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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

2.4

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.

2.8

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

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 tax partner probably spends some time in non-billable activities. CPAs do keep detailed time records.000 $11. and Piecewise Linear Cost Functions A. TC = $10. In a service business such as this. For the firm to make this cost direct for the personal returns cost object.000 + $8. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.000 Total Cost $12.000 $9. The time records that the tax partner maintains support this cost as a direct cost.000 $10. 2.000 $8.000 $13. Of course. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. the CPA's time is the product being sold. Stepwise Linear.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 .13 Linear.00*Q Graph of Cost Function $14.

for Q ≤ 2. TC = $25.000 Number of Units C.000 .000)/(12.$390.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 units: $450.000 .000 * $45 = $450.00*Q.000 $60.2-6 Cost Management B.000 4.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 TC = $35.000 * $44 = $528.000 – 10.000 = F + $39*10. Convert the average costs to total costs for each production level: Total cost at 10.000 Total cost at 12.000/2.000 + $39*Q .00*Q. for Q > 2.000 Total Cost $50.000 = $60.000 $40.000 units = 10.000 + $8. To estimate the costs at another production level.000 2.000 Graph of Cost Function $80.$450.000 + $8.000 $10. it is first necessary to estimate the cost function.000) = $78.000 $70.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 $0 0 1.000 F = $450.000 $20.000 3.000 $30.000 units = 12.

000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .500 2.000 1. total cost is estimated as: TC = $5. Inserting $10.000 = $9.00*(Q-1.00) + $9.000 For Q > 1.000 = $43 D.000 $55.00*Q .000 + $9.000/15.000 units: TC = $60.000: TC = $50. TC = $50.000 TC = $51.000 + $39*15.000 Estimated cost per unit = $645.$9.500 2.000 0 500 1.000 + (1.000 + 45%*$10.000 + $10.000 + $9.000 $65.000 + $10.Chapter 2: The Cost Function Estimated total cost at 15.00*Q 2-7 Graph of Cost Function $75.000 $45.000 = $645.000) TC = $50.000 + $585.000 = $60.000 $50.000 in revenues into the cost function.14 Piecewise Linear Cost Function A.000 * $10.000 $70.000 $60.00*Q. for Q < 1.

using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.000 units but would underestimate total cost for Q ≤ 1.80/ln2) = −0.2-8 Cost Management B.8 hours (average time for each of the next two returns) B. 2.00*Q. There are three general situations: 1.3219 Y = 4. 2. This cost function would provide reasonable estimates for Q ≤ 1.000 units.000 units. then the cost function would appear to be: TC = $51. the cost function mismeasurement depends on the values of 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 . If the data estimation points occurred across the two relevant ranges.3219 Y = 6 hours*2-0. 3. then the cost function would appear to be: TC = $50.000 + $9.00*Q.3 and 2A.000 units but would overestimate total cost for Q > 1.15 Tax Plus A. then the cost function would be some mixture of the functions for the two relevant ranges.4. This cost function would provide reasonable estimates for Q > 1. If all of the data estimation points occurred when Q was ≤ 1.000 + $10.000 units. If all of the data estimation points occurred when Q was > 1.000 units. If the accountant did not detect that there were two different relevant ranges. Hours for two returns would be determined as follows.

000 + 25%*Total sales B.000 on total sales of $32. making it a fixed cost.000 = 0. Assuming that the cost of clay can be traced to each bowl.16 Bison Sandwiches A. In addition. if time is not traced to individual bowls (for example. 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. B. D or I. it is a common cost of production for all of the bowls that are heat-treated in the kiln.000. and variable costs remain constant within the relevant range. 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. F . I. 2. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. as their performance improves. or 25% of sales Combining fixed and variable costs. the cost function is: TC = $20. then wages would be an indirect cost. 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).Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. and their productivity rate will remain stable. F Assuming that employee time can be traced to each bowl.] A. Eventually their learning will plateau. that is.25. Note: Depreciation using a method such as declining balance is not constant over time. V C. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). 2. If total variable costs were $8.000/$32.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. it improves less quickly for the next return. Assumptions: Fixed costs remain fixed within the relevant range. this particular cost function assumes that variable costs are driven by sales. Total clay cost will vary with the number of bowls made. it is a direct cost. wages are a direct cost. but would still be considered fixed because it does not vary with production volume. D. However. their productivity increases. However.

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

] A. In the fishing boat business. While hourly wages may be related to number of fish caught. costs vary with dollars of revenue. . Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. and unemployment insurance. Therefore. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. C. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). There most likely would not be any ingredients in a fishing boat business. 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. they are more likely related to time on the boat than pounds of fish. 2. because of uncertainty in the success of each fishing expedition. B. F There would be no reason to incur fishing equipment costs in a pizza business.000 = 0. In this type of situation. D. FB. V. the cost function is: TC = $3. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. V Ingredients are used in making pizzas. Benefits might include mandated items such as social security. E. B. and the cost would vary with number of pizzas produced. In the pizza shop. The cost of rent is irrelevant because it will not change with either alternative. employees are likely scheduled in advance on a fixed schedule. F or M Employee benefits occur in any business in which employees are hired.Chapter 2: The Cost Function 2-11 B. D.50.500/$9. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior.300 + 50%*Total revenue C. PS. or 50% of revenue Combining fixed and variable costs. Benefit costs often vary with level of wages or salaries. F. as well as voluntary items such as health insurance and retirement benefits. In many organizations. these costs would be mixed with a large proportion of the cost fixed. workers’ compensation. F. Some may be sent home if business is very slow. B.

Lettuce ($. F.3489 $0. Cost of plain burger = $0. B. depending on how the insurance cost is calculated.59/40) 0.2-12 Cost Management E.0863 0.69/8) 0.95/2.2414 $0. G. In general.1075 3. but it might be mixed if a portion of the cost relates to levels of business activity.000) * 4] 0.56 .0863 5. If the fishing boat is for tourists. Mustard ($.0148 6.49/(16 x 4)] 0. newspaper advertisements. Cost of burger with everything except cheese = ($0. Tomato ($.0233 0. Because advertising costs tend to be discretionary. 2.0179 0.0033 $0.3489 (calculated above) B. F or M Any type of business will have insurance costs.0198 0. Cheese ($2.5196 Suggested selling price: 300% * $0. the utility costs for these two businesses would tend to be fixed (would not vary with production).29/12) 0. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.0033 0.2414 2. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop. they are treated as fixed costs. F Most pizza shops incur advertising costs such as flyers.59/16) 0. Dill pickles [($8. advertising costs would be incurred.79/150) 0.2414 $0.20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1.5195 = $1. Hamburger patty ($1.0053 0.0198 9.1619) = $0.1619 0.6815 A.$0.0053 8.69/7) $0. B.99/50) 0. and yellow pages advertisements. Hamburger bun ($1. Catsup ($. PS. The cost might be fixed or mixed. there might be some utility costs for the fishing operation and for a business office.1619 10. For the fishing boat business.0148 0.15/45) 0.0233 7. It will be a fixed cost if it is a flat amount.1075 0.0179 4.1075 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. Onions ($.6815 . Mayonnaise [$1.

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

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

78591283 0. Potential Cost Driver: Output Maintenance Costs Against Output $2.500 $1.582691 P-value 6.58824812 182.761602 4.Chapter 2: The Cost Function 2-15 A.61765897 0.113687834 Intercept Output t Stat 5.4342166 0.58E-05 0.000514 .52099624 Standard Error 153.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.119724 15 Coefficient s 884.000 $1.026826 0.500 Maintenance Costs $2.

02569657 Standard Error 261.36224828 0.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.000 $500 $0 0 50 100 150 200 250 300 350 Direct Labor Hours Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 $1.60187065 0.291084 2.500 Maintenance Costs $2.005847 0.717372 P-value 0.500 $1.210849 15 Coefficient s 861.113464425 Intercept Direct Labor Hours t Stat 3.457384 3.017601 .7549386 1.31319046 235.

the trend line for machine setups looks as if the intercept could be zero or very close to zero. In a scatter plot.197755 8. However.96E-10 B.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2.910475729 Intercept Machine Setups t Stat 1.815737 29.500 $1.94888217 0. the cost driver does not explain the variation in cost and either it is the wrong driver.5343 P-value 0.97410583 0.94495003 66. If the observations are widely scattered. Sometimes a cost that is mostly variable can be identified from a scatter plot.500 Maintenance Costs $2. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver.42597461 1. In Part A. . This indicates that the cost could be totally variable. all three potential cost drivers appear to be positively related to maintenance costs. a good cost driver would present a linear or football-shaped positive slope or trend.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 126.6778973 0. For example.5913391 15 Standard Error 93. or the cost is mostly fixed.000 $1.357393 15.

but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. the cost is likely to be totally variable. the t-statistic is significant for the independent variable but not for the intercept. business processes.025*Direct Labor Hours TC = $29. D. This means that variation in setups explains about 95% of the variation in cost. and technology can cause future costs to be different than estimated. R-Square 0. The regression using machine setups has the highest adjusted R-Square of 0. Changes in many factors such as resource prices.945 Cost Function TC = $884 + $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.588 0. This provides confidence that the variable cost part of the cost function is not zero.521*Output TC = $861 +$3. the economic environment. In the machine setups regression.313 0. so it is excluded from the cost function. .68* Machine Setups The machine setups intercept coefficient is not significant. E. Therefore.945.2-18 Cost Management C. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj.

Under the high-low method.100 – $632.05.132.000 = 0.000/$500.100) = $25. on average.24 Big Jack Burgers A.100 F = $68.$56.605 = $11. that is. That means that the cost function might not represent the actual cost. which could be outliers. not represent the cost most of the time. .Chapter 2: The Cost Function 2-19 PROBLEMS 2. The high low method uses the most extreme cost driver values.333 = F + 5%*$1.132.728 Thus. the cost function is calculated using the highest and lowest values of the cost driver. First. the total cost function is: TC = $11.728 + 5%*Sales B. this cost function might provide poor estimates of future costs. the variable cost is calculated: ($68.333 – $43. Therefore. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.333 . Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.333)/($1.

the p-value result for the tstatistic is atypical. Notice that the t-statistic for the intercept coefficient is 2. Chart of data with trend line added by Excel. In that case.000 $0 $0 $300.162. Analysis at the account level can be used to increase the understanding of this cost. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.000 Administrative Costs $60. Because this regression has few observations. Following is the regression output. analysis at the account level might indicate that there are few fixed costs. Alternatively.000 $1. the cost function would be: TC = 4.000 $20.2-20 Cost Management C. the cost function would be TC = $16. but the p-value is greater than 10% at 0. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.5% x sales . D. Based on the p-value. Then. If this cost pool includes items such as salaries and other fixed costs (insurance.200.000 $40.800 + 4.172. etc). Then.000 $600.000 Sales It appears that the cost is most likely mixed.5% x sales. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. there is a 16% probability that the intercept (fixed cost) is not different from zero. the regression intercept can be used as an estimate of the fixed costs. The upward slope of the line indicates that there are variable costs. fixed costs are likely to be zero and would be excluded from the cost function.000 $900.

Sales might not be the activity that drives administrative costs.186. F.00818212 t Stat 2. . B.4038 4 Coefficients Standard Error 16800. Cost Function Using Regression A. Therefore. the high-low method may be the best option available. and possible changes in costs such as those described in Part E are ignored.82%*Sales C. The adjusted R-Square statistic is very low at 0. there does appear to be a general upward trend. the cost function is: TC = $50.9680477 0. In addition. Because of unforeseen changes in cost behavior. Using the regression results. The cons of the high-low method as an estimation technique were discussed in Part B above. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost. There might be a change in business operations or in the economy that would cause future costs to be different than in the past.45937486 P-value 0.93711636 0. If there are more data points. Both methods assume that the cost function is linear and that all data points come from a single relevant range.90567454 3293. causing fluctuations in cost that are unrelated to any cost driver. This method can be used in cases where there is not enough data to perform regression.17205158 5. 2. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. then both methods may be unsuitable for estimating future costs.73545 0. especially because so few observations were used in the estimation. This means that variation in sales explains only about 18% of the variation in research and development cost.365 + 0. There might be a large discretionary component in administrative costs. on average.04466925 0. both of these methods assume that the data points are representative of future costs. If these assumptions do not hold.16197623 0.25 Scatter Plot.2444 7734. the results rely on more complete information and provide a better estimate. however. Sales does not appear to explain much of the variation in research and development costs.0319523 Intercept X Variable 1 E. Unusual cost items are assumed to continue in the future.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. a cost function may not provide a good estimate for the next month’s costs. However. If there are only two or three data points. regression analysis incorporates all of the observations into the analysis. The plot shows costs that are widely scattered. The past costs used for estimation might not be representative.

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

27 Fancy Furniture A. In this case the learning rate would be wrong and so the time would also be wrong.00 + (700-500)*$0. students may think of others. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). Here are some of the reasons. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. Cons • If Susan has a number of projects in her local area or will be traveling a lot. so Susan may need to maintain her own records if she wishes to trace telephone usage. 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.10 = $40.00 $20. her phone bill will be less than it would be at a rate 5 cents per minute. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month.Chapter 2: The Cost Function 2-23 consulting jobs.1 hours (average time for the first four batches) B. she will pay a very high rate of 10 cents per minute 2.10 = $30.90/ln2) = −0.152 Y = 10 hours*4-0. I.067 $0.05 $0. Hours per batch would be determined as follows.04 $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.05 $0.00 $20.or overestimated the amount of hand work performed.00 $20. In . It is possible that the managers under.152 Y = 8. Many cellular telephone bills do not list the calls made.057 The average cost is lowest at exactly 500 minutes per month. Minutes 300 400 500 600 700 Total Cost $20. There are many different reasons that the time could be different from the amount determined above.00 Average Cost $0.00 + (600-500)*$0.00 $20. In most businesses. telephone costs are viewed as an indirect cost. If her calls are over 400 minutes or under 600 minutes.

000 .000 .000 + 40%*Total revenue D. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 = 0.000 Variable $21. If these values are used in a regression to estimate a cost function. 2. then the chart suggests that the learning rate estimate is reasonable. if managers believe that 25% of the work is done by hand. or 40% or revenue Combining fixed and variable costs. and the University surcharge is specifically based on sales.2-24 Cost Management addition.000 + 40%*80.40. Because revenue is the cost driver for both variable costs.500 10. 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. Food costs are likely to vary proportionately with sales.000 = $79. C.000 5. then the cost would be overestimated. then this chart suggests that the learning curve will be slower than the 90% estimate. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. However. C. The estimate of total costs given revenues of $80. if managers believe that more than 25% of the work is done by hand. it is possible that different types of wood affect the rate at which chairs can be produced.000 = $1.000 using the cost function is: TC = $47. D.000 _______ $28.500 $47. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30.000 7. or has a great deal of experience on the machine. they would be higher than the labor costs in later periods.000 1.000 Profit = Revenues – Total costs = $80. If a worker is absent one day. the cost function is: TC = $47. Thus.$79.000 Total revenue is the most likely cost driver for both variable costs.28 Wildcat Lair A.000/$70. the rate will change if the replacement employee has never worked on this machine.

000 . total variable costs are expected to increase by $4.000 (47. if the bathing suit shop is located in a geographic region $80. Lair’s fixed costs are assumed to be unchanged with the $10. so the estimated profit in August is $1. and the increase is estimated to be 40% of the increase in revenues. F.000— the operating loss of $(5.000+$6. costs would be higher when there were fewer sales.000). In July there was a loss of $5.000 ($10. To estimate the opportunity cost for August. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. Item D will be VERY difficult for most students.000 ($10.000) of revenues.000) (24. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. In a retail business.000 (-$5.) The adjusted cost function is: TC = $47. for July the opportunity cost would have been $2.000. the shop might experience very little business activity. C.000 increase in revenues. Thus. it might even close when the ski area shuts down. 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). During the spring and summer months.000*40%). generating most its sales around the ski season (fall and winter). However. Variable food costs are estimated to be 30% ($21. the variable cost part of the cost function can be adjusted.000/$70.29 Polar Bear Ski Wear [Notes about problem complexity: Item A is not coded as Step 2 because this is explicitly discussed in the chapter. Because the university surcharge is an allocation within the university.000). electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning). The shop is most likely a seasonal business.000 + 30%*Total revenue During August. B. less the fixed costs and the variable food costs. it would lose the revenues. So.000 . but this is not considered a cost driver (a business activity that causes variations in total variable cost).000) $ 9. A shop located near a ski area is likely to incur high heating costs during the winter.] A. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.$4. Only total variable costs are expected to increase.000. Electricity costs also vary with changes in electricity rates. If the university were to close the Lair.Chapter 2: The Cost Function 2-25 E. So.000) Net 2.000 increase in revenues is expected to be $6. so the trend would be the opposite of this plot. the additional profit from a $10.000)+the university surcharge of $7.

85/ln2) = 0. correlation does not necessarily mean causation. D.45 Although each customer paid a different price.5 = $152. 2. Many costs can be related to volume of activity. Higher profits. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. they are discretionary expenditures and not caused by the level of activity.542.542. a 50% markup on total cost will cause sales to be: $1. A correlation may appear in a scatter plot or regression analysis. Although these expenditures are made because more money is available. employee training.89 x 1. and new office furniture or equipment.2345 Y = $101. generally mean there is more money available to spend on administrative travel.50 = $1.2345 Y = $300*5-0. However. given a 100 unit production level: Y = α Xr Y = $300*100-0.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning. in turn.2345 Y = $205.45 x 1.67 1.84 .028.67 Firm A's income for last year was: Sales Costs Income $1. firm B's selling price is: $101.45 $ 514.69 x 5 = $1. For example. higher profits generally occur during periods when activity is high.028.028.22 Firm B set its selling price based on the average cost.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. special promotions. then the highest sales might coincide with the highest electricity costs.

897.10 $ 172. assuming an 85% learning effect would be: Y = $300*150-0.40 Firm A's costs may be computed as follows: Y = $300*15-0.10 $22.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.55 1.Chapter 2: The Cost Function 2-27 Firm B's costs.897.926.625.85 x 1.45 $1.28 $23.384.356.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158. Total cumulative production cost (300 x $78.00 13.028.00 13.50 .50 $ 9.50 = $97.2345 Y= $78.356.30 $2.2345 Y = $92.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.65) Income Firm A's revenues for this year are: (10 x $152.2345 (notice that the cumulative units produced is 15) Y = $158.40 1.028.528.50 $ 9.50/150 units = $64.528.85 Thus Firm B's selling price this year was $64.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.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 $ 92.727.97) 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 $1.84) = $1.727.

wiley.00 9.000 $6.356.000 $8.000 Marketing Dept.85) Income $14.864.727.10/10 = $135. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. and most of the observations appear to have a fairly linear trend.61. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.500. such extreme differences in cost can occur. There is a positive slope.000 $7.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000 $135. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales. available on both the Instructor and Student web sites for the textbook (available at www.com/college/eldenburg).592.500.000 $155.28) Costs (150 x $64.50 $ 4.000 $5.50 Note that Firm B's selling price for this year of $97.500. .wiley. A. Costs $165. 2.000 $145.com/college/eldenburg).500.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.000 Sales B. Scatter Plot of Marketing Costs Against Sales $175.28 is lower than Firm A's average cost per unit: $1.

86656716 Standard Error 4015.5289E-14 Intercept X Variable 1 Based on the regression results. the cost function is: TC = $65.34%*Sales D.63816 0. In addition.584 + 1. Here is the regression output. F.08144 Observations 30 Coefficients 65584. the decision maker(s) should be asked what next year’s cost will be.87116829 Adjusted R Square 0. usually annually.Chapter 2: The Cost Function 2-29 C. If the variable portion of the marketing cost is sales commissions. there would be a positive correlation between marketing department costs and sales.4501E-10 5.7600071 P-value 2.93336396 R Square 0. discretionary costs such as marketing are often increased when profits increase. they may be positively correlated with sales. Discretionary costs are set by decision. using regression or any other technique. Even if marketing department costs are discretionary. Regression Statistics Multiple R 0. the cost estimate should not be based on past costs.2608 0. sales may go up. it is economically plausible for sales to be a cost driver. E. . Assuming that profits are more likely to increase when sales increase.01335108 Standard Error 6844.58184484 13. Instead. When more money is spent on marketing.00097028 t Stat 9. Therefore.

000 $160.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.000 $160.000 $80.com/college/eldenburg).000 $80.000 $120.000 $120.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.2-30 Cost Management 2.wiley. A.com/college/eldenburg).wiley. available on both the Instructor and Student web sites for the textbook (available at www.000 $40. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $40. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.

000 $0 0 100 200 300 400 500 600 700 Raw Materials B. D. If the observations are widely scattered.8173 Observations Coefficient s 150410. the cost driver does not explain the variation in cost. The plots help determine whether regression analysis should be performed using any of the potential drivers. labor hours could be deleted as a potential cost driver.86E-11 0. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.000 $160.1543 0.000 $120.000 $40.01272369 Adjusted R Square -0. but the plot for labor hours appears to have the least trend. Sometimes a cost that is mostly variable.11279932 R Square 0.552864 .600936029 Intercept Labor Hours t Stat 10.600712 P-value 6. Labor Hours Regression: Regression Statistics Multiple R 0.02253618 Standard Error 11114.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200. None of the plots show a definite trend.000 $80.682 4.56597156 30 Standard Error 14812. C.50852 7. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. either the driver is wrong or the cost is mostly fixed. Based only on the cost plots.

22* Raw materials .9786 Observations 30 Coefficient s 126216.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.599 + $38.2-32 Cost Management Only the intercept term is significantly different from zero.1555 Observations 30 Coefficient s 117598.11E-12 0. so the cost function is estimated as: TC = $150.62907 3.53627459 Intercept Raw Materials t Stat 11.612063 R Square 0.67 38.3522862 Standard Error 8846.3746211 Adjusted R Square 0.56778 19.5033241 R Square 0.331580777 Intercept Machine Hours t Stat 11.004579 Both the intercept and slope coefficients are significant.217 + $60.411 Machine Hours Regression: Regression Statistics Multiple R 0.082222 P-value 3.2266685 Standard Error 9665.91 60.095468 P-value 4.000325 Both the intercept and slope coefficients are significant.68E-12 0.4268 4. so the cost function is estimated as: TC = $117.47803 9. so the cost function is estimated as: TC = $126.217192 Standard Error 10291.215128 Standard Error 10853.2533351 Adjusted R Square 0.

wiley. Yes. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0. The coefficients for each of the other potential cost drivers are significantly different from zero.com/college/eldenburg).5558 Observations 30 Coefficient s 60988.05878 9. this driver explains only 35% of the variation in cost. F.3E-06 0. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.218173 8.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.12E-09 1.333162437 5.8266982 Adjusted R Square 0.352 0. available on both the Instructor and Student web sites for the textbook (available at www.wiley.976635 Standard Error 10361. however. 2. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).489 -0.9092294 R Square 0. A.778501 82.8067018 Standard Error 4832.1959303 48.Chapter 2: The Cost Function 2-33 E.com/college/eldenburg).953575 1.226 Based on the simple regression results. machine hours appears to do the best job of explaining manufacturing overhead costs. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.2349 3.291558412 10. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.886218 -0.08E-08 .10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.210187 P-value 3.

29E-09 The cost function is: TC = $60.352 0. machine hours and raw materials explain different activity .20 (0.86E-07 4.599 (<0.001) B.450561 8.881964042 Intercept Machine Hours Raw Materials t Stat 6.352 and 0.57 (0.98 (<0.806 $150.001) $4. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.55) $38.157604083 9. Thus. The adjusted RSquare is far higher in the multiple regression (0.411 (<0.678 + $48.22 (0.806) than in either of the simple regressions (0.925842 30 Standard Error 8743.217 (<0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.22 (<0. its coefficient is negative rather than positive in the multiple regression. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.022 0. In this example.7422519 82.939606 9.78 (<0.001) $117.2-34 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.90921678 R Square 0.5348 Observations Coefficient s 60677. labor hours can be eliminated as a potential cost driver.005) $82. C. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.226 0. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.74*Machine hours + $82.001) $-0. its coefficient is not significantly different from zero in either regression. Manufacturing can be a complex activity requiring a number of different tasks.226) for these two cost drivers. Costs for these activities are likely related to specific cost drivers.82667515 Adjusted R Square 0.71E-10 5.001) $60.93*Raw materials D.81383627 Standard Error 4742. Also.954) $48. Each task includes different activities.5902 48.664851 5.988 (<0.001) $60.001) $126.391636 P-value 1.

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

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

9 244.74*maintenance hours worked. 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.832184392 Standard Error 1217.135 + $35.061172 Adjusted R Square -0.807201 P-value 0.920565237 R Square 0.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. it is logical to expect a strong relation between hours worked and cost.68624 0.0261 Standard Error 130954.06772 Observations 12 Standard Error 965.875134 35. However.173 Observations 12 Coefficient s -89867 197.438328 According to the R Square statistics. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none. 2.03271 Standard Error 3019.0857 Intercept X Variable 1 t Stat -0.453062 P-value 2. The total cost function is: TC = $9.5045837 4. maintenance hours is a reasonable cost driver.796328319 Intercept X Variable 1 Coefficients 9134. From the analyses performed. The most current value is used to . it is considered fixed. and rent for this type of facility is usually fixed. The p-values on the Tstatistics are very small.63E-06 2.247329 R Square 0.847440356 Adjusted R Square 0. An unidentified cost driver could have a higher R-Square. E.36 The Elder Clinic A and B Salaries are always fixed. Therefore.461245 7. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0. Utilities cost varies with season not visits.Chapter 2: The Cost Function 2-37 D. providing high confidence that both the intercept and slope are different from zero.508157 0.74733262 t Stat 9. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.

2-38 Cost Management predict next period’s utilities.07*940 = $25.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. There are many possible reasons that could be listed.182 = F + $3. Therefore.80 D.736 + $6.412 1.441. Medical supplies vary with number of patient-visits. July expenses are estimated to be: TC = $19.100 226 664 $19. such as tongue depressors. There is no one answer to this part. Given the preceding computations and cost summary.736 + $6. . This analysis suggests that there are some of the other expenses are variable costs and some fixed. medical supplies is a mixed cost. and costs go up as patient-visits increase. other facilities may open or close. • Prices of all inputs could change (usually increase). and so on. high point of medical supplies cost and patient data. Use the same method for other expenses. gloves. and so on.$2. Some supplies. affecting the number of visits at this clinic. variable cost is $3. At 940 patient-visits.49 Cost Driver Patient-visits Mixed X 2. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. each patient requires a certain number of supplies. or there are changes in treatment procedures for certain illnesses. Also.wiley. weather.115 219 3. Other expenses appear to increase and decrease with number of patientvisits. current illnesses that are circulating in the area. must be kept on hand whether or not they are used. 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.736 Variable $3. but not proportionately. the cost function is: TC = $19. **Using high-low. so this cost is classified as a mixed cost. E.07*patient-visits C.49*849. These would be fixed. Use March.com/college/eldenburg).182 . • Treatments and related costs may change as new drugs are available. to find fixed: $3. These would be variable.49 ($3.934)/(849 – 778). new equipment is acquired.58 $6. Here are some of the reasons: • The managers will not know how many visits they will receive. such as snake anti-venom. Visits are affected by season.

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

83/mo.686 71.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68.2-40 Cost Management 2. these are correctly handled. Because of the large difference between these values and the values in other months.150 73.2.790 80.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4. The miscellaneous supplies account also looks suspicious. No adjustments are needed for items (c) and (d).800.036 68.236 69. but there is insufficient information to make an adjustment.800 41. (rounded to $36) 2 Note IB-4's power added to Dept.800 .736 To predict future overhead. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.500 x 1/2 = 2.wiley.com/college/eldenburg).736 67. as shown in the scatter plot below.750 + 4. the first month is adjusted even though it is not an actual cost: 4.200 +$2. If these observations are included in the regression analysis. IP-14 3 Payroll paid every two weeks.200 Apr 71.000 = 4.300/10 x 12 = 35.286 68. 80% of September 2 payroll to August: .750 .39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. Operations in the month of July are not typical of the rest of the time period.486 68.4.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.750 68.596 73. B.com/college/eldenburg).376 65.500 38. available on both the Instructor and Student web sites for the textbook (available at www.8 x 6. .350 68.310 70. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.850 2 .10. A. the trend line is likely to distort costs. 1/2 of August 5 payroll goes to July: 5.750.wiley. July’s result is an outlier and should be removed from the data. Similarly.

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).Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75. supplies were a large proportion of overhead cost.086126 Based on the t-statistic and p-value for the intercept.000 9. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 2.000 Overhead Costs $70.050976 P-value 0.47 8 Standard Error 29406.000 $50. Based on the variation in dates at which supplies are recorded.314163 1980.641981 0.500 Outlier Direct Labor Hours C. the fixed cost does not appear to be different from zero.775388 0.000 $65.412139 0. Thus. Therefore. According to the details provided for August and September. the cost function is estimated as: Overhead cost = $6.500 8.000 3.000 $45. Monthly overhead costs for supplies may be significantly overstated or understated .818 6.000 $55.000 $60.789722 t Stat 0.000 6.298502 2.000 $40.26 3. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. they are most likely recorded at the time of purchase rather than at the time of use.500 5. D.310484 Intercept X Variable 1 Coefficient s 8777.

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

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

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

the regression explains only about 59% of the variation in labor costs. Considerable variation in labor costs is not explained by changes in the volume of production. using monthly data for the prior 4 years.848277 8.com/college/eldenburg).7748991 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. The cost function is estimated as: Labor cost = $133. Because of the annual pay increases. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.957296 Standard Error 6710. Here are the simple regression results: Regression Statistics Multiple R 0. . However.04 13. the degree of downward bias is higher for older data than for more recent data.6004687 Adjusted R Square 0. available on both the Instructor and Student web sites for the textbook (available at www. A.Chapter 2: The Cost Function 2-45 2.02E-10 Based on the regression results.678620854 Intercept X Variable 1 t Stat 19.wiley. the cost function was estimated by regressing actual labor costs on number of chairs produced.5917832 Standard Error 6216.609693 1. Also. students are likely to struggle interpreting and choosing a method (Parts E and F).] The data for this problem can be found on the datasets file for chapter 2. the fixed cost and the variable cost per unit are each positive and statistically different from zero.com/college/eldenburg).96 x number of chairs produced However.194 + $13.3147402 P-value 3.437E-24 1.7995 Observations 48 Coefficient s 133194. In prior years. B. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.wiley.

486389 P-value 4.05E-27 2. this cost function would result in a higher estimate for future costs.23439 Standard Error 5557. The fixed cost is nearly the same.274 Using the adjusted labor cost data.932541 R Square 0.96 to $16. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203. D.8 16.57E-23 2.35E-15 Based on the regression results.533 x (1.02)4 $196.411 Observations 48 Coefficient s 107748.390275 Intercept X Variable 1 t Stat 24.905 Observations 48 Coefficient s 133736 16.347 Calculation $203. which is reasonable given the increase in wage rates over time.02 Adjusted Labor Cost $220.010513 1.747745 Adjusted R Square 0.09577 6. Nevertheless.869633 Adjusted R Square 0. here are the regression results: Regression Statistics Multiple R 0.67711 P-value 1.2-46 Cost Management C.492 1.736 + $16.347 x 1.742261 Standard Error 5148.891 1.23 per chair. Here are the multiple regression results: Regression Statistics Multiple R 0.863839 Standard Error 3742. The cost function is estimated as: Labor cost = $133.93821 16.06236 11.00872 Intercept X Variable 1 X Variable 2 t Stat 18.54295 Standard Error 5689.533 Dec 20X4 196.23 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 0.864722 R Square 0.91E-08 . Also.26499 6. approximately 26% of the variation in labor costs is still unexplained.74). but the variable cost increased from $13.311 200. the fixed cost and the variable cost per unit are each positive and statistically different from zero.73E-20 5.

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

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