity. b. resource spending. c. resource usage. #. unused capacity. e. none of the above. 2. 8hich of the follo!ing costs remain constant i" total !hen the level of the activity driver variesK a. conversion costs b. direct costs c. fixed costs #. mixed costs e. variable costs

52 3. Committed fixed expenses are costs: a. incurred that provide long term activity capacity. b. that can easily be changed. c. incurred that provide short term activity capacity. #. that are allocated from another organi&ational unit. 4. Discretionary fixed expenses are costs: a. incurred that provide long term activity capacity. b. that are supplied as used and needed. c. that cannot be changed. #. incurred that provide short term activity capacity. e. that are allocated from another organi&ational unit.

Chapter3

5. 8hich of the follo!ing is true about resources supplied in advance of usageK a. $here is no unused activity capacity for this category of resources. b. $he organi&ation is free to buy only the "uantity of resources needed. c. $hese resources may ta'e the form of either committed fixed expenses or discretionary fixed expenses. #. <ormally a long term commitment is not re"uired. e. All of the above are true. 6. 8hich of the follo!ing is the best definition of a step fixed costK a. %t is a cost that is constant i" total over the relevant range. b. %t is a cost that varies i" total in direct proportion to changes in activity. c. %t is a cost that follo!s a step cost behavior !ith narro! steps. #. %t is a cost that follo!s a step cost behavior !ith !ide steps. e. %t is a cost that measures activity usage in steps>first, the fixed cost of resources usedH then, the fixed cost of unused capacity. 7. $he variable !hose value is based on the value of another variable is the: a. activity variable. b. dependent variable. c. independent variable. #. intercept parameter. e. slope parameter. =. $he item that corresponds to the variable cost per unit of activity is the: a. activity variable. b. dependent variable. c. independent variable. #. intercept parameter. e. slope parameter.

Activity Cost Behavior

53

9. 8hich of the follo!ing best describes the difference bet!een the high lo! method and the scatterplot methodK a. $he high lo! method uses all of the activity pointsH the scatterplot method uses only t!o points. b. $he high lo! method uses the high activity point and the lo! activity pointH the scatterplot method allo!s the user to select t!o points that better represent the relationship bet!een activity and costs. c. $he high lo! method uses the coefficient of correlationH the scatterplot method uses the coefficient of determination. #. $he high lo! method uses costs from the accounting recordsH the scatterplot method uses costs from the operating records. e. <one of the above accurately describe the difference bet!een the high lo! method and the scatterplot method. 10. 8hich of the follo!ing is "ot an advantage of using the least s"uares method rather than the high lo! methodK a. $he e"uation line is the best fitting line to the data points. b. All of the data points, rather than #ust t!o points, are used. c. A measure of the goodness of fit is available. #. 2easures of the reliability of the resulting line are available. e. All of the above are advantages of the least s"uares method. 11. 8hich of the follo!ing is true about the coefficient of determination R 2K a. R 2 is the probability that the actual value !ill be included in the confidence interval. b. An R 2 of LCM means that LCM of the data points fall on the e"uation line. c. A negative R 2 means that as activity increases, costs !ill decrease. #. R 2 measures the percentage of the total variability of the costs that is explained by the e"uation line. e. <one of the above are true. 12. 8hy is managerial #udgment so critical in determining cost behaviorK a. All statistical methods are notoriously unreliable. b. Statistical methods are highly accurate in depicting the past, but they cannot foresee the future. c. $he fixed and variable cost brea'do!ns are recorded in the accounting recordsH management #ust needs to 'no! the appropriate accounts to search. #. $he managers can use their experience to refine the statistical estimates. e. 2anagerial #udgment is not criticalH statistical methods can capture all of the manager;s expertise !ithout any bias. 13. NOP Corporation has reported activity costs. 8hen ,B,BBB units are produced, the average cost is Q01 per unit. 8hen the activity is only F,BBB units, the average cost is Q1B per unit. 8hat are the fixed and variable costsK
$i%e# ariab!e

a. Q,BC,BBB.BB b. ,0.CB c. ,L.CB #. 3R,5BB.BB4 e. ,RB,BBB.BB

Q ,0.CB ,BC,BBB.BB 3,.IC4 B.BR I.BB

54

Chapter3

14. Almost Company had setup costs totaling Q0FC,BBB !hen 0,ICB setups !ere performed. 8hen 1,CBB setups !ere performed, setup costs totaled Q1,B,BBB. Determine the fixed and variable cost brea'do!n for setup costs.
$i%e# ariab!e

a. Q 3,,FFF .FI4 b. 5IC,BBB.BB c. ,BB,BBB.BB #. ,0,BBB.BB e. 3,0,BBB.BB4

Q ,F.FI 3FB.BB4 FB.BB L0.BB L0.BB

15. Colfax, %nc., had pac'aging costs of Q,CB,BBB !hen ,0,CBB pac'ages !ere shipped. :ac'aging costs !ere Q,LB,BBB !hen ,I,CBB pac'ages !ere shipped. $he variable costs !ere: a. QR.BB. b. Q,B.RF. c. Q,,.11. #. Q,0.BB. e. none of the above. 16. Acme Company has #ust completed a least s"uares regression analysis of its material handling costs. $he cost analyst has provided you !ith the follo!ing summary, !ith apologies that the original computer output !as not available:
'arameter ?stimate Sta"#ar# ?rror of 'arameter

%ntercept.................................... <umber of moves.....................

15I.RF 1.I1,

F,.ICR B.01RI

Summary regression statistics are provided as follo!s: 7 S"uare 3R 04........................... B.RIF Standard Error 3*e4................... C1.C, *bservations............................. 00 8hat is a LC percent confidence interval for an estimated ,CB moves of material 3use t 9 0.BRF4K a. LI.CF S 5F.RI b. 1C,.CL S ,CB.BB c. IL5.LR S 5C.RL #. LBI.C, S ,,,.F0 e. LBI.C, S ,0R.R1

Activity Cost Behavior

55

PRACTICE TEST
?A?+CIS? 1
.is' Engineering is an independent testing laboratory !ith contracts to perform standardi&ed "uality testing for local manufacturers. .is' employs four engineers !ho are responsible for all phases of the testing. Each engineer is paid an average salary of Q5B,BBB and is capable of conducting 1,0BB tests per year. $he facility !as recently constructed for Q5CB,BBB and is being depreciated on a straight line basis over 0B years. $esting e"uipment is leased for QF,BBB per year on a five year lease. Consumable supplies are expected to average Q,IC,BBB per year at full capacity. During 0BNN, there !ere ,,,BBB tests performed.
Req ired!

1. Classify the resources into one of the follo!ing: 3,4 long term resources supplied in advance, 304 short term resources supplied in advance, or 314 resources supplied as needed.

2. Calculate the activity rate, brea'ing it do!n into fixed and variable components.

3. Calculate the total activity available, brea'ing it do!n into activity usage and unused activity.

56

Chapter3

?A?+CIS? 2
Ant& %ndustries has provided you !ith the follo!ing data for its materials storeroom:
)o"th <umber of Shipme"ts Storeroom Costs

Tanuary...................... .ebruary.................... 2arch......................... April........................... 2ay............................ Tune........................... Tuly............................ August....................... September................. *ctober...................... <ovember.................. December..................
Req ired!

,IC 00C 0IC ,IC 0BB 00C 1BB 10C 0IC 0BB ,CB ,IC

Q1,BBB 1,FBB 5,1BB 1,RBB 0,IBB 1,0BB 5,0CB 5,5BB 5,,BB 1,,CB 0,FCB 0,ICB

1. Determine the cost behavior using the high lo! method.

2. :repare a scattergraph of the data points, using cost as the vertical axis and number of shipments as the hori&ontal axis. Do any of the points seem to be outliersK

Activity Cost Behavior

57

?A?+CIS? 2"Contin ed#

3. Determine the cost behavior using the scatterplot method. /o! do these results compare !ith the high lo! methodK

?A?+CIS? 3
$he Saints Company !ants to develop an estimate of its supplies costs. =eorge Saint, the controller, has collected !hat he believes to be the relevant data for the past ,0 months. %t is 2r. Saint;s professional opinion that the supplies cost should be closely related to the volume of the product producedH thus, he has provided you !ith the follo!ing information:
)o"th ("its 'ro#uce# Cost of Supp!ies

Tanuary...................... .ebruary.................... 2arch......................... April........................... 2ay............................ Tune........................... Tuly............................ August....................... September................. *ctober...................... <ovember.................. December..................

,BB RB IB CB FB RB IB RB ,BB IB FB CB

Q1,CCB 0,LRB 0,LIB 0,5,B 0,C1B 1,,RB 0,R1B 0,R0B 1,00B 0,LCB 0,CFB 0,50B

7E=7ESS%*< S622A7O *6$:6$ Regressio" *tatistics 2ultiple 7 B.L105,0L 7 S"uare B.RFL1L1L Ad#usted 7 S"uare B.RCF1111 Standard Error ,10.0FBL, *bservations ,0 A<*-A 7egression 7esidual $otal df , ,B ,, 2oefficie"ts ,55C.RLC1 ,L.F,LR1C ** ,,F551I.,L ,I5L0L.5IFF ,11L1FF.FFI *ta"dard Error ,IR.5ICF0FI 0.5B5I51II1 1* ,,F551I ,I5L0.L % FF.CFFBL1C5 *ig"ifica"ce % L.LBLE BF

%ntercept 6nits :roduced

t *tat R.,B,1F R.,CRR

3-value ,.BC51IE BC L.LBRCE BF

4ower (55 ,B5R.00FR ,5.0F,I1,

)pper (55 ,R51.CF1L 05.LIIL1L

5=

Chapter3

?A?+CIS? 3"Contin ed#

Req ired!

1. :repare a cost formula for the supplies cost using the regression output.

2. Determine the coefficient of determination.

3. Determine the coefficient of correlation.

4. :repare a LC percent confidence interval for supplies cost !hen LB units are produced 3using t statistic 9 0.00R4.

Activity Cost Behavior

59

?A?+CIS? 4
$he Ouma Company has accumulated the follo!ing information in its "uest to determine the cost behavior of the 7eceiving Department. =ail <elson, the manager of Ouma, feels that tons of material received, the dollar value of receipts, the number of purchase orders, and the number of incoming shipments could all reasonably influence the 7eceiving Department costs.
+eceivi"* 0epartme"t Costs &o"s of )ateria! +eceive# 0o!!ar a!ue of +eceipts <umber of 'Bs <umber of I"comi"* Shipme"ts

QFI,,BB IC,0BB L0,0BB RR,FBB RI,IBB RB,0BB LR,BBB FI,FBB FR,CBB IR,CBB I,,IBB RB,1BB IR,BBB RB,BBB L1,RBB
Req ired!

5I,1BB FR,0BB L1,CBB IL,0BB LF,RBB 5L,CBB I1,IBB 5B,IBB 5F,0BB F1,RBB CB,FBB 5R,5BB CC,BBB FL,1BB C1,LBB

Q,1R,FBB ,CI,BBB ,CR,5BB ,1L,LBB ,55,BBB ,15,,BB ,F0,BBB ,,I,BBB ,C0,,BB ,51,,BB ,,I,BBB ,5R,CBB ,0I,RBB ,1F,RBB ,C1,BBB

LB RL LF ,BC L, ,,B ,0R RC RR LB RI ,BR ,B1 LR ,0C

,B1 ,,I ,1L ,5R ,0B ,1R ,CF ,,5 ,,I ,11 ,1B ,1F ,,C ,0F ,FR

1. :repare a cost formula for the 7eceiving Department costs. /o! many activity drivers are usedK Are they all different from &eroK

60

Chapter3

?A?+CIS? 4"Contin ed#

)se this space to co"ti"ue your a"swer.

2. /o! !ell does your model explain the variability in the costsK

3. :repare an estimate of costs for a month !hen IC,BBB tons valued at Q,0C,BBB are received, LB purchase orders are handled, and ,0C shipments are received.

4. :repare a LC percent confidence interval for the point estimate you prepared in 7e"uirement 1.

Activity Cost Behavior

61

?A?+CIS? 5 $itan Corp. manufactures high tech e"uipment for space shuttles. %t has completed manufacturing the first unit of the ne! $< 1 machine design. 2anagement believes that the ,BB labor hours re"uired to complete this unit are reasonable and is prepared to go for!ard !ith the manufacture of additional units. An RB percent cumulative average time learning curve model for direct labor hours is assumed to be valid. Data on costs are as follo!s: Direct materials Direct labor -ariable manufacturing overhead +e8uire#C ,. Set up a table !ith columns for cumulative number of units, cumulative average time per unit in hours, cumulative total time in hours, and individual unit time for the "th unit in hours. Complete the table for ,, 0, 5, and R units. QICB per unit Q,C per direct labor hour Q5B per direct labor hour

0. 8hat is the total variable cost of producing ,, 0, 5, and R unitsK 8hat is the variable cost per unit for ,, 0, 5, and R unitsK

62

Chapter3

C A N YO U ? C H E C K L I S T

Can you explain the relationship among activities, resource usage, and cost behaviorK Can you explain ho! resource spending, resource usage, and unused capacity are interrelatedK Can you describe ho! resources supplied affect cost behaviorK Can you describe the different patterns of step cost behaviorK Can you explain ho! the con cept of the relevant range affects the estimation of these costsK Can you determine cost behavior using either the high lo! method or the scatterplot methodK Can you explain the difference bet!een these t!o methodsK Can you explain ho! the method of least s"uares defines closest and best-fitti"g li"e K Can you use the least s"uares method to develop a cost formulaK Can you determine !hether or not the resulting cost formula is reliableK Can you use the cumulative average time learning curve model and the incremental unit time learning curve model to produce more accurate estimates in budgeting and performance evaluation for processes in !hich learning occursK Can you describe the role that managerial #udgment plays in determining cost behaviorK

ANSWERS
D?E &?+)S &?S& S?& @1
1. 2. 3. 4. 5. 6. 7. =. 9. 10. step fixed cost, step variable cost activity capacity cumulative average time learning curve model practical capacity long run, short run cost of resource usage activity rate discretionary fixed expenses Cost behavior unused capacity 11. committed fixed expenses 12. step cost function 13. .lexible resources, resources supplied in advance of usage 14. -ariable costs 15. 2ixed costs 16. .ixed costs 17. relevant range 1=. learning curve

S?& @2
1. 2. 3. 4. 5. 6. Deviation coefficient of correlation scattergraph independent variable, dependent variable coefficient of determination goodness of fit 7. =. 9. 10. 11. 12. high lo! method, scatterplot method confidence interval intercept parameter, slope parameter method of least s"uares, multiple regression incremental unit time learning curve learning rate

Activity Cost Behavior

63

)(;&I';?1CFBIC? G(IH
1. 2. 3. 4. 5. 6. 7. =. 9. c c a d c d b e b 10. 11. 12. 13. e d b a -ariable 9 3Q01 U ,B,BBB D Q1B U F,BBB4 G 3,B,BBB D F,BBB4 9 QCB,BBB G 5,BBB 9 Q,0.CB .ixed 9 Q01B,BBB D 3Q,0.CB U ,B,BBB4 9 Q,BC,BBB 14. c -ariable 9 3Q1,B,BBB D Q0FC,BBB4 G 31,CBB D 0,ICB4 9 Q5C,BBB G ICB 9 QFB.BB .ixed 9 Q1,B,BBB D 3QFB U 1,CBB4 9 Q,BB,BBB 15. a -ariable 9 3Q,LB,BBB D Q,CB,BBB4 G 3,I,CBB D ,0,CBB4 9 Q5B,BBB G C,BBB 9 QR.BB 16. d O 9 15I.RF E 31.I1, U ,CB4 9 LBI.C, O 9 0.BRF U C1.C, 9 ,,,.F0

'+-C&IC? &?S& ?A?+CIS? 16+esources a"# -ctivities7

1. Engineers: .acility: )eased E"uipment: Supplies: short term resources supplied in advance long term resources supplied in advance long term resources supplied in advance resources supplied as needed

2. Activity rate: .ixed: V5 U Q5B,BBB E 3Q5CB,BBB G 0B4 E QF,BBBW G 35 U 1,0BB4 9 Q,RR,CBB G ,0,RBB 9 Q,5.I0FF per test -ariable: Q,IC,BBB G ,0,RBB 9 Q,1.FI,L 3. Activity available 9 Activity usage E 6nused Activity ,0,RBB 9 ,,,BBB E ,,RBB

?A?+CIS? 26Fi*h1;o4 )etho# a"# Scatterp!ot )etho#7

1. -ariable: 3Q5,5BB D Q0,FCB4 G 310C D ,CB4 9 Q,,ICB G ,IC 9 Q,B.BB per shipment .ixed: Q5,5BB D 3Q,B U 10C4 9 Q5,5BB D Q1,0CB 9 Q,,,CB Storeroom Cost 9 Q,,,CB E Q,B U number of shipments 2. %n Excel, clic' on the Chart 8i&ard button and choose NO 3Scatter4 to produce a scattergraph as follo!s:

CBBB Storeroom costs 5BBB 1BBB Series, 0BBB ,BBB B B ,BB 0BB 1BB 5BB <umber of shipme"ts

An analysis of the scattergraph indicates that further investigation on April data is needed. $he storeroom costs in April do not fit the general pattern of behavior in the data and, thus, can be an outlier.

64

Chapter3

3. Any t!o points that appear reasonable could be used to calculate the cost formula. %ndividual results may be very similar to the high lo! results, or they could be very different.

?A?+CIS? 36;east S8uares7

1. $he estimated cost formula using the regression output can be expressed as follo!s: Supplies cost 9 Q,,55C.RLC E Q,L.F,LR U 6nits produced 2. $he coefficient of determination 37 S"uare4 is B.RFL. 3.
r = B.RFL = B.L10

-ctua! Q1,CCB 0,LRB 0,LIB 0,5,B 0,C1B 1,,RB 0,R1B 0,R0B 1,00B 0,LCB 0,CFB 0,50B

're#icte# Q1,5BR 1,B,C 0,R,L 0,50I 0,F01 1,B,C 0,R,L 1,B,C 1,5BR 0,R,L 0,F01 0,50I

0eviatio" ,504 31C4 ,C,4 3,I4 3L14 ,FC4 ,,4 3,LC4 3,RR4 ,1,4 3F14 3I4 Sum................

0eviatio"2 0B,,LR ,,0CL 00,I,C 0RC R,FFC 0I,BFF ,,C 1R,0,1 1C,0LR ,I,BRI 1,LRB 5I ,I5,L0R

4. Confidence interval Confidence interval Confidence interval Confidence interval

9 :redicted value S t U Standard error 9 ,,55C.RLC E 3,L.F,LR1 U LB4 S 0.00R U ,10.0F 9 1,0,,.FILI S 0L5.FIC0 9 0,L,I.BB5C X # X 1,CBF.1C5L

?A?+CIS? 46)u!tip!e +e*ressio"7

1. $he main ob#ective is to decide ho! many independent variables should be included in the cost formula. $o deter mine !hether or not an independent variable should be included, perform the hypothesis test of the parameters. Any variable that is not significantly different from &ero should be excluded. $hus, the multiple regression analysis !ill be performed in the follo!ing step !ise manner. $irst 'assC%nclude all four variables in the regression. S622A7O *6$:6$:All .*67 -A7%AB)ES Regressio" *tatistics 2ultiple 7 7 S"uare Ad#usted 7 S"uare Standard Error *bservations A<*-A 7egression 7esidual $otal df 5 ,B ,5 ** 1* ,105BFRII1 11,B,I,L1 ,LC5BCFB.I ,LC5BCF., ,151FBL111 % ,FL.5 *ig"ifica"ce % 1.RCF15E BL B.LL0IB,I B.LRC5CFFF B.LILF1L11 ,1LI.RICCF ,C

Activity Cost Behavior

2oefficie"ts *ta"dard Error CBCR.,CFLC 5BLB.,BBI5R B.101FIRIC B.B0CFB,,BI B.BBII,C,F B.B11I00RRC 15L.I0IBC1 CB.I1CB0000 ,F5.IB0I15 1R.C50RCL11 t *tat ,.01FFR0I ,0.F51,C5 B.00RIR, F.RL10BIR 5.0I101F 3-value B.0555F ,.RE BI B.R01FC 5.0E BC B.BB,F1 4ower (55 5BCC.,CIB, B.0FFF1CL,R B.BR0RC555 01F.FR01CL1 IR.R01RIIB0

65
)pper (55 ,5,I,.5IBL B.1RBI0,CR B.BFI505,1 5F0.II,I5I 0CB.CR,CL,

%ntercept $ons of D2 received Dollar value of receipts <o. of purchase orders <o. of incoming shipments

Based on the : values, the results suggest that the tons of direct material received, number of purchase orders, and number of incoming shipments are significantly different from &ero, because their : values are less than the CM degree of confidence. $hese variables seem to be good explanatory variables of the cost behavior of the 7eceiving Department. Ad#usted R 0 9 B.LILF, or LI.LFMStandard Error 9 ,1LI.RIF Seco"# 'assCDrop the variable and redo the regression, since the : value for the variable of @dollar value of receiptsA is not significant. S622A7O *6$:6$:$/7EE -A7%AB)ES Regressio" *tatistics 2ultiple 7 B.LL0FF11F 7 S"uare B.LRC1RBC5 Ad#usted 7 S"uare B.LR,1L150 Standard Error ,11F.1BCC5 *bservations ,C A<*-A 7egression 7esidual $otal df 1 ,, ,5 ** 1* ,101LFF5LF 55,100,FC ,LF50R1I.5C ,IRCI,0.C ,151FBL111 t *tat ,.C,1II1I ,5.R0LCFR I.5CLCR,R 5.5II0I55 % 05I.,5, *ig"ifica"ce % 0.0F5CIE ,B

%ntercept $ons of D2 received <o. of purchase orders <o. of incoming shipments

2oefficie"ts *ta"dard Error 551L.0CC1I 0L10.CIC01L B.10BL55, B.B0,F50,IC 15F.1I5I,I 5F.511C1BB1 ,F5.L,I1,R 1F.R151,,50

3-value B.,CR0I ,.1E BR ,.1E BC B.BBBL5

4ower (55 0B,C.1B05R B.0I11BLLI 055.,IC,CC, R1.R5CCB5F,

)pper (55 ,BRL1.R,10 B.1FRCIR01 55R.CI50R 05C.LRL,10

Ad#usted R 0 9 B.LR,5, or LR.,5MStandard Error 9 ,11F.1BF Since all : values of explanatory variables are significant at a CM confidence level, the three variable model is ade"uate. $he three variable model also has a higher ad#usted R 0 value 3LR.,5M4 than the four variable model 3LI.LFM4. $hus, the estimated cost formula is as follo!s: 7eceiving Department costs 9 Q5,51L.0CC E 3QB.10BL55 U tons4 E 3Q15F.1I5I U :*s4 E 3Q,F5.L,I1 U shipments4 2. $he model chosen explains the variability in 7eceiving Department costs very !ell, because the ad#usted 7 0 e"uals LR.,5M. 3. Based on the estimated cost formula, an estimate of 7eceiving Department costs for a month !hen IC,BBB tons are received, LB purchase orders are handled, and ,0C shipments are received !ill be as follo!s: 7eceiving Department costs 9 Q5,51L.0CC E 3QB.10BL55 U IC,BBB4 E 3Q15F.1I5I U LB4 E 3Q,F5.L,I1 U ,0C4 7eceiving Department costs 9 QRB,0LR.55

66
4. Confidence interval of the estimated 7eceiving Department costs 9 QRB,0LR.55 S t 3LCM, ,, degrees of freedom4 U *e 9 QRB,0LR.55 S 0.0B, U ,,11F.1BF $hus, QRB,0LR.55 S Q0,L5,.0, $hat is, QII,1CI.01 X Estimated 7eceiving Department costs X QR1,01L.FC

Chapter3

?A?+CIS? 56;ear"i"* Curve7

,. $he table !ith columns for cumulative number of units, cumulative average time per unit in hours, cumulative total time in hours, and individual unit time for the nth unit in hours for ,, 0, 5, and R units is presented belo!.

Cumulative <umber of 6nits 3,4 , 0 5 R

Cumulative Average Cumulative $otal %ndividual $ime for $ime per 6nit in $ime: )abor "th 6nit: )abor /ours /ours /ours 304 ,BB RB 3B.R x ,BB4 F5 3B.R x RB4 C,.0 3B.R x F54 314 9 3,4 x 304 ,BB ,FB 0CF 5BL.F 354 ,BB FB 5C.5 1C.C

0. $he calculation of total variable cost of producing ,, 0, 5, and R units and the variable cost per unit for ,, 0, 5, and R units is presented belo!.

, unit Direct materials Direct labor -ariable overhead $otal variable cost Divided by units 6nit variable cost Q ICB ,,CBB 5,BBB Q F,0CB ,

0 units Q ,,CBB 0,5BB F,5BB Q,B,1BB 0

5 units Q 1,BBB 1,R5B ,B,05B Q ,I,BRB 5

R units Q F,BBB F,,55 ,F,1R5 Q 0R,C0R R

Q F,0CB

Q C,,CB

Q 5,0IB

Q 1,CFF