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.

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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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2-4

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

For the firm to make this cost direct for the personal returns cost object.13 Linear.00*Q Graph of Cost Function $14. In a service business such as this. the CPA's time is the product being sold. Stepwise Linear.000 $9. Of course. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns.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 . 2. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.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. The time records that the tax partner maintains support this cost as a direct cost.000 $11. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. and Piecewise Linear Cost Functions A.000 Total Cost $12.000 $13. TC = $10. CPAs do keep detailed time records.000 + $8. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects.000 $10.000 $8.

000 4.000 Number of Units C.000 2.000 units: $450.000 .000 Total cost at 12.000 3. TC = $25.000 – 10.000/2.000 + $39*Q .000 $40.000 Graph of Cost Function $80. Convert the average costs to total costs for each production level: Total cost at 10. for Q > 2.00*Q.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10. To estimate the costs at another production level.000 $70.000 $0 0 1. for Q ≤ 2.000 $30.000 + $8.00*Q.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 TC = $35.000 = F + $39*10.000 * $45 = $450.000 .000 $60.000 Total Cost $50.000 F = $450.000) = $78. it is first necessary to estimate the cost function.$450.000 + $8.$390.000 = $60.000 units = 12.000 units = 10.000)/(12.2-6 Cost Management B.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 $10.000 * $44 = $528.000 $20.

000 Estimated cost per unit = $645.000 $55.000) TC = $50.000 = $60.000 + 45%*$10.000 For Q > 1.00*(Q-1.Chapter 2: The Cost Function Estimated total cost at 15. total cost is estimated as: TC = $5.000 $70.500 2.000 + $9.000 1.000 $50.000/15.000 = $645.000: TC = $50.000 in revenues into the cost function.00*Q.000 units: TC = $60.000 + $585.00*Q 2-7 Graph of Cost Function $75.000 + (1.000 + $39*15.500 2.$9.000 0 500 1. TC = $50.000 = $43 D.000 * $10.000 TC = $51.000 = $9. Inserting $10.000 + $10.000 $65.000 + $10.000 + $9.00*Q .00) + $9. for Q < 1.000 $45.000 $60.14 Piecewise Linear Cost Function A.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .

3219 Y = 4. 2.4.000 units.000 + $10. This cost function would provide reasonable estimates for Q ≤ 1.000 units. 2.00*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. This cost function would provide reasonable estimates for Q > 1.00*Q. Hours for two returns would be determined as follows.000 units. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A. If all of the data estimation points occurred when Q was > 1. then the cost function would appear to be: TC = $51.80/ln2) = −0.15 Tax Plus A.8 hours (average time for each of the next two returns) B. then the cost function would be some mixture of the functions for the two relevant ranges. If all of the data estimation points occurred when Q was ≤ 1. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.000 units but would underestimate total cost for Q ≤ 1. the cost function mismeasurement depends on the values of Q. 3. If the accountant did not detect that there were two different relevant ranges.2-8 Cost Management B. There are three general situations: 1.3219 Y = 6 hours*2-0. If the data estimation points occurred across the two relevant ranges.000 units but would overestimate total cost for Q > 1.3 and 2A.000 + $9. then the cost function would appear to be: TC = $50.

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. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls.] A. D. Assumptions: Fixed costs remain fixed within the relevant range. and their productivity rate will remain stable. then wages would be an indirect cost. If total variable costs were $8. 2. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). Note: Depreciation using a method such as declining balance is not constant over time. the cost function is: TC = $20. I.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. their productivity increases. or 25% of sales Combining fixed and variable costs. then variable cost per dollar of revenue is calculated as follows: $8. if time is not traced to individual bowls (for example. 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. D or I. F Assuming that employee time can be traced to each bowl. Wages are fixed because they remain constant (the employee always works 40 hours). this particular cost function assumes that variable costs are driven by sales. it is a common cost of production for all of the bowls that are heat-treated in the kiln. In addition. as their performance improves. Eventually their learning will plateau.25.000 on total sales of $32. V C. However. making it a fixed cost. it is a direct cost.000 = 0.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. 2. it improves less quickly for the next return. F . B. wages are a direct cost.000. Assuming that the cost of clay can be traced to each bowl.000/$32. but would still be considered fixed because it does not vary with production volume.16 Bison Sandwiches A. However.000 + 25%*Total sales B. that is. Total clay cost will vary with the number of bowls made.

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

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

Onions ($.99/50) 0.3489 $0. The cost might be fixed or mixed.0053 8.59/16) 0.3489 (calculated above) B.95/2.0179 0.0233 0. Because advertising costs tend to be discretionary. Mustard ($.1619) = $0. and yellow pages advertisements.0148 0.1075 0.6815 .2414 $0.000) * 4] 0. 2. Cost of burger with everything except cheese = ($0.$0. Hamburger bun ($1.2414 2. F Most pizza shops incur advertising costs such as flyers.15/45) 0. advertising costs would be incurred. For the fishing boat business. Hamburger patty ($1. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.49/(16 x 4)] 0.0148 6.1619 10. Cheese ($2. If the fishing boat is for tourists.1075 0.0033 $0.0863 5.69/7) $0.0198 0. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. Catsup ($.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 1.0033 0.56 . 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. G.2414 $0. Lettuce ($. B. there might be some utility costs for the fishing operation and for a business office. F or M Any type of business will have insurance costs.0863 0. B.0198 9.2-12 Cost Management E. It will be a fixed cost if it is a flat amount.0053 0. Mayonnaise [$1.59/40) 0. F.0233 7. depending on how the insurance cost is calculated. Dill pickles [($8.6815 A. In general. Cost of plain burger = $0.5195 = $1. they are treated as fixed costs. but it might be mixed if a portion of the cost relates to levels of business activity.5196 Suggested selling price: 300% * $0. the utility costs for these two businesses would tend to be fixed (would not vary with production). newspaper advertisements.1075 3.69/8) 0.1619 0.29/12) 0. PS.79/150) 0.0179 4. Tomato ($.

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

(Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. Other Potential Cost Drivers A.2-14 Cost Management K. the fixed cost is set at zero. In this problem. If this is the case. In addition.23 Central Industries [Note about problem complexity: Item B is not coded as Step 1 because it is fairly clear which cost driver appears to be best. C. Therefore.wiley.wiley. Other possible cost drivers for marketing department costs could be revenue. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. 2. the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management.35*units sold. it is possible that marketing costs are discretionary. The cost analyst needs to gather information about how marketing costs are set each year. available on both the Instructor and Student web sites for the textbook (available at www. the cost is discretionary and will be set through the negotiating process.com/college/eldenburg). Advertising – Fixed and discretionary 2.com/college/eldenburg). number of advertisements placed. TC = $222. For example. . the variation in units sold explains about 61% of the variation in marketing department cost. or profits.] The data for this problem can be found on the datasets file for chapter 2.) B.22 Cost Function Using Regression.

582691 P-value 6.119724 15 Coefficient s 884.78591283 0. Potential Cost Driver: Output Maintenance Costs Against Output $2.52099624 Standard Error 153.761602 4.4342166 0.000514 .026826 0.58824812 182.500 $1.Chapter 2: The Cost Function 2-15 A.500 Maintenance Costs $2.113687834 Intercept Output t Stat 5.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.61765897 0.000 $1.58E-05 0.

2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.500 $1.36224828 0.02569657 Standard Error 261.291084 2.60187065 0.005847 0.31319046 235.7549386 1.457384 3.000 $1.210849 15 Coefficient s 861.000 $500 $0 0 50 100 150 200 250 300 350 Direct Labor Hours Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 Maintenance Costs $2.717372 P-value 0.017601 .113464425 Intercept Direct Labor Hours t Stat 3.

6778973 0. If the observations are widely scattered.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. or the cost is mostly fixed. .94495003 66.357393 15. all three potential cost drivers appear to be positively related to maintenance costs.000 $1. the cost driver does not explain the variation in cost and either it is the wrong driver. a good cost driver would present a linear or football-shaped positive slope or trend. For example.5343 P-value 0.197755 8. In Part A.500 $1. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. In a scatter plot. However.500 Maintenance Costs $2.815737 29.96E-10 B. the trend line for machine setups looks as if the intercept could be zero or very close to zero.97410583 0. Sometimes a cost that is mostly variable can be identified from a scatter plot.5913391 15 Standard Error 93.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 1.42597461 1.94888217 0. This indicates that the cost could be totally variable.

the t-statistic is significant for the independent variable but not for the intercept. 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. The regression using machine setups has the highest adjusted R-Square of 0. This means that variation in setups explains about 95% of the variation in cost. .588 0.521*Output TC = $861 +$3. business processes.945. the cost is likely to be totally variable.2-18 Cost Management C. This provides confidence that the variable cost part of the cost function is not zero. R-Square 0. D.025*Direct Labor Hours TC = $29. the economic environment. E. Therefore. so it is excluded from the cost function.945 Cost Function TC = $884 + $0. and technology can cause future costs to be different than estimated. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. In the machine setups regression. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero.68* Machine Setups The machine setups intercept coefficient is not significant. Changes in many factors such as resource prices.313 0.

$56. Under the high-low method. .605 = $11.333 = F + 5%*$1. Therefore. The high low method uses the most extreme cost driver values.100 F = $68.333 . the cost function is calculated using the highest and lowest values of the cost driver. not represent the cost most of the time.728 + 5%*Sales B.728 Thus. First. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. on average.05. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.333)/($1.100 – $632. this cost function might provide poor estimates of future costs.000 = 0.132.24 Big Jack Burgers A.100) = $25.132. that is. the total cost function is: TC = $11. That means that the cost function might not represent the actual cost. the variable cost is calculated: ($68.000/$500.333 – $43.Chapter 2: The Cost Function 2-19 PROBLEMS 2. which could be outliers.

000 Sales It appears that the cost is most likely mixed. Following is the regression output. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80.5% x sales . analysis at the account level might indicate that there are few fixed costs.172. the cost function would be TC = $16. but the p-value is greater than 10% at 0. Analysis at the account level can be used to increase the understanding of this cost. Then.2-20 Cost Management C. the regression intercept can be used as an estimate of the fixed costs. In that case. Alternatively. Because this regression has few observations. Chart of data with trend line added by Excel.000 Administrative Costs $60. the p-value result for the tstatistic is atypical.000 $900. Notice that the t-statistic for the intercept coefficient is 2. the cost function would be: TC = 4.000 $1. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. If this cost pool includes items such as salaries and other fixed costs (insurance.000 $600.162. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. etc). Then. fixed costs are likely to be zero and would be excluded from the cost function. D. The upward slope of the line indicates that there are variable costs.800 + 4.000 $20.000 $0 $0 $300. Based on the p-value.000 $40.5% x sales. there is a 16% probability that the intercept (fixed cost) is not different from zero.200.

If there are more data points. Using the regression results. 2.45937486 P-value 0. There might be a large discretionary component in administrative costs.9680477 0. on average. Because of unforeseen changes in cost behavior. then both methods may be unsuitable for estimating future costs. however. The adjusted R-Square statistic is very low at 0. The cons of the high-low method as an estimation technique were discussed in Part B above.82%*Sales C.4038 4 Coefficients Standard Error 16800. a cost function may not provide a good estimate for the next month’s costs. causing fluctuations in cost that are unrelated to any cost driver.365 + 0. If these assumptions do not hold.00818212 t Stat 2.93711636 0. This means that variation in sales explains only about 18% of the variation in research and development cost.186. Both methods assume that the cost function is linear and that all data points come from a single relevant range. If there are only two or three data points. F. Unusual cost items are assumed to continue in the future.16197623 0. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. In addition. and possible changes in costs such as those described in Part E are ignored. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.73545 0. the cost function is: TC = $50. Sales might not be the activity that drives administrative costs. This method can be used in cases where there is not enough data to perform regression. . However. there does appear to be a general upward trend. the high-low method may be the best option available.2444 7734.25 Scatter Plot. especially because so few observations were used in the estimation. the results rely on more complete information and provide a better estimate. both of these methods assume that the data points are representative of future costs.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. The past costs used for estimation might not be representative. regression analysis incorporates all of the observations into the analysis.04466925 0. B. Therefore.0319523 Intercept X Variable 1 E.17205158 5. The plot shows costs that are widely scattered. Sales does not appear to explain much of the variation in research and development 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.90567454 3293. Cost Function Using Regression A.

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

90/ln2) = −0.10 = $30. Many cellular telephone bills do not list the calls made. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). It is possible that the managers under.00 + (700-500)*$0. telephone costs are viewed as an indirect cost. I.057 The average cost is lowest at exactly 500 minutes per month.00 + (600-500)*$0. In .or overestimated the amount of hand work performed. she will pay a very high rate of 10 cents per minute 2.00 $20.05 $0.Chapter 2: The Cost Function 2-23 consulting jobs. Here are some of the reasons. In this case the learning rate would be wrong and so the time would also be wrong. students may think of others. so Susan may need to maintain her own records if she wishes to trace telephone usage. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. In most businesses.00 $20.05 $0.27 Fancy Furniture A. Hours per batch would be determined as follows.00 $20.00 Average Cost $0.10 = $40. her phone bill will be less than it would be at a rate 5 cents per minute. 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. If her calls are over 400 minutes or under 600 minutes. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. Cons • If Susan has a number of projects in her local area or will be traveling a lot.152 Y = 10 hours*4-0.152 Y = 8.00 $20. 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. Pros: • Susan might prefer the convenience of not switching telephone companies • If Susan is happy with her current quality of service she might prefer to stay with the same company and not investigate other companies’ plans • Susan may be able to predict her cost better.04 $0.067 $0.1 hours (average time for the first four batches) B.

or has a great deal of experience on the machine.000 + 40%*80. The estimate of total costs given revenues of $80.000 + 40%*Total revenue D.000 . The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 Total revenue is the most likely cost driver for both variable costs. 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. and the University surcharge is specifically based on sales. C.000 . or 40% or revenue Combining fixed and variable costs.000/$70.000 Variable $21.500 $47.000 Profit = Revenues – Total costs = $80. they would be higher than the labor costs in later periods.000 using the cost function is: TC = $47.000 _______ $28. Food costs are likely to vary proportionately with sales.000 1. If a worker is absent one day. and B. then this chart suggests that the learning curve will be slower than the 90% estimate. However. Thus. 2. C.500 10. if managers believe that more than 25% of the work is done by hand. If these values are used in a regression to estimate a cost function.000 5.000 = $79. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28.2-24 Cost Management addition. it is possible that different types of wood affect the rate at which chairs can be produced.40.28 Wildcat Lair A. then the cost would be overestimated. Because revenue is the cost driver for both variable costs.000 = $1.000 7. if managers believe that 25% of the work is done by hand. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30.000 = 0. the cost function is: TC = $47. D. the rate will change if the replacement employee has never worked on this machine. then the chart suggests that the learning rate estimate is reasonable.$79.

but this is not considered a cost driver (a business activity that causes variations in total variable cost). electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning). During the spring and summer months. Because the university surcharge is an allocation within the university. it would lose the revenues. So.000) (24. so the estimated profit in August is $1.] A. A shop located near a ski area is likely to incur high heating costs during the winter. Variable food costs are estimated to be 30% ($21.000+$6. generating most its sales around the ski season (fall and winter). and the increase is estimated to be 40% of the increase in revenues. If the university were to close the Lair. So.000) of revenues. Only total variable costs are expected to increase.000 .000 increase in revenues is expected to be $6.000 increase in revenues. F. C.000.000— the operating loss of $(5.000/$70.000 (47. it might even close when the ski area shuts down. total variable costs are expected to increase by $4.000*40%).000). if the bathing suit shop is located in a geographic region $80. Electricity costs also vary with changes in electricity rates. costs would be higher when there were fewer sales. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80.000 + 30%*Total revenue During August. so the trend would be the opposite of this plot. 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) Net 2.Chapter 2: The Cost Function 2-25 E.) The adjusted cost function is: TC = $47. Thus. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold.000 ($10. However.000)+the university surcharge of $7.000 (-$5.29 Polar Bear Ski Wear [Notes about problem complexity: Item A is not coded as Step 2 because this is explicitly discussed in the chapter. Item D will be VERY difficult for most students. In July there was a loss of $5. To estimate the opportunity cost for August. Lair’s fixed costs are assumed to be unchanged with the $10.000) $ 9.000. less the fixed costs and the variable food costs. the additional profit from a $10.000 .000 ($10. for July the opportunity cost would have been $2. the shop might experience very little business activity. The shop is most likely a seasonal business.$4. In a retail business. the variable cost part of the cost function can be adjusted. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.000). B.

and new office furniture or equipment.67 Firm A's income for last year was: Sales Costs Income $1.45 $ 514.028.69 (average cost for each of the 5 units) Total cost = $205. Although these expenditures are made because more money is available. Higher profits.542. Many costs can be related to volume of activity.45 x 1.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.2345 Y = $300*5-0. given a 100 unit production level: Y = α Xr Y = $300*100-0.50 = $1.67 1. they are discretionary expenditures and not caused by the level of activity.84 .22 Firm B set its selling price based on the average cost. For example.028. A correlation may appear in a scatter plot or regression analysis. generally mean there is more money available to spend on administrative travel. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.028. correlation does not necessarily mean causation. D. However. employee training.542.45 Although each customer paid a different price.2345 Y = $101. then the highest sales might coincide with the highest electricity costs.85/ln2) = 0. a 50% markup on total cost will cause sales to be: $1. 2. firm B's selling price is: $101.89 (average cost for each of the 100 units produced) Given a 50% markup on cost. higher profits generally occur during periods when activity is high.69 x 5 = $1. special promotions. in turn.5 = $152.2345 Y = $205.89 x 1.

65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.84) = $1.528.50 .50/150 units = $64.85 x 1.384.50 $ 9.28 $23.75) 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 = $9.897.10 $ 172.00 13.40 Firm A's costs may be computed as follows: Y = $300*15-0.00 13.Chapter 2: The Cost Function 2-27 Firm B's costs. Total cumulative production cost (300 x $78.2345 Y = $92.30 $2.85 Thus Firm B's selling price this year was $64.97) 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 $1.356.356.028.84) Costs (150 x $ 92.50 $ 9. assuming an 85% learning effect would be: Y = $300*150-0.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.727.40 1.50 = $97.45 $1.897.028.727.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.55 1.528.2345 (notice that the cumulative units produced is 15) Y = $158.2345 Y= $78.926.10 $22.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.65) Income Firm A's revenues for this year are: (10 x $152.625.

Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.000 $135.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.000 $8. Scatter Plot of Marketing Costs Against Sales $175. such extreme differences in cost can occur.500.000 Marketing Dept.500.000 $155.000 $6. .28 is lower than Firm A's average cost per unit: $1.10/10 = $135. A.31 Belford’s 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.wiley.wiley. and most of the observations appear to have a fairly linear trend.864.000 $7.com/college/eldenburg). Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.000 Sales B.com/college/eldenburg).727. Costs $165. There is a positive slope.000 $145.356.50 Note that Firm B's selling price for this year of $97.000 $5. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.61.28) Costs (150 x $64.85) Income $14. 2.00 9.500.500.50 $ 4.592.

If the variable portion of the marketing cost is sales commissions. In addition. the decision maker(s) should be asked what next year’s cost will be. using regression or any other technique.58184484 13.86656716 Standard Error 4015. the cost function is: TC = $65.584 + 1. Regression Statistics Multiple R 0.00097028 t Stat 9. there would be a positive correlation between marketing department costs and sales. F. When more money is spent on marketing. Instead. they may be positively correlated with sales. E. Therefore. Here is the regression output. Assuming that profits are more likely to increase when sales increase. it is economically plausible for sales to be a cost driver.5289E-14 Intercept X Variable 1 Based on the regression results.34%*Sales D. sales may go up.01335108 Standard Error 6844. discretionary costs such as marketing are often increased when profits increase. the cost estimate should not be based on past costs.2608 0.Chapter 2: The Cost Function 2-29 C. Even if marketing department costs are discretionary.63816 0.93336396 R Square 0.08144 Observations 30 Coefficients 65584. .87116829 Adjusted R Square 0.7600071 P-value 2.4501E-10 5. usually annually. Discretionary costs are set by decision.

wiley.000 $40.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $120.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $160. A.000 $120.com/college/eldenburg).000 $40. available on both the Instructor and Student web sites for the textbook (available at www.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.wiley.2-30 Cost Management 2.000 $80.com/college/eldenburg).000 $80. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $160.

The plots help determine whether regression analysis should be performed using any of the potential drivers.1543 0.02253618 Standard Error 11114.56597156 30 Standard Error 14812.000 $120.50852 7.01272369 Adjusted R Square -0. If the observations are widely scattered.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.552864 . but the plot for labor hours appears to have the least trend.86E-11 0.000 $0 0 100 200 300 400 500 600 700 Raw Materials B. None of the plots show a definite trend.600936029 Intercept Labor Hours t Stat 10.000 $160.000 $80. C. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.8173 Observations Coefficient s 150410.600712 P-value 6. Based only on the cost plots.000 $40. Labor Hours Regression: Regression Statistics Multiple R 0. D.11279932 R Square 0. the cost driver does not explain the variation in cost. either the driver is wrong or the cost is mostly fixed.682 4. Sometimes a cost that is mostly variable. labor hours could be deleted as a potential cost driver. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.

3746211 Adjusted R Square 0.5033241 R Square 0.004579 Both the intercept and slope coefficients are significant.411 Machine Hours Regression: Regression Statistics Multiple R 0.2266685 Standard Error 9665.11E-12 0.2533351 Adjusted R Square 0.9786 Observations 30 Coefficient s 126216.62907 3. so the cost function is estimated as: TC = $126.612063 R Square 0.000325 Both the intercept and slope coefficients are significant.217 + $60.22* Raw materials .91 60.082222 P-value 3.1555 Observations 30 Coefficient s 117598.53627459 Intercept Raw Materials t Stat 11.67 38.47803 9.215128 Standard Error 10853.68E-12 0.2-32 Cost Management Only the intercept term is significantly different from zero.217192 Standard Error 10291. so the cost function is estimated as: TC = $150.56778 19. so the cost function is estimated as: TC = $117.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.4268 4.331580777 Intercept Machine Hours t Stat 11.599 + $38.095468 P-value 4.3522862 Standard Error 8846.

352 0. A.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5. however.778501 82. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.489 -0.8067018 Standard Error 4832.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.333162437 5.953575 1.886218 -0. F.9092294 R Square 0.291558412 10.218173 8.08E-08 .226 Based on the simple regression results.12E-09 1. The coefficients for each of the other potential cost drivers are significantly different from zero. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). 2. this driver explains only 35% of the variation in cost.210187 P-value 3.2349 3.com/college/eldenburg). and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.Chapter 2: The Cost Function 2-33 E.5558 Observations 30 Coefficient s 60988.wiley. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.1959303 48.wiley. machine hours appears to do the best job of explaining manufacturing overhead costs. available on both the Instructor and Student web sites for the textbook (available at www.3E-06 0. Yes. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.8266982 Adjusted R Square 0.05878 9.com/college/eldenburg).976635 Standard Error 10361.

954) $48.001) $60.881964042 Intercept Machine Hours Raw Materials t Stat 6.7422519 82. Costs for these activities are likely related to specific cost drivers.20 (0.55) $38.226 0.001) $-0.98 (<0. Each task includes different activities. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.71E-10 5.5348 Observations Coefficient s 60677.664851 5.022 0.001) $60. In this example. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.22 (0. Manufacturing can be a complex activity requiring a number of different tasks.93*Raw materials D.22 (<0.57 (0. machine hours and raw materials explain different activity . its coefficient is negative rather than positive in the multiple regression.001) B. Thus. The adjusted RSquare is far higher in the multiple regression (0.352 and 0. its coefficient is not significantly different from zero in either regression.939606 9. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.599 (<0.2-34 Cost Management Comparison of simple and multiple regression results: Intercept t-stat (p-value) Independent Variables t-stat (p-value) Labor Machine Raw Hours Hours Materials Adj.001) $4.352 0.78 (<0.90921678 R Square 0.806) than in either of the simple regressions (0. C.217 (<0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.157604083 9.74*Machine hours + $82.391636 P-value 1. Also.86E-07 4.001) $117.925842 30 Standard Error 8743.82667515 Adjusted R Square 0. labor hours can be eliminated as a potential cost driver.806 $150.411 (<0.81383627 Standard Error 4742.29E-09 The cost function is: TC = $60.678 + $48.450561 8.005) $82.001) $126.988 (<0.5902 48.226) for these two cost drivers. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.

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

or number of classes and activities per period.000 $5. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.000 $20. number of hours students attend school.000 $20.2-36 Cost Management 2. Dept. Costs $25.000 $15.com/college/eldenburg).000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. A. B.000 $15. Costs $25. number of hours the building is open. .wiley. square feet cleaned.000 $5.com/college/eldenburg).000 $10. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.000 $10. 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. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley. available on both the Instructor and Student web sites for the textbook (available at www. Dept. Other cost drivers for total maintenance cost could be number of rooms cleaned.000 $0 528 530 532 534 536 538 540 542 Number of Students C.

173 Observations 12 Coefficient s -89867 197.508157 0.247329 R Square 0.0261 Standard Error 130954.920565237 R Square 0.796328319 Intercept X Variable 1 Coefficients 9134. 2.06772 Observations 12 Standard Error 965. it is considered fixed. maintenance hours is a reasonable cost driver.135 + $35.0857 Intercept X Variable 1 t Stat -0. it is rational to conclude that hours worked will provide a reasonable estimate of future costs. E. Utilities cost varies with season not visits.Chapter 2: The Cost Function 2-37 D.74*maintenance hours worked. The p-values on the Tstatistics are very small.74733262 t Stat 9. However. and rent for this type of facility is usually fixed.847440356 Adjusted R Square 0.875134 35. From the analyses performed. The most current value is used to .807201 P-value 0. it is logical to expect a strong relation between hours worked and cost.36 The Elder Clinic A and B Salaries are always fixed. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.461245 7.061172 Adjusted R Square -0.03271 Standard Error 3019.68624 0.453062 P-value 2.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. 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. The total cost function is: TC = $9. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.438328 According to the R Square statistics.832184392 Standard Error 1217.63E-06 2. Therefore. providing high confidence that both the intercept and slope are different from zero.9 244.5045837 4. An unidentified cost driver could have a higher R-Square.

Other expenses appear to increase and decrease with number of patientvisits. such as tongue depressors.934)/(849 – 778). Given the preceding computations and cost summary. July expenses are estimated to be: TC = $19.49 Cost Driver Patient-visits Mixed X 2. Visits are affected by season.182 = F + $3. 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.49*849. current illnesses that are circulating in the area.441. Also. and so on. such as snake anti-venom. These would be fixed.182 . each patient requires a certain number of supplies. This analysis suggests that there are some of the other expenses are variable costs and some fixed.07*patient-visits C.58 $6. Use the same method for other expenses. Use March. . Therefore. other facilities may open or close.100 226 664 $19.115 219 3. must be kept on hand whether or not they are used. medical supplies is a mixed cost. the cost function is: TC = $19.07*940 = $25.736 + $6.736 Variable $3. **Using high-low. • Treatments and related costs may change as new drugs are available.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. new equipment is acquired. to find fixed: $3. but not proportionately. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. gloves. high point of medical supplies cost and patient data.736 + $6. weather. Some supplies. These would be variable.$2.49 ($3. There is no one answer to this part. and so on.412 1. or there are changes in treatment procedures for certain illnesses.com/college/eldenburg). Here are some of the reasons: • The managers will not know how many visits they will receive. variable cost is $3.wiley. • Prices of all inputs could change (usually increase). affecting the number of visits at this clinic. Medical supplies vary with number of patient-visits. E.2-38 Cost Management predict next period’s utilities. and costs go up as patient-visits increase. There are many possible reasons that could be listed.80 D. At 940 patient-visits. so this cost is classified as a mixed cost.

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

83/mo.2-40 Cost Management 2.750.4.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3. 80% of September 2 payroll to August: . If these observations are included in the regression analysis.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4. .286 68.800. A.800 . Similarly.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68. B. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.150 73.wiley. IP-14 3 Payroll paid every two weeks.596 73. but there is insufficient information to make an adjustment.750 68.686 71. these are correctly handled. Operations in the month of July are not typical of the rest of the time period.236 69. the first month is adjusted even though it is not an actual cost: 4. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.750 + 4.000 = 4.736 To predict future overhead.wiley. July’s result is an outlier and should be removed from the data.850 2 . No adjustments are needed for items (c) and (d).8 x 6. the trend line is likely to distort costs.10. The miscellaneous supplies account also looks suspicious.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.2.200 +$2.310 70. available on both the Instructor and Student web sites for the textbook (available at www.486 68.376 65.300/10 x 12 = 35.750 .800 41. as shown in the scatter plot below. (rounded to $36) 2 Note IB-4's power added to Dept.500 x 1/2 = 2.350 68.736 67.com/college/eldenburg).com/college/eldenburg). Because of the large difference between these values and the values in other months.200 Apr 71.790 80. 1/2 of August 5 payroll goes to July: 5.500 38.036 68.

Monthly overhead costs for supplies may be significantly overstated or understated . Thus. supplies were a large proportion of overhead cost.775388 0.500 5.000 Overhead Costs $70. D. they are most likely recorded at the time of purchase rather than at the time of use.310484 Intercept X Variable 1 Coefficient s 8777.818 6. the cost function is estimated as: Overhead cost = $6.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 $65.000 9.000 $45. the fixed cost does not appear to be different from zero.000 3.000 $55.26 3.412139 0.000 $50.000 $40. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.050976 P-value 0. According to the details provided for August and September.641981 0.789722 t Stat 0.79 * 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).47 8 Standard Error 29406.314163 1980.000 6.000 $60.500 Outlier Direct Labor Hours C.086126 Based on the t-statistic and p-value for the intercept.298502 2. Based on the variation in dates at which supplies are recorded.000 2. Therefore.500 8.

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

the best choice of estimation technique. 4. Uncertainties prevent identification of single “correct” measurement methods. Thus. B. for example. in Chapter 2 pointed out that a cost function is estimated within a relevant range of activity. A measurement is relevant if the resulting cost function information helps decision makers choose between alternative courses of action. . The costs and benefits of alternative measures should also be considered. A measurement is appropriate if it is suitable for the purpose. Chapter 2 introduced the following measurement methods for estimating a cost function: Engineered estimate of cost. 2. and they prevent complete accuracy in making accounting measurements. See Exhibit 2. variable or mixed. In Chapter 2. For example. 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. the main focus was on measuring costs for a cost object. two-point method. A measurement is reliable if it if it is reasonably free from error and bias. 1.40 Focus on Professional Competency: Measurement A. For example. and reliable measure for estimating a cost function because of uncertainties about: data availability. and multiple regression (Appendix 2A). Fixed costs are often irrelevant to decisions. 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 how to interpret computational results. If the cost is believed to be nonlinear. then simple regression is inappropriate. whether past cost behaviors will continue in the future. C. sometimes the cost of obtaining a better measure exceeds the benefits. how to categorize costs as fixed. It is also necessary to evaluate the quality of measurement results when using accounting information. relevant. When estimating a cost function: a. whereas variable costs are often relevant. it is necessary to use judgment when choosing and applying measurement methods. which factors drive variable costs.Chapter 2: The Cost Function 2-43 BUILD YOUR PROFESSIONAL COMPETENCIES 2. c. b. simple regression.17 for the pros and cons of each method. It is often difficult to identify an appropriate. analysis at the account level. high-low method. 3. which typically involved creating a cost function for one or more individual costs. a cost function should distinguish between fixed and variable costs. Suppose a cost function is measured for the purpose of estimating future costs.

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

However. Also. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.609693 1. B. Considerable variation in labor costs is not explained by changes in the volume of production. using monthly data for the prior 4 years.678620854 Intercept X Variable 1 t Stat 19.com/college/eldenburg).7748991 R Square 0. A.] The data for this problem can be found on the datasets file for chapter 2.194 + $13. available on both the Instructor and Student web sites for the textbook (available at www. Because of the annual pay increases. students are likely to struggle interpreting and choosing a method (Parts E and F).5917832 Standard Error 6216. Here are the simple regression results: Regression Statistics Multiple R 0.Chapter 2: The Cost Function 2-45 2.04 13.6004687 Adjusted R Square 0. the fixed cost and the variable cost per unit are each positive and statistically different from zero.7995 Observations 48 Coefficient s 133194.wiley.02E-10 Based on the regression results. the regression explains only about 59% of the variation in labor costs.96 x number of chairs produced However. The cost function is estimated as: Labor cost = $133.41 Integrating Across the Curriculum: Statistics [Note about problem complexity: This homework problem was written with adequate instructions so that students should be able to perform the various regression analyses that are called for. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.com/college/eldenburg). In prior years. the degree of downward bias is higher for older data than for more recent data. the cost function was estimated by regressing actual labor costs on number of chairs produced. .wiley.848277 8.957296 Standard Error 6710.3147402 P-value 3.437E-24 1.

23 per chair. Also. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.05E-27 2. The cost function is estimated as: Labor cost = $133.2-46 Cost Management C.91E-08 . The fixed cost is nearly the same.863839 Standard Error 3742.02)4 $196.02 Adjusted Labor Cost $220. approximately 26% of the variation in labor costs is still unexplained. here are the regression results: Regression Statistics Multiple R 0.747745 Adjusted R Square 0.274 Using the adjusted labor cost data.06236 11.96 to $16.891 1.864722 R Square 0.67711 P-value 1.8 16.010513 1.411 Observations 48 Coefficient s 107748.54295 Standard Error 5689.73E-20 5.905 Observations 48 Coefficient s 133736 16.93821 16. the fixed cost and the variable cost per unit are each positive and statistically different from zero.35E-15 Based on the regression results.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 0.492 1.932541 R Square 0. which is reasonable given the increase in wage rates over time.74). but the variable cost increased from $13.23439 Standard Error 5557.347 x 1.09577 6.869633 Adjusted R Square 0.742261 Standard Error 5148.390275 Intercept X Variable 1 t Stat 24. Here are the multiple regression results: Regression Statistics Multiple R 0.57E-23 2.736 + $16. D.533 x (1. this cost function would result in a higher estimate for future costs.26499 6.311 200.347 Calculation $203.00872 Intercept X Variable 1 X Variable 2 t Stat 18. Nevertheless.533 Dec 20X4 196.486389 P-value 4.

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

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