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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2.9

2.10

2-4

Cost Management

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

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

D D I D D D D

D I I I I D D

I I I I I D D

000 0 100 200 Number of Units 300 400 The cost function includes the following assumptions: • Operations are within a relevant range of activity • Within the relevant range of activity: o Fixed costs will remain fixed o Variable cost per unit will remain constant .000 $9. The time records that the tax partner maintains support this cost as a direct cost.000 $10.000 Total Cost $12. 2. In a service business such as this. Now notice that the tax partner's salary is considered a direct cost for all three cost objects. the tax partner probably spends some time in non-billable activities. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. Of course. the CPA's time is the product being sold.00*Q Graph of Cost Function $14. and Piecewise Linear Cost Functions A.000 $8.000 $13. For the firm to make this cost direct for the personal returns cost object.000 $11.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 administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. Stepwise Linear.000 + $8. TC = $10.13 Linear. CPAs do keep detailed time records.

for Q > 2.000 .000 units: $450. for Q ≤ 2.000 $30.000) = $78.000 Total Cost $50. TC = $25.000 units = 10.00*Q.2-6 Cost Management B. To estimate the costs at another production level.000 + $39*Q .000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 = $60.000 Graph of Cost Function $80.000 Number of Units C.00*Q.$450.000 $10.$390.000 3.000 .000 $70.000)/(12.000 TC = $35.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 Combining the fixed and variable costs to create the cost function: TC = $60. Convert the average costs to total costs for each production level: Total cost at 10.000 $0 0 1.000 4.000 $20.000 $40. it is first necessary to estimate the cost function.000 – 10.000 + $8.000 F = $450.000 * $45 = $450.000 2.000/2.000 units = 12.000 + $8.000 Total cost at 12.000 = F + $39*10.000 $60.000 * $44 = $528.

$9. for Q < 1.000 Estimated cost per unit = $645.000 $50.000 $70.500 2.000/15.000 + $39*15.14 Piecewise Linear Cost Function A.000 = $645.000 0 500 1.000 in revenues into the cost function.000: TC = $50.000 + 45%*$10.000 * $10.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 1.00*Q 2-7 Graph of Cost Function $75.000 = $43 D. total cost is estimated as: TC = $5.000 $45.000 TC = $51.000 + $9. Inserting $10.000 For Q > 1.000 $65.000 = $9.000 $60.00*Q .Chapter 2: The Cost Function Estimated total cost at 15.00*(Q-1.00*Q.000 $55.000 + $585.000 + (1.000 units: TC = $60.000 + $10.500 2.00) + $9. TC = $50.000 + $9.000) TC = $50.000 = $60.000 + $10.

000 units but would overestimate total cost 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. If the accountant did not detect that there were two different relevant ranges.000 units.4.00*Q.000 + $9.000 units but would underestimate total cost for Q ≤ 1.2-8 Cost Management B.000 units. then the cost function would be some mixture of the functions for the two relevant ranges. 3. There are three general situations: 1. then the cost function would appear to be: TC = $51. If all of the data estimation points occurred when Q was ≤ 1. 2. If all of the data estimation points occurred when Q was > 1.00*Q.15 Tax Plus A. This cost function would provide reasonable estimates for Q ≤ 1. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared . the cost function mismeasurement depends on the values of Q.80/ln2) = −0. This cost function would provide reasonable estimates for Q > 1. If the data estimation points occurred across the two relevant ranges.000 units. then the cost function would appear to be: TC = $50.3219 Y = 6 hours*2-0. Hours for two returns would be determined as follows.8 hours (average time for each of the next two returns) B.000 + $10.3219 Y = 4. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.3 and 2A. 2.000 units.

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

] A. V Assuming that the cost of packing materials is traced to each bowl. Also.500 ______ $4. making it an indirect cost. It might be fixed or mixed. part of the cost might vary proportionately with volume. They might be fixed or variable. depending on what causes the cost to vary. J. If the cost of glaze is very small. G. D or I.000 in sales $1.2-10 Cost Management D. if the cost is too small to justify tracing them). making it a direct and variable cost. making it an indirect cost. H. depending on whether they are “used up” after a certain quantity of production. Advertising is not directly related to production. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume. I.300 $3.300 Variable $4. making it a fixed cost. If the packing materials are not traced (for example. making it an indirect cost. I. If it is an hourly charge. because the production area may need more cleaning as volumes increase. F. D or I.000 2.500 . E. it might not be traced to individual bowls. if the cost is small it might be grouped with overhead costs (variable). This cost is also discretionary. If the kiln is electric. Packing costs are most likely variable because they will increase as production increases. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. V or F Brushes for the glaze are most likely used for multiple bowls. it is most likely traced to individual bowls. F The business license is not related to production. so it is treated as fixed. I. this is a direct cost. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. F I. I. 2. making them a common cost for multiple units and an indirect cost. it is probably a mixed cost. V If the glaze is expensive and therefore a relatively large cost. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. I.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. then this cost could be indirect.

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

Tomato ($. there might be some utility costs for the fishing operation and for a business office. and yellow pages advertisements.56 .1619 10.0233 0.2414 $0.2414 $0. Hamburger patty ($1. they are treated as fixed costs. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. advertising costs would be incurred.0198 0.0863 5.59/16) 0.1075 0. Onions ($.59/40) 0. B. Cheese ($2.69/7) $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. Hamburger bun ($1. 2.6815 .0053 8.1619) = $0.5196 Suggested selling price: 300% * $0.49/(16 x 4)] 0.20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1. Lettuce ($.2414 2. G.5195 = $1. If the fishing boat is for tourists.0233 7.2-12 Cost Management E. newspaper advertisements. It will be a fixed cost if it is a flat amount.15/45) 0.000) * 4] 0.0148 6. The cost might be fixed or mixed.1619 0.6815 A. the utility costs for these two businesses would tend to be fixed (would not vary with production). depending on how the insurance cost is calculated.0033 $0.0179 0.0053 0. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop. Cost of burger with everything except cheese = ($0.3489 $0. F Most pizza shops incur advertising costs such as flyers. Mustard ($.0179 4.3489 (calculated above) B. Mayonnaise [$1.99/50) 0.29/12) 0. B.0198 9.0033 0. Catsup ($.1075 3. In general. For the fishing boat business.$0.69/8) 0.0148 0. Dill pickles [($8.1075 0. Because advertising costs tend to be discretionary.0863 0.79/150) 0. but it might be mixed if a portion of the cost relates to levels of business activity. PS. Cost of plain burger = $0.95/2. F or M Any type of business will have insurance costs. F.

Mostly fixed and discretionary H.Fixed and discretionary I. that cost would be variable. The Step 2 questions (A. if her prices are too low. D. Alternatively. Selling price of cheeseburger with everything: 300% * $0. It is just a general guideline. In the current business environment. volumes will drop because customers will go to other fast food restaurants that sell hamburgers.Fixed D. and F) are the ones requiring significant assumptions to generate an answer. Professional dues.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. there is no moral obligation to maintain a 300% markup on each item. This means that her costs need to be below the competitive price. Long is able to differentiate her hamburgers from others in the market. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. Long’s prices are too high. in which case the total cost would be primarily fixed. Professional subscriptions. the price of the plain hamburger should be: $2.25 = $1.$0. Staff wages – Could be variable or mixed (salary + overtime) for regular staff.79 Some students will view this higher price as "unfair.04 . Rent . Insurance. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. 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. Office supplies .Mixed. If there is part time help." However. mostly variable G. Market forces will dictate achievable prices. Alternatively. if Ms. she foregoes profits and people may believe there could be quality problems with her food. 2.Fixed E. they set prices considering their competitors’ prices. Property taxes.Chapter 2: The Cost Function 2-13 C. If Ms.04 Therefore. B.6815 = $2. Therefore.] A. Licenses. that is. and then mixed C. However staff are often salaried.Fixed .Fixed F. B. Clerical wages – Fixed unless overtime is regularly scheduled. most organizations are price takers.

For example. the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management. available on both the Instructor and Student web sites for the textbook (available at www.35*units sold. it is possible that marketing costs are discretionary. C. .com/college/eldenburg). 2.2-14 Cost Management K.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.22 Cost Function Using Regression. In addition. number of advertisements placed. 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. Other possible cost drivers for marketing department costs could be revenue.) B. If this is the case. Therefore. the fixed cost is set at zero. or profits. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero. The cost analyst needs to gather information about how marketing costs are set each year. the variation in units sold explains about 61% of the variation in marketing department cost.wiley. TC = $222. In this problem. the cost is discretionary and will be set through the negotiating process.] The data for this problem can be found on the datasets file for chapter 2. Advertising – Fixed and discretionary 2.com/college/eldenburg).wiley.

4342166 0.58824812 182.026826 0.52099624 Standard Error 153.500 $1.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.582691 P-value 6.000 $1.58E-05 0.761602 4.61765897 0.119724 15 Coefficient s 884.000514 .113687834 Intercept Output t Stat 5. Potential Cost Driver: Output Maintenance Costs Against Output $2.500 Maintenance Costs $2.Chapter 2: The Cost Function 2-15 A.78591283 0.

2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.005847 0.113464425 Intercept Direct Labor Hours t Stat 3.36224828 0.02569657 Standard Error 261.717372 P-value 0.000 $1.457384 3.291084 2.31319046 235.60187065 0.7549386 1.500 $1.000 $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 0.017601 .500 Maintenance Costs $2.210849 15 Coefficient s 861.

97410583 0. This indicates that the cost could be totally variable.815737 29. For example. the trend line for machine setups looks as if the intercept could be zero or very close to zero.500 Maintenance Costs $2. However.6778973 0.42597461 1.500 $1.5343 P-value 0. In a scatter plot. a good cost driver would present a linear or football-shaped positive slope or trend. all three potential cost drivers appear to be positively related to maintenance costs. If the observations are widely scattered. the cost driver does not explain the variation in cost and either it is the wrong driver.910475729 Intercept Machine Setups t Stat 1.5913391 15 Standard Error 93. or the cost is mostly fixed.94888217 0. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver.000 $1. Sometimes a cost that is mostly variable can be identified from a scatter plot.96E-10 B.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 126.94495003 66.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2. In Part A.357393 15. .197755 8.

so it is excluded from the cost function. Therefore. the t-statistic is significant for the independent variable but not for the intercept. . This means that variation in setups explains about 95% of the variation in cost. the cost is likely to be totally variable. E. 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. In the machine setups regression.313 0. D. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. R-Square 0. Changes in many factors such as resource prices.945 Cost Function TC = $884 + $0.945. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. the economic environment. The regression using machine setups has the highest adjusted R-Square of 0. This provides confidence that the variable cost part of the cost function is not zero.2-18 Cost Management C. business processes. and technology can cause future costs to be different than estimated.68* Machine Setups The machine setups intercept coefficient is not significant.025*Direct Labor Hours TC = $29.588 0.521*Output TC = $861 +$3.

this cost function might provide poor estimates of future costs. First. The high low method uses the most extreme cost driver values. that is. That means that the cost function might not represent the actual cost. Under the high-low method. which could be outliers.05.100) = $25. the total cost function is: TC = $11.000 = 0.132. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.100 – $632.333)/($1. the variable cost is calculated: ($68.132.100 F = $68.$56. on average.24 Big Jack Burgers A.728 + 5%*Sales B. the cost function is calculated using the highest and lowest values of the cost driver. not represent the cost most of the time.728 Thus.333 .605 = $11. . Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.Chapter 2: The Cost Function 2-19 PROBLEMS 2. Therefore.333 = F + 5%*$1.333 – $43.000/$500.

Then.200. the cost function would be: TC = 4.2-20 Cost Management C.5% x sales . Based on the p-value. Alternatively. Chart of data with trend line added by Excel. D.000 $20. analysis at the account level might indicate that there are few fixed costs. Analysis at the account level can be used to increase the understanding of this cost. Notice that the t-statistic for the intercept coefficient is 2.162. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. the cost function would be TC = $16. Then.000 Sales It appears that the cost is most likely mixed. etc).000 $900.000 $0 $0 $300.000 $600. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. The upward slope of the line indicates that there are variable costs.172.800 + 4.000 $1. but the p-value is greater than 10% at 0. fixed costs are likely to be zero and would be excluded from the cost function. the regression intercept can be used as an estimate of the fixed costs. Because this regression has few observations.5% x sales. Following is the regression output. In that case. there is a 16% probability that the intercept (fixed cost) is not different from zero.000 Administrative Costs $60. If this cost pool includes items such as salaries and other fixed costs (insurance.000 $40. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. the p-value result for the tstatistic is atypical. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.

9680477 0. If there are more data points. F. however.17205158 5.45937486 P-value 0. Using the regression results. The cons of the high-low method as an estimation technique were discussed in Part B above. This method can be used in cases where there is not enough data to perform regression. However.4038 4 Coefficients Standard Error 16800. there does appear to be a general upward trend. The past costs used for estimation might not be representative. There might be a large discretionary component in administrative costs. The plot shows costs that are widely scattered. 2. causing fluctuations in cost that are unrelated to any cost driver. Sales does not appear to explain much of the variation in research and development costs. both of these methods assume that the data points are representative of future costs. then both methods may be unsuitable for estimating future costs. the cost function is: TC = $50. and possible changes in costs such as those described in Part E are ignored. In addition. Sales might not be the activity that drives administrative costs. Cost Function Using Regression A.82%*Sales C. .00818212 t Stat 2.2444 7734.04466925 0.25 Scatter Plot. Because of unforeseen changes in cost behavior.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. If there are only two or three data points. The adjusted R-Square statistic is very low at 0. especially because so few observations were used in the estimation.0319523 Intercept X Variable 1 E.365 + 0. B. regression analysis incorporates all of the observations into the analysis.16197623 0. 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 high-low method may be the best option available.93711636 0. Both methods assume that the cost function is linear and that all data points come from a single relevant range. on average. Unusual cost items are assumed to continue in the future. If these assumptions do not hold. Therefore. a cost function may not provide a good estimate for the next month’s costs. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. This means that variation in sales explains only about 18% of the variation in research and development 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.90567454 3293. the results rely on more complete information and provide a better estimate.186.

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

students may think of others.067 $0. Pros: • Susan might prefer the convenience of not switching telephone companies • If Susan is happy with her current quality of service she might prefer to stay with the same company and not investigate other companies’ plans • Susan may be able to predict her cost better. she will pay a very high rate of 10 cents per minute 2. 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.1 hours (average time for the first four batches) B.10 = $30.Chapter 2: The Cost Function 2-23 consulting jobs. I.10 = $40. If her calls are over 400 minutes or under 600 minutes.05 $0. There are many different reasons that the time could be different from the amount determined above. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. In . Here are some of the reasons. Many cellular telephone bills do not list the calls made.00 $20. It is possible that the managers under.00 $20.057 The average cost is lowest at exactly 500 minutes per month.27 Fancy Furniture A. In this case the learning rate would be wrong and so the time would also be wrong. telephone costs are viewed as an indirect cost.00 $20. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). Cons • If Susan has a number of projects in her local area or will be traveling a lot. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0.00 $20.or overestimated the amount of hand work performed. Hours per batch would be determined as follows.05 $0. so Susan may need to maintain her own records if she wishes to trace telephone usage.00 Average Cost $0.90/ln2) = −0.152 Y = 8. Minutes 300 400 500 600 700 Total Cost $20.00 + (600-500)*$0.152 Y = 10 hours*4-0.00 + (700-500)*$0. her phone bill will be less than it would be at a rate 5 cents per minute.04 $0. In most businesses.

000 = 0.000 = $1. then the cost would be overestimated.000 using the cost function is: TC = $47. the cost function is: TC = $47. However.000 .500 10. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. Because revenue is the cost driver for both variable costs. if managers believe that more than 25% of the work is done by hand.40.000/$70.000 Profit = Revenues – Total costs = $80.000 + 40%*Total revenue D. the rate will change if the replacement employee has never worked on this machine. and the University surcharge is specifically based on sales.$79. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. If a worker is absent one day.000 + 40%*80. C. 2. then this chart suggests that the learning curve will be slower than the 90% estimate. Thus. If these values are used in a regression to estimate a cost function. and B.000 Variable $21. it is possible that different types of wood affect the rate at which chairs can be produced. then the chart suggests that the learning rate estimate is reasonable. or has a great deal of experience on the machine. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.2-24 Cost Management addition.000 = $79.500 $47. if managers believe that 25% of the work is done by hand.000 1. D. 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.000 Total revenue is the most likely cost driver for both variable costs. or 40% or revenue Combining fixed and variable costs. C. they would be higher than the labor costs in later periods.28 Wildcat Lair A.000 . Food costs are likely to vary proportionately with sales. The estimate of total costs given revenues of $80.000 _______ $28.000 5.000 7.

However. the additional profit from a $10. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).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. 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). To estimate the opportunity cost for August.000 increase in revenues is expected to be $6.000). Only total variable costs are expected to increase.000. the shop might experience very little business activity. Because the university surcharge is an allocation within the university.000 .000. During the spring and summer months.000 increase in revenues. Item D will be VERY difficult for most students. A shop located near a ski area is likely to incur high heating costs during the winter. So.000). So. it would lose the revenues. In July there was a loss of $5.000) Net 2.000 + 30%*Total revenue During August. The shop is most likely a seasonal business. the variable cost part of the cost function can be adjusted. In a retail business. less the fixed costs and the variable food costs. so the estimated profit in August is $1. for July the opportunity cost would have been $2.000 .000 (47.000 ($10. F. If the university were to close the Lair.000) (24. it might even close when the ski area shuts down.000) $ 9.000+$6.000 (-$5. total variable costs are expected to increase by $4.) The adjusted cost function is: TC = $47. but this is not considered a cost driver (a business activity that causes variations in total variable cost).$4.000— the operating loss of $(5.] A. if the bathing suit shop is located in a geographic region $80.000) of revenues.000/$70. B. C. Lair’s fixed costs are assumed to be unchanged with the $10. so the trend would be the opposite of this plot. Thus. costs would be higher when there were fewer sales. generating most its sales around the ski season (fall and winter). Variable food costs are estimated to be 30% ($21. and the increase is estimated to be 40% of the increase in revenues.000 ($10.000*40%).000)+the university surcharge of $7. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold.Chapter 2: The Cost Function 2-25 E. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. Electricity costs also vary with changes in electricity rates. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.

50 = $1. employee training.45 Although each customer paid a different price.2345 Y = $101. and new office furniture or equipment. special promotions.22 Firm B set its selling price based on the average cost. 2.45 $ 514. Although these expenditures are made because more money is available.542.84 .028. a 50% markup on total cost will cause sales to be: $1.85/ln2) = 0.2345 Y = $205. A correlation may appear in a scatter plot or regression analysis. correlation does not necessarily mean causation.542.028. Many costs can be related to volume of activity.67 1. However. they are discretionary expenditures and not caused by the level of activity. D.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows.89 x 1. generally mean there is more money available to spend on administrative travel. then the highest sales might coincide with the highest electricity costs.69 (average cost for each of the 5 units) Total cost = $205. given a 100 unit production level: Y = α Xr Y = $300*100-0. in turn. higher profits generally occur during periods when activity is high.028. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.89 (average cost for each of the 100 units produced) Given a 50% markup on cost. For example. Higher profits.45 x 1.2345 Y = $300*5-0.67 Firm A's income for last year was: Sales Costs Income $1.69 x 5 = $1.5 = $152.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning. firm B's selling price is: $101.

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 $1.50 .727.528.84) = $1.625.10 $ 172.75) 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 = $9.65) Income Firm A's revenues for this year are: (10 x $152.10 $22.028.926.897.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.727.384.55 1.50 = $97.00 13.85 Thus Firm B's selling price this year was $64.00 13.Chapter 2: The Cost Function 2-27 Firm B's costs. assuming an 85% learning effect would be: Y = $300*150-0.528.50 $ 9.2345 (notice that the cumulative units produced is 15) Y = $158.28 $23.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.897.50/150 units = $64.356.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.2345 Y= $78.40 1.40 Firm A's costs may be computed as follows: Y = $300*15-0.2345 Y = $92.85 x 1.45 $1.84) Costs (150 x $ 92. Total cumulative production cost (300 x $78.356.028.50 $ 9.30 $2.

50 $ 4.000 $145. such extreme differences in cost can occur.28) Costs (150 x $64. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. .10/10 = $135.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000 $8. and most of the observations appear to have a fairly linear trend.000 Sales B.com/college/eldenburg).com/college/eldenburg). Scatter Plot of Marketing Costs Against Sales $175. Costs $165. available on both the Instructor and Student web sites for the textbook (available at www.500.356.000 $135.500.000 $5.50 Note that Firm B's selling price for this year of $97. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.28 is lower than Firm A's average cost per unit: $1. 2.727.000 $7.500.592.000 Marketing Dept.500. A. There is a positive slope.00 9.000 $6.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.000 $155.wiley. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.wiley.864.85) Income $14.61.

Chapter 2: The Cost Function 2-29 C.87116829 Adjusted R Square 0. Instead. the cost function is: TC = $65.5289E-14 Intercept X Variable 1 Based on the regression results.86656716 Standard Error 4015.584 + 1. Even if marketing department costs are discretionary.2608 0.58184484 13.4501E-10 5. there would be a positive correlation between marketing department costs and sales. usually annually.00097028 t Stat 9.93336396 R Square 0. In addition. the decision maker(s) should be asked what next year’s cost will be.01335108 Standard Error 6844. Therefore. If the variable portion of the marketing cost is sales commissions.63816 0. Assuming that profits are more likely to increase when sales increase. it is economically plausible for sales to be a cost driver.7600071 P-value 2. When more money is spent on marketing.34%*Sales D. they may be positively correlated with sales.08144 Observations 30 Coefficients 65584. using regression or any other technique. . Regression Statistics Multiple R 0. the cost estimate should not be based on past costs. Discretionary costs are set by decision. discretionary costs such as marketing are often increased when profits increase. E. F. Here is the regression output. sales may go up.

A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $120.wiley.000 $40.000 $40.000 $120.com/college/eldenburg).000 $0 0 300 600 900 1200 1500 Machine Hours .wiley. A.000 $160. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $80.000 $160.000 $80.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.com/college/eldenburg).2-30 Cost Management 2. available on both the Instructor and Student web sites for the textbook (available at www.

Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.600936029 Intercept Labor Hours t Stat 10.86E-11 0.000 $120. C.50852 7. but the plot for labor hours appears to have the least trend. labor hours could be deleted as a potential cost driver. the cost driver does not explain the variation in cost. Sometimes a cost that is mostly variable.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200. The plots help determine whether regression analysis should be performed using any of the potential drivers.8173 Observations Coefficient s 150410.02253618 Standard Error 11114.682 4. Based only on the cost plots. None of the plots show a definite trend. Labor Hours Regression: Regression Statistics Multiple R 0.11279932 R Square 0. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.000 $40.600712 P-value 6.01272369 Adjusted R Square -0.1543 0.552864 .000 $0 0 100 200 300 400 500 600 700 Raw Materials B.000 $160. D. either the driver is wrong or the cost is mostly fixed. If the observations are widely scattered.56597156 30 Standard Error 14812.000 $80.

217 + $60.22* Raw materials .000325 Both the intercept and slope coefficients are significant.599 + $38.47803 9.56778 19.2-32 Cost Management Only the intercept term is significantly different from zero.095468 P-value 4.217192 Standard Error 10291.215128 Standard Error 10853.2266685 Standard Error 9665.67 38.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.612063 R Square 0.53627459 Intercept Raw Materials t Stat 11.62907 3.082222 P-value 3.004579 Both the intercept and slope coefficients are significant.411 Machine Hours Regression: Regression Statistics Multiple R 0.2533351 Adjusted R Square 0.3522862 Standard Error 8846.1555 Observations 30 Coefficient s 117598.68E-12 0.3746211 Adjusted R Square 0.11E-12 0. so the cost function is estimated as: TC = $150. so the cost function is estimated as: TC = $126.91 60.5033241 R Square 0.9786 Observations 30 Coefficient s 126216.331580777 Intercept Machine Hours t Stat 11.4268 4. so the cost function is estimated as: TC = $117.

9092294 R Square 0.291558412 10.08E-08 . Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.12E-09 1.226 Based on the simple regression results. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.wiley.Chapter 2: The Cost Function 2-33 E.wiley.5558 Observations 30 Coefficient s 60988. machine hours appears to do the best job of explaining manufacturing overhead costs.3E-06 0. A. Yes. The coefficients for each of the other potential cost drivers are significantly different from zero.489 -0. this driver explains only 35% of the variation in cost.976635 Standard Error 10361.778501 82.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). however. 2.com/college/eldenburg).05878 9.1959303 48.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.210187 P-value 3.953575 1.886218 -0. available on both the Instructor and Student web sites for the textbook (available at www.333162437 5.352 0.2349 3.com/college/eldenburg).218173 8. F. 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. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.8067018 Standard Error 4832.

599 (<0.411 (<0.78 (<0.22 (<0.352 and 0.71E-10 5. Also.352 0.81383627 Standard Error 4742. labor hours can be eliminated as a potential cost driver. Manufacturing can be a complex activity requiring a number of different tasks.90921678 R Square 0.450561 8.93*Raw materials D.20 (0. Each task includes different activities.005) $82. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.001) $60.881964042 Intercept Machine Hours Raw Materials t Stat 6.57 (0.391636 P-value 1.806) than in either of the simple regressions (0.954) $48.98 (<0. its coefficient is not significantly different from zero in either regression. machine hours and raw materials explain different activity . Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.925842 30 Standard Error 8743.82667515 Adjusted R Square 0.001) $126.022 0. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.664851 5.806 $150.55) $38.5902 48.157604083 9.988 (<0.001) $4.678 + $48.226) for these two cost drivers. In this example. its coefficient is negative rather than positive in the multiple regression.22 (0. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.001) $-0.001) B.226 0.217 (<0.7422519 82.2-34 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.5348 Observations Coefficient s 60677.74*Machine hours + $82.86E-07 4. Costs for these activities are likely related to specific cost drivers.001) $117. C. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.29E-09 The cost function is: TC = $60.939606 9. The adjusted RSquare is far higher in the multiple regression (0. Thus.001) $60.

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

A.000 $20. Dept. Other cost drivers for total maintenance cost could be number of rooms cleaned.000 $20. Dept. Costs $25.000 $15.000 $5.wiley.com/college/eldenburg). A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. 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. .000 $5.000 $0 528 530 532 534 536 538 540 542 Number of Students C. number of hours students attend school. available on both the Instructor and Student web sites for the textbook (available at www.2-36 Cost Management 2. or number of classes and activities per period.wiley. Costs $25.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint.com/college/eldenburg).35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. square feet cleaned. B. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.000 $10. number of hours the building is open.000 $15.

it is rational to conclude that hours worked will provide a reasonable estimate of future costs. 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. it is logical to expect a strong relation between hours worked and cost.74*maintenance hours worked. and rent for this type of facility is usually fixed.0261 Standard Error 130954. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.06772 Observations 12 Standard Error 965.920565237 R Square 0.875134 35. maintenance hours is a reasonable cost driver.63E-06 2.68624 0.247329 R Square 0. The most current value is used to .5045837 4.0857 Intercept X Variable 1 t Stat -0. The total cost function is: TC = $9. E.9 244. 2.135 + $35. Utilities cost varies with season not visits.061172 Adjusted R Square -0.453062 P-value 2.74733262 t Stat 9.508157 0.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. The p-values on the Tstatistics are very small. Therefore. An unidentified cost driver could have a higher R-Square.03271 Standard Error 3019.461245 7.796328319 Intercept X Variable 1 Coefficients 9134.36 The Elder Clinic A and B Salaries are always fixed. it is considered fixed.438328 According to the R Square statistics. However.173 Observations 12 Coefficient s -89867 197. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.Chapter 2: The Cost Function 2-37 D. providing high confidence that both the intercept and slope are different from zero.847440356 Adjusted R Square 0. From the analyses performed.807201 P-value 0.

E. Therefore. each patient requires a certain number of supplies.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future.$2.com/college/eldenburg).182 = F + $3. must be kept on hand whether or not they are used. Also. Here are some of the reasons: • The managers will not know how many visits they will receive. variable cost is $3. and costs go up as patient-visits increase. high point of medical supplies cost and patient data. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. Visits are affected by season. Given the preceding computations and cost summary. There is no one answer to this part. such as tongue depressors. Medical supplies vary with number of patient-visits.441.736 Variable $3. There are many possible reasons that could be listed. such as snake anti-venom. Some supplies.736 + $6. Other expenses appear to increase and decrease with number of patientvisits.736 + $6.412 1.58 $6. July expenses are estimated to be: TC = $19. Use the same method for other expenses.100 226 664 $19. and so on. weather. . This analysis suggests that there are some of the other expenses are variable costs and some fixed.49*849. **Using high-low.80 D.07*940 = $25. other facilities may open or close. but not proportionately.115 219 3. new equipment is acquired. 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.934)/(849 – 778). so this cost is classified as a mixed cost. At 940 patient-visits.wiley. and so on. the cost function is: TC = $19. to find fixed: $3. These would be variable. current illnesses that are circulating in the area. or there are changes in treatment procedures for certain illnesses. • Prices of all inputs could change (usually increase).49 ($3.49 Cost Driver Patient-visits Mixed X 2. Use March. gloves.2-38 Cost Management predict next period’s utilities. • Treatments and related costs may change as new drugs are available. These would be fixed.182 .07*patient-visits C. medical supplies is a mixed cost. affecting the number of visits at this clinic.

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

8 x 6.686 71. .000 = 4.486 68.500 38.350 68.10. these are correctly handled. 1/2 of August 5 payroll goes to July: 5. the trend line is likely to distort costs.596 73.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4. IP-14 3 Payroll paid every two weeks.200 Apr 71. Operations in the month of July are not typical of the rest of the time period.200 +$2. B.com/college/eldenburg). Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.300/10 x 12 = 35. available on both the Instructor and Student web sites for the textbook (available at www.850 2 . 80% of September 2 payroll to August: . A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.2-40 Cost Management 2. Similarly.036 68.500 x 1/2 = 2.750. (rounded to $36) 2 Note IB-4's power added to Dept. A. No adjustments are needed for items (c) and (d).wiley. but there is insufficient information to make an adjustment.800.2.286 68.750 .800 41. Because of the large difference between these values and the values in other months.236 69.310 70.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.4.150 73.376 65.750 68. The miscellaneous supplies account also looks suspicious.750 + 4.com/college/eldenburg).39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.83/mo.736 To predict future overhead.wiley. If these observations are included in the regression analysis.800 . as shown in the scatter plot below. July’s result is an outlier and should be removed from the data.790 80. the first month is adjusted even though it is not an actual cost: 4.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68.736 67.

789722 t Stat 0.775388 0. they are most likely recorded at the time of purchase rather than at the time of use.000 3.641981 0.26 3. the cost function is estimated as: Overhead cost = $6. the fixed cost does not appear to be different from zero. Therefore. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 $60.314163 1980. supplies were a large proportion of overhead cost. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.000 $65. D.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.298502 2. Monthly overhead costs for supplies may be significantly overstated or understated .818 6.79 * 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).000 $45.000 $40.000 $55.47 8 Standard Error 29406.000 Overhead Costs $70.000 9. According to the details provided for August and September.500 Outlier Direct Labor Hours C.500 8.086126 Based on the t-statistic and p-value for the intercept.412139 0.310484 Intercept X Variable 1 Coefficient s 8777.050976 P-value 0. Thus.500 5.000 2. Based on the variation in dates at which supplies are recorded.000 $50.000 6.

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

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

then it should probably describe all of the major decisions involved in developing the cost function. . the user should be informed about the priorities used in creating the report. and/or unreliable.2-44 Cost Management 5.9). and easy to understand. It is important to present the cost function information objectively to improve its relevance and reliability for the user. If the report will be used by a manager who needs to estimate future costs. • The use of technical language should depend on the audience. • The desired quality of the report should be weighed against the timeliness of information for the user. irrelevant. It is typically appropriate to use more technical language in reports written for other accountants than in reports written for non-accounting audiences. then it may be more important to provide the cost function information rapidly than to prepare a high quality report. • The format should be concise. Here are some desirable characteristics of a report about an estimated cost function. clear. taking into account the knowledge and interests of the user. However. 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. then the details of the estimation process may be irrelevant. However. • The report should focus on information that will be relevant to the user. Note: Some of these ideas were adapted from the Path to Higher-Quality Management Decisions presented in Chapter 1 (Exhibit 1. Changing circumstances can change the patterns of cost behavior and cause an estimated cost function to be inappropriate. D. If the report will be presented to a superior within the accounting department. If the user needs to make a decision quickly. students might think of others.

96 x number of chairs produced However. available on both the Instructor and Student web sites for the textbook (available at www. the regression explains only about 59% of the variation in labor costs. Here are the simple regression results: Regression Statistics Multiple R 0.Chapter 2: The Cost Function 2-45 2.04 13.7748991 R Square 0.194 + $13. students are likely to struggle interpreting and choosing a method (Parts E and F).6004687 Adjusted R Square 0.957296 Standard Error 6710. Considerable variation in labor costs is not explained by changes in the volume of production.437E-24 1. Because of the annual pay increases. the cost function was estimated by regressing actual labor costs on number of chairs produced.wiley. B.678620854 Intercept X Variable 1 t Stat 19.com/college/eldenburg).5917832 Standard Error 6216. using monthly data for the prior 4 years.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.3147402 P-value 3. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.848277 8.] The data for this problem can be found on the datasets file for chapter 2. The cost function is estimated as: Labor cost = $133. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs. In prior years.7995 Observations 48 Coefficient s 133194. the fixed cost and the variable cost per unit are each positive and statistically different from zero.02E-10 Based on the regression results.wiley.609693 1. A. However. .com/college/eldenburg). the degree of downward bias is higher for older data than for more recent data. Also.

approximately 26% of the variation in labor costs is still unexplained.869633 Adjusted R Square 0.533 Dec 20X4 196. here are the regression results: Regression Statistics Multiple R 0.411 Observations 48 Coefficient s 107748.486389 P-value 4.23 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 0.905 Observations 48 Coefficient s 133736 16. The fixed cost is nearly the same.932541 R Square 0. which is reasonable given the increase in wage rates over time.390275 Intercept X Variable 1 t Stat 24.93821 16.864722 R Square 0.742261 Standard Error 5148. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.26499 6.74).492 1.8 16. this cost function would result in a higher estimate for future costs. the fixed cost and the variable cost per unit are each positive and statistically different from zero.05E-27 2. The cost function is estimated as: Labor cost = $133.311 200.02)4 $196.863839 Standard Error 3742.010513 1.23439 Standard Error 5557.891 1. Also. but the variable cost increased from $13.2-46 Cost Management C. Nevertheless.73E-20 5.54295 Standard Error 5689.57E-23 2.06236 11. Here are the multiple regression results: Regression Statistics Multiple R 0.35E-15 Based on the regression results.347 x 1.736 + $16. D.09577 6.347 Calculation $203.96 to $16.02 Adjusted Labor Cost $220.747745 Adjusted R Square 0.91E-08 .00872 Intercept X Variable 1 X Variable 2 t Stat 18.23 per chair.67711 P-value 1.274 Using the adjusted labor cost data.533 x (1.

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

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