# Chapter 2 The Cost Function

LEARNING OBJECTIVES

Chapter 2 addresses the following questions: Q1 What are different ways to describe cost behavior? Q2 What is a learning curve? Q3 What process is used to estimate future costs? Q4 How are the engineered estimate, account analysis, and two-point methods used to estimate cost functions? Q5 How does a scatter plot assist with categorizing a cost? Q6 How is regression analysis used to estimate a mixed cost function? Q7 What are the uses and limitations of future cost estimates? These learning questions (Q1 through Q7) are cross-referenced in the textbook to individual exercises and problems.

COMPLEXITY SYMBOLS

The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems. Questions Having a Single Correct Answer: No Symbol This question requires students to recall or apply knowledge as shown in the textbook. This question requires students to extend knowledge beyond the applications e shown in the textbook. Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10): Step 1 skills (Identifying) Step 2 skills (Exploring) Step 3 skills (Prioritizing) Step 4 skills (Envisioning)

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Cost Management

QUESTIONS

2.1 This function has both fixed costs and variable costs. If at least part of the cost is variable; total cost increases as production volumes increase. If at least part of the cost is fixed, the average total per-unit cost decreases because the average fixed cost decreases as volume increases.

Total Cost

Q 2.2 Several years’ worth of data for August would be helpful for estimating the overhead cost function for subsequent Augusts, but the August data should not be used for estimating the overhead cost function for other months during the year. It is highly unlikely that the August data would be representative of the data during normal operations. However, August’s costs are probably a good estimate of the fixed costs for other months. When zero production occurs, only fixed costs are incurred. Since time appears to be of the essence, one of several cost estimation techniques might be employed. First, account analysis will provide a rough estimate. Second, the two most recent income statements could be used to approximate fixed and variable costs using the two-point method, but the president would need to understand that the quality of information could be low using this method. Third, if enough observations of cost data are readily available, regression analysis can be run. However, usually it takes more time to collect the data necessary to use regression analysis. The information leads to a conclusion that fixed costs exist because cost per unit changes between two levels of activity within the relevant range. The information is not sufficient to determine the amount of fixed costs or whether variable costs exist. The opportunities foregone could include spectator or participative sports activities, movies, going out to dinner, the opportunity to work at a part-time job, etc. The relevant cash flows include the cost of transportation, parking, tickets, food and beverages, and so on. There is no way to assign a quantitative value to the social experiences. It is difficult to identify a true opportunity cost because the costs and benefits of the next best alternative must be compared. However, lost wages, less the cost of transportation, can be quantified if the next if the next best alternative is working. Analysis of a scatter plot provided general information about whether a cost appears to be variable, fixed, or mixed. If there is a linear pattern in the scatter plot and the trend appears to go to zero, the cost could be variable. If a scatter plot with a linear trend intersects the vertical axis at a nonzero value, it could be mixed. If the scatter plot has no discernable pattern, the cost could be fixed. And if the pattern is linear with little or no slope, the cost could be fixed.

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Chapter 2: The Cost Function

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The pattern of a cost over time in the accounting system, together with knowledge of operations, is used to classify costs as variable, fixed, or mixed. Costs such as managers' salaries are usually fixed; they are often directly associated in the general ledger with a particular department or product. Costs for variable materials used in the production process are usually available in the general ledger or in production records. Costs such as manufacturing overhead are often mixed; they tend to include fixed costs such as insurance and property taxes for the plant and variable costs such as indirect supplies used in manufacturing. For costs identified as mixed, another cost estimation technique such as the two-point method or regression analysis must be used to determine the fixed and variable components. Learning curves are nonlinear representations of direct labor cost. The cumulative average time approach can be used to determine an approximation of total cost when labor experiences a learning rate. Economies of scale are a nonlinear function. Information about past experience with economies of scale can be used to help estimate future costs. For example, volume discounts are examples of economies of scale. The required volumes needed to reach discounted prices are generally known, so these can be estimated using several different ranges to reflect the changes in price. The cumulative average learning-time approach is a quantitative approach to calculating the average amount of time it should take to perform a task for people who are just learning to do the task. The director can use this formula to more accurately predict the amount of time it should take to deliver meals to the elderly. With a more accurate prediction, the volunteers’ schedules should also more accurately reflect the amount of time they need to set aside for their work at Meals on Wheels. The trend line developed using regression analysis incorporates all of the cost observations, while the two-point method uses only two observations. Because there is fluctuation in cost over time, better estimates are developed using more observations, because they better reflect the past fluctuations and therefore should better estimate future fluctuations.

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Cost Management

EXERCISES

2.11 Computer Manufacturer A. Production of a large monitor with a thin flat screen B. If all of the parts for the monitor are currently used in the organization, all of the information is likely to be contained in the accounting records. But new parts are most likely needed, since the monitor is large and probably involves different technology to achieve thin size. Thus, estimates of costs from suppliers will be needed. In addition, estimates for the amount of labor time will be needed. Although labor cost per hour can be found in the records, the amount of labor time is likely to be different for this monitor than for other monitors. If machines are used in production, an estimation of machine hours is necessary to determine whether maintenance and repair costs will increase. C. Estimating the cost of parts and the time involved in production is part of the engineered estimate of cost method. D. The opportunity cost of using idle capacity for one product is the contribution of other uses of the capacity. If another product could be manufactured and sold, that product’s contribution margin is the opportunity cost. If the capacity can be rented or leased out, the rent or lease payments are the opportunity cost. If there are no other uses for the capacity, the opportunity cost is zero. 2.12 Frida’s Tax Practice Cost Object Cost Subscription to personal tax law updates publication Ink supplies for tax department photocopy machine Portion of total rent for tax department office space Wages for tax department administrative assistant Tax partner's salary Charges for long distance call to Mr. Gruper about personal tax return questions Tax partner lunch with Mr. Gruper; the tax partner has lunch with each client at least once per year

Tax Department Personal Returns Mr. Gruper’s Personal Tax Return

A. B. C. D. E. F. G.

D D I D D D D

D I I I I D D

I I I I I D D

and Piecewise Linear Cost Functions A.000 $10. the CPA's time is the product being sold.000 0 100 200 Number of Units 300 400
The cost function includes the following assumptions: • Operations are within a relevant range of activity • Within the relevant range of activity: o Fixed costs will remain fixed o Variable cost per unit will remain constant
.000 $9.00*Q Graph of Cost Function
$14. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns.000 Total Cost $12.000 + $8. The time records that the tax partner maintains support this cost as a direct cost.000 $8. Now notice that the tax partner's salary is considered a direct cost for all three cost objects. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. For the firm to make this cost direct for the personal returns cost object.Chapter 2: The Cost Function
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Explanation for Parts D and E: Notice that the wages of the tax department administrative assistant are considered a direct cost when the cost object is the entire tax department but are considered indirect for the other two cost objects. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. 2. Of course. In a service business such as this. Stepwise Linear.000 $11. CPAs do keep detailed time records. TC = $10.13 Linear. the tax partner probably spends some time in non-billable activities.000 $13.

000 2.000 – 10. for Q ≤ 2.000 $10.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 = $60.000 * $45 = $450.$450.000/2.000 + $8.000 F = $450.000 4.000 $20.000 TC = $35.000 $40. it is first necessary to estimate the cost function.000 $30.000 Total cost at 12.000 $70.000 3.00*Q.000 Graph of Cost Function
$80.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 = F + $39*10.000 .000 + $8.000 Total Cost $50.000 units: $450.000)
= $78.2-6
Cost Management B. TC = $25.000 $60.000 units = 10.000)/(12.000 Number of Units
C. Convert the average costs to total costs for each production level: Total cost at 10.000 units = 12.000 + $39*Q
.000 $0 0 1.000 Calculate the variable cost per unit using the Two-Point method:
Change in cost Change in volume
= ($528. for Q > 2.00*Q.$390.000 * $44 = $528. To estimate the costs at another production level.000 .

000 For Q > 1.000 + $9.00*(Q-1. for Q < 1.14 Piecewise Linear Cost Function A.000: TC = $50.000 = $60.000 TC = $51.000 Number of Units
Slope is $10 per unit Slope is $9 per unit
Total Cost
. total cost is estimated as: TC = $5.000 + $585.000 0 500 1.000 units: TC = $60.00*Q.500 2. Inserting $10.00*Q
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Graph of Cost Function
$75.000) TC = $50.000/15.Chapter 2: The Cost Function Estimated total cost at 15.000 = $645.000 + $39*15.000 $65.000 $70.00) + $9.$9.000 $50.500 2.000 in revenues into the cost function.000 $60.000 + (1.00*Q . TC = $50.000 Estimated cost per unit = $645.000 + $10.000 = $9.000 $45.000 + 45%*$10.000 * $10.000 1.000 + $10.000 $55.000 = $43 D.000 + $9.

then the cost function would appear to be: TC = $50.
2. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A. This cost function would provide reasonable estimates for Q ≤ 1. If all of the data estimation points occurred when Q was ≤ 1. then the cost function would be some mixture of the functions for the two relevant ranges.000 units.3219 Y = 6 hours*2-0. 3.000 + $9. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.80/ln2) = −0.4. This cost function would provide reasonable estimates for Q > 1.2-8
Cost Management B. the cost function mismeasurement depends on the values of Q.000 units.000 units. If all of the data estimation points occurred when Q was > 1.000 units but would overestimate total cost for Q > 1. 2. If the accountant did not detect that there were two different relevant ranges.00*Q.00*Q. If the data estimation points occurred across the two relevant ranges.8 hours (average time for each of the next two returns) B. then the cost function would appear to be: TC = $51.
Graph of Learning Curve
Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared
. Hours for two returns would be determined as follows.3219 Y = 4.15 Tax Plus A.000 units but would underestimate total cost for Q ≤ 1.000 units.000 + $10.3 and 2A. There are three general situations: 1.

In addition. F Assuming that employee time can be traced to each bowl. However. their productivity increases. this particular cost function assumes that variable costs are driven by sales. However. V C. the cost function is: TC = $20. Note: Depreciation using a method such as declining balance is not constant over time.000 on total sales of $32. Assuming that the cost of clay can be traced to each bowl.
B.000 = 0. then wages would be an indirect cost. D or I. Eventually their learning will plateau.
2. F
. If total variable costs were $8. wages are a direct cost.] A.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. but would still be considered fixed because it does not vary with production volume. and variable costs remain constant within the relevant range.Chapter 2: The Cost Function
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As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. it is a common cost of production for all of the bowls that are heat-treated in the kiln. then variable cost per dollar of revenue is calculated as follows: $8. making it a fixed cost. and their productivity rate will remain stable. that is. it is a direct cost.000/$32. Total clay cost will vary with the number of bowls made. as their performance improves. D. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls.25. if time is not traced to individual bowls (for example. 2.000. I. it improves less quickly for the next return. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). if the employee performs different types of tasks and records are not kept of the types of work performed) or if the employee does not work directly in production. Assumptions: Fixed costs remain fixed within the relevant range. or 25% of sales Combining fixed and variable costs. Chapter 3 will point out another assumption for this cost function: the sales mix (the proportion of sales of different products) remains constant within the relevant range.16 Bison Sandwiches A.000 + 25%*Total sales B. Wages are fixed because they remain constant (the employee always works 40 hours).

V Assuming that the cost of packing materials is traced to each bowl. this is a direct cost. Advertising is not directly related to production. D or I. making it an indirect cost. I.300 $3. because the production area may need more cleaning as volumes increase.
F. Packing costs are most likely variable because they will increase as production increases. E.300 Variable $4. Also. This cost is also discretionary. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume.000 in sales $1. J. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. They might be fixed or variable. V If the glaze is expensive and therefore a relatively large cost. it is most likely traced to individual bowls. making them a common cost for multiple units and an indirect cost. depending on whether they are “used up” after a certain quantity of production. I. D or I. If the packing materials are not traced (for example. making it an indirect cost. if the cost is small it might be grouped with overhead costs (variable). then this cost could be indirect. making it a direct and variable cost. it is probably a mixed cost. If it is an hourly charge. F The business license is not related to production. I. if the cost is too small to justify tracing them).18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization.2-10 Cost Management D.
H. V or F Brushes for the glaze are most likely used for multiple bowls.500
. G. so it is treated as fixed. part of the cost might vary proportionately with volume. If the kiln is electric. depending on what causes the cost to vary. I. F
I. If the cost of glaze is very small.] A. 2. making it a fixed cost. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week.000 2. It might be fixed or mixed.500 ______ $4. I. making it an indirect cost. it might not be traced to individual bowls.

In the pizza shop. While hourly wages may be related to number of fish caught. F. E. these costs would be mixed with a large proportion of the cost fixed. PS. costs vary with dollars of revenue. Benefit costs often vary with level of wages or salaries.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. Benefits might include mandated items such as social security. B. F or M Employee benefits occur in any business in which employees are hired.500/$9.000 = 0. as well as voluntary items such as health insurance and retirement benefits.50. they are more likely related to time on the boat than pounds of fish. F.] A. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced.Chapter 2: The Cost Function 2-11 B. F There would be no reason to incur fishing equipment costs in a pizza business. In many organizations. D.
. 2. because of uncertainty in the success of each fishing expedition. or 50% of revenue Combining fixed and variable costs. B. Therefore. V Ingredients are used in making pizzas. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. so they would tend to be fixed or mixed (see Item A above). FB. C. In this type of situation. In the fishing boat business. Some may be sent home if business is very slow. There most likely would not be any ingredients in a fishing boat business. D. workers’ compensation. V. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. the cost function is: TC = $3. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. The cost of rent is irrelevant because it will not change with either alternative. and unemployment insurance. employees are likely scheduled in advance on a fixed schedule.300 + 50%*Total revenue C. and the cost would vary with number of pizzas produced. B.

2414 $0. Hamburger patty ($1. Cost of burger with everything except cheese = ($0.0148 0.0198 0.1075 0. Onions ($.2414 2. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.29/12) 0. Cost of plain burger = $0.0233 7.0179 0. B.3489 $0. For the fishing boat business.6815 A.95/2. F or M Any type of business will have insurance costs.0053 0. In general. G.0863 5.69/8) 0.0053 8.2414 $0.0198 9.59/40) 0. It will be a fixed cost if it is a flat amount.15/45) 0. Dill pickles [($8.56
. Cheese ($2. F.000) * 4] 0. Lettuce ($. advertising costs would be incurred. F Most pizza shops incur advertising costs such as flyers. PS.59/16) 0.5196 Suggested selling price: 300% * $0. The cost might be fixed or mixed. B. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop. the utility costs for these two businesses would tend to be fixed (would not vary with production). If the fishing boat is for tourists.0033 $0.6815 .0863 0. Mayonnaise [$1. Hamburger bun ($1. there might be some utility costs for the fishing operation and for a business office.5195 = $1.$0. Tomato ($.0033 0. Because advertising costs tend to be discretionary. depending on how the insurance cost is calculated.69/7) $0. but it might be mixed if a portion of the cost relates to levels of business activity.99/50) 0. newspaper advertisements.1619) = $0. 2.2-12 Cost Management E. and yellow pages advertisements. they are treated as fixed costs. Catsup ($.1075 0.1075 3. Mustard ($.79/150) 0.20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1.1619 10.0148 6. however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship.0233 0.0179 4.1619 0.3489 (calculated above) B.49/(16 x 4)] 0.

In the current business environment.04 . Long is able to differentiate her hamburgers from others in the market.21 Spencer and Church [Note about problem complexity: These are difficult questions because students will need to first visualize the costs (with very little information) and then apply chapter concepts.Fixed F. that cost would be variable.Fixed D. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. B.Fixed E. mostly variable G.Chapter 2: The Cost Function 2-13 C. D. Selling price of cheeseburger with everything: 300% * $0. most organizations are price takers. Alternatively.Mixed. Therefore.25 = $1. Staff wages – Could be variable or mixed (salary + overtime) for regular staff.79 Some students will view this higher price as "unfair. 2.04 Therefore. Office supplies . If there is part time help. Insurance. B. if Ms. they set prices considering their competitors’ prices. Rent ." However. Licenses. and F) are the ones requiring significant assumptions to generate an answer. Professional subscriptions. Long’s prices are too high. This means that her costs need to be below the competitive price. there is no moral obligation to maintain a 300% markup on each item. It is just a general guideline. Property taxes.Fixed
. Clerical wages – Fixed unless overtime is regularly scheduled. in which case the total cost would be primarily fixed. then she may be able to charge a price that is higher than competitors—as long as customers are willing to pay the higher price.6815 = $2.] A. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. Market forces will dictate achievable prices. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. the price of the plain hamburger should be: $2. Professional dues. If Ms.$0. she foregoes profits and people may believe there could be quality problems with her food.Mostly fixed and discretionary H. and then mixed C. Alternatively. However staff are often salaried. that is. if her prices are too low.Fixed and discretionary I. The Step 2 questions (A.

2-14 Cost Management
K.com/college/eldenburg).] The data for this problem can be found on the datasets file for chapter 2.23 Central Industries [Note about problem complexity: Item B is not coded as Step 1 because it is fairly clear which cost driver appears to be best. available on both the Instructor and Student web sites for the textbook (available at www.
. In addition. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. The cost analyst needs to gather information about how marketing costs are set each year. or profits. If this is the case. Therefore. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. For example.wiley. the cost is discretionary and will be set through the negotiating process.35*units sold. C. Other Potential Cost Drivers A. the variation in units sold explains about 61% of the variation in marketing department cost.com/college/eldenburg). (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero.) B. Other possible cost drivers for marketing department costs could be revenue.wiley. number of advertisements placed. the fixed cost is set at zero.22 Cost Function Using Regression. 2. Advertising – Fixed and discretionary 2. it is possible that marketing costs are discretionary. TC = $222. In this problem. the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management.

113687834
Intercept Output
t Stat 5.61765897 0.78591283 0.500 $1.4342166 0.761602 4.000 $1.026826 0.58824812 182.58E-05 0. Potential Cost Driver: Output
Maintenance Costs Against Output
$2.52099624 Standard Error 153.000 $500 $0 0 500 1000 Output 1500 2000
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.582691
P-value 6.119724 15 Coefficient s 884.500 Maintenance Costs $2.Chapter 2: The Cost Function 2-15 A.000514
.

210849 15 Coefficient s 861.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours
$2.500 $1.291084 2.500 Maintenance Costs $2.000 $500 $0 0 50 100 150 200 250 300 350 Direct Labor Hours
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.02569657 Standard Error 261.717372
P-value 0.60187065 0.000 $1.457384 3.7549386 1.005847 0.36224828 0.31319046 235.017601
.113464425
Intercept Direct Labor Hours
t Stat 3.

the cost driver does not explain the variation in cost and either it is the wrong driver.94888217 0.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups
Maintenance Costs Against Machine Set-Ups
$2. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver.5913391 15 Standard Error 93. a good cost driver would present a linear or football-shaped positive slope or trend.6778973 0.000 $1.500 Maintenance Costs $2.357393 15. In Part A. However.910475729
Intercept Machine Setups
t Stat 1. Sometimes a cost that is mostly variable can be identified from a scatter plot.94495003 66. For example. This indicates that the cost could be totally variable. or the cost is mostly fixed.500 $1.5343
P-value 0.
.815737 29. all three potential cost drivers appear to be positively related to maintenance costs. In a scatter plot.197755 8. the trend line for machine setups looks as if the intercept could be zero or very close to zero.96E-10
B. If the observations are widely scattered.42597461 1.000 $500 $0 0 20 40 Machine Set-Ups 60 80
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations Coefficient s 126.97410583 0.

This provides confidence that the variable cost part of the cost function is not zero.2-18 Cost Management C. In the machine setups regression.025*Direct Labor Hours TC = $29. Changes in many factors such as resource prices. Therefore.68* Machine Setups
The machine setups intercept coefficient is not significant. R-Square 0. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. the economic environment. E.313 0. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. The use of past cost data to predict the future assumes that future resource costs and volumes of activities will remain the same as in the past.
. and technology can cause future costs to be different than estimated. business processes. The regression using machine setups has the highest adjusted R-Square of 0.945. so it is excluded from the cost function.521*Output TC = $861 +$3.588 0.945 Cost Function TC = $884 + $0. This means that variation in setups explains about 95% of the variation in cost. the cost is likely to be totally variable. D. the t-statistic is significant for the independent variable but not for the intercept.

333)/($1.$56. not represent the cost most of the time.132.000/$500. First. the cost function is calculated using the highest and lowest values of the cost driver.
.605 = $11.000 = 0.728 + 5%*Sales B. That means that the cost function might not represent the actual cost. on average. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. this cost function might provide poor estimates of future costs.Chapter 2: The Cost Function 2-19
PROBLEMS
2.728 Thus. the variable cost is calculated: ($68. Under the high-low method.132. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.100) = $25.333 . Therefore.05. which could be outliers. the total cost function is: TC = $11.24 Big Jack Burgers A. The high low method uses the most extreme cost driver values.100 – $632.100 F = $68.333 = F + 5%*$1.333 – $43. that is.

000
Sales
It appears that the cost is most likely mixed.000 $0 $0 $300. The upward slope of the line indicates that there are variable costs.5% x sales. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line
$80. Then.200.162. etc). analysis at the account level might indicate that there are few fixed costs. the p-value result for the tstatistic is atypical. the cost function would be TC = $16. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.5% x sales
.000
Administrative Costs
$60.800 + 4. there is a 16% probability that the intercept (fixed cost) is not different from zero. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. Chart of data with trend line added by Excel.000 $1. Based on the p-value. Analysis at the account level can be used to increase the understanding of this cost. In that case. Alternatively. D. but the p-value is greater than 10% at 0.000 $40.000 $600.000 $20. Notice that the t-statistic for the intercept coefficient is 2. If this cost pool includes items such as salaries and other fixed costs (insurance. Then.000 $900.172. the cost function would be: TC = 4. the regression intercept can be used as an estimate of the fixed costs. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. Because this regression has few observations. fixed costs are likely to be zero and would be excluded from the cost function. Following is the regression output.2-20 Cost Management C.

Sales might not be the activity that drives administrative costs. regression analysis incorporates all of the observations into the analysis. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. The cons of the high-low method as an estimation technique were discussed in Part B above. The past costs used for estimation might not be representative. B. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. a cost function may not provide a good estimate for the next month’s costs.2444 7734.16197623 0. Therefore. Both methods assume that the cost function is linear and that all data points come from a single relevant range. the high-low method may be the best option available.365 + 0. If there are more data points. causing fluctuations in cost that are unrelated to any cost driver. on average. 2. and possible changes in costs such as those described in Part E are ignored. especially because so few observations were used in the estimation. This means that variation in sales explains only about 18% of the variation in research and development cost. Sales does not appear to explain much of the variation in research and development costs.186. the results rely on more complete information and provide a better estimate.82%*Sales C.73545 0. Cost Function Using Regression A. the cost function is: TC = $50.90567454 3293. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost. there does appear to be a general upward trend.Chapter 2: The Cost Function 2-21
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.00818212 t Stat 2. However. In addition. The adjusted R-Square statistic is very low at 0. If these assumptions do not hold. Unusual cost items are assumed to continue in the future. then both methods may be unsuitable for estimating future costs.17205158 5.4038 4 Coefficients Standard Error 16800.45937486 P-value 0. both of these methods assume that the data points are representative of future costs. There might be a large discretionary component in administrative costs.93711636 0. The plot shows costs that are widely scattered. Using the regression results.25 Scatter Plot. Because of unforeseen changes in cost behavior.9680477 0.
. however. F.04466925 0.0319523
Intercept X Variable 1
E. This method can be used in cases where there is not enough data to perform regression. If there are only two or three data points.

The fixed cost is the $20 flat fee. although she could use email. assuming that the cost function is linear may not be appropriate. Therefore. Yes. The classification as direct or indirect depends on whether Susan’s calls are directly related to specific projects she works on or are indirect activities such as business promotion. the cost is assumed to be linear within the relevant range. the relation makes sense from an economic standpoint. These costs are set by decision. Susan already knows the cost function. Managers set the costs depending on the organization’s strategies and funds available for research and development. Since she probably can cut back on calls when her consulting work is not providing enough income. a portion of the cost is likely to be discretionary. C. F. 2. G. as she has in the past. the number of calls and whether they are long distance or local calls will vary. the underlying cost function is assumed to be linear and that the cost driver is assumed to be economically plausible as a cost driver. the cost of alternatives such as cellular service or any other types of telephone or communication service. In this problem. The scatter plot shows little evidence of linearity. E. In addition. It also depends on whether she can trace telephone calls to individual
. that is. In this problem. She cannot be certain that she will use the same amount of time. Several very general assumptions apply to a linear cost function. Regression is useful for estimating a cost function when fixed and variable costs are unknown. D. H. The variable cost is 10 cents per minute for those minutes over 500 per month. When regression analysis is used to specify a cost function. usually annually. on average. Additional information could include the location of Susan’s future consulting work. Better cost estimates for discretionary costs can be obtained by gathering information about planned expenditures from the department head or from the managers who are responsible for costs. It is likely that Susan has to call people to conduct business. B. The cost driver for long distance calls is the number of minutes on the telephone. so she does not need to estimate the cost function using regression or any other estimation technique. the amount of traveling she will be doing since she cannot call from home when she is traveling. research and development cost is often discretionary. First. Since she has to have telephone service to stay in business. part of the cost is committed and cannot be reduced. fixed costs would remain fixed and variable costs would remain constant within that range. to make a decision she needs to compare her costs under the old plan to what costs would be under the new plan.2-22 Cost Management
D. Since her consulting work varies.26 Susan’s Telephone Service A.

students may think of others. Cons • If Susan has a number of projects in her local area or will be traveling a lot. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. especially if she usually calls less than 500 minutes a month • Below is Susan’s average cost per minute at different levels of calls per month.00 $20.00 + (700-500)*$0. Minutes 300 400 500 600 700 Total Cost $20.00 $20. In most businesses.152 Y = 8. Many cellular telephone bills do not list the calls made.00 $20. Hours per batch would be determined as follows. so Susan may need to maintain her own records if she wishes to trace telephone usage.067 $0.04 $0. In
. If her calls are over 400 minutes or under 600 minutes. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). Here are some of the reasons.00 + (600-500)*$0.90/ln2) = −0. It is possible that the managers under. her phone bill will be less than it would be at a rate 5 cents per minute.05 $0.05 $0.00 Average Cost $0.Chapter 2: The Cost Function 2-23 consulting jobs. There are many different reasons that the time could be different from the amount determined above. In this case the learning rate would be wrong and so the time would also be wrong.057
The average cost is lowest at exactly 500 minutes per month. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0.10 = $30. telephone costs are viewed as an indirect cost.00 $20.10 = $40. I.27 Fancy Furniture A.152 Y = 10 hours*4-0. Pros: • Susan might prefer the convenience of not switching telephone companies • If Susan is happy with her current quality of service she might prefer to stay with the same company and not investigate other companies’ plans • Susan may be able to predict her cost better. she will pay a very high rate of 10 cents per minute 2.or overestimated the amount of hand work performed.1 hours (average time for the first four batches) B.

However.000 = $1.000 5. The estimate of total costs given revenues of $80.40.28 Wildcat Lair A. or 40% or revenue Combining fixed and variable costs. then the chart suggests that the learning rate estimate is reasonable. If a worker is absent one day.000/$70. Because revenue is the cost driver for both variable costs.000 + 40%*80. C. and the University surcharge is specifically based on sales.000
7. Thus.000 _______ $28.$79. D. if managers believe that more than 25% of the work is done by hand. the rate will change if the replacement employee has never worked on this machine.000
.000 Profit = Revenues – Total costs = $80. or has a great deal of experience on the machine.000 1. if managers believe that 25% of the work is done by hand. C. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals
Fixed $ 30.000
Total revenue is the most likely cost driver for both variable costs.2-24 Cost Management addition.000 + 40%*Total revenue D.000 using the cost function is: TC = $47.000
Variable $21. The chart suggests that a 90% learning curve is likely to occur if 25% of the work is hand assembly and 75% of the work is done by machine. then this chart suggests that the learning curve will be slower than the 90% estimate.000 . Food costs are likely to vary proportionately with sales.000 = 0. If these values are used in a regression to estimate a cost function. 2. and B. then the cost would be overestimated. the cost function is: TC = $47. it is possible that different types of wood affect the rate at which chairs can be produced. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 = $79. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28.500 $47. they would be higher than the labor costs in later periods.500 10.

the variable cost part of the cost function can be adjusted.29 Polar Bear Ski Wear [Notes about problem complexity: Item A is not coded as Step 2 because this is explicitly discussed in the chapter. total variable costs are expected to increase by $4. During the spring and summer months. However. In July there was a loss of $5. but this is not considered a cost driver (a business activity that causes variations in total variable cost). In a retail business.000— the operating loss of $(5.000)+the university surcharge of $7.000*40%). Only total variable costs are expected to increase. so the trend would be the opposite of this plot. Electricity costs also vary with changes in electricity rates. B. Thus. If the university were to close the Lair. Lair’s fixed costs are assumed to be unchanged with the $10.000 . generating most its sales around the ski season (fall and winter). the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80.000) Net 2.000 + 30%*Total revenue During August.] A.000. To estimate the opportunity cost for August. it would lose the revenues. costs would be higher when there were fewer sales.) The adjusted cost function is: TC = $47.000 increase in revenues is expected to be $6. Item D will be VERY difficult for most students.000) $ 9.000 ($10. So. it might even close when the ski area shuts down. if the bathing suit shop is located in a geographic region $80.000 (-$5. Because the university surcharge is an allocation within the university. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000+$6. for July the opportunity cost would have been $2.Chapter 2: The Cost Function 2-25 E. the shop might experience very little business activity. A shop located near a ski area is likely to incur high heating costs during the winter. less the fixed costs and the variable food costs.000) of revenues. The shop is most likely a seasonal business. so the estimated profit in August is $1.000 increase in revenues. this surcharge should be ignored when computing the university’s opportunity cost (assuming that the charge does not relate to any variable costs for the university that arise because of the Lair). Variable food costs are estimated to be 30% ($21. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold.000 ($10.000. So.000). F. C.000).000
.000/$70. and the increase is estimated to be 40% of the increase in revenues. the additional profit from a $10.$4.000) (24. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.000 (47.

67 1. 2.45 Although each customer paid a different price.45 $ 514. special promotions. a 50% markup on total cost will cause sales to be: $1. given a 100 unit production level: Y = α Xr Y = $300*100-0. A correlation may appear in a scatter plot or regression analysis.028.85/ln2) = 0.2345 Y = $205. then the highest sales might coincide with the highest electricity costs. For example. employee training. Higher profits.028.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows.2345 Y = $101.5 = $152.67 Firm A's income for last year was: Sales Costs Income $1. and new office furniture or equipment.542. However. Although these expenditures are made because more money is available. they are discretionary expenditures and not caused by the level of activity. correlation does not necessarily mean causation. Many costs can be related to volume of activity.45 x 1.50 = $1. higher profits generally occur during periods when activity is high.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.89 x 1.028.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning. D.84
. firm B's selling price is: $101.2345 Y = $300*5-0. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.69 (average cost for each of the 5 units) Total cost = $205.69 x 5 = $1.22
Firm B set its selling price based on the average cost.542. in turn. generally mean there is more money available to spend on administrative travel.

40 1.2345 Y = $92.00 13.10 $ 172.40 Firm A's costs may be computed as follows: Y = $300*15-0.50
Firm B's calculation for its selling price is as follows: Y = $300*300-0.356.85 Thus Firm B's selling price this year was $64.528.28 $23.384.028.028.50 = $97.2345 (notice that the cumulative units produced is 15) Y = $158.85 x 1.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.65) Income Firm A's revenues for this year are: (10 x $152. Total cumulative production cost (300 x $78.926.50 $ 9.50
.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158. assuming an 85% learning effect would be: Y = $300*150-0.10 $22.84) Costs (150 x $ 92.00 13.97) Less costs from last year’s income statement for first five units Cost to produce the 10 units for this year Thus Firm A's income statement for this year is Sales Costs Income $1.45 $1.727.897.84) = $1.Chapter 2: The Cost Function 2-27 Firm B's costs.528.75) Total costs to produce the first 150 (from last year’s income statement) Total costs of this year’s production (150 units) Average cost per unit = $9.625.55 1.50 $ 9.2345 Y= $78.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.50/150 units = $64.727.897.356.30 $2.

000 $155.10/10 = $135.356.864.wiley.000
$8.000 $145. Costs
$165. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes. and most of the observations appear to have a fairly linear trend.000 $5.61.50
Note that Firm B's selling price for this year of $97. Scatter Plot of Marketing Costs Against Sales
$175.wiley.000
$6.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000
$7.727. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.28 is lower than Firm A's average cost per unit: $1.com/college/eldenburg). There is a positive slope.00 9.500.500.com/college/eldenburg).000 $135.85) Income $14.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.592.50 $ 4. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.500. A.28) Costs (150 x $64. such extreme differences in cost can occur.000
Sales
B. available on both the Instructor and Student web sites for the textbook (available at www.
. 2.500.000
Marketing Dept.

. When more money is spent on marketing. Therefore. Discretionary costs are set by decision. using regression or any other technique. they may be positively correlated with sales. the cost estimate should not be based on past costs.Chapter 2: The Cost Function 2-29 C.63816 0. it is economically plausible for sales to be a cost driver. E. discretionary costs such as marketing are often increased when profits increase.34%*Sales D.93336396 R Square 0.01335108 Standard Error 6844.87116829 Adjusted R Square 0.7600071 P-value 2.86656716 Standard Error 4015.4501E-10 5.08144 Observations 30 Coefficients 65584. Assuming that profits are more likely to increase when sales increase. Even if marketing department costs are discretionary. usually annually.00097028 t Stat 9. the cost function is: TC = $65. there would be a positive correlation between marketing department costs and sales.584 + 1. F. If the variable portion of the marketing cost is sales commissions.
Regression Statistics Multiple R 0. sales may go up.2608 0. Here is the regression output. the decision maker(s) should be asked what next year’s cost will be.58184484 13.5289E-14
Intercept X Variable 1
Based on the regression results. In addition. Instead.

000 $80.000 $120.000 $40.wiley. A.000 $0 0 500 1000 1500 2000 2500 Labor Hours
Manufacturing Overhead Against Machine Hours
Manufacturing Overhead Cost $200.000 $120.com/college/eldenburg).2-30 Cost Management 2. available on both the Instructor and Student web sites for the textbook (available at www. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $160.000 $0 0 300 600 900 1200 1500 Machine Hours
.
Manufacturing Overhead Against Labor Hours
Manufacturing Overhead Cost $200.000 $40.wiley.000 $80.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.com/college/eldenburg).000 $160.

D. but the plot for labor hours appears to have the least trend. C.1543 0. Based only on the cost plots.86E-11 0. If the observations are widely scattered.000 $40.682 4. Sometimes a cost that is mostly variable. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.000 $80.8173 Observations Coefficient s 150410.01272369 Adjusted R Square -0. labor hours could be deleted as a potential cost driver. None of the plots show a definite trend.000 $0 0 100 200 300 400 500 600 700 Raw Materials
B.552864
.11279932 R Square 0.600712
P-value 6. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.50852 7.Chapter 2: The Cost Function 2-31
Manufacturing Overhead Against Raw Materials
Manufacturing Overhead Cost $200.000 $120.02253618 Standard Error 11114. The plots help determine whether regression analysis should be performed using any of the potential drivers.600936029
Intercept Labor Hours
t Stat 10. either the driver is wrong or the cost is mostly fixed. Labor Hours Regression:
Regression Statistics Multiple R 0. the cost driver does not explain the variation in cost.000 $160.56597156 30 Standard Error 14812.

56778 19.1555 Observations 30 Coefficient s 117598. so the cost function is estimated as: TC = $126.095468
P-value 4.599 + $38.331580777
Intercept Machine Hours
t Stat 11.3746211 Adjusted R Square 0.68E-12 0.22*Machine hours Raw Materials Regression:
Regression Statistics Multiple R 0.2266685 Standard Error 9665.9786 Observations 30 Coefficient s 126216.217192 Standard Error 10291.62907 3. so the cost function is estimated as: TC = $117.411 Machine Hours Regression:
Regression Statistics Multiple R 0.91 60.612063 R Square 0.000325
Both the intercept and slope coefficients are significant.5033241 R Square 0.47803 9.2533351 Adjusted R Square 0. so the cost function is estimated as: TC = $150.217 + $60.3522862 Standard Error 8846.004579
Both the intercept and slope coefficients are significant.4268 4.215128 Standard Error 10853.67 38.2-32 Cost Management Only the intercept term is significantly different from zero.22* Raw materials
.53627459
Intercept Raw Materials
t Stat 11.11E-12 0.082222
P-value 3.

886218 -0.333162437 5.218173 8. 2.12E-09 1. Multiple regression with all three potential cost drivers:
Regression Statistics Multiple R 0. F. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.226
Based on the simple regression results. Yes.8266982 Adjusted R Square 0.1959303 48.wiley.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.com/college/eldenburg).352 0.953575 1.com/college/eldenburg).08E-08
.489 -0. available on both the Instructor and Student web sites for the textbook (available at www.2349 3.291558412 10.778501 82.wiley. machine hours appears to do the best job of explaining manufacturing overhead costs.10654585
Intercept Labor Hours Machine Hours Raw Materials
t Stat 5.210187
P-value 3.Chapter 2: The Cost Function 2-33 E.9092294 R Square 0. The coefficients for each of the other potential cost drivers are significantly different from zero.3E-06 0.5558 Observations 30 Coefficient s 60988.05878 9. A. however. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). this driver explains only 35% of the variation in cost.8067018 Standard Error 4832.976635 Standard Error 10361.

954) $48.71E-10 5.81383627 Standard Error 4742.22 (0.22 (<0.7422519 82.001) $-0. In this example.98 (<0. Also. Thus.599 (<0.664851 5. Costs for these activities are likely related to specific cost drivers. Each task includes different activities.5348 Observations Coefficient s 60677. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression. Multiple regression using machine hours and raw materials as cost drivers:
Regression Statistics Multiple R 0.005) $82.82667515 Adjusted R Square 0. The adjusted RSquare is far higher in the multiple regression (0.93*Raw materials D. C.226) for these two cost drivers. machine hours and raw materials explain different activity
. its coefficient is not significantly different from zero in either regression.57 (0.352 0.2-34 Cost Management Comparison of simple and multiple regression results:
Intercept t-stat (p-value) Independent Variables t-stat (p-value) Labor Machine Raw Hours Hours Materials
Adj.022 0.20 (0.55) $38. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone. labor hours can be eliminated as a potential cost driver.001) $60.001) $60.90921678 R Square 0. R2
Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression
0.806) than in either of the simple regressions (0.29E-09
The cost function is: TC = $60. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.881964042
Intercept Machine Hours Raw Materials
t Stat 6.226 0.988 (<0.001)
$4. Manufacturing can be a complex activity requiring a number of different tasks.5902 48. its coefficient is negative rather than positive in the multiple regression.450561 8.806
$150.001) $117.217 (<0.411 (<0.939606 9.74*Machine hours + $82.86E-07 4.352 and 0.157604083 9.001) $126.678 + $48.391636
P-value 1.925842 30 Standard Error 8743.001)
B.78 (<0.

A better understanding of the manufacturing process improves the ability to determine the types and number of cost drivers that can be used in a more complete cost function. If Regina uses last period’s budget. and use last year’s budgets for departments that have not turned theirs in. When the budget is complete the board will likely see it again and notice the discrepancies between the preliminary and actual budgets and wonder why the first budget was so inaccurate. B. and the Director of Finance will present the board with information that is unreliable. This is a potential ethical dilemma for Regina because the Direct of Finance believes that he can rely on Regina’s work when he presents the budget to the board. the board may make inappropriate decisions based on faulty data. and materials handling for the units. Regina has at least two choices in this situation. in their role of oversight. The relationship between the CEO and the board should be one of trust and confidence. She can tell the Director of Finance that she cannot produce a very accurate budget within two days or she can pull together something that may not be very accurate. such as a business expansion. The board of directors monitors the performance of the CEO and top management. Regina should submit the most current information she has. C. they will draw erroneous conclusions about the performance of the organization and the top management. Although the board is not directly involved in day-to-day operations.34 Software Solutions A. More importantly. such as machining work on units. She may believe that her reputation as a diligent employee would suffer if she cannot produce something. with a flag indicating that the information quality is low for the budgets in those departments and an explanation that the budget is currently based on last year’s information. but with large increases in department costs. If they have outdated information and inaccurate information.
. and that could reflect negatively on the Finance Director. If Regina submits unrealistically low budgets this month and then more accurate budgets next month. However. her reputation would also suffer. if she submits a budget based on last year’s budget and she knows that this is likely to be inaccurate. the department amounts and total budget may be quite inaccurate. they need the most current information available and explanations for information that is not available. 2. the board may begin to lose trust in the CEO’s ability to manage operations. They may either praise or criticize top management when the situation may not warrant it. They may also use the inaccurate information to help them approve decisions.Chapter 2: The Cost Function 2-35 costs.

com/college/eldenburg). number of hours students attend school.000 $15. square feet cleaned.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2. number of hours the building is open. Dept.000 $10.000 $5.000 $20. Students may have thought of other drivers that could be logically related to cleaning maintenance costs.wiley.000 $0 528 530 532 534 536 538 540 542
Number of Students
C.000 $5. available on both the Instructor and Student web sites for the textbook (available at www. Costs
$25.000 $15.000 $20. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.2-36 Cost Management 2.wiley.
Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked
Maint. B. Dept. Other cost drivers for total maintenance cost could be number of rooms cleaned. Costs
$25. or number of classes and activities per period.000 $10. A.com/college/eldenburg). A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.
.000 $0 50 100 150 200 250 300 350
Maintenance Hours Worked
Scatter Plot of Maintenance Costs Against Number of Students
Maint.

461245 7.247329 R Square 0. providing high confidence that both the intercept and slope are different from zero.0857
Intercept X Variable 1
t Stat -0.796328319
Intercept X Variable 1
Coefficients 9134.061172 Adjusted R Square -0. From the analyses performed. maintenance hours is a reasonable cost driver. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.832184392 Standard Error 1217. An unidentified cost driver could have a higher R-Square.173 Observations 12 Coefficient s -89867 197.807201
P-value 0.18E-05
Regression output for maintenance cost and number of students:
Regression Statistics Multiple R 0.0261 Standard Error 130954. it is considered fixed.63E-06 2. It cannot be known for certain whether the number of maintenance hours is the best cost driver because every single possible cost driver cannot be identified. Regression results for maintenance cost and number of maintenance hours worked:
Regression Statistics Multiple R 0. The most current value is used to
.Chapter 2: The Cost Function 2-37 D.36 The Elder Clinic A and B Salaries are always fixed.875134 35. However.135 + $35.68624 0.5045837 4. 2.06772 Observations 12 Standard Error 965.920565237 R Square 0. and rent for this type of facility is usually fixed.9 244.508157 0.74*maintenance hours worked.74733262
t Stat 9.847440356 Adjusted R Square 0. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none. E. The p-values on the Tstatistics are very small. Utilities cost varies with season not visits.453062
P-value 2. it is logical to expect a strong relation between hours worked and cost.438328
According to the R Square statistics. The total cost function is: TC = $9. Therefore.03271 Standard Error 3019.

Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14.80 D. Some supplies. Other expenses appear to increase and decrease with number of patientvisits. or there are changes in treatment procedures for certain illnesses. affecting the number of visits at this clinic. must be kept on hand whether or not they are used. This analysis suggests that there are some of the other expenses are variable costs and some fixed. and so on. weather. variable cost is $3. and so on. to find fixed: $3. but not proportionately. **Using high-low. such as snake anti-venom. Given the preceding computations and cost summary. gloves.com/college/eldenburg). the cost function is: TC = $19.wiley.736 Variable $3. each patient requires a certain number of supplies.182 = F + $3.412 1.2-38 Cost Management predict next period’s utilities.182 .49 Cost Driver Patient-visits Mixed X
2.49*849.736 + $6.441. Visits are affected by season.07
Patient-visits
X
* The value in June is used for fixed costs because the increase in salaries will hold into the future. Use March. so this cost is classified as a mixed cost.07*940 = $25.934)/(849 – 778). Here are some of the reasons: • The managers will not know how many visits they will receive.49 ($3. These would be fixed.736 + $6. • Treatments and related costs may change as new drugs are available. high point of medical supplies cost and patient data. E. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www. medical supplies is a mixed cost. At 940 patient-visits. Medical supplies vary with number of patient-visits.100 226 664 $19. • Prices of all inputs could change (usually increase). and costs go up as patient-visits increase. There is no one answer to this part. There are many possible reasons that could be listed. Use the same method for other expenses.115 219 3. Also.58 $6. These would be variable. current illnesses that are circulating in the area. such as tongue depressors. new equipment is acquired.
.$2. Therefore.07*patient-visits C. other facilities may open or close. July expenses are estimated to be: TC = $19.

Chapter 2: The Cost Function 2-39
2.38 Personal Cost Function A. Other costs are highly uncertain and subject to external factors that cannot be controlled. cost allocation records could be used to identify past costs. If enough data points are available. This data could be found in the accounting system. In some ways. C. B. If the service is housed in a common building. and D. Accounting records could be accessed to determine the wage rates and time worked for help support staff and supervisors. Number of work stations might come from the department head. If not. Analysis of general ledger entries could be used to determine past costs for phone service. department heads. The cost object is the help line. C. Regression analysis makes use of all data points and is more accurate than twopoint methods. Some future costs can be estimated with high accuracy based on prior commitments (e. a two point method might be best. E. depreciation schedules. It would be useful to obtain several years of monthly data from which to prepare scatter plots and run regression analysis. could be used to identify costs for building and occupancy costs. assuming a linear cost function. B. Number of customers is part of the revenue accounting records. number of employees. regression analysis would probably be the best choice.
. with representative points selected from a scatter plot.. analysis at the account level could be used to develop a cost function using information from the general ledger. supplies. etc. D. or it might need to be estimated if it has not been tracked in the past. If the help line is housed in its own building. The choice of information sources depends on how the past cost information is to be used. number of hours worked. The answers to these questions depend on the individual student’s data and cost behavior. rent). Vendors. or total number of Internet customers. prepaid insurance schedules. a personal budget estimation problem is similar to the cost estimation problem for a business. and others could be interviewed to identify any potential cost increases or other expected changes in cost behavior from prior periods. number of work stations. and other miscellaneous costs.g. Information about number of employees and hours worked is found in the payroll accounting system. Number of calls might have to be tracked by employees or by the telephone system. Alternatively.37 Cost function Judgment and Method A. Possible cost drivers include number of calls handled. 2. Some costs are discretionary.

available on both the Instructor and Student web sites for the textbook (available at www. IP-14 3 Payroll paid every two weeks.800 .
. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. Because of the large difference between these values and the values in other months. If these observations are included in the regression analysis.150 73. 80% of September 2 payroll to August: .790 80.300/10 x 12 = 35.350 68. Operations in the month of July are not typical of the rest of the time period.596 73.686 71.500 x 1/2 = 2.200
+$2. as shown in the scatter plot below.8 x 6. B.750 + 4.83/mo. Similarly.2.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. 1/2 of August 5 payroll goes to July: 5.500 38.10.com/college/eldenburg).376 65. the first month is adjusted even though it is not an actual cost: 4.750 . A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. No adjustments are needed for items (c) and (d).000 = 4.wiley.com/college/eldenburg). these are correctly handled.736
To predict future overhead.310 70. the trend line is likely to distort costs.200 Apr 71.736 67.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36
Other
Payroll3
Adjusted Cost $68. July’s result is an outlier and should be removed from the data.750.2-40 Cost Management 2.850 2 . (rounded to $36) 2 Note IB-4's power added to Dept.4.036
68.000 + 500 + 500 + 500 + 500 + 500
Depreciation(b) +$36 1 + 36 -4. A.800.236 69. The miscellaneous supplies account also looks suspicious.250 May June July Aug Sept Oct Nov
1
Property Tax(a) +$500 + 500 + 500 + 500 -3. but there is insufficient information to make an adjustment.286 68.486 68.800
41.750 68.wiley.

000 9.000 $65.000 $50.Chapter 2: The Cost Function 2-41
Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours
$75.086126
Based on the t-statistic and p-value for the intercept.500 8. According to the details provided for August and September. Thus. they are most likely recorded at the time of purchase rather than at the time of use.000 $45. the cost function is estimated as: Overhead cost = $6.000 $55.818 6.298502 2.310484
Intercept X Variable 1
Coefficient s 8777.000
Overhead Costs
$70.000 $40.000 6.775388 0.47 8 Standard Error 29406. Monthly overhead costs for supplies may be significantly overstated or understated
.641981 0.000 $60. the fixed cost does not appear to be different from zero. D. Based on the variation in dates at which supplies are recorded.412139 0. Here are the regression results:
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.26 3. Therefore.000 3.79 * direct labor hours This cost function might not provide a very accurate estimate for future costs because the direct labor hours explain only about 31% of the variation in overhead costs (based on the adjusted R-square). considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.500 5.000 2.500
Outlier
Direct Labor Hours
C.789722
t Stat 0.050976
P-value 0.314163 1980. supplies were a large proportion of overhead cost.

2-42 Cost Management if the amount of supplies inventory varies significantly from month to month. Second. The process of preparing financial statements often includes adjustments so that costs are recorded in the correct time period. financial statements may be prepared less frequently than data is collected for cost estimation. these variations would need to be considered. Thus. In addition. the accounting records might not accurately reflect the costs incurred during each time period. Prior cost data should be adjusted for these changes before the data are used to estimate future costs. However. adjustments could be made to adjust the balance in supplies inventory each month.
. this may not be a problem. but if the company would like information about predicted monthly costs. E. sometimes known changes have occurred in prices or cost behavior. Following are three reasons for making adjustments when estimating cost functions. First. Third. Additional adjustments include any expected changes in costs from prior periods. For example. small adjustments that may be material when estimating a cost might not be sufficiently material to the financial statements for adjustments in the accounting records. power costs could be adjusted upward if utility rates in the future are expected to be higher than in the past. there could be seasonal variation in costs such as overtime pay and utilities. If the cost function is for annual costs.

it is necessary to use judgment when choosing and applying measurement methods. high-low method. A measurement is relevant if the resulting cost function information helps decision makers choose between alternative courses of action. Suppose a cost function is measured for the purpose of estimating future costs. b. A measurement is appropriate if it is suitable for the purpose. then simple regression is inappropriate. a cost function should distinguish between fixed and variable costs. See Exhibit 2. Thus.40 Focus on Professional Competency: Measurement A. Chapter 2 introduced the following measurement methods for estimating a cost function: Engineered estimate of cost. Fixed costs are often irrelevant to decisions. in Chapter 2 pointed out that a cost function is estimated within a relevant range of activity. 3. variable or mixed. whereas variable costs are often relevant. If the cost is believed to be nonlinear. two-point method. 4. For example. B. which factors drive variable costs. It is often difficult to identify an appropriate. simple regression. Uncertainties prevent identification of single “correct” measurement methods. It is also necessary to evaluate the quality of measurement results when using accounting information. and they prevent complete accuracy in making accounting measurements. for example. 2. and how to interpret computational results. relevant. sometimes the cost of obtaining a better measure exceeds the benefits.
. C. analysis at the account level. the main focus was on measuring costs for a cost object. In Chapter 2. A measurement method such as simple regression is appropriate if past cost patterns are expected to continue in the future and i the cost is linearly related to the cost driver. When estimating a cost function: a.17 for the pros and cons of each method. which typically involved creating a cost function for one or more individual costs. and multiple regression (Appendix 2A). and reliable measure for estimating a cost function because of uncertainties about: data availability. A cost function estimated from past cost data may be unreliable if future operating activities are expected to occur in a different relevant range. For example. 1. how to categorize costs as fixed. c. A measurement is reliable if it if it is reasonably free from error and bias. the best choice of estimation technique.Chapter 2: The Cost Function 2-43
BUILD YOUR PROFESSIONAL COMPETENCIES
2. whether past cost behaviors will continue in the future. The costs and benefits of alternative measures should also be considered.

People who lack objectivity are likely to present biased information that impairs high quality decision making. taking into account the knowledge and interests of the user. If the report will be presented to a superior within the accounting department. D. irrelevant. Note: Some of these ideas were adapted from the Path to Higher-Quality Management Decisions presented in Chapter 1 (Exhibit 1. Here are some desirable characteristics of a report about an estimated cost function. • The report should focus on information that will be relevant to the user. then it may be more important to provide the cost function information rapidly than to prepare a high quality report. then it should probably describe all of the major decisions involved in developing the cost function.2-44 Cost Management
5. the user should be informed about the priorities used in creating the report. students might think of others. and/or unreliable. • The use of technical language should depend on the audience. If the user needs to make a decision quickly. Changing circumstances can change the patterns of cost behavior and cause an estimated cost function to be inappropriate. • The format should be concise. However. the manager should be informed about key uncertainties or risks associated with using the cost function. If the report will be used by a manager who needs to estimate future costs. However. • The desired quality of the report should be weighed against the timeliness of information for the user. It is typically appropriate to use more technical language in reports written for other accountants than in reports written for non-accounting audiences. and easy to understand.9). It is important to present the cost function information objectively to improve its relevance and reliability for the user. then the details of the estimation process may be irrelevant. clear.
.

Considerable variation in labor costs is not explained by changes in the volume of production. Because of the annual pay increases.957296 Standard Error 6710.194 + $13.7995 Observations 48 Coefficient s 133194.609693 1. the fixed cost and the variable cost per unit are each positive and statistically different from zero.678620854
Intercept X Variable 1
t Stat 19. B.wiley.5917832 Standard Error 6216.7748991 R Square 0.6004687 Adjusted R Square 0. In prior years. A. Also.wiley.3147402
P-value 3. using monthly data for the prior 4 years.02E-10
Based on the regression results. Here are the simple regression results:
Regression Statistics Multiple R 0. The cost function is estimated as: Labor cost = $133. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.] The data for this problem can be found on the datasets file for chapter 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. the regression explains only about 59% of the variation in labor costs.com/college/eldenburg).848277 8.96 x number of chairs produced However. students are likely to struggle interpreting and choosing a method (Parts E and F).Chapter 2: The Cost Function 2-45 2. the cost function was estimated by regressing actual labor costs on number of chairs produced. However.437E-24 1. the degree of downward bias is higher for older data than for more recent data.04 13.41 Integrating Across the Curriculum: Statistics [Note about problem complexity: This homework problem was written with adequate instructions so that students should be able to perform the various regression analyses that are called for.
.com/college/eldenburg). available on both the Instructor and Student web sites for the textbook (available at www.

35E-15
Based on the regression results.54295 Standard Error 5689.411 Observations 48 Coefficient s 107748.863839 Standard Error 3742.869633 Adjusted R Square 0.91E-08
.57E-23 2. approximately 26% of the variation in labor costs is still unexplained.347 Calculation $203.274
Using the adjusted labor cost data. but the variable cost increased from $13.891 1.23 per chair. The fixed cost is nearly the same.96 to $16.311 200. the fixed cost and the variable cost per unit are each positive and statistically different from zero.010513 1. Nevertheless. which is reasonable given the increase in wage rates over time.02 Adjusted Labor Cost $220. Also.00872
Intercept X Variable 1 X Variable 2
t Stat 18.23 x number of chairs produced This regression provides a more reasonable cost function than the previous version because it explains a higher proportion of the variation in labor costs (adjusted R-square of 0. here are the regression results:
Regression Statistics Multiple R 0.747745 Adjusted R Square 0.492 1.09577 6.73E-20 5. The cost function is estimated as: Labor cost = $133.347 x 1.486389
P-value 4. this cost function would result in a higher estimate for future costs.390275
Intercept X Variable 1
t Stat 24.06236 11.67711
P-value 1.93821 16. D.932541 R Square 0.74).736 + $16.2-46 Cost Management C.8 16.864722 R Square 0. Here are the multiple regression results:
Regression Statistics Multiple R 0.905 Observations 48 Coefficient s 133736 16.533 Dec 20X4 196.26499 6.23439 Standard Error 5557. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.742261 Standard Error 5148.02)4 $196.05E-27 2.533 x (1.

F. E. then this month’s labor costs will reflect the higher level of labor cost.26 x current month number of chairs produced + $6.
. In addition. Thus. there may be some lag between the time that production volumes change and labor costs change. As explained in the problem. and to decrease the number of workers when production volumes decrease.l6 for each chair produced during the month. However.749 + $16. Conversely. then this month’s labor costs will reflect a lower level of labor cost. and the managers often delay laying off employees when volumes decline.Chapter 2: The Cost Function 2-47 Based on the regression results. each month’s labor costs are expected to increase by $16. the fixed cost and the variable cost per unit for each cost driver are all positive and statistically different from zero. if the prior month’s production was lower than this month’s production.54 x prior month number of chairs produced The statistics suggest that this is a more reasonable cost function than the previous version because all coefficients are positive statistically different from zero. the two cost drivers together explain a very high proportion (86%) of the variation in past labor costs. According to the multiple regression results. and they both have positive and statistically significant coefficients. On the other hand. There is no one single answer to this question. and this regression explains more of the variation in labor costs (86%). The first slope coefficient ($16.54 for each chair produced during the prior month. If the prior month’s production was higher than this month’s production. each month’s labor costs are expected to increase by $6.26) is interpreted in a straight-forward way. The cost function is estimated as: Labor cost = $107. The second slope coefficient requires more thought. it appears that both independent variables should be included in the cost function because they both have a logical cause-and-effect relationship with labor costs. On one hand. it could be argued that some other cost driver might do a better job of predicting future labor costs. it often takes time for the company to hire qualified new workers. the company’s policy is to increase the number of workers when production volumes increase.