Chapter 2 The Cost Function

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.

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)


Cost Management

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.





Chapter 2: The Cost Function



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.





Cost Management

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.




In a service business such as this.000 $9. the tax partner probably spends some time in non-billable activities.000 $10.00*Q Graph of Cost Function $14. The time records that the tax partner maintains support this cost as a direct cost. 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. TC = $10. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.000 $8. For the firm to make this cost direct for the personal returns cost object.000 + $8. the CPA's time is the product being sold.000 $11. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects.000 $13.13 Linear.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. Stepwise Linear. 2.000 Total Cost $12. CPAs do keep detailed time records. Of course.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 Number of Units C.000 4.000 * $45 = $450.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 = F + $39*10.000 + $8.$450. it is first necessary to estimate the cost function. To estimate the costs at another production level.000 $10.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 units = 10.000 $30.00*Q.000 – 10.000 Total cost at 12.000 F = $450.000 Total Cost $50.00*Q.000 3.000)/(12.000 + $8. for Q > 2.000 . TC = $25.000 units = 12.000 $60.000 units: $450.000 Graph of Cost Function $80.000 TC = $35.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 $40.000 .000 * $44 = $528.000) = $78.000 2.000/2.000 + $39*Q .$390.000 $20.000 $70.000 = $60.000 $0 0 1.2-6 Cost Management B. Convert the average costs to total costs for each production level: Total cost at 10. for Q ≤ 2.

000 0 500 1.000) TC = $50.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 Estimated cost per unit = $645.000 = $60.000 $50.000 1.000 + $585.000 = $645.000 TC = $51.000 units: TC = $60.000 $70.000 + $10.000 + (1.500 2.000: TC = $50.000 $45.000 $65.000 = $43 D.000 + $9.000 $60.Chapter 2: The Cost Function Estimated total cost at 15.000 + $39*15.000 + $10.00*(Q-1.00*Q . for Q < 1.500 2. Inserting $10.000 in revenues into the cost function.00*Q 2-7 Graph of Cost Function $75.000 $55.14 Piecewise Linear Cost Function A.000 + $9.000 * $10.00) + $9. total cost is estimated as: TC = $5.000/15.00*Q.000 + 45%*$10. TC = $50.000 For Q > 1.$9.000 = $9.

using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.3 and 2A.000 + $9.15 Tax Plus A.000 units. If the data estimation points occurred across the two relevant ranges. This cost function would provide reasonable estimates for Q > 1. If all of the data estimation points occurred when Q was ≤ 1.3219 Y = 4.00*Q.000 units. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.4.000 + $10. This cost function would provide reasonable estimates for Q ≤ 1.2-8 Cost Management B.00*Q. 2. then the cost function would be some mixture of the functions for the two relevant ranges.80/ln2) = −0.3219 Y = 6 hours*2-0. then the cost function would appear to be: TC = $51. 2. Hours for two returns would be determined as follows. 3. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared . then the cost function would appear to be: TC = $50. If all of the data estimation points occurred when Q was > 1. If the accountant did not detect that there were two different relevant ranges.000 units but would overestimate total cost for Q > 1.000 units.8 hours (average time for each of the next two returns) B. the cost function mismeasurement depends on the values of Q.000 units.000 units but would underestimate total cost for Q ≤ 1. There are three general situations: 1.

their productivity increases. I. this particular cost function assumes that variable costs are driven by sales. it improves less quickly for the next return.25. Note: Depreciation using a method such as declining balance is not constant over time.16 Bison Sandwiches A. and variable costs remain constant within the relevant range. making it a fixed cost. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). B.000 = 0. Total clay cost will vary with the number of bowls made. the cost function is: TC = $20. if time is not traced to individual bowls (for example. or 25% of sales Combining fixed and variable costs. Chapter 3 will point out another assumption for this cost function: the sales mix (the proportion of sales of different products) remains constant within the relevant range. F Assuming that employee time can be traced to each bowl.000. However. then variable cost per dollar of revenue is calculated as follows: $8. 2. Assuming that the cost of clay can be traced to each bowl.000 on total sales of $32. V C. However. but would still be considered fixed because it does not vary with production volume. then wages would be an indirect cost. that is. it is a common cost of production for all of the bowls that are heat-treated in the kiln. it is a direct cost. D. 2. 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.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. Eventually their learning will plateau.000 + 25%*Total sales B. If total variable costs were $8. Assumptions: Fixed costs remain fixed within the relevant range. and their productivity rate will remain stable. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. D or I. as their performance improves. Wages are fixed because they remain constant (the employee always works 40 hours).000/$32. wages are a direct cost. In addition. F .] A.

making it an indirect cost. I. because the production area may need more cleaning as volumes increase. Advertising is not directly related to production.300 $3.2-10 Cost Management D. J. If the cost of glaze is very small.000 in sales $1. If it is an hourly charge. it might not be traced to individual bowls. making it an indirect cost. making it a direct and variable cost. D or I. D or I. if the cost is small it might be grouped with overhead costs (variable). I. V If the glaze is expensive and therefore a relatively large cost. if the cost is too small to justify tracing them). depending on whether they are “used up” after a certain quantity of production. I. then this cost could be indirect. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. V or F Brushes for the glaze are most likely used for multiple bowls. F I. making them a common cost for multiple units and an indirect cost.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. G. this is a direct cost. making it a fixed cost. Packing costs are most likely variable because they will increase as production increases. I. making it an indirect cost. It might be fixed or mixed. 2. so it is treated as fixed. They might be fixed or variable. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. If the packing materials are not traced (for example. it is most likely traced to individual bowls. E.] A. Also. F The business license is not related to production.000 2. part of the cost might vary proportionately with volume. V Assuming that the cost of packing materials is traced to each bowl. F. H. If the kiln is electric. I.500 . This cost is also discretionary.300 Variable $4.500 ______ $4. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume. it is probably a mixed cost. depending on what causes the cost to vary.

as well as voluntary items such as health insurance and retirement benefits. V. FB. . In this type of situation.] A. PS. D. Benefits might include mandated items such as social security. In the pizza shop. F. Therefore. D. V Ingredients are used in making pizzas. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing.50. employees are likely scheduled in advance on a fixed schedule.500/$9. so they would tend to be fixed or mixed (see Item A above). While hourly wages may be related to number of fish caught. costs vary with dollars of revenue. F. B. E. 2. F There would be no reason to incur fishing equipment costs in a pizza business. and unemployment insurance. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. workers’ compensation. In many organizations. and the cost would vary with number of pizzas produced. B. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior.300 + 50%*Total revenue C.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. the cost function is: TC = $3.000 = 0. they are more likely related to time on the boat than pounds of fish. The cost of rent is irrelevant because it will not change with either alternative. these costs would be mixed with a large proportion of the cost fixed. Some may be sent home if business is very slow. In the fishing boat business.Chapter 2: The Cost Function 2-11 B. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. B. Benefit costs often vary with level of wages or salaries. There most likely would not be any ingredients in a fishing boat business. because of uncertainty in the success of each fishing expedition. F or M Employee benefits occur in any business in which employees are hired. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. or 50% of revenue Combining fixed and variable costs. C. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired).

0033 $0.1075 3. It will be a fixed cost if it is a flat amount.6815 A.0863 5. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. advertising costs would be incurred. but it might be mixed if a portion of the cost relates to levels of business activity. depending on how the insurance cost is calculated.69/7) $0. Cheese ($2. In general. Lettuce ($.0233 7.0179 4. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop. Mustard ($.2414 $0. If the fishing boat is for tourists. Mayonnaise [$1. B.1619 10.2414 $0.1075 0. Cost of burger with everything except cheese = ($0. F Most pizza shops incur advertising costs such as flyers.79/150) 0. there might be some utility costs for the fishing operation and for a business office. Hamburger patty ($1. newspaper advertisements.0198 0. Because advertising costs tend to be discretionary. F. 2. G.49/(16 x 4)] 0.0053 8. and yellow pages advertisements.3489 $0. Hamburger bun ($1.0033 0. B.0863 0.2414 2.1619 0.6815 .3489 (calculated above) B.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 1.99/50) 0.000) * 4] 0.0148 6. For the fishing boat business. 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.0179 0.1075 0. PS.15/45) 0.1619) = $0.59/16) 0.59/40) 0. The cost might be fixed or mixed. they are treated as fixed costs.5196 Suggested selling price: 300% * $0. Tomato ($.0148 0.5195 = $1. Onions ($. the utility costs for these two businesses would tend to be fixed (would not vary with production).69/8) 0.0233 0.56 .95/2.0053 0. Dill pickles [($8.$0. Catsup ($.2-12 Cost Management E. Cost of plain burger = $0.29/12) 0. F or M Any type of business will have insurance costs.0198 9.

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

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

500 Maintenance Costs $2.58824812 182.61765897 0.52099624 Standard Error 153.119724 15 Coefficient s 884.000514 .000 $1.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.761602 4.Chapter 2: The Cost Function 2-15 A. Potential Cost Driver: Output Maintenance Costs Against Output $2.113687834 Intercept Output t Stat 5.4342166 0.026826 0.582691 P-value 6.58E-05 0.500 $1.78591283 0.

457384 3.31319046 235.000 $1.291084 2.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.60187065 0.717372 P-value 0.500 Maintenance Costs $2.113464425 Intercept Direct Labor Hours t Stat 3.7549386 1.36224828 0.02569657 Standard Error 261.017601 .005847 0.500 $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 0.210849 15 Coefficient s 861.

6778973 0.000 $1.000 $500 $0 0 20 40 Machine Set-Ups 60 80 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations Coefficient s 126.96E-10 B. However. In a scatter plot.197755 8.5913391 15 Standard Error 93.94495003 66.357393 15. In Part A. If the observations are widely scattered.42597461 1. all three potential cost drivers appear to be positively related to maintenance costs.500 $1. a good cost driver would present a linear or football-shaped positive slope or trend. For example. This indicates that the cost could be totally variable.5343 P-value 0.97410583 0. or the cost is mostly fixed.94888217 0.500 Maintenance Costs $2. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. . Sometimes a cost that is mostly variable can be identified from a scatter plot. the trend line for machine setups looks as if the intercept could be zero or very close to zero.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2.910475729 Intercept Machine Setups t Stat 1.815737 29. the cost driver does not explain the variation in cost and either it is the wrong driver.

the cost is likely to be totally variable.025*Direct Labor Hours TC = $29. This means that variation in setups explains about 95% of the variation in cost. This provides confidence that the variable cost part of the cost function is not zero.945.68* Machine Setups The machine setups intercept coefficient is not significant. R-Square 0. Therefore. D. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. so it is excluded from the cost function. business processes. E. Changes in many factors such as resource prices. and technology can cause future costs to be different than estimated.521*Output TC = $861 +$3.2-18 Cost Management C.313 0.945 Cost Function TC = $884 + $0. . The use of past cost data to predict the future assumes that future resource costs and volumes of activities will remain the same as in the past.588 0. 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. In the machine setups regression. The regression using machine setups has the highest adjusted R-Square of 0. the t-statistic is significant for the independent variable but not for the intercept.

That means that the cost function might not represent the actual cost. this cost function might provide poor estimates of future costs. which could be outliers. the cost function is calculated using the highest and lowest values of the cost driver. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.100 F = $68.100 – $632.132.000 = 0.728 + 5%*Sales B. First. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.132. on average.333 . the total cost function is: TC = $11. The high low method uses the most extreme cost driver values.333 = F + 5%*$1.05.100) = $25. the variable cost is calculated: ($68.333 – $43. not represent the cost most of the time. .605 = $11.728 Thus. Under the high-low method.Chapter 2: The Cost Function 2-19 PROBLEMS 2.$56. Therefore.333)/($1. that is.24 Big Jack Burgers A.000/$500.

fixed costs are likely to be zero and would be excluded from the cost function. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. D. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80.000 $900. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.000 $600. Analysis at the account level can be used to increase the understanding of this cost. there is a 16% probability that the intercept (fixed cost) is not different from zero.5% x sales . the regression intercept can be used as an estimate of the fixed costs.000 Sales It appears that the cost is most likely mixed. etc).000 Administrative Costs $60. but the p-value is greater than 10% at 0. If this cost pool includes items such as salaries and other fixed costs (insurance.2-20 Cost Management C.172. Then.000 $0 $0 $300. The upward slope of the line indicates that there are variable costs. Because this regression has few observations. Then. Notice that the t-statistic for the intercept coefficient is 2.800 + 4.200. Following is the regression output. the p-value result for the tstatistic is atypical. the cost function would be TC = $16. Chart of data with trend line added by Excel.000 $40. analysis at the account level might indicate that there are few fixed costs. In that case.000 $1. Based on the p-value. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.000 $20.162. the cost function would be: TC = 4.5% x sales. Alternatively.

the results rely on more complete information and provide a better estimate. Using the regression results.82%*Sales C. The plot shows costs that are widely scattered. however.93711636 0. Sales might not be the activity that drives administrative costs.186. 2. If there are more data points. on average. This method can be used in cases where there is not enough data to perform regression. F.90567454 3293.73545 0. The cons of the high-low method as an estimation technique were discussed in Part B above.17205158 5. Therefore. There might be a large discretionary component in administrative costs. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver.365 + 0.00818212 t Stat 2. both of these methods assume that the data points are representative of future costs. The past costs used for estimation might not be representative.9680477 0. If there are only two or three data points.0319523 Intercept X Variable 1 E. Because of unforeseen changes in cost behavior. there does appear to be a general upward trend. In addition. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. B. However.45937486 P-value 0. The adjusted R-Square statistic is very low at 0. Cost Function Using Regression A.04466925 0. 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.25 Scatter Plot. regression analysis incorporates all of the observations into the analysis. If these assumptions do not hold. especially because so few observations were used in the estimation. the cost function is: TC = $50. and possible changes in costs such as those described in Part E are ignored. Sales does not appear to explain much of the variation in research and development costs. Unusual cost items are assumed to continue in the future. then both methods may be unsuitable for estimating future costs. the high-low method may be the best option available. This means that variation in sales explains only about 18% of the variation in research and development cost.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.2444 7734.4038 4 Coefficients Standard Error 16800.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. Both methods assume that the cost function is linear and that all data points come from a single relevant range. .

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

Cons • If Susan has a number of projects in her local area or will be traveling a lot.10 = $40. If her calls are over 400 minutes or under 600 minutes.05 $0. In this case the learning rate would be wrong and so the time would also be wrong.90/ln2) = −0. It is possible that the managers under. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. her phone bill will be less than it would be at a rate 5 cents per minute.00 + (600-500)*$0. telephone costs are viewed as an indirect cost.00 $20.067 $0.05 $0. There are many different reasons that the time could be different from the amount determined above.Chapter 2: The Cost Function 2-23 consulting jobs. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). Minutes 300 400 500 600 700 Total Cost $20. In .10 = $30. Many cellular telephone bills do not list the calls made. so Susan may need to maintain her own records if she wishes to trace telephone usage.00 $20.00 $20. Pros: • Susan might prefer the convenience of not switching telephone companies • If Susan is happy with her current quality of service she might prefer to stay with the same company and not investigate other companies’ plans • Susan may be able to predict her cost better.152 Y = 10 hours*4-0.04 $0. Here are some of the reasons. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. she will pay a very high rate of 10 cents per minute 2.00 $20.27 Fancy Furniture A.00 + (700-500)*$0.00 Average Cost $0. especially if she usually calls less than 500 minutes a month • Below is Susan’s average cost per minute at different levels of calls per month.057 The average cost is lowest at exactly 500 minutes per month. students may think of others.or overestimated the amount of hand work performed. In most businesses.1 hours (average time for the first four batches) B. Hours per batch would be determined as follows.152 Y = 8. I.

000 + 40%*Total revenue D. the rate will change if the replacement employee has never worked on this machine. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized. then the chart suggests that the learning rate estimate is reasonable.000 Profit = Revenues – Total costs = $80.000 1. However. If these values are used in a regression to estimate a cost function.000 5. the cost function is: TC = $47.28 Wildcat Lair A.000 _______ $28. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. 2. if managers believe that more than 25% of the work is done by hand.000/$70. C. or 40% or revenue Combining fixed and variable costs.000 = $1.500 10. if managers believe that 25% of the work is done by hand. Because revenue is the cost driver for both variable costs.2-24 Cost Management addition. then the cost would be overestimated.500 $47.000 using the cost function is: TC = $47. Thus.000 + 40%*80. Food costs are likely to vary proportionately with sales.$79. and B.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. C. they would be higher than the labor costs in later periods.000 7. D.000 . or has a great deal of experience on the machine.40. and the University surcharge is specifically based on sales.000 = 0. The estimate of total costs given revenues of $80.000 = $79. then this chart suggests that the learning curve will be slower than the 90% estimate. it is possible that different types of wood affect the rate at which chairs can be produced.000 .000 Variable $21. If a worker is absent one day.

A shop located near a ski area is likely to incur high heating costs during the winter. To estimate the opportunity cost for August. In a retail business. Lair’s fixed costs are assumed to be unchanged with the $10. but this is not considered a cost driver (a business activity that causes variations in total variable cost). the shop might experience very little business activity.000/$70.000.000+$6.000— the operating loss of $(5. so the estimated profit in August is $1. for July the opportunity cost would have been $2. if the bathing suit shop is located in a geographic region $80. Item D will be VERY difficult for most students.$4. Because the university surcharge is an allocation within the university. the additional profit from a $10.000 (47.000 . Thus.000).] A. So. F. Only total variable costs are expected to increase. B.000 . The shop is most likely a seasonal business. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.Chapter 2: The Cost Function 2-25 E. so the trend would be the opposite of this plot. During the spring and summer months. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000*40%).000. and the increase is estimated to be 40% of the increase in revenues. In July there was a loss of $5. less the fixed costs and the variable food costs. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. it would lose the revenues. it might even close when the ski area shuts down.000 (-$5.000)+the university surcharge of $7. However. 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). generating most its sales around the ski season (fall and winter). costs would be higher when there were fewer sales.000) of revenues. Variable food costs are estimated to be 30% ($21. So.000 increase in revenues is expected to be $6. total variable costs are expected to increase by $4. If the university were to close the Lair. C. Electricity costs also vary with changes in electricity rates. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80.000 ($10.000 increase in revenues. the variable cost part of the cost function can be adjusted.000) Net 2.000).000) (24.000 + 30%*Total revenue During August.000) $ 9.000 ($10.29 Polar Bear Ski Wear [Notes about problem complexity: Item A is not coded as Step 2 because this is explicitly discussed in the chapter.) The adjusted cost function is: TC = $47.

028. they are discretionary expenditures and not caused by the level of activity.84 .50 = $1.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows.69 (average cost for each of the 5 units) Total cost = $205.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.22 Firm B set its selling price based on the average cost. Higher profits.67 1.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning. 2. Many costs can be related to volume of activity.028. higher profits generally occur during periods when activity is high. a 50% markup on total cost will cause sales to be: $1. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0. and new office furniture or equipment.542.85/ln2) = 0. given a 100 unit production level: Y = α Xr Y = $300*100-0.45 $ 514.89 x 1.2345 Y = $205.2345 Y = $300*5-0. firm B's selling price is: $101.45 Although each customer paid a different price. However.542.69 x 5 = $1. D. correlation does not necessarily mean causation.2345 Y = $101. For example. employee training.028. generally mean there is more money available to spend on administrative travel. in turn. A correlation may appear in a scatter plot or regression analysis. then the highest sales might coincide with the highest electricity costs.5 = $152. Although these expenditures are made because more money is available. special promotions.67 Firm A's income for last year was: Sales Costs Income $1.45 x 1.

625.50 .50/150 units = $64.84) = $1.528.2345 Y= $78.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.55 1.50 $ 9.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.65) Income Firm A's revenues for this year are: (10 x $152.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.2345 (notice that the cumulative units produced is 15) Y = $158.40 Firm A's costs may be computed as follows: Y = $300*15-0.028.45 $1.00 13. assuming an 85% learning effect would be: Y = $300*150-0.528.10 $ 172.97) 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 $1.2345 Y = $92.028.384.897.356. Total cumulative production cost (300 x $78.727.28 $23.50 = $97.75) 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 = $9.00 13.30 $2.85 x 1.50 $ 9.897.356.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.Chapter 2: The Cost Function 2-27 Firm B's costs.85 Thus Firm B's selling price this year was $64.40 1.84) Costs (150 x $ 92.727.926.10 $22.

such extreme differences in cost can occur.500. There is a positive slope. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.592.000 $155.500.50 Note that Firm B's selling price for this year of $97.000 $8.85) Income $14.500. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.000 $6. Costs $ available on both the Instructor and Student web sites for the textbook (available at www.864.500.50 $ 4.28 is lower than Firm A's average cost per unit: $1. .wiley. A.727.000 Sales B.000 $5.356. and most of the observations appear to have a fairly linear trend.000 Marketing Dept.wiley.28) Costs (150 x $64. Scatter Plot of Marketing Costs Against Sales $175.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000 $7.000 $145.000 $135. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.61. 2.10/10 = $135.00

they may be positively correlated with sales.01335108 Standard Error 6844.08144 Observations 30 Coefficients 65584.86656716 Standard Error 4015. Therefore. the cost estimate should not be based on past costs. the cost function is: TC = $65.Chapter 2: The Cost Function 2-29 C. using regression or any other technique. Instead. usually annually.5289E-14 Intercept X Variable 1 Based on the regression results.63816 0. Even if marketing department costs are discretionary. the decision maker(s) should be asked what next year’s cost will be.4501E-10 5. it is economically plausible for sales to be a cost driver.7600071 P-value 2.58184484 13. there would be a positive correlation between marketing department costs and sales. Assuming that profits are more likely to increase when sales increase. sales may go up.93336396 R Square 0. F.2608 0. When more money is spent on marketing. Discretionary costs are set by decision.584 + 1.34%*Sales D. . If the variable portion of the marketing cost is sales commissions.00097028 t Stat 9. discretionary costs such as marketing are often increased when profits increase. In addition.87116829 Adjusted R Square 0. Regression Statistics Multiple R 0. Here is the regression output. E.

available on both the Instructor and Student web sites for the textbook (available at $160. 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 $160.000 $80. A.wiley. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.wiley.000 $40.000 $120.000 $40.000 $120.2-30 Cost Management $80.000 $0 0 300 600 900 1200 1500 Machine Hours .

Costs and potential cost driver data are plotted to determine whether further analysis is necessary. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.50852 7. the cost driver does not explain the variation in cost.600712 P-value 6. D.11279932 R Square 0. If the observations are widely scattered.000 $120.682 4. but the plot for labor hours appears to have the least trend.000 $40.552864 .000 $0 0 100 200 300 400 500 600 700 Raw Materials B. Based only on the cost plots.02253618 Standard Error 11114. Labor Hours Regression: Regression Statistics Multiple R 0.56597156 30 Standard Error 14812. labor hours could be deleted as a potential cost driver.000 $160. C.000 $80.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200. either the driver is wrong or the cost is mostly fixed. The plots help determine whether regression analysis should be performed using any of the potential drivers. Sometimes a cost that is mostly variable.01272369 Adjusted R Square -0.86E-11 0.600936029 Intercept Labor Hours t Stat 10.1543 0. None of the plots show a definite trend.8173 Observations Coefficient s 150410.

215128 Standard Error 10853. so the cost function is estimated as: TC = $150.331580777 Intercept Machine Hours t Stat 11.9786 Observations 30 Coefficient s 126216.612063 R Square 0.22* Raw materials .095468 P-value 4.2533351 Adjusted R Square 0.599 + $38.217 + $60.000325 Both the intercept and slope coefficients are significant.3746211 Adjusted R Square 0.91 60.004579 Both the intercept and slope coefficients are significant. so the cost function is estimated as: TC = $117.62907 3.217192 Standard Error 10291.67 38.1555 Observations 30 Coefficient s 117598.47803 9.2266685 Standard Error 9665.5033241 R Square 0.53627459 Intercept Raw Materials t Stat 11.56778 19. so the cost function is estimated as: TC = $126.68E-12 0.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.3522862 Standard Error 8846.4268 4.11E-12 0.082222 P-value 3.411 Machine Hours Regression: Regression Statistics Multiple R 0.2-32 Cost Management Only the intercept term is significantly different from zero.

F.953575 1.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.976635 Standard Error 10361.489 -0.352 0. 2.291558412 10. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0. machine hours appears to do the best job of explaining manufacturing overhead costs.333162437 5.2349 3.Chapter 2: The Cost Function 2-33 E. however.08E-08 . Yes.wiley.226 Based on the simple regression results.1959303 48. The coefficients for each of the other potential cost drivers are significantly different from zero.886218 -0. this driver explains only 35% of the variation in R Square 0.778501 82.3E-06 0.05878 9.8266982 Adjusted R Square 0.5558 Observations 30 Coefficient s Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.12E-09 1. A.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.8067018 Standard Error 4832.218173 8.wiley. available on both the Instructor and Student web sites for the textbook (available at www.210187 P-value 3. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.

450561 8.226 0.82667515 Adjusted R Square 0. its coefficient is not significantly different from zero in either regression.001) B.001) $60. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.001) $4.57 (0.005) $82.29E-09 The cost function is: TC = $60.93*Raw materials D.001) $60. labor hours can be eliminated as a potential cost driver.20 (0.001) $126.81383627 Standard Error 4742.678 + $48.226) for these two cost drivers.925842 30 Standard Error 8743.881964042 Intercept Machine Hours Raw Materials t Stat 6. its coefficient is negative rather than positive in the multiple regression. Manufacturing can be a complex activity requiring a number of different tasks.352 0.78 (<0.7422519 82.90921678 R Square 0.939606 9.806) than in either of the simple regressions (0. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.001) $117.2-34 Cost Management Comparison of simple and multiple regression results: Intercept t-stat (p-value) Independent Variables t-stat (p-value) Labor Machine Raw Hours Hours Materials Adj.71E-10 5. Each task includes different activities.5902 48. Costs for these activities are likely related to specific cost drivers. machine hours and raw materials explain different activity .22 (<0.217 (<0. Thus. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.806 $150.74*Machine hours + $82.664851 5. In this example.86E-07 4.022 0.391636 P-value 1.001) $-0.157604083 9.5348 Observations Coefficient s 60677.954) $48. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.988 (<0.599 (<0.22 (0.352 and 0.98 (<0. The adjusted RSquare is far higher in the multiple regression (0.411 (<0. Also. C.55) $38.

the board may begin to lose trust in the CEO’s ability to manage operations. her reputation would also suffer. they need the most current information available and explanations for information that is not available. and use last year’s budgets for departments that have not turned theirs in. Regina has at least two choices in this situation. . in their role of oversight. and materials handling for the units. The board of directors monitors the performance of the CEO and top management. 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. the department amounts and total budget may be quite inaccurate. such as machining work on units.Chapter 2: The Cost Function 2-35 costs. Regina should submit the most current information she has. but with large increases in department costs. More importantly. If Regina submits unrealistically low budgets this month and then more accurate budgets next month. Although the board is not directly involved in day-to-day operations. 2.34 Software Solutions A. She may believe that her reputation as a diligent employee would suffer if she cannot produce something. They may either praise or criticize top management when the situation may not warrant it. and that could reflect negatively on the Finance Director. They may also use the inaccurate information to help them approve decisions. When the budget is complete the board will likely see it again and notice the discrepancies between the preliminary and actual budgets and wonder why the first budget was so inaccurate. they will draw erroneous conclusions about the performance of the organization and the top management. If Regina uses last period’s budget. B. This is a potential ethical dilemma for Regina because the Direct of Finance believes that he can rely on Regina’s work when he presents the budget to the board. However. A better understanding of the manufacturing process improves the ability to determine the types and number of cost drivers that can be used in a more complete cost function. If they have outdated information and inaccurate information. the board may make inappropriate decisions based on faulty data. and the Director of Finance will present the board with information that is unreliable. C. such as a business expansion. if she submits a budget based on last year’s budget and she knows that this is likely to be inaccurate. 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. The relationship between the CEO and the board should be one of trust and confidence.

000 $5.000 $20. square feet cleaned. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. Costs $25. or number of classes and activities per period. number of hours the building is open.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter Costs $25. 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 $15.000 $10.wiley. number of hours students attend school.000 $15. Dept. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.000 $5.2-36 Cost Management 2. . Other cost drivers for total maintenance cost could be number of rooms cleaned. B.000 $10.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. Dept.000 $0 528 530 532 534 536 538 540 542 Number of Students C.wiley. available on both the Instructor and Student web sites for the textbook (available at www. A.000 $

74*maintenance hours worked.875134 35. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.0261 Standard Error 130954.68624 0. The total cost function is: TC = $9. However.796328319 Intercept X Variable 1 Coefficients 9134. providing high confidence that both the intercept and slope are different from zero.63E-06 2.847440356 Adjusted R Square 0.74733262 t Stat 9.508157 0.453062 P-value 2.438328 According to the R Square statistics.Chapter 2: The Cost Function 2-37 D.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. Therefore. 2. The most current value is used to . maintenance hours is a reasonable cost driver.0857 Intercept X Variable 1 t Stat -0. The p-values on the Tstatistics are very small.03271 Standard Error 3019.461245 7.36 The Elder Clinic A and B Salaries are always fixed.173 Observations 12 Coefficient s -89867 197.247329 R Square 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. Utilities cost varies with season not visits.06772 Observations 12 Standard Error 965.9 244. it is rational to conclude that hours worked will provide a reasonable estimate of future costs. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0. E.832184392 Standard Error 1217. it is logical to expect a strong relation between hours worked and cost. An unidentified cost driver could have a higher R-Square. and rent for this type of facility is usually fixed. From the analyses performed.5045837 4.135 + $35.807201 P-value 0.061172 Adjusted R Square -0. it is considered fixed.920565237 R Square 0.

Also.100 226 664 $19. Given the preceding computations and cost summary.441.80 D. variable cost is $3.07*patient-visits C.49 Cost Driver Patient-visits Mixed X 2. to find fixed: $3. each patient requires a certain number of supplies. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14.736 + $6.wiley.736 Variable $3.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. the cost function is: TC = $19. Some supplies. weather. current illnesses that are circulating in the area. so this cost is classified as a mixed cost. • Prices of all inputs could change (usually increase). new equipment is acquired.49 ($3. and so on. **Using high-low. Other expenses appear to increase and decrease with number of patientvisits.182 = F + $3. and costs go up as patient-visits increase.182 . must be kept on hand whether or not they are used. Use the same method for other expenses. Therefore. other facilities may open or close. and so on. 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. This analysis suggests that there are some of the other expenses are variable costs and some fixed.412 1. medical supplies is a mixed cost. These would be fixed. but not proportionately.934)/(849 – 778).736 + $6. such as tongue depressors. These would be variable. • Treatments and related costs may change as new drugs are available.49*849. Medical supplies vary with number of patient-visits.07*940 = $ gloves.$2. . Visits are affected by season. July expenses are estimated to be: TC = $19. high point of medical supplies cost and patient data. At 940 patient-visits. affecting the number of visits at this clinic. Here are some of the reasons: • The managers will not know how many visits they will receive.115 219 3. There is no one answer to this part. E.58 $6.2-38 Cost Management predict next period’s utilities. There are many possible reasons that could be listed. Use March. such as snake anti-venom. or there are changes in treatment procedures for certain illnesses.

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

as shown in the scatter plot below. 80% of September 2 payroll to August: . B. the trend line is likely to distort costs.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.wiley.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.790 80. No adjustments are needed for items (c) and (d). July’s result is an outlier and should be removed from the data.4.036 68.286 68. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.800.300/10 x 12 = If these observations are included in the regression analysis.750 68.596 73.83/mo.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68. Operations in the month of July are not typical of the rest of the time period.8 x 6. A.310 70.750.736 67.500 38.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. the first month is adjusted even though it is not an actual cost: 4.10. The miscellaneous supplies account also looks suspicious.2-40 Cost Management 2.800 41.236 69.376 65. available on both the Instructor and Student web sites for the textbook (available at www. but there is insufficient information to make an adjustment.750 .200 Apr 71.750 + 4. Because of the large difference between these values and the values in other months.150 73.500 x 1/2 = 2. IP-14 3 Payroll paid every two weeks. (rounded to $36) 2 Note IB-4's power added to Dept.wiley. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. . 1/2 of August 5 payroll goes to July: 5.736 To predict future overhead.000 = 4.686 71.2.486 68.200 +$2. these are correctly handled.800 .350 68.850 2 .

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). Therefore.818 6. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. the cost function is estimated as: Overhead cost = $6.298502 2.000 6.086126 Based on the t-statistic and p-value for the intercept. D.000 $65. Based on the variation in dates at which supplies are recorded. supplies were a large proportion of overhead cost. Monthly overhead costs for supplies may be significantly overstated or understated . Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 $50.500 Outlier Direct Labor Hours C.000 $40.000 $55.26 3.000 2.000 3.500 5.314163 1980.641981 0.775388 0.500 8. According to the details provided for August and September.789722 t Stat 0.000 $45.47 8 Standard Error 29406.000 9.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75. they are most likely recorded at the time of purchase rather than at the time of use.412139 0.310484 Intercept X Variable 1 Coefficient s 8777. the fixed cost does not appear to be different from zero. Thus.000 $60.050976 P-value 0.000 Overhead Costs $70.

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

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

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

wiley. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.7995 Observations 48 Coefficient s 133194.957296 Standard Error 1. using monthly data for the prior 4 years.02E-10 Based on the regression results. .com/college/eldenburg).7748991 R Square 0.wiley. B. The cost function is estimated as: Labor cost = $133. Also. students are likely to struggle interpreting and choosing a method (Parts E and F).96 x number of chairs produced However.3147402 P-value 3. Considerable variation in labor costs is not explained by changes in the volume of production.5917832 Standard Error 6216.6004687 Adjusted R Square 0. the cost function was estimated by regressing actual labor costs on number of chairs produced. A. the fixed cost and the variable cost per unit are each positive and statistically different from zero. However.Chapter 2: The Cost Function 2-45 2.609693 1.194 + $13. the degree of downward bias is higher for older data than for more recent data. In prior years. the regression explains only about 59% of the variation in labor costs. available on both the Instructor and Student web sites for the textbook (available at www. Because of the annual pay increases.04 13.] The data for this problem can be found on the datasets file for chapter 2.848277 8.41 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. Here are the simple regression results: Regression Statistics Multiple R 0.678620854 Intercept X Variable 1 t Stat 19.

74).8 16.863839 Standard Error 3742.23 per chair.23439 Standard Error 5557.533 x (1. the fixed cost and the variable cost per unit are each positive and statistically different from zero.492 1.869633 Adjusted R Square 0. The fixed cost is nearly the same. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203. approximately 26% of the variation in labor costs is still unexplained.347 Calculation $203.864722 R Square 0.2-46 Cost Management C.26499 6. Here are the multiple regression results: Regression Statistics Multiple R 0.486389 P-value 4.411 Observations 48 Coefficient s 107748. here are the regression results: Regression Statistics Multiple R 0.06236 11. Nevertheless.274 Using the adjusted labor cost data.00872 Intercept X Variable 1 X Variable 2 t Stat 18.57E-23 2.67711 P-value 1.02)4 $196.35E-15 Based on the regression results. The cost function is estimated as: Labor cost = $133. which is reasonable given the increase in wage rates over time.533 Dec 20X4 196.96 to $16. Also.54295 Standard Error 5689.742261 Standard Error 5148.010513 1. this cost function would result in a higher estimate for future costs.347 x 1.02 Adjusted Labor Cost $220. but the variable cost increased from $13. D.91E-08 .891 1.390275 Intercept X Variable 1 t Stat 24.311 200.736 + $16.932541 R Square 0.05E-27 2.23 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 0.93821 16.747745 Adjusted R Square 0.73E-20 5.09577 6.905 Observations 48 Coefficient s 133736 16.

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

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