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)

2-2

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.

2.3

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2.5

2.6

Chapter 2: The Cost Function

2-3

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

2.10

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

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 administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. For the firm to make this cost direct for the personal returns cost object. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. In a service business such as this. Stepwise Linear. the CPA's time is the product being sold.000 $13.000 Total Cost $12.000 $8. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained.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. The time records that the tax partner maintains support this cost as a direct cost.000 $10. and Piecewise Linear Cost Functions A.13 Linear. CPAs do keep detailed time records.00*Q Graph of Cost Function $14.000 $9.000 + $8. the tax partner probably spends some time in non-billable activities. Of course. TC = $10. 2.000 $11. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.

000 Combining the fixed and variable costs to create the cost function: TC = $60.000 $30.000 = $60.000 3.000 2.2-6 Cost Management B.000)/(12. it is first necessary to estimate the cost function.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 Total cost at 12.000 TC = $35.000 $10.000 units = 10.00*Q.000 = F + $39*10.$450. TC = $25.000 4.000 * $44 = $528. for Q > 2.000/2.000 + $8.000 Total Cost $50.000) = $78.000 – 10.000 units = 12.00*Q.000 .000 F = $450.$390.000 Graph of Cost Function $80. for Q ≤ 2.000 $20.000 $40.000 + $8.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 $60.000 $0 0 1.000 . Convert the average costs to total costs for each production level: Total cost at 10.000 + $39*Q .000 Number of Units C. To estimate the costs at another production level.000 units: $450.000 * $45 = $450.000 $70.

000 $55.000 + $39*15.000/15.000 + $10.000 = $9.000 units: TC = $60.00) + $9. total cost is estimated as: TC = $5.500 2.$9.00*(Q-1. Inserting $10.000: TC = $50.00*Q.14 Piecewise Linear Cost Function A.000) TC = $50.000 TC = $51.000 = $60.Chapter 2: The Cost Function Estimated total cost at 15.000 For Q > 1. for Q < 1. TC = $50.000 = $645.000 + $585.000 $50.000 $70.000 + $9.000 in revenues into the cost function.000 + $9.000 $45.000 Estimated cost per unit = $645.500 2.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 + $10.000 1.000 + 45%*$10.00*Q 2-7 Graph of Cost Function $75.000 = $43 D.00*Q .000 $60.000 + (1.000 * $10.000 0 500 1.000 $65.

This cost function would provide reasonable estimates for Q ≤ 1.3219 Y = 4. If all of the data estimation points occurred when Q was > 1. then the cost function would appear to be: TC = $50.000 units. 3. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.3 and 2A.000 + $9. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.15 Tax Plus A.00*Q.3219 Y = 6 hours*2-0.000 units.00*Q. 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 units but would underestimate total cost for Q ≤ 1.000 units. This cost function would provide reasonable estimates for Q > 1.80/ln2) = −0.8 hours (average time for each of the next two returns) B. then the cost function would appear to be: TC = $51.4. If the data estimation points occurred across the two relevant ranges.000 + $10. the cost function mismeasurement depends on the values of Q. If all of the data estimation points occurred when Q was ≤ 1. There are three general situations: 1. 2.000 units but would overestimate total cost for Q > 1. then the cost function would be some mixture of the functions for the two relevant ranges. 2. Hours for two returns would be determined as follows. If the accountant did not detect that there were two different relevant ranges.2-8 Cost Management B.

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

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

they are more likely related to time on the boat than pounds of fish. Therefore. F. D. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). In the pizza shop. FB. as well as voluntary items such as health insurance and retirement benefits. B. or 50% of revenue Combining fixed and variable costs.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. The cost of rent is irrelevant because it will not change with either alternative. F or M Employee benefits occur in any business in which employees are hired. B. F.Chapter 2: The Cost Function 2-11 B. 2. F There would be no reason to incur fishing equipment costs in a pizza business. costs vary with dollars of revenue. In the fishing boat business. V Ingredients are used in making pizzas. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced.50.000 = 0. so they would tend to be fixed or mixed (see Item A above). Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. While hourly wages may be related to number of fish caught. the cost function is: TC = $3. In this type of situation. B. C. There most likely would not be any ingredients in a fishing boat business. . Benefits might include mandated items such as social security. In many organizations. Benefit costs often vary with level of wages or salaries. these costs would be mixed with a large proportion of the cost fixed. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. and unemployment insurance. PS. because of uncertainty in the success of each fishing expedition. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. workers’ compensation.500/$9. and the cost would vary with number of pizzas produced. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. employees are likely scheduled in advance on a fixed schedule.] A. D. Some may be sent home if business is very slow.300 + 50%*Total revenue C. V. E.

0233 0.79/150) 0.49/(16 x 4)] 0.1619 10. Cost of plain burger = $0. Mayonnaise [$1. B.1619) = $0.3489 (calculated above) B. Dill pickles [($8. Cheese ($2. they are treated as fixed costs. advertising costs would be incurred. B.2414 2. Hamburger patty ($1. Catsup ($.0053 8.0233 7.99/50) 0. Mustard ($.69/8) 0.1619 0.0863 0.000) * 4] 0.3489 $0.59/40) 0.0198 0.95/2.0053 0.56 . but it might be mixed if a portion of the cost relates to levels of business activity.0863 5. F or M Any type of business will have insurance costs. G. Tomato ($. 2.1075 0.5196 Suggested selling price: 300% * $0. For the fishing boat business.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 1.0179 4. and yellow pages advertisements.2414 $0.15/45) 0.0148 6.0198 9.5195 = $1. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop. Because advertising costs tend to be discretionary.0179 0.0033 0.6815 . It will be a fixed cost if it is a flat amount.$0. newspaper advertisements. Cost of burger with everything except cheese = ($0.2-12 Cost Management E.2414 $0.0148 0.1075 0.1075 3. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. the utility costs for these two businesses would tend to be fixed (would not vary with production). Hamburger bun ($1. depending on how the insurance cost is calculated. The cost might be fixed or mixed.0033 $0. PS. there might be some utility costs for the fishing operation and for a business office. however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship.6815 A. Onions ($. F Most pizza shops incur advertising costs such as flyers. In general.59/16) 0. If the fishing boat is for tourists. Lettuce ($.69/7) $0.29/12) 0. F.

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

com/college/eldenburg). it is possible that marketing costs are discretionary. C.com/college/eldenburg). the fixed cost is set at zero. Other Potential Cost Drivers A. Advertising – Fixed and discretionary 2.35*units sold. If this is the case. For example. available on both the Instructor and Student web sites for the textbook (available at www.) B. Therefore. Other possible cost drivers for marketing department costs could be revenue. number of advertisements placed. or profits. the cost is discretionary and will be set through the negotiating process. the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management. 2. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero. The cost analyst needs to gather information about how marketing costs are set each year. In addition. the variation in units sold explains about 61% of the variation in marketing department cost.22 Cost Function Using Regression. .2-14 Cost Management K. TC = $222. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold.wiley.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.] The data for this problem can be found on the datasets file for chapter 2. In this problem.

500 $1.113687834 Intercept Output t Stat 5. Potential Cost Driver: Output Maintenance Costs Against Output $2.000514 .4342166 0.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.582691 P-value 6.52099624 Standard Error 153.119724 15 Coefficient s 884.61765897 0.58824812 182.500 Maintenance Costs $2.026826 0.761602 4.Chapter 2: The Cost Function 2-15 A.000 $1.78591283 0.58E-05 0.

457384 3.36224828 0.7549386 1.717372 P-value 0.005847 0.113464425 Intercept Direct Labor Hours t Stat 3.60187065 0.500 $1.02569657 Standard Error 261.017601 .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 0.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.210849 15 Coefficient s 861.000 $1.500 Maintenance Costs $2.31319046 235.291084 2.

machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. . all three potential cost drivers appear to be positively related to maintenance costs.5343 P-value 0.42597461 1. If the observations are widely scattered.000 $1.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2. In a scatter plot. This indicates that the cost could be totally variable. a good cost driver would present a linear or football-shaped positive slope or trend.6778973 0.5913391 15 Standard Error 93.357393 15.500 Maintenance Costs $2.815737 29. For example.94495003 66.500 $1. In Part A. or the cost is mostly fixed.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 126.910475729 Intercept Machine Setups t Stat 1. Sometimes a cost that is mostly variable can be identified from a scatter plot.197755 8.97410583 0. the trend line for machine setups looks as if the intercept could be zero or very close to zero.94888217 0. However.96E-10 B. the cost driver does not explain the variation in cost and either it is the wrong driver.

the cost is likely to be totally variable. In the machine setups regression. business processes.945. This means that variation in setups explains about 95% of the variation in cost.945 Cost Function TC = $884 + $0.2-18 Cost Management C. 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. so it is excluded from the cost function. 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. the economic environment.313 0. Changes in many factors such as resource prices. the t-statistic is significant for the independent variable but not for the intercept. . R-Square 0. E. Therefore.68* Machine Setups The machine setups intercept coefficient is not significant. This provides confidence that the variable cost part of the cost function is not zero. D.588 0.521*Output TC = $861 +$3.025*Direct Labor Hours TC = $29. The regression using machine setups has the highest adjusted R-Square of 0. and technology can cause future costs to be different than estimated.

000/$500. . Therefore.132.Chapter 2: The Cost Function 2-19 PROBLEMS 2.728 Thus. which could be outliers.$56. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.000 = 0.333 = F + 5%*$1.132. on average. That means that the cost function might not represent the actual cost. not represent the cost most of the time. The high low method uses the most extreme cost driver values.100 F = $68. the variable cost is calculated: ($68. this cost function might provide poor estimates of future costs. the total cost function is: TC = $11.100) = $25.333 – $43.333 .728 + 5%*Sales B.100 – $632.05. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.605 = $11. the cost function is calculated using the highest and lowest values of the cost driver.333)/($1. First. Under the high-low method. that is.24 Big Jack Burgers A.

In that case.000 $600.5% x sales. Based on the p-value. the p-value result for the tstatistic is atypical. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. analysis at the account level might indicate that there are few fixed costs.172. fixed costs are likely to be zero and would be excluded from the cost function. Alternatively. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. Because this regression has few observations. the cost function would be: TC = 4.000 $20.000 Sales It appears that the cost is most likely mixed. etc). Then.000 $0 $0 $300.000 $1. D.200. Following is the regression output. there is a 16% probability that the intercept (fixed cost) is not different from zero.5% x sales . Chart of data with trend line added by Excel.800 + 4. Then.162.000 $900. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.000 $40. If this cost pool includes items such as salaries and other fixed costs (insurance. the regression intercept can be used as an estimate of the fixed costs.000 Administrative Costs $60. Notice that the t-statistic for the intercept coefficient is 2.2-20 Cost Management C. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. the cost function would be TC = $16. Analysis at the account level can be used to increase the understanding of this cost. but the p-value is greater than 10% at 0. The upward slope of the line indicates that there are variable costs.

73545 0. both of these methods assume that the data points are representative of future costs. Therefore. a cost function may not provide a good estimate for the next month’s costs. There might be a large discretionary component in administrative costs.4038 4 Coefficients Standard Error 16800. there does appear to be a general upward trend. 2. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver.82%*Sales C. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.365 + 0. The past costs used for estimation might not be representative.00818212 t Stat 2.93711636 0. . the high-low method may be the best option available. Using the regression results. Because of unforeseen changes in cost behavior. The cons of the high-low method as an estimation technique were discussed in Part B above.9680477 0. This means that variation in sales explains only about 18% of the variation in research and development cost. Both methods assume that the cost function is linear and that all data points come from a single relevant range. This method can be used in cases where there is not enough data to perform regression. The plot shows costs that are widely scattered.17205158 5. If these assumptions do not hold. If there are only two or three data points. The adjusted R-Square statistic is very low at 0. then both methods may be unsuitable for estimating future costs.0319523 Intercept X Variable 1 E.04466925 0. Sales does not appear to explain much of the variation in research and development costs. Unusual cost items are assumed to continue in the future.25 Scatter Plot.16197623 0. F. and possible changes in costs such as those described in Part E are ignored. however. Cost Function Using Regression A. the cost function is: TC = $50. regression analysis incorporates all of the observations into the analysis.186. especially because so few observations were used in the estimation.90567454 3293. If there are more data points. However. on average.45937486 P-value 0. In addition. Sales might not be the activity that drives administrative costs. There might be a change in business operations or in the economy that would cause future costs to be different than in the past.2444 7734. the results rely on more complete information and provide a better estimate. B.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. causing fluctuations in cost that are unrelated to any cost driver.

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

05 $0.27 Fancy Furniture A.90/ln2) = −0. students may think of others. so Susan may need to maintain her own records if she wishes to trace telephone usage.00 $20. It is possible that the managers under. If her calls are over 400 minutes or under 600 minutes.00 $20. 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. Here are some of the reasons. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0.04 $0.00 $20.00 + (700-500)*$0. Minutes 300 400 500 600 700 Total Cost $20.1 hours (average time for the first four batches) B. Cons • If Susan has a number of projects in her local area or will be traveling a lot. In most businesses. 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.152 Y = 10 hours*4-0.00 + (600-500)*$0. she will pay a very high rate of 10 cents per minute 2. her phone bill will be less than it would be at a rate 5 cents per minute.Chapter 2: The Cost Function 2-23 consulting jobs.05 $0. In .057 The average cost is lowest at exactly 500 minutes per month.or overestimated the amount of hand work performed.067 $0. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). Many cellular telephone bills do not list the calls made. There are many different reasons that the time could be different from the amount determined above.152 Y = 8.10 = $40.00 $20. I.10 = $30.00 Average Cost $0. In this case the learning rate would be wrong and so the time would also be wrong. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. telephone costs are viewed as an indirect cost. Hours per batch would be determined as follows.

000 Profit = Revenues – Total costs = $80. Because revenue is the cost driver for both variable costs. the rate will change if the replacement employee has never worked on this machine.500 $47. then the cost would be overestimated. The estimate of total costs given revenues of $80. C.40. and B. 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.500 10.000 = $1.000 using the cost function is: TC = $47.000 5. and the University surcharge is specifically based on sales.28 Wildcat Lair A. If a worker is absent one day. or 40% or revenue Combining fixed and variable costs. then the chart suggests that the learning rate estimate is reasonable.000 = $79.000 Variable $21.000 7.000/$70. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. if managers believe that more than 25% of the work is done by hand. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized. then this chart suggests that the learning curve will be slower than the 90% estimate.000 .000 _______ $28.000 + 40%*Total revenue D. they would be higher than the labor costs in later periods. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. the cost function is: TC = $47.$79. 2.000 1. Food costs are likely to vary proportionately with sales. D. Thus.000 = 0.000 Total revenue is the most likely cost driver for both variable costs. if managers believe that 25% of the work is done by hand.000 .2-24 Cost Management addition. it is possible that different types of wood affect the rate at which chairs can be produced. If these values are used in a regression to estimate a cost function. or has a great deal of experience on the machine.000 + 40%*80. C. However.

000 increase in revenues is expected to be $6. if the bathing suit shop is located in a geographic region $80. Electricity costs also vary with changes in electricity rates.000) $ 9. So. total variable costs are expected to increase by $4. C. During the spring and summer months. In a retail business. However.000/$70. F.) The adjusted cost function is: TC = $47.000). the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. the shop might experience very little business activity. costs would be higher when there were fewer sales. Because the university surcharge is an allocation within the university. Lair’s fixed costs are assumed to be unchanged with the $10. Thus. To estimate the opportunity cost for August. the variable cost part of the cost function can be adjusted. and the increase is estimated to be 40% of the increase in revenues. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. Item D will be VERY difficult for most students. but this is not considered a cost driver (a business activity that causes variations in total variable cost).$4.000 (47.000 increase in revenues. so the estimated profit in August is $1.] A.Chapter 2: The Cost Function 2-25 E. 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. In July there was a loss of $5. for July the opportunity cost would have been $2. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning). so the trend would be the opposite of this plot.000)+the university surcharge of $7.29 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*40%). If the university were to close the Lair.000) (24. Variable food costs are estimated to be 30% ($21.000 ($10. it would lose the revenues.000— the operating loss of $(5. the additional profit from a $10. Only total variable costs are expected to increase. it might even close when the ski area shuts down. less the fixed costs and the variable food costs. generating most its sales around the ski season (fall and winter).000 ($10.000 (-$5.000+$6.000) Net 2.000) of revenues.000. 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).000 + 30%*Total revenue During August.000 . The shop is most likely a seasonal business.000 . So. B.000.000).

028.542.45 x 1. special promotions.028. they are discretionary expenditures and not caused by the level of activity.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.69 (average cost for each of the 5 units) Total cost = $205.67 1.2345 Y = $205. D.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows.2345 Y = $300*5-0.45 Although each customer paid a different price.5 = $152.89 x 1.2345 Y = $101. Many costs can be related to volume of activity.69 x 5 = $1. generally mean there is more money available to spend on administrative travel. 2.84 . a 50% markup on total cost will cause sales to be: $1.22 Firm B set its selling price based on the average cost. higher profits generally occur during periods when activity is high. However.50 = $1. then the highest sales might coincide with the highest electricity costs.45 $ 514. employee training.028. and new office furniture or equipment. in turn. Although these expenditures are made because more money is available. A correlation may appear in a scatter plot or regression analysis. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0. correlation does not necessarily mean causation. given a 100 unit production level: Y = α Xr Y = $300*100-0. For example.67 Firm A's income for last year was: Sales Costs Income $1.85/ln2) = 0. firm B's selling price is: $101. Higher profits.542.

85 Thus Firm B's selling price this year was $64.528.75) 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 = $9.50/150 units = $64.028.50 = $97.00 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 $1.926.727.00 13.356.356.50 $ 9. assuming an 85% learning effect would be: Y = $300*150-0.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.10 $ 172.028.55 1. Total cumulative production cost (300 x $78.65) Income Firm A's revenues for this year are: (10 x $152.10 $22.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.40 1.50 .727.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.2345 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.30 $2.2345 (notice that the cumulative units produced is 15) Y = $158.84) = $1.40 Firm A's costs may be computed as follows: Y = $300*15-0.2345 Y = $92.84) Costs (150 x $ 92.897.50 $ 9.897.28 $23.625.384.Chapter 2: The Cost Function 2-27 Firm B's costs.528.85 x 1.

592.864. Scatter Plot of Marketing Costs Against Sales $175.50 Note that Firm B's selling price for this year of $97.61. Costs $165.00 9.wiley.com/college/eldenburg). Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.000 $155.85) Income $14.50 $ 4.10/10 = $135.500. such extreme differences in cost can occur.28) Costs (150 x $64.000 $6.500. There is a positive slope.000 $5.28 is lower than Firm A's average cost per unit: $1.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000 $145.com/college/eldenburg). available on both the Instructor and Student web sites for the textbook (available at www. .500. 2.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97. and most of the observations appear to have a fairly linear trend.000 $7.500.000 Sales B.000 Marketing Dept.000 $135. A.wiley.000 $8.356. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.727. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.

the cost function is: TC = $65. the decision maker(s) should be asked what next year’s cost will be.58184484 13. Assuming that profits are more likely to increase when sales increase. When more money is spent on marketing.08144 Observations 30 Coefficients 65584.5289E-14 Intercept X Variable 1 Based on the regression results.34%*Sales D. discretionary costs such as marketing are often increased when profits increase.00097028 t Stat 9.4501E-10 5.63816 0. there would be a positive correlation between marketing department costs and sales. Here is the regression output. E. usually annually. the cost estimate should not be based on past costs. F.93336396 R Square 0.7600071 P-value 2.2608 0. Discretionary costs are set by decision. using regression or any other technique. In addition. Instead.584 + 1. If the variable portion of the marketing cost is sales commissions. .Chapter 2: The Cost Function 2-29 C. sales may go up. Therefore. they may be positively correlated with sales. it is economically plausible for sales to be a cost driver.87116829 Adjusted R Square 0. Regression Statistics Multiple R 0.86656716 Standard Error 4015.01335108 Standard Error 6844. Even if marketing department costs are discretionary.

32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.com/college/eldenburg).000 $120.000 $40. A.com/college/eldenburg).000 $120.000 $160.2-30 Cost Management 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $40.wiley. available on both the Instructor and Student web sites for the textbook (available at www. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $80.000 $160.wiley.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.000 $80.

01272369 Adjusted R Square -0.1543 0. the cost driver does not explain the variation in cost.000 $0 0 100 200 300 400 500 600 700 Raw Materials B. C. labor hours could be deleted as a potential cost driver. Sometimes a cost that is mostly variable. D. Based only on the cost plots.000 $80. either the driver is wrong or the cost is mostly fixed. If the observations are widely scattered.552864 . Labor Hours Regression: Regression Statistics Multiple R 0.56597156 30 Standard Error 14812.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.000 $40.11279932 R Square 0.50852 7.682 4. None of the plots show a definite trend.02253618 Standard Error 11114. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. The plots help determine whether regression analysis should be performed using any of the potential drivers.600936029 Intercept Labor Hours t Stat 10.8173 Observations Coefficient s 150410.86E-11 0.000 $120.000 $160.600712 P-value 6. Costs and potential cost driver data are plotted to determine whether further analysis is necessary. but the plot for labor hours appears to have the least trend.

11E-12 0.217192 Standard Error 10291.62907 3.1555 Observations 30 Coefficient s 117598.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.9786 Observations 30 Coefficient s 126216.411 Machine Hours Regression: Regression Statistics Multiple R 0.91 60.331580777 Intercept Machine Hours t Stat 11.68E-12 0. so the cost function is estimated as: TC = $126.082222 P-value 3.2266685 Standard Error 9665.56778 19.095468 P-value 4.22* Raw materials .67 38.2533351 Adjusted R Square 0.004579 Both the intercept and slope coefficients are significant.3746211 Adjusted R Square 0.000325 Both the intercept and slope coefficients are significant.53627459 Intercept Raw Materials t Stat 11. so the cost function is estimated as: TC = $117.2-32 Cost Management Only the intercept term is significantly different from zero.599 + $38.47803 9.612063 R Square 0. so the cost function is estimated as: TC = $150.5033241 R Square 0.217 + $60.3522862 Standard Error 8846.4268 4.215128 Standard Error 10853.

A. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0. machine hours appears to do the best job of explaining manufacturing overhead costs. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.489 -0.com/college/eldenburg). available on both the Instructor and Student web sites for the textbook (available at www.886218 -0.wiley.778501 82.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.Chapter 2: The Cost Function 2-33 E.976635 Standard Error 10361. Yes.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.3E-06 0.12E-09 1. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). however. 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.291558412 10.5558 Observations 30 Coefficient s 60988.wiley.210187 P-value 3.2349 3.08E-08 . F.8067018 Standard Error 4832.05878 9. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.9092294 R Square 0.953575 1.com/college/eldenburg). this driver explains only 35% of the variation in cost.226 Based on the simple regression results.8266982 Adjusted R Square 0.352 0.333162437 5. The coefficients for each of the other potential cost drivers are significantly different from zero.218173 8.1959303 48.

R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.881964042 Intercept Machine Hours Raw Materials t Stat 6. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0. labor hours can be eliminated as a potential cost driver.022 0. Each task includes different activities. In this example. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.81383627 Standard Error 4742. Costs for these activities are likely related to specific cost drivers.82667515 Adjusted R Square 0.5348 Observations Coefficient s 60677.678 + $48.71E-10 5. its coefficient is not significantly different from zero in either regression. machine hours and raw materials explain different activity .226 0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.450561 8.226) for these two cost drivers.74*Machine hours + $82.391636 P-value 1.411 (<0.664851 5.22 (<0.29E-09 The cost function is: TC = $60.005) $82.157604083 9.599 (<0.001) $126.988 (<0.939606 9.001) $117.217 (<0. Manufacturing can be a complex activity requiring a number of different tasks.78 (<0.93*Raw materials D.7422519 82.001) B. Thus.001) $-0.20 (0.5902 48.806) than in either of the simple regressions (0.55) $38. The adjusted RSquare is far higher in the multiple regression (0. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.001) $4.352 and 0. Also. C.98 (<0.352 0.22 (0.90921678 R Square 0.001) $60.806 $150.2-34 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.954) $48. its coefficient is negative rather than positive in the multiple regression.001) $60.86E-07 4.57 (0.925842 30 Standard Error 8743.

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

wiley.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. Dept.000 $5.000 $15.000 $10. square feet cleaned. number of hours students attend school.com/college/eldenburg). I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.wiley. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $20. Dept. Costs $25.2-36 Cost Management 2. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.com/college/eldenburg).000 $5.000 $15. number of hours the building is open.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint.000 $0 528 530 532 534 536 538 540 542 Number of Students C. or number of classes and activities per period.000 $10. . A. B. Costs $25. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. Other cost drivers for total maintenance cost could be number of rooms cleaned.000 $20.

and rent for this type of facility is usually fixed.03271 Standard Error 3019. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0. it is logical to expect a strong relation between hours worked and cost.453062 P-value 2.68624 0. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.796328319 Intercept X Variable 1 Coefficients 9134.135 + $35.832184392 Standard Error 1217.63E-06 2. The p-values on the Tstatistics are very small.5045837 4. 2.Chapter 2: The Cost Function 2-37 D.36 The Elder Clinic A and B Salaries are always fixed.06772 Observations 12 Standard Error 965.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.508157 0. providing high confidence that both the intercept and slope are different from zero.0261 Standard Error 130954.061172 Adjusted R Square -0.0857 Intercept X Variable 1 t Stat -0. Therefore.461245 7. Utilities cost varies with season not visits.247329 R Square 0. The total cost function is: TC = $9.807201 P-value 0.920565237 R Square 0.173 Observations 12 Coefficient s -89867 197. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.847440356 Adjusted R Square 0.9 244. 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. From the analyses performed.74*maintenance hours worked. it is considered fixed. The most current value is used to . However.74733262 t Stat 9. E. maintenance hours is a reasonable cost driver.438328 According to the R Square statistics.875134 35. An unidentified cost driver could have a higher R-Square.

441. such as snake anti-venom. new equipment is acquired. Given the preceding computations and cost summary. .100 226 664 $19.07*patient-visits C.736 Variable $3. affecting the number of visits at this clinic. high point of medical supplies cost and patient data.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future.412 1.736 + $6. There is no one answer to this part. the cost function is: TC = $19. but not proportionately.80 D. Medical supplies vary with number of patient-visits. Visits are affected by season. and costs go up as patient-visits increase. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14.736 + $6.182 . and so on. Some supplies. and so on.49 Cost Driver Patient-visits Mixed X 2. Also.182 = F + $3.$2.wiley.115 219 3.49*849. **Using high-low. must be kept on hand whether or not they are used. At 940 patient-visits. Here are some of the reasons: • The managers will not know how many visits they will receive.2-38 Cost Management predict next period’s utilities. • Prices of all inputs could change (usually increase).com/college/eldenburg). such as tongue depressors. Other expenses appear to increase and decrease with number of patientvisits. or there are changes in treatment procedures for certain illnesses. These would be fixed.934)/(849 – 778). 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. There are many possible reasons that could be listed. each patient requires a certain number of supplies. gloves. E.07*940 = $25. medical supplies is a mixed cost. Use the same method for other expenses.49 ($3. other facilities may open or close. Use March. July expenses are estimated to be: TC = $19. so this cost is classified as a mixed cost. These would be variable. • Treatments and related costs may change as new drugs are available. current illnesses that are circulating in the area. Therefore. This analysis suggests that there are some of the other expenses are variable costs and some fixed. weather.58 $6. variable cost is $3. to find fixed: $3.

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

500 x 1/2 = 2.750.790 80.000 = 4.350 68. If these observations are included in the regression analysis.200 +$2.200 Apr 71. Because of the large difference between these values and the values in other months. the first month is adjusted even though it is not an actual cost: 4. but there is insufficient information to make an adjustment.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.2-40 Cost Management 2.750 68. the trend line is likely to distort costs.4.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.800.500 38. IP-14 3 Payroll paid every two weeks.736 To predict future overhead.wiley.750 .596 73.236 69. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. these are correctly handled. Similarly. A.736 67.800 .10. 80% of September 2 payroll to August: .com/college/eldenburg).850 2 .300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68. as shown in the scatter plot below.036 68.310 70. The miscellaneous supplies account also looks suspicious. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.8 x 6. (rounded to $36) 2 Note IB-4's power added to Dept. Operations in the month of July are not typical of the rest of the time period. July’s result is an outlier and should be removed from the data.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.150 73. 1/2 of August 5 payroll goes to July: 5. available on both the Instructor and Student web sites for the textbook (available at www.800 41.300/10 x 12 = 35.376 65.com/college/eldenburg).286 68. .83/mo. B.750 + 4.486 68.2. No adjustments are needed for items (c) and (d).686 71.wiley.

considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.050976 P-value 0.000 9.818 6.000 $55.500 5.500 8.000 6. According to the details provided for August and September.000 $65. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 3.47 8 Standard Error 29406. D. the fixed cost does not appear to be different from zero.000 $60.500 Outlier Direct Labor Hours C.000 Overhead Costs $70. Therefore.412139 0. Monthly overhead costs for supplies may be significantly overstated or understated . Thus.310484 Intercept X Variable 1 Coefficient s 8777. Based on the variation in dates at which supplies are recorded.000 $40.641981 0.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75. they are most likely recorded at the time of purchase rather than at the time of use. supplies were a large proportion of overhead cost.775388 0. the cost function is estimated as: Overhead cost = $6.26 3.000 $50.79 * 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).314163 1980.298502 2.789722 t Stat 0.000 2.086126 Based on the t-statistic and p-value for the intercept.000 $45.

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

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

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

available on both the Instructor and Student web sites for the textbook (available at www.678620854 Intercept X Variable 1 t Stat 19. the regression explains only about 59% of the variation in labor costs.194 + $13. the fixed cost and the variable cost per unit are each positive and statistically different from zero. A.96 x number of chairs produced However. 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. B. In prior years.Chapter 2: The Cost Function 2-45 2.] The data for this problem can be found on the datasets file for chapter 2. the cost function was estimated by regressing actual labor costs on number of chairs produced.7995 Observations 48 Coefficient s 133194.wiley. using monthly data for the prior 4 years.3147402 P-value 3.02E-10 Based on the regression results. Because of the annual pay increases. Here are the simple regression results: Regression Statistics Multiple R 0. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.com/college/eldenburg).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. The cost function is estimated as: Labor cost = $133. However.5917832 Standard Error 6216.com/college/eldenburg). students are likely to struggle interpreting and choosing a method (Parts E and F).wiley. . the degree of downward bias is higher for older data than for more recent data.957296 Standard Error 6710.609693 1.7748991 R Square 0. Considerable variation in labor costs is not explained by changes in the volume of production.6004687 Adjusted R Square 0.04 13. Also.848277 8.

932541 R Square 0.347 Calculation $203.864722 R Square 0. this cost function would result in a higher estimate for future costs.23 per chair.010513 1. here are the regression results: Regression Statistics Multiple R 0. Nevertheless. The fixed cost is nearly the same.00872 Intercept X Variable 1 X Variable 2 t Stat 18.311 200.09577 6.02 Adjusted Labor Cost $220.863839 Standard Error 3742.736 + $16.747745 Adjusted R Square 0.8 16.93821 16. approximately 26% of the variation in labor costs is still unexplained.274 Using the adjusted labor cost data. Here are the multiple regression results: Regression Statistics Multiple R 0.02)4 $196.26499 6.91E-08 .905 Observations 48 Coefficient s 133736 16. D.486389 P-value 4. but the variable cost increased from $13.54295 Standard Error 5689.23439 Standard Error 5557.35E-15 Based on the regression results.05E-27 2. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.67711 P-value 1. which is reasonable given the increase in wage rates over time.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 = $133.492 1.96 to $16.533 Dec 20X4 196.742261 Standard Error 5148.2-46 Cost Management C.891 1.347 x 1.411 Observations 48 Coefficient s 107748.06236 11. the fixed cost and the variable cost per unit are each positive and statistically different from zero. Also.869633 Adjusted R Square 0.74).390275 Intercept X Variable 1 t Stat 24.533 x (1.73E-20 5.57E-23 2.

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

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