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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2.7

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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2.9

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2-4

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 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 . the CPA's time is the product being sold. CPAs do keep detailed time records. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. TC = $10. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.00*Q Graph of Cost Function $14. In a service business such as this. Stepwise Linear. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects.000 $8. 2.Chapter 2: The Cost Function 2-5 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.000 $13. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained.000 $10. Of course. For the firm to make this cost direct for the personal returns cost object.000 $11.000 $9.13 Linear. the tax partner probably spends some time in non-billable activities.000 Total Cost $12.000 + $8. The time records that the tax partner maintains support this cost as a direct cost.

000 * $44 = $528.000 .000 2.000 = $60.000 Graph of Cost Function $80. for Q ≤ 2.000 – 10.$450.00*Q.000 + $8.000 + $39*Q .000 $70.000)/(12. Convert the average costs to total costs for each production level: Total cost at 10.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528. To estimate the costs at another production level.000 * $45 = $450.2-6 Cost Management B.000 Total cost at 12.$390. for Q > 2.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 $20.000 units: $450.000 .000 F = $450.000 Number of Units C.000 = F + $39*10.000 units = 10.000 Total Cost $50.000 units = 12. TC = $25.000 $0 0 1.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 4. it is first necessary to estimate the cost function.00*Q.000 $30.000 TC = $35.000 $10.000 $60.000) = $78.000 $40.000 + $8.000/2.000 3.

Inserting $10.000 + $39*15.000 Estimated cost per unit = $645.500 2.000 units: TC = $60.00*Q 2-7 Graph of Cost Function $75.000 + $10.500 2.000 = $60. for Q < 1. TC = $50.000 $45.000 1.000 in revenues into the cost function.00*(Q-1.000/15.14 Piecewise Linear Cost Function A.000 = $9.000 TC = $51.000 For Q > 1.00*Q .000) TC = $50.000: TC = $50.000 + $9.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 = $645.000 + $585.$9. total cost is estimated as: TC = $5.000 + 45%*$10.000 $50.000 $55.000 + (1.000 $65.Chapter 2: The Cost Function Estimated total cost at 15.00*Q.000 = $43 D.00) + $9.000 $70.000 $60.000 0 500 1.000 * $10.000 + $9.000 + $10.

000 + $10.000 units. There are three general situations: 1.00*Q.15 Tax Plus A. then the cost function would appear to be: TC = $51. This cost function would provide reasonable estimates for Q > 1. If the accountant did not detect that there were two different relevant ranges. 2.2-8 Cost Management B. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. the cost function mismeasurement depends on the values of Q. This cost function would provide reasonable estimates for Q ≤ 1.3219 Y = 4.3 and 2A. 3. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared .000 units.000 + $9. 2. then the cost function would be some mixture of the functions for the two relevant ranges. If all of the data estimation points occurred when Q was > 1.000 units but would overestimate total cost for Q > 1. then the cost function would appear to be: TC = $50.000 units. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.00*Q. If the data estimation points occurred across the two relevant ranges.000 units.80/ln2) = −0. If all of the data estimation points occurred when Q was ≤ 1. Hours for two returns would be determined as follows.8 hours (average time for each of the next two returns) B.3219 Y = 6 hours*2-0.4.000 units but would underestimate total cost for Q ≤ 1.

Total clay cost will vary with the number of bowls made. F Assuming that employee time can be traced to each bowl. Eventually their learning will plateau. V C.000 on total sales of $32. Assumptions: Fixed costs remain fixed within the relevant range. as their performance improves. it is a direct cost. this particular cost function assumes that variable costs are driven by sales. their productivity increases. that is. If total variable costs were $8. F . 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. In addition. 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.] A. D. B. if time is not traced to individual bowls (for example. Assuming that the cost of clay can be traced to each bowl.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. then wages would be an indirect cost. making it a fixed cost.000.000 = 0. then variable cost per dollar of revenue is calculated as follows: $8. Wages are fixed because they remain constant (the employee always works 40 hours). I. and variable costs remain constant within the relevant range. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). it is a common cost of production for all of the bowls that are heat-treated in the kiln. 2. the cost function is: TC = $20. However. Note: Depreciation using a method such as declining balance is not constant over time.16 Bison Sandwiches A. However.000 + 25%*Total sales B. and their productivity rate will remain stable. but would still be considered fixed because it does not vary with production volume. D or I. 2.000/$32. wages are a direct cost. it improves less quickly for the next return.25. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. or 25% of sales Combining fixed and variable costs.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization.

500 . G. it might not be traced to individual bowls. depending on whether they are “used up” after a certain quantity of production.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. it is most likely traced to individual bowls. They might be fixed or variable. making it an indirect cost.2-10 Cost Management D. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week.300 Variable $4.000 2. I. F. if the cost is small it might be grouped with overhead costs (variable). Packing costs are most likely variable because they will increase as production increases. H. V or F Brushes for the glaze are most likely used for multiple bowls.] A. It might be fixed or mixed. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. E. J.300 $3. If it is an hourly charge. If the packing materials are not traced (for example. making them a common cost for multiple units and an indirect cost. D or I. depending on what causes the cost to vary. D or I. because the production area may need more cleaning as volumes increase. I. so it is treated as fixed. making it an indirect cost. V Assuming that the cost of packing materials is traced to each bowl. then this cost could be indirect. 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. Advertising is not directly related to production. I. making it a fixed cost. If the cost of glaze is very small. F I. V If the glaze is expensive and therefore a relatively large cost. this is a direct cost. F The business license is not related to production. I. making it a direct and variable cost. making it an indirect cost. if the cost is too small to justify tracing them). This cost is also discretionary. If the kiln is electric. part of the cost might vary proportionately with volume. 2. I.500 ______ $4. it is probably a mixed cost. Also.

V. or 50% of revenue Combining fixed and variable costs. FB. While hourly wages may be related to number of fish caught. so they would tend to be fixed or mixed (see Item A above).19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C.500/$9. F or M Employee benefits occur in any business in which employees are hired. employees are likely scheduled in advance on a fixed schedule. and the cost would vary with number of pizzas produced. these costs would be mixed with a large proportion of the cost fixed. D. 2. In this type of situation.300 + 50%*Total revenue C. D. B. as well as voluntary items such as health insurance and retirement benefits. B. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. Some may be sent home if business is very slow. F There would be no reason to incur fishing equipment costs in a pizza business. The cost of rent is irrelevant because it will not change with either alternative. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. the cost function is: TC = $3. In the fishing boat business. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). B. .Chapter 2: The Cost Function 2-11 B. they are more likely related to time on the boat than pounds of fish. Therefore. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. There most likely would not be any ingredients in a fishing boat business. F.50. In many organizations. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. PS.000 = 0. because of uncertainty in the success of each fishing expedition. and unemployment insurance. V Ingredients are used in making pizzas. Benefits might include mandated items such as social security. Benefit costs often vary with level of wages or salaries. F. E. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. workers’ compensation. In the pizza shop. costs vary with dollars of revenue. C.] A.

0863 0. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. B. Cheese ($2. For the fishing boat business. Lettuce ($. Hamburger bun ($1. The cost might be fixed or mixed. there might be some utility costs for the fishing operation and for a business office.0233 0. the utility costs for these two businesses would tend to be fixed (would not vary with production). but it might be mixed if a portion of the cost relates to levels of business activity.0198 0. 2.3489 $0.0233 7.0148 0. B. Mustard ($.$0.2414 2.0033 0.0179 4.0033 $0. Cost of plain burger = $0.99/50) 0.15/45) 0. they are treated as fixed costs.0198 9.79/150) 0. and yellow pages advertisements. G. Mayonnaise [$1.59/40) 0. Tomato ($.2414 $0. Hamburger patty ($1.1619 0. In general.2414 $0.1619 10. F or M Any type of business will have insurance costs. Catsup ($. It will be a fixed cost if it is a flat amount.000) * 4] 0. F Most pizza shops incur advertising costs such as flyers. Because advertising costs tend to be discretionary.0053 8.69/8) 0.0179 0.0053 0. 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. PS. Dill pickles [($8.5196 Suggested selling price: 300% * $0. newspaper advertisements.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. depending on how the insurance cost is calculated.1075 0.69/7) $0. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.56 .5195 = $1.59/16) 0.1075 0.6815 .0148 6.1619) = $0.0863 5.6815 A. If the fishing boat is for tourists. F.29/12) 0.2-12 Cost Management E.1075 3. advertising costs would be incurred.95/2.3489 (calculated above) B.49/(16 x 4)] 0. Onions ($. Cost of burger with everything except cheese = ($0.

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

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

58824812 182.761602 4.Chapter 2: The Cost Function 2-15 A.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.026826 0.113687834 Intercept Output t Stat 5.61765897 0.500 $1.58E-05 0.582691 P-value 6.500 Maintenance Costs $2.000514 . Potential Cost Driver: Output Maintenance Costs Against Output $2.000 $1.119724 15 Coefficient s 884.78591283 0.4342166 0.52099624 Standard Error 153.

210849 15 Coefficient s 861.60187065 0.457384 3.000 $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 0.500 $1.717372 P-value 0.005847 0.000 $1.7549386 1.36224828 0.02569657 Standard Error 261.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.113464425 Intercept Direct Labor Hours t Stat 3.31319046 235.291084 2.500 Maintenance Costs $2.017601 .

815737 29. In Part A. the cost driver does not explain the variation in cost and either it is the wrong driver.197755 8.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.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. However. all three potential cost drivers appear to be positively related to maintenance costs.5913391 15 Standard Error 93.000 $1.357393 15.97410583 0.94495003 66. the trend line for machine setups looks as if the intercept could be zero or very close to zero.500 $1. In a scatter plot.910475729 Intercept Machine Setups t Stat 1. For example.5343 P-value 0.96E-10 B. . If the observations are widely scattered.6778973 0.94888217 0. a good cost driver would present a linear or football-shaped positive slope or trend. This indicates that the cost could be totally variable. or the cost is mostly fixed. Sometimes a cost that is mostly variable can be identified from a scatter plot.500 Maintenance Costs $2.42597461 1.

so it is excluded from the cost function. the cost is likely to be totally variable.945 Cost Function TC = $884 + $0.2-18 Cost Management C. business processes.588 0. The regression using machine setups has the highest adjusted R-Square of 0. Therefore. Changes in many factors such as resource prices. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. and technology can cause future costs to be different than estimated. . D. the t-statistic is significant for the independent variable but not for the intercept. R-Square 0. 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. E. This provides confidence that the variable cost part of the cost function is not zero.025*Direct Labor Hours TC = $29.945.521*Output TC = $861 +$3. This means that variation in setups explains about 95% of the variation in cost. In the machine setups regression. the economic environment.68* Machine Setups The machine setups intercept coefficient is not significant.313 0.

First.100) = $25. the cost function is calculated using the highest and lowest values of the cost driver.100 F = $68.605 = $11.333)/($1. The high low method uses the most extreme cost driver values. Therefore.000 = 0. not represent the cost most of the time.000/$500. the variable cost is calculated: ($68.Chapter 2: The Cost Function 2-19 PROBLEMS 2. this cost function might provide poor estimates of future costs. which could be outliers. That means that the cost function might not represent the actual cost. Under the high-low method. on average.$56.132.728 + 5%*Sales B.333 = F + 5%*$1. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.24 Big Jack Burgers A. that is.05.100 – $632. the total cost function is: TC = $11. .728 Thus.132.333 – $43.333 . or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.

there is a 16% probability that the intercept (fixed cost) is not different from zero.2-20 Cost Management C. Based on the p-value. the regression intercept can be used as an estimate of the fixed costs. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.000 $20.000 $40.800 + 4.5% x sales . The upward slope of the line indicates that there are variable costs. Alternatively. Then. analysis at the account level might indicate that there are few fixed costs.172.200. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. Analysis at the account level can be used to increase the understanding of this cost.5% x sales.000 $900. Chart of data with trend line added by Excel.000 $1. etc).000 $0 $0 $300. Following is the regression output. Because this regression has few observations. fixed costs are likely to be zero and would be excluded from the cost function. but the p-value is greater than 10% at 0. D. the cost function would be TC = $16.162.000 $600. the cost function would be: TC = 4. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80.000 Sales It appears that the cost is most likely mixed. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. Notice that the t-statistic for the intercept coefficient is 2. the p-value result for the tstatistic is atypical. If this cost pool includes items such as salaries and other fixed costs (insurance.000 Administrative Costs $60. In that case. Then.

Sales might not be the activity that drives administrative costs.9680477 0.365 + 0. and possible changes in costs such as those described in Part E are ignored.2444 7734. The plot shows costs that are widely scattered. however. The adjusted R-Square statistic is very low at 0. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. both of these methods assume that the data points are representative of future costs. Unusual cost items are assumed to continue in the future. the cost function is: TC = $50.4038 4 Coefficients Standard Error 16800. regression analysis incorporates all of the observations into the analysis. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost. If there are only two or three data points. then both methods may be unsuitable for estimating future costs.00818212 t Stat 2.17205158 5. there does appear to be a general upward trend. F. The cons of the high-low method as an estimation technique were discussed in Part B above.45937486 P-value 0. . If these assumptions do not hold. This method can be used in cases where there is not enough data to perform regression. on average.04466925 0.93711636 0. 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. If there are more data points. 2. Because of unforeseen changes in cost behavior. causing fluctuations in cost that are unrelated to any cost driver.82%*Sales C.25 Scatter Plot. the results rely on more complete information and provide a better estimate. Cost Function Using Regression A.0319523 Intercept X Variable 1 E. This means that variation in sales explains only about 18% of the variation in research and development cost.90567454 3293. The past costs used for estimation might not be representative.16197623 0. Therefore. Using the regression results. In addition. the high-low method may be the best option available. Both methods assume that the cost function is linear and that all data points come from a single relevant range. There might be a large discretionary component in administrative costs. However.73545 0. Sales does not appear to explain much of the variation in research and development costs.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. B. especially because so few observations were used in the estimation.186.

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

In most businesses.00 $20. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. Here are some of the reasons. Hours per batch would be determined as follows.10 = $30.152 Y = 10 hours*4-0.00 $20.00 $20. If her calls are over 400 minutes or under 600 minutes. In . she will pay a very high rate of 10 cents per minute 2. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0.152 Y = 8.90/ln2) = −0.or overestimated the amount of hand work performed.00 $20.10 = $40. telephone costs are viewed as an indirect cost.00 + (600-500)*$0.1 hours (average time for the first four batches) B.057 The average cost is lowest at exactly 500 minutes per month. Cons • If Susan has a number of projects in her local area or will be traveling a lot.27 Fancy Furniture A.Chapter 2: The Cost Function 2-23 consulting jobs. In this case the learning rate would be wrong and so the time would also be wrong. It is possible that the managers under. Many cellular telephone bills do not list the calls made.00 Average Cost $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.04 $0.00 + (700-500)*$0. her phone bill will be less than it would be at a rate 5 cents per minute. Minutes 300 400 500 600 700 Total Cost $20.05 $0. 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. There are many different reasons that the time could be different from the amount determined above.05 $0. I. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls).067 $0. students may think of others. so Susan may need to maintain her own records if she wishes to trace telephone usage.

The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.$79. if managers believe that more than 25% of the work is done by hand. then the cost would be overestimated. The estimate of total costs given revenues of $80.000/$70. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28.000 1.000 .40.500 $47. if managers believe that 25% of the work is done by hand. Thus. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30.28 Wildcat Lair A.000 Profit = Revenues – Total costs = $80. and the University surcharge is specifically based on sales. then the chart suggests that the learning rate estimate is reasonable.2-24 Cost Management addition. or 40% or revenue Combining fixed and variable costs. then this chart suggests that the learning curve will be slower than the 90% estimate.000 Total revenue is the most likely cost driver for both variable costs.000 using the cost function is: TC = $47. Food costs are likely to vary proportionately with sales.000 = $79.000 .000 + 40%*Total revenue D. If these values are used in a regression to estimate a cost function. the rate will change if the replacement employee has never worked on this machine. and B. D. it is possible that different types of wood affect the rate at which chairs can be produced. 2. However. C.000 + 40%*80.500 10.000 5.000 7. C. they would be higher than the labor costs in later periods. 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. If a worker is absent one day. Because revenue is the cost driver for both variable costs.000 _______ $28. the cost function is: TC = $47.000 Variable $21. or has a great deal of experience on the machine.000 = 0.000 = $1.

so the estimated profit in August is $1.000 increase in revenues. C. Electricity costs also vary with changes in electricity rates. 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). total variable costs are expected to increase by $4.000 increase in revenues is expected to be $6.000 (47. the variable cost part of the cost function can be adjusted.000— the operating loss of $(5. it would lose the revenues. To estimate the opportunity cost for August.000) (24.000) of revenues. F.000. So.000 ($10. the shop might experience very little business activity.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.000/$70.] A. In July there was a loss of $5. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. Item D will be VERY difficult for most students. The shop is most likely a seasonal business. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. but this is not considered a cost driver (a business activity that causes variations in total variable cost).000 + 30%*Total revenue During August.000 ($10.000).000) Net 2. If the university were to close the Lair. Variable food costs are estimated to be 30% ($21.000) $ 9.000*40%). less the fixed costs and the variable food costs. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000 .$4. B. the additional profit from a $10.) The adjusted cost function is: TC = $47. In a retail business. Lair’s fixed costs are assumed to be unchanged with the $10. Thus. So. and the increase is estimated to be 40% of the increase in revenues.000). Only total variable costs are expected to increase. if the bathing suit shop is located in a geographic region $80.000 (-$5.000+$6. However.000 . During the spring and summer months. so the trend would be the opposite of this plot. Because the university surcharge is an allocation within the university. for July the opportunity cost would have been $2.000. generating most its sales around the ski season (fall and winter). A shop located near a ski area is likely to incur high heating costs during the winter. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.000)+the university surcharge of $7.Chapter 2: The Cost Function 2-25 E. it might even close when the ski area shuts down. costs would be higher when there were fewer sales.

For example.028. employee training. a 50% markup on total cost will cause sales to be: $1.028. they are discretionary expenditures and not caused by the level of activity. and new office furniture or equipment.45 $ 514.45 x 1. Many costs can be related to volume of activity. in turn.542.67 Firm A's income for last year was: Sales Costs Income $1.67 1.50 = $1.2345 Y = $300*5-0. Although these expenditures are made because more money is available.22 Firm B set its selling price based on the average cost. 2. firm B's selling price is: $101.89 x 1.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. then the highest sales might coincide with the highest electricity costs.028. A correlation may appear in a scatter plot or regression analysis.5 = $152. correlation does not necessarily mean causation. special promotions.69 (average cost for each of the 5 units) Total cost = $205.45 Although each customer paid a different price.85/ln2) = 0.2345 Y = $205. higher profits generally occur during periods when activity is high.542.69 x 5 = $1.84 . given a 100 unit production level: Y = α Xr Y = $300*100-0. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0. generally mean there is more money available to spend on administrative travel. D.2345 Y = $101. Higher profits. However.

028.30 $2.625.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.50 $ 9.2345 Y = $92. Total cumulative production cost (300 x $78.356.75) 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 = $9.84) Costs (150 x $ 92.00 13.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.45 $1.897.2345 (notice that the cumulative units produced is 15) Y = $158.528.40 Firm A's costs may be computed as follows: Y = $300*15-0.528.84) = $1.727.00 13.50/150 units = $64.50 .727.40 1.356.2345 Y= $78.384.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units. assuming an 85% learning effect would be: Y = $300*150-0.50 $ 9.926.Chapter 2: The Cost Function 2-27 Firm B's costs.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.97) 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 $1.65) Income Firm A's revenues for this year are: (10 x $152.897.28 $23.55 1.85 x 1.50 = $97.10 $ 172.85 Thus Firm B's selling price this year was $64.10 $22.028.

000 $155.000 $145.500. 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.28) Costs (150 x $64. available on both the Instructor and Student web sites for the textbook (available at www. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.000 Sales B.50 $ 4.85) Income $14.000 $135.28 is lower than Firm A's average cost per unit: $1.592.50 Note that Firm B's selling price for this year of $97. A.31 Belford’s The data for this problem can be found on the datasets file for chapter 2. Scatter Plot of Marketing Costs Against Sales $175.000 Marketing Dept. and most of the observations appear to have a fairly linear trend. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.500.000 $7.356. There is a positive slope.727.wiley.com/college/eldenburg).10/10 = $135.wiley.000 $6.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97. such extreme differences in cost can occur.000 $5.000 $8.500. Costs $165.61.500.com/college/eldenburg).864.00 9. .

08144 Observations 30 Coefficients 65584.2608 0. the cost function is: TC = $65.7600071 P-value 2. the cost estimate should not be based on past costs. If the variable portion of the marketing cost is sales commissions.01335108 Standard Error 6844. Instead. F.93336396 R Square 0. using regression or any other technique.34%*Sales D.63816 0. usually annually.4501E-10 5. the decision maker(s) should be asked what next year’s cost will be. E.00097028 t Stat 9. Here is the regression output. . discretionary costs such as marketing are often increased when profits increase. When more money is spent on marketing.87116829 Adjusted R Square 0.58184484 13. In addition. there would be a positive correlation between marketing department costs and sales. they may be positively correlated with sales.86656716 Standard Error 4015. Assuming that profits are more likely to increase when sales increase. it is economically plausible for sales to be a cost driver. Regression Statistics Multiple R 0.Chapter 2: The Cost Function 2-29 C. sales may go up. Therefore.5289E-14 Intercept X Variable 1 Based on the regression results.584 + 1. Even if marketing department costs are discretionary. Discretionary costs are set by decision.

wiley.000 $40.000 $120. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $40.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.com/college/eldenburg).000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.2-30 Cost Management 2. available on both the Instructor and Student web sites for the textbook (available at www.000 $80.000 $120.000 $80.000 $160.wiley.com/college/eldenburg). A. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $160.

552864 . Based only on the cost plots. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.01272369 Adjusted R Square -0.8173 Observations Coefficient s 150410.02253618 Standard Error 11114. labor hours could be deleted as a potential cost driver.000 $0 0 100 200 300 400 500 600 700 Raw Materials B.50852 7. The plots help determine whether regression analysis should be performed using any of the potential drivers.56597156 30 Standard Error 14812.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.600936029 Intercept Labor Hours t Stat 10. D. either the driver is wrong or the cost is mostly fixed. the cost driver does not explain the variation in cost.1543 0. but the plot for labor hours appears to have the least trend.000 $40.86E-11 0. C. Sometimes a cost that is mostly variable.000 $160. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.000 $120.600712 P-value 6.682 4. None of the plots show a definite trend. If the observations are widely scattered.000 $80. Labor Hours Regression: Regression Statistics Multiple R 0.11279932 R Square 0.

so the cost function is estimated as: TC = $126. so the cost function is estimated as: TC = $117.612063 R Square 0.11E-12 0.47803 9.91 60.2533351 Adjusted R Square 0.53627459 Intercept Raw Materials t Stat 11. so the cost function is estimated as: TC = $150.67 38.2266685 Standard Error 9665.217 + $60.004579 Both the intercept and slope coefficients are significant.095468 P-value 4.331580777 Intercept Machine Hours t Stat 11.9786 Observations 30 Coefficient s 126216.217192 Standard Error 10291.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.000325 Both the intercept and slope coefficients are significant.3746211 Adjusted R Square 0.56778 19.62907 3.1555 Observations 30 Coefficient s 117598.411 Machine Hours Regression: Regression Statistics Multiple R 0.3522862 Standard Error 8846.68E-12 0.22* Raw materials .4268 4.599 + $38.215128 Standard Error 10853.5033241 R Square 0.2-32 Cost Management Only the intercept term is significantly different from zero.082222 P-value 3.

Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0. this driver explains only 35% of the variation in cost.886218 -0.5558 Observations 30 Coefficient s 60988. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).com/college/eldenburg).953575 1.333162437 5.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.08E-08 .976635 Standard Error 10361.Chapter 2: The Cost Function 2-33 E.218173 8.9092294 R Square 0.12E-09 1.210187 P-value 3. however.778501 82.226 Based on the simple regression results. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0. A. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.3E-06 0.2349 3. available on both the Instructor and Student web sites for the textbook (available at www. 2.8266982 Adjusted R Square 0.com/college/eldenburg). Yes.291558412 10.352 0. F. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.489 -0.1959303 48. The coefficients for each of the other potential cost drivers are significantly different from zero.05878 9. machine hours appears to do the best job of explaining manufacturing overhead costs.wiley.wiley.8067018 Standard Error 4832.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.

001) $117.806) than in either of the simple regressions (0.157604083 9.5348 Observations Coefficient s 60677.86E-07 4. Thus.226) for these two cost drivers.005) $82.806 $150.29E-09 The cost function is: TC = $60.001) $126.93*Raw materials D. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.001) $60. The adjusted RSquare is far higher in the multiple regression (0.001) $4.71E-10 5.925842 30 Standard Error 8743.90921678 R Square 0.74*Machine hours + $82.881964042 Intercept Machine Hours Raw Materials t Stat 6.55) $38. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone. its coefficient is negative rather than positive in the multiple regression. In this example.391636 P-value 1.7422519 82. Manufacturing can be a complex activity requiring a number of different tasks. Each task includes different activities.664851 5. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.001) $60.001) $-0.001) B.22 (<0.20 (0. C. Costs for these activities are likely related to specific cost drivers.98 (<0. labor hours can be eliminated as a potential cost driver.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. its coefficient is not significantly different from zero in either regression.022 0.217 (<0.82667515 Adjusted R Square 0.5902 48.599 (<0. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0. machine hours and raw materials explain different activity .57 (0.411 (<0.678 + $48.954) $48.81383627 Standard Error 4742.78 (<0.22 (0.939606 9. Also.226 0.352 and 0.450561 8.352 0.988 (<0.

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. such as a business expansion. If they have outdated information and inaccurate information. the board may make inappropriate decisions based on faulty data. 2. 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. If Regina submits unrealistically low budgets this month and then more accurate budgets next month. if she submits a budget based on last year’s budget and she knows that this is likely to be inaccurate. They may also use the inaccurate information to help them approve decisions. They may either praise or criticize top management when the situation may not warrant it. . 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.Chapter 2: The Cost Function 2-35 costs. The relationship between the CEO and the board should be one of trust and confidence. and use last year’s budgets for departments that have not turned theirs in. the board may begin to lose trust in the CEO’s ability to manage operations. The board of directors monitors the performance of the CEO and top management. her reputation would also suffer. 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. C. 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. However. 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. and the Director of Finance will present the board with information that is unreliable. and that could reflect negatively on the Finance Director. Regina has at least two choices in this situation. B. but with large increases in department costs. She may believe that her reputation as a diligent employee would suffer if she cannot produce something.34 Software Solutions A. they need the most current information available and explanations for information that is not available. More importantly. in their role of oversight. the department amounts and total budget may be quite inaccurate. Regina should submit the most current information she has. and materials handling for the units. If Regina uses last period’s budget. such as machining work on units.

square feet cleaned.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2. . available on both the Instructor and Student web sites for the textbook (available at www.000 $15.000 $10. Dept.wiley. A.com/college/eldenburg). or number of classes and activities per period. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.com/college/eldenburg). Other cost drivers for total maintenance cost could be number of rooms cleaned.000 $20. number of hours the building is open.000 $15. Costs $25. number of hours students attend school.wiley.000 $20.000 $5.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. Costs $25. Students may have thought of other drivers that could be logically related to cleaning maintenance costs.000 $5. B.000 $10.2-36 Cost Management 2.000 $0 528 530 532 534 536 538 540 542 Number of Students C. Dept. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.

061172 Adjusted R Square -0.920565237 R Square 0.03271 Standard Error 3019. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.247329 R Square 0.453062 P-value 2.847440356 Adjusted R Square 0.135 + $35.438328 According to the R Square statistics.832184392 Standard Error 1217.74733262 t Stat 9.36 The Elder Clinic A and B Salaries are always fixed. E. Therefore.0857 Intercept X Variable 1 t Stat -0.508157 0.875134 35.807201 P-value 0. From the analyses performed.0261 Standard Error 130954.461245 7.06772 Observations 12 Standard Error 965.9 244. 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. and rent for this type of facility is usually fixed. An unidentified cost driver could have a higher R-Square. providing high confidence that both the intercept and slope are different from zero.173 Observations 12 Coefficient s -89867 197.5045837 4. The most current value is used to . 2. The total cost function is: TC = $9.Chapter 2: The Cost Function 2-37 D. it is considered fixed. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.796328319 Intercept X Variable 1 Coefficients 9134. it is logical to expect a strong relation between hours worked and cost. maintenance hours is a reasonable cost driver. Utilities cost varies with season not visits.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. The p-values on the Tstatistics are very small.74*maintenance hours worked.63E-06 2. However.68624 0. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.

medical supplies is a mixed cost. Also. Other expenses appear to increase and decrease with number of patientvisits. Therefore. These would be variable. 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. E. affecting the number of visits at this clinic. Some supplies. **Using high-low. Use the same method for other expenses. current illnesses that are circulating in the area. Given the preceding computations and cost summary.182 . July expenses are estimated to be: TC = $19.58 $6. new equipment is acquired.934)/(849 – 778).wiley. the cost function is: TC = $19.2-38 Cost Management predict next period’s utilities. but not proportionately. weather. must be kept on hand whether or not they are used. • Prices of all inputs could change (usually increase).441.49*849.80 D. .07*940 = $25. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. There is no one answer to this part. and costs go up as patient-visits increase. to find fixed: $3. Medical supplies vary with number of patient-visits.100 226 664 $19. Visits are affected by season. such as snake anti-venom.182 = F + $3.736 + $6. so this cost is classified as a mixed cost.49 Cost Driver Patient-visits Mixed X 2. There are many possible reasons that could be listed.736 Variable $3.736 + $6.49 ($3. These would be fixed.$2.com/college/eldenburg). each patient requires a certain number of supplies. and so on. such as tongue depressors. variable cost is $3.07*patient-visits C. This analysis suggests that there are some of the other expenses are variable costs and some fixed.412 1. and so on.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. Here are some of the reasons: • The managers will not know how many visits they will receive.115 219 3. other facilities may open or close. At 940 patient-visits. gloves. • Treatments and related costs may change as new drugs are available. Use March. high point of medical supplies cost and patient data. or there are changes in treatment procedures for certain illnesses.

number of hours worked. depreciation schedules. rent). . If enough data points are available. department heads. If the service is housed in a common building.g. number of employees. It would be useful to obtain several years of monthly data from which to prepare scatter plots and run regression analysis. C. and others could be interviewed to identify any potential cost increases or other expected changes in cost behavior from prior periods. etc. Number of work stations might come from the department head. If not.38 Personal Cost Function A. This data could be found in the accounting system. Other costs are highly uncertain and subject to external factors that cannot be controlled. and D. Vendors. Accounting records could be accessed to determine the wage rates and time worked for help support staff and supervisors. cost allocation records could be used to identify past costs. regression analysis would probably be the best choice. and other miscellaneous costs. analysis at the account level could be used to develop a cost function using information from the general ledger. a two point method might be best. a personal budget estimation problem is similar to the cost estimation problem for a business. Some costs are discretionary. Analysis of general ledger entries could be used to determine past costs for phone service. number of work stations. with representative points selected from a scatter plot. Number of calls might have to be tracked by employees or by the telephone system. or it might need to be estimated if it has not been tracked in the past. 2.Chapter 2: The Cost Function 2-39 2. C. Alternatively. Some future costs can be estimated with high accuracy based on prior commitments (e. supplies. B. or total number of Internet customers. E. In some ways. If the help line is housed in its own building.37 Cost function Judgment and Method A. The cost object is the help line. The answers to these questions depend on the individual student’s data and cost behavior. D. Regression analysis makes use of all data points and is more accurate than twopoint methods. Number of customers is part of the revenue accounting records. The choice of information sources depends on how the past cost information is to be used. B. Information about number of employees and hours worked is found in the payroll accounting system.. assuming a linear cost function. could be used to identify costs for building and occupancy costs. Possible cost drivers include number of calls handled. prepaid insurance schedules.

.790 80. Similarly.800.2-40 Cost Management 2.036 68.736 67.310 70.800 .200 Apr 71. but there is insufficient information to make an adjustment.686 71.10.850 2 .376 65.150 73.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.4.350 68.750 . July’s result is an outlier and should be removed from the data. these are correctly handled.286 68. Operations in the month of July are not typical of the rest of the time period.596 73.83/mo. Because of the large difference between these values and the values in other months. No adjustments are needed for items (c) and (d). A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.236 69.wiley.wiley.8 x 6. the first month is adjusted even though it is not an actual cost: 4.750 + 4.500 38.200 +$2. 1/2 of August 5 payroll goes to July: 5.750 68. If these observations are included in the regression analysis. available on both the Instructor and Student web sites for the textbook (available at www.000 = 4. B.736 To predict future overhead. as shown in the scatter plot below.com/college/eldenburg).500 x 1/2 = 2. 80% of September 2 payroll to August: . Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.2. IP-14 3 Payroll paid every two weeks.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68.800 41. The miscellaneous supplies account also looks suspicious.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.750. A. the trend line is likely to distort costs.com/college/eldenburg). (rounded to $36) 2 Note IB-4's power added to Dept.486 68.300/10 x 12 = 35.

789722 t Stat 0.47 8 Standard Error 29406.79 * 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). D.310484 Intercept X Variable 1 Coefficient s 8777.050976 P-value 0.000 $40. Based on the variation in dates at which supplies are recorded. the cost function is estimated as: Overhead cost = $6.000 $60.000 6.000 2.641981 0. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 5. supplies were a large proportion of overhead cost.775388 0. Thus. Therefore.314163 1980.000 Overhead Costs $70.000 3.000 9.000 $50.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75. Monthly overhead costs for supplies may be significantly overstated or understated .298502 2. they are most likely recorded at the time of purchase rather than at the time of use.086126 Based on the t-statistic and p-value for the intercept.500 8. the fixed cost does not appear to be different from zero. According to the details provided for August and September.500 Outlier Direct Labor Hours C.818 6.26 3.412139 0.000 $45.000 $55.000 $65. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.

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

See Exhibit 2.17 for the pros and cons of each method. A measurement is relevant if the resulting cost function information helps decision makers choose between alternative courses of action. For example. whereas variable costs are often relevant. which typically involved creating a cost function for one or more individual costs. 1. two-point method. b. 2. and multiple regression (Appendix 2A). For example.Chapter 2: The Cost Function 2-43 BUILD YOUR PROFESSIONAL COMPETENCIES 2. Uncertainties prevent identification of single “correct” measurement methods. a cost function should distinguish between fixed and variable costs. the best choice of estimation technique. C. 4. A measurement is reliable if it if it is reasonably free from error and bias. whether past cost behaviors will continue in the future. and how to interpret computational results. 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. c. The costs and benefits of alternative measures should also be considered. sometimes the cost of obtaining a better measure exceeds the benefits. it is necessary to use judgment when choosing and applying measurement methods. Fixed costs are often irrelevant to decisions. . Suppose a cost function is measured for the purpose of estimating future costs. and they prevent complete accuracy in making accounting measurements. and reliable measure for estimating a cost function because of uncertainties about: data availability. analysis at the account level. relevant. how to categorize costs as fixed. If the cost is believed to be nonlinear. simple regression. A measurement is appropriate if it is suitable for the purpose.40 Focus on Professional Competency: Measurement A. It is also necessary to evaluate the quality of measurement results when using accounting information. A cost function estimated from past cost data may be unreliable if future operating activities are expected to occur in a different relevant range. Chapter 2 introduced the following measurement methods for estimating a cost function: Engineered estimate of cost. B. the main focus was on measuring costs for a cost object. Thus. high-low method. In Chapter 2. in Chapter 2 pointed out that a cost function is estimated within a relevant range of activity. When estimating a cost function: a. variable or mixed. then simple regression is inappropriate. for example. which factors drive variable costs. 3. It is often difficult to identify an appropriate.

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

957296 Standard Error 6710.194 + $13.wiley.6004687 Adjusted R Square 0.41 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. A.] 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.437E-24 1. Because of the annual pay increases. students are likely to struggle interpreting and choosing a method (Parts E and F). using monthly data for the prior 4 years. However. Considerable variation in labor costs is not explained by changes in the volume of production. The cost function is estimated as: Labor cost = $133.7995 Observations 48 Coefficient s 133194.96 x number of chairs produced However.678620854 Intercept X Variable 1 t Stat 19.04 13. the regression explains only about 59% of the variation in labor costs. the fixed cost and the variable cost per unit are each positive and statistically different from zero.3147402 P-value 3. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.5917832 Standard Error 6216. the degree of downward bias is higher for older data than for more recent data.609693 1. available on both the Instructor and Student web sites for the textbook (available at www.com/college/eldenburg).com/college/eldenburg). Also.wiley. . Here are the simple regression results: Regression Statistics Multiple R 0. In prior years. the cost function was estimated by regressing actual labor costs on number of chairs produced. B.02E-10 Based on the regression results.Chapter 2: The Cost Function 2-45 2.848277 8.7748991 R Square 0.

The fixed cost is nearly the same.09577 6.02)4 $196. the fixed cost and the variable cost per unit are each positive and statistically different from zero.864722 R Square 0.26499 6.274 Using the adjusted labor cost data.411 Observations 48 Coefficient s 107748. Here are the multiple regression results: Regression Statistics Multiple R 0. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.2-46 Cost Management C.93821 16.23 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. The cost function is estimated as: Labor cost = $133.54295 Standard Error 5689.486389 P-value 4. approximately 26% of the variation in labor costs is still unexplained.23439 Standard Error 5557.010513 1.74).869633 Adjusted R Square 0. which is reasonable given the increase in wage rates over time.35E-15 Based on the regression results. Nevertheless.736 + $16.390275 Intercept X Variable 1 t Stat 24.02 Adjusted Labor Cost $220.57E-23 2.932541 R Square 0.747745 Adjusted R Square 0.91E-08 .06236 11.533 x (1. this cost function would result in a higher estimate for future costs.00872 Intercept X Variable 1 X Variable 2 t Stat 18. Also.347 Calculation $203.492 1.311 200.533 Dec 20X4 196. here are the regression results: Regression Statistics Multiple R 0. D.863839 Standard Error 3742.05E-27 2.347 x 1. but the variable cost increased from $13.96 to $16.742261 Standard Error 5148.891 1.73E-20 5.905 Observations 48 Coefficient s 133736 16.23 per chair.67711 P-value 1.8 16.

On one hand. F. E. The cost function is estimated as: Labor cost = $107. Conversely. then this month’s labor costs will reflect a lower level of labor cost. then this month’s labor costs will reflect the higher level of labor cost. and the managers often delay laying off employees when volumes decline.749 + $16.26) is interpreted in a straight-forward way. The second slope coefficient requires more thought. Thus. On the other hand.Chapter 2: The Cost Function 2-47 Based on the regression results. However. it often takes time for the company to hire qualified new workers. and to decrease the number of workers when production volumes decrease. The first slope coefficient ($16. the fixed cost and the variable cost per unit for each cost driver are all positive and statistically different from zero.l6 for each chair produced during the month. As explained in the problem. 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. and they both have positive and statistically significant coefficients. In addition.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.54 for each chair produced during the prior month. the company’s policy is to increase the number of workers when production volumes increase. There is no one single answer to this question. each month’s labor costs are expected to increase by $16. If the prior month’s production was higher than this month’s production. and this regression explains more of the variation in labor costs (86%). there may be some lag between the time that production volumes change and labor costs change.26 x current month number of chairs produced + $6. each month’s labor costs are expected to increase by $6. if the prior month’s production was lower than this month’s production. According to the multiple regression results. . it could be argued that some other cost driver might do a better job of predicting future labor costs.

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