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LEARNING OBJECTIVES

Chapter 2 addresses the following questions: Q1 What are different ways to describe cost behavior? Q2 What is a learning curve? Q3 What process is used to estimate future costs? Q4 How are the engineered estimate, account analysis, and two-point methods used to estimate cost functions? Q5 How does a scatter plot assist with categorizing a cost? Q6 How is regression analysis used to estimate a mixed cost function? Q7 What are the uses and limitations of future cost estimates? These learning questions (Q1 through Q7) are cross-referenced in the textbook to individual exercises and problems.

COMPLEXITY SYMBOLS

The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems. Questions Having a Single Correct Answer: No Symbol This question requires students to recall or apply knowledge as shown in the textbook. This question requires students to extend knowledge beyond the applications e shown in the textbook. Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10): Step 1 skills (Identifying) Step 2 skills (Exploring) Step 3 skills (Prioritizing) Step 4 skills (Envisioning)

2-2

Cost Management

QUESTIONS

2.1 This function has both fixed costs and variable costs. If at least part of the cost is variable; total cost increases as production volumes increase. If at least part of the cost is fixed, the average total per-unit cost decreases because the average fixed cost decreases as volume increases.

Total Cost

Q 2.2 Several years’ worth of data for August would be helpful for estimating the overhead cost function for subsequent Augusts, but the August data should not be used for estimating the overhead cost function for other months during the year. It is highly unlikely that the August data would be representative of the data during normal operations. However, August’s costs are probably a good estimate of the fixed costs for other months. When zero production occurs, only fixed costs are incurred. Since time appears to be of the essence, one of several cost estimation techniques might be employed. First, account analysis will provide a rough estimate. Second, the two most recent income statements could be used to approximate fixed and variable costs using the two-point method, but the president would need to understand that the quality of information could be low using this method. Third, if enough observations of cost data are readily available, regression analysis can be run. However, usually it takes more time to collect the data necessary to use regression analysis. The information leads to a conclusion that fixed costs exist because cost per unit changes between two levels of activity within the relevant range. The information is not sufficient to determine the amount of fixed costs or whether variable costs exist. The opportunities foregone could include spectator or participative sports activities, movies, going out to dinner, the opportunity to work at a part-time job, etc. The relevant cash flows include the cost of transportation, parking, tickets, food and beverages, and so on. There is no way to assign a quantitative value to the social experiences. It is difficult to identify a true opportunity cost because the costs and benefits of the next best alternative must be compared. However, lost wages, less the cost of transportation, can be quantified if the next if the next best alternative is working. Analysis of a scatter plot provided general information about whether a cost appears to be variable, fixed, or mixed. If there is a linear pattern in the scatter plot and the trend appears to go to zero, the cost could be variable. If a scatter plot with a linear trend intersects the vertical axis at a nonzero value, it could be mixed. If the scatter plot has no discernable pattern, the cost could be fixed. And if the pattern is linear with little or no slope, the cost could be fixed.

2.3

2.4

2.5

2.6

Chapter 2: The Cost Function

2-3

2.7

The pattern of a cost over time in the accounting system, together with knowledge of operations, is used to classify costs as variable, fixed, or mixed. Costs such as managers' salaries are usually fixed; they are often directly associated in the general ledger with a particular department or product. Costs for variable materials used in the production process are usually available in the general ledger or in production records. Costs such as manufacturing overhead are often mixed; they tend to include fixed costs such as insurance and property taxes for the plant and variable costs such as indirect supplies used in manufacturing. For costs identified as mixed, another cost estimation technique such as the two-point method or regression analysis must be used to determine the fixed and variable components. Learning curves are nonlinear representations of direct labor cost. The cumulative average time approach can be used to determine an approximation of total cost when labor experiences a learning rate. Economies of scale are a nonlinear function. Information about past experience with economies of scale can be used to help estimate future costs. For example, volume discounts are examples of economies of scale. The required volumes needed to reach discounted prices are generally known, so these can be estimated using several different ranges to reflect the changes in price. The cumulative average learning-time approach is a quantitative approach to calculating the average amount of time it should take to perform a task for people who are just learning to do the task. The director can use this formula to more accurately predict the amount of time it should take to deliver meals to the elderly. With a more accurate prediction, the volunteers’ schedules should also more accurately reflect the amount of time they need to set aside for their work at Meals on Wheels. The trend line developed using regression analysis incorporates all of the cost observations, while the two-point method uses only two observations. Because there is fluctuation in cost over time, better estimates are developed using more observations, because they better reflect the past fluctuations and therefore should better estimate future fluctuations.

2.8

2.9

2.10

2-4

Cost Management

EXERCISES

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

Tax Department Personal Returns Mr. Gruper’s Personal Tax Return

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

D D I D D D D

D I I I I D D

I I I I I D D

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

000 3.000 $60.000 $70.000/2.000 + $39*Q .000 $30.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 . it is first necessary to estimate the cost function. for Q > 2.000 4.00*Q.000 Total Cost $50.$390. TC = $25.000)/(12.000 2.$450.000 .000 Combining the fixed and variable costs to create the cost function: TC = $60.000 * $45 = $450. for Q ≤ 2.000 $10.000 units = 12.000) = $78.000 F = $450.000 * $44 = $528. Convert the average costs to total costs for each production level: Total cost at 10.000 $40.000 Number of Units C.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 = F + $39*10.000 + $8.000 units = 10.000 $0 0 1.2-6 Cost Management B.00*Q.000 Graph of Cost Function $80.000 = $60.000 units: $450.000 $20. To estimate the costs at another production level.000 + $8.000 TC = $35.000 – 10.000 Total cost at 12.

000 $55.000 + $10.000/15. for Q < 1.000 + $10.000 + $585.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 $45.000 TC = $51.000 = $60. Inserting $10.000 $60.000 * $10.Chapter 2: The Cost Function Estimated total cost at 15.000 $65.000 Estimated cost per unit = $645.000 + $39*15.00*Q 2-7 Graph of Cost Function $75.000 + 45%*$10.000 + $9.000: TC = $50.00*Q .000) TC = $50.000 = $43 D.00) + $9.000 For Q > 1.500 2.000 $50.000 = $645.000 1.000 + $9.00*Q.000 + (1.500 2.00*(Q-1.000 in revenues into the cost function. total cost is estimated as: TC = $5.$9.000 = $9.14 Piecewise Linear Cost Function A.000 0 500 1. TC = $50.000 $70.000 units: TC = $60.

Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared . 2.3 and 2A. 3. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.00*Q. This cost function would provide reasonable estimates for Q > 1.3219 Y = 6 hours*2-0.000 units but would underestimate total cost for Q ≤ 1. then the cost function would appear to be: TC = $51. There are three general situations: 1. If the data estimation points occurred across the two relevant ranges. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.3219 Y = 4.000 units.000 + $9.80/ln2) = −0. If the accountant did not detect that there were two different relevant ranges. then the cost function would be some mixture of the functions for the two relevant ranges. 2.00*Q. If all of the data estimation points occurred when Q was > 1.2-8 Cost Management B. If all of the data estimation points occurred when Q was ≤ 1. then the cost function would appear to be: TC = $50.4. Hours for two returns would be determined as follows.15 Tax Plus A.000 units.000 units. This cost function would provide reasonable estimates for Q ≤ 1. the cost function mismeasurement depends on the values of Q.000 units.000 units but would overestimate total cost for Q > 1.8 hours (average time for each of the next two returns) B.000 + $10.

then variable cost per dollar of revenue is calculated as follows: $8. However. but would still be considered fixed because it does not vary with production volume.000 = 0.25. I.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. it is a common cost of production for all of the bowls that are heat-treated in the kiln. it improves less quickly for the next return. and variable costs remain constant within the relevant range. Total clay cost will vary with the number of bowls made. B. If total variable costs were $8. as their performance improves. this particular cost function assumes that variable costs are driven by sales. it is a direct cost.000 on total sales of $32.000. 2. The cost probably does not depend on production volume (assuming depreciation is not based on units produced).000 + 25%*Total sales B. Eventually their learning will plateau. if time is not traced to individual bowls (for example. 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. 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. the cost function is: TC = $20.] A. However. F Assuming that employee time can be traced to each bowl. D. that is. then wages would be an indirect cost. Wages are fixed because they remain constant (the employee always works 40 hours). their productivity increases. D or I.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. F . making it a fixed cost. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. V C. 2. and their productivity rate will remain stable. Assumptions: Fixed costs remain fixed within the relevant range.000/$32. Assuming that the cost of clay can be traced to each bowl. In addition. or 25% of sales Combining fixed and variable costs. wages are a direct cost.16 Bison Sandwiches A. Note: Depreciation using a method such as declining balance is not constant over time.

making it a direct and variable cost. E. F. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. I. it is probably a mixed cost. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume.300 Variable $4. making it an indirect cost. If the cost of glaze is very small. making them a common cost for multiple units and an indirect cost. making it a fixed cost. If the packing materials are not traced (for example. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. F I. V If the glaze is expensive and therefore a relatively large cost. it is most likely traced to individual bowls. H. I. I. J. D or I. Advertising is not directly related to production. They might be fixed or variable. I. if the cost is too small to justify tracing them).300 $3.000 2. then this cost could be indirect. Also. F The business license is not related to production. making it an indirect cost. V Assuming that the cost of packing materials is traced to each bowl. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. part of the cost might vary proportionately with volume. Packing costs are most likely variable because they will increase as production increases. I.] A. depending on what causes the cost to vary. making it an indirect cost. so it is treated as fixed.2-10 Cost Management D.000 in sales $1. V or F Brushes for the glaze are most likely used for multiple bowls. G. It might be fixed or mixed. This cost is also discretionary. if the cost is small it might be grouped with overhead costs (variable). If it is an hourly charge. If the kiln is electric. because the production area may need more cleaning as volumes increase. 2. depending on whether they are “used up” after a certain quantity of production.500 ______ $4.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. D or I. this is a direct cost. it might not be traced to individual bowls.500 .

F or M Employee benefits occur in any business in which employees are hired. D. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. While hourly wages may be related to number of fish caught. E. C. as well as voluntary items such as health insurance and retirement benefits. F. so they would tend to be fixed or mixed (see Item A above). the cost function is: TC = $3. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. In many organizations. The cost of rent is irrelevant because it will not change with either alternative.500/$9. Benefit costs often vary with level of wages or salaries. B. workers’ compensation. F. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4.50. and the cost would vary with number of pizzas produced. D. V. costs vary with dollars of revenue.Chapter 2: The Cost Function 2-11 B. There most likely would not be any ingredients in a fishing boat business. Benefits might include mandated items such as social security.000 = 0. Therefore. because of uncertainty in the success of each fishing expedition. 2.] A.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. B. FB. or 50% of revenue Combining fixed and variable costs. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. Some may be sent home if business is very slow. V Ingredients are used in making pizzas. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. B. and unemployment insurance. In the pizza shop. these costs would be mixed with a large proportion of the cost fixed. In the fishing boat business. F There would be no reason to incur fishing equipment costs in a pizza business. . employees are likely scheduled in advance on a fixed schedule. they are more likely related to time on the boat than pounds of fish.300 + 50%*Total revenue C. In this type of situation. PS.

95/2. It will be a fixed cost if it is a flat amount.2-12 Cost Management E.0053 8.0863 0.0033 0.2414 $0.0148 6. they are treated as fixed costs.1075 3. newspaper advertisements. Catsup ($.1619 10. G. If the fishing boat is for tourists.69/8) 0. Hamburger bun ($1. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. F or M Any type of business will have insurance costs. In general. Cost of plain burger = $0.99/50) 0.0148 0. Hamburger patty ($1.0033 $0.5196 Suggested selling price: 300% * $0. F.000) * 4] 0. Lettuce ($. B. Onions ($. and yellow pages advertisements. the utility costs for these two businesses would tend to be fixed (would not vary with production). Dill pickles [($8.6815 A. Cost of burger with everything except cheese = ($0.2414 2.1075 0.2414 $0. there might be some utility costs for the fishing operation and for a business office. F Most pizza shops incur advertising costs such as flyers.1619 0.56 . however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship.$0.6815 . The cost might be fixed or mixed.5195 = $1. Mustard ($. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.0863 5. Tomato ($. Mayonnaise [$1. B.0233 7.49/(16 x 4)] 0. depending on how the insurance cost is calculated. PS.0179 0.0179 4.0198 0. Because advertising costs tend to be discretionary.0233 0.15/45) 0.1619) = $0.3489 (calculated above) B.3489 $0.59/16) 0.1075 0. advertising costs would be incurred. Cheese ($2.0053 0.0198 9.79/150) 0. but it might be mixed if a portion of the cost relates to levels of business activity. For the fishing boat business.59/40) 0.29/12) 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. 2.69/7) $0.

D. Alternatively. Long is able to differentiate her hamburgers from others in the market.$0.04 Therefore. Property taxes. Therefore. Professional subscriptions. that is. However staff are often salaried. 2. the price of the plain hamburger should be: $2. B." However. and F) are the ones requiring significant assumptions to generate an answer. Clerical wages – Fixed unless overtime is regularly scheduled. Licenses. Office supplies . The Step 2 questions (A. 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. most organizations are price takers. Long’s prices are too high.Fixed D.6815 = $2. B. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. Selling price of cheeseburger with everything: 300% * $0. Insurance.25 = $1. she foregoes profits and people may believe there could be quality problems with her food. mostly variable G. Professional dues. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. if her prices are too low.Fixed . If Ms.Mixed. there is no moral obligation to maintain a 300% markup on each item.Mostly fixed and discretionary H. In the current business environment.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 .] A.Fixed E. and then mixed C. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. This means that her costs need to be below the competitive price.Fixed and discretionary I. in which case the total cost would be primarily fixed. Alternatively. If there is part time help.Chapter 2: The Cost Function 2-13 C.79 Some students will view this higher price as "unfair. if Ms.04 . they set prices considering their competitors’ prices. Market forces will dictate achievable prices. that cost would be variable. It is just a general guideline.Fixed F.

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

61765897 0. Potential Cost Driver: Output Maintenance Costs Against Output $2.761602 4.000 $1.500 Maintenance Costs $2.500 $1.58E-05 0.4342166 0.58824812 182.026826 0.113687834 Intercept Output t Stat 5.52099624 Standard Error 153.78591283 0.119724 15 Coefficient s 884.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000514 .Chapter 2: The Cost Function 2-15 A.582691 P-value 6.

36224828 0.000 $1.457384 3.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.000 $500 $0 0 50 100 150 200 250 300 350 Direct Labor Hours Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.60187065 0.500 $1.717372 P-value 0.31319046 235.02569657 Standard Error 261.7549386 1.500 Maintenance Costs $2.291084 2.017601 .113464425 Intercept Direct Labor Hours t Stat 3.210849 15 Coefficient s 861.005847 0.

In Part A. This indicates that the cost could be totally variable.96E-10 B. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver.197755 8. all three potential cost drivers appear to be positively related to maintenance costs.94495003 66. Sometimes a cost that is mostly variable can be identified from a scatter plot.500 $1.97410583 0.42597461 1.500 Maintenance Costs $2.910475729 Intercept Machine Setups t Stat 1. However. In a scatter plot. a good cost driver would present a linear or football-shaped positive slope or trend. For example.5913391 15 Standard Error 93. If the observations are widely scattered. . the cost driver does not explain the variation in cost and either it is the wrong driver.5343 P-value 0.94888217 0. 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 $2.000 $500 $0 0 20 40 Machine Set-Ups 60 80 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations Coefficient s 126.815737 29.6778973 0.357393 15. or the cost is mostly fixed.000 $1.

so it is excluded from the cost function.313 0. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj.945 Cost Function TC = $884 + $0. The regression using machine setups has the highest adjusted R-Square of 0. Changes in many factors such as resource prices. business processes.945. . In the machine setups regression. and technology can cause future costs to be different than estimated. Therefore. D. the t-statistic is significant for the independent variable but not for the intercept. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero.588 0. the economic environment. 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.521*Output TC = $861 +$3.2-18 Cost Management C. E.025*Direct Labor Hours TC = $29. This provides confidence that the variable cost part of the cost function is not zero. This means that variation in setups explains about 95% of the variation in cost.68* Machine Setups The machine setups intercept coefficient is not significant. R-Square 0. the cost is likely to be totally variable.

728 Thus.333 – $43.05.333 .132. the variable cost is calculated: ($68. The high low method uses the most extreme cost driver values.100 F = $68. .000 = 0. this cost function might provide poor estimates of future costs.333)/($1.24 Big Jack Burgers A. That means that the cost function might not represent the actual cost. First.100) = $25. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.333 = F + 5%*$1. that is.$56.Chapter 2: The Cost Function 2-19 PROBLEMS 2.605 = $11. Therefore.000/$500.728 + 5%*Sales B. not represent the cost most of the time. Under the high-low method. the cost function is calculated using the highest and lowest values of the cost driver. on average. the total cost function is: TC = $11.100 – $632. which could be outliers.132. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.

Based on the p-value. the p-value result for the tstatistic is atypical. D. the cost function would be TC = $16. etc).000 Sales It appears that the cost is most likely mixed. Notice that the t-statistic for the intercept coefficient is 2. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80.172.5% x sales. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. Then.800 + 4.000 Administrative Costs $60.000 $900. Then. Analysis at the account level can be used to increase the understanding of this cost. Alternatively.5% x sales . fixed costs are likely to be zero and would be excluded from the cost function. Chart of data with trend line added by Excel.000 $40. Because this regression has few observations. In that case. Following is the regression output. the regression intercept can be used as an estimate of the fixed costs.2-20 Cost Management C.162.000 $600. but the p-value is greater than 10% at 0. The upward slope of the line indicates that there are variable costs. the cost function would be: TC = 4.000 $0 $0 $300.000 $1. If this cost pool includes items such as salaries and other fixed costs (insurance.000 $20. analysis at the account level might indicate that there are few fixed costs. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. there is a 16% probability that the intercept (fixed cost) is not different from zero.200. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.

In addition. on average. then both methods may be unsuitable for estimating future costs. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.45937486 P-value 0.82%*Sales C.25 Scatter Plot. Sales might not be the activity that drives administrative costs. . the high-low method may be the best option available.0319523 Intercept X Variable 1 E. and possible changes in costs such as those described in Part E are ignored. Therefore. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. However. Both methods assume that the cost function is linear and that all data points come from a single relevant range. F. Using the regression results.90567454 3293. however. If these assumptions do not hold.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. 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. The past costs used for estimation might not be representative. Because of unforeseen changes in cost behavior.73545 0. 2. This means that variation in sales explains only about 18% of the variation in research and development cost.186. the cost function is: TC = $50.00818212 t Stat 2.2444 7734.17205158 5. If there are more data points. causing fluctuations in cost that are unrelated to any cost driver. This method can be used in cases where there is not enough data to perform regression. the results rely on more complete information and provide a better estimate. Unusual cost items are assumed to continue in the future. there does appear to be a general upward trend.93711636 0. Sales does not appear to explain much of the variation in research and development costs.4038 4 Coefficients Standard Error 16800. a cost function may not provide a good estimate for the next month’s costs.16197623 0. If there are only two or three data points. both of these methods assume that the data points are representative of future costs. Cost Function Using Regression A. The adjusted R-Square statistic is very low at 0. B.365 + 0.9680477 0. The plot shows costs that are widely scattered. especially because so few observations were used in the estimation. regression analysis incorporates all of the observations into the analysis. The cons of the high-low method as an estimation technique were discussed in Part B above.04466925 0.

Additional information could include the location of Susan’s future consulting work. C. Regression is useful for estimating a cost function when fixed and variable costs are unknown. Since she has to have telephone service to stay in business. 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. Susan already knows the cost function. B. fixed costs would remain fixed and variable costs would remain constant within that range. First. In this problem. Yes. the amount of traveling she will be doing since she cannot call from home when she is traveling. assuming that the cost function is linear may not be appropriate. a portion of the cost is likely to be discretionary. to make a decision she needs to compare her costs under the old plan to what costs would be under the new plan. research and development cost is often discretionary. When regression analysis is used to specify a cost function. It is likely that Susan has to call people to conduct business. the cost is assumed to be linear within the relevant range. D. Better cost estimates for discretionary costs can be obtained by gathering information about planned expenditures from the department head or from the managers who are responsible for costs. The scatter plot shows little evidence of linearity. Managers set the costs depending on the organization’s strategies and funds available for research and development. Several very general assumptions apply to a linear cost function. although she could use email. In addition. as she has in the past. In this problem. These costs are set by decision. Since her consulting work varies. H. The cost driver for long distance calls is the number of minutes on the telephone. E. Therefore. 2.26 Susan’s Telephone Service A. the number of calls and whether they are long distance or local calls will vary. part of the cost is committed and cannot be reduced. the underlying cost function is assumed to be linear and that the cost driver is assumed to be economically plausible as a cost driver. usually annually. She cannot be certain that she will use the same amount of time. 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. It also depends on whether she can trace telephone calls to individual . G. on average. F. so she does not need to estimate the cost function using regression or any other estimation technique. the relation makes sense from an economic standpoint. that is. The fixed cost is the $20 flat fee.2-22 Cost Management D. Since she probably can cut back on calls when her consulting work is not providing enough income.

152 Y = 8. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). If her calls are over 400 minutes or under 600 minutes.00 $20. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0.10 = $40.04 $0.Chapter 2: The Cost Function 2-23 consulting jobs.00 + (600-500)*$0.10 = $30.27 Fancy Furniture A. It is possible that the managers under. Minutes 300 400 500 600 700 Total Cost $20. telephone costs are viewed as an indirect cost. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month.057 The average cost is lowest at exactly 500 minutes per month.90/ln2) = −0. she will pay a very high rate of 10 cents per minute 2. There are many different reasons that the time could be different from the amount determined above. her phone bill will be less than it would be at a rate 5 cents per minute.05 $0.00 $20.00 $20. especially if she usually calls less than 500 minutes a month • Below is Susan’s average cost per minute at different levels of calls per month. Cons • If Susan has a number of projects in her local area or will be traveling a lot.00 + (700-500)*$0. students may think of others. so Susan may need to maintain her own records if she wishes to trace telephone usage. In .or overestimated the amount of hand work performed. In this case the learning rate would be wrong and so the time would also be wrong. Here are some of the reasons. 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.067 $0. I. Hours per batch would be determined as follows.152 Y = 10 hours*4-0. In most businesses.05 $0.00 $20. Many cellular telephone bills do not list the calls made.00 Average Cost $0.1 hours (average time for the first four batches) B.

500 10. the cost function is: TC = $47. 2. The estimate of total costs given revenues of $80. or 40% or revenue Combining fixed and variable costs. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. if managers believe that 25% of the work is done by hand. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized. If a worker is absent one day. 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. it is possible that different types of wood affect the rate at which chairs can be produced. the rate will change if the replacement employee has never worked on this machine. Because revenue is the cost driver for both variable costs.000 = $1. then the cost would be overestimated. Food costs are likely to vary proportionately with sales.000 _______ $28. then the chart suggests that the learning rate estimate is reasonable.000 1. D. If these values are used in a regression to estimate a cost function. if managers believe that more than 25% of the work is done by hand.000 + 40%*80. they would be higher than the labor costs in later periods.000/$70. Thus.2-24 Cost Management addition.000 Total revenue is the most likely cost driver for both variable costs. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. However.000 .$79.000 5. and B.40. then this chart suggests that the learning curve will be slower than the 90% estimate.000 + 40%*Total revenue D.000 Variable $21.000 Profit = Revenues – Total costs = $80.000 = 0. and the University surcharge is specifically based on sales.28 Wildcat Lair A.000 = $79.000 7.000 using the cost function is: TC = $47. or has a great deal of experience on the machine. C.500 $47.000 .

it would lose the revenues. So. Lair’s fixed costs are assumed to be unchanged with the $10. The shop is most likely a seasonal business. costs would be higher when there were fewer sales. the shop might experience very little business activity. In July there was a loss of $5.000+$6.000 increase in revenues. if the bathing suit shop is located in a geographic region $80.000) Net 2.] A.Chapter 2: The Cost Function 2-25 E.000). electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000 . C.000)+the university surcharge of $7.000— the operating loss of $(5. Electricity costs also vary with changes in electricity rates. Because the university surcharge is an allocation within the university. Only total variable costs are expected to increase. F. B. so the trend would be the opposite of this plot. less the fixed costs and the variable food costs. To estimate the opportunity cost for August.000 ($10.000 (-$5. it might even close when the ski area shuts down.000 increase in revenues is expected to be $6.29 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. 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). for July the opportunity cost would have been $2.000) of revenues. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. A shop located near a ski area is likely to incur high heating costs during the winter.$4.000. but this is not considered a cost driver (a business activity that causes variations in total variable cost). Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. so the estimated profit in August is $1. Variable food costs are estimated to be 30% ($21. In a retail business. During the spring and summer months. Item D will be VERY difficult for most students.000/$70.000 + 30%*Total revenue During August.000*40%). However. generating most its sales around the ski season (fall and winter). the variable cost part of the cost function can be adjusted.000) (24.000. and the increase is estimated to be 40% of the increase in revenues. Thus.000).000 ($10.000 . total variable costs are expected to increase by $4. If the university were to close the Lair. So. the additional profit from a $10. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.000) $ 9.000 (47.

5 = $152.22 Firm B set its selling price based on the average cost. A correlation may appear in a scatter plot or regression analysis.69 (average cost for each of the 5 units) Total cost = $205. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.542. Although these expenditures are made because more money is available. firm B's selling price is: $101.50 = $1.2345 Y = $300*5-0.028.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.45 Although each customer paid a different price. special promotions. a 50% markup on total cost will cause sales to be: $1.84 . then the highest sales might coincide with the highest electricity costs.542.85/ln2) = 0.69 x 5 = $1. However. D. employee training. Many costs can be related to volume of activity.028. higher profits generally occur during periods when activity is high. in turn. and new office furniture or equipment.2345 Y = $205.2345 Y = $101. given a 100 unit production level: Y = α Xr Y = $300*100-0.028. 2. they are discretionary expenditures and not caused by the level of activity.67 Firm A's income for last year was: Sales Costs Income $1.45 $ 514.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. generally mean there is more money available to spend on administrative travel. For example.67 1. correlation does not necessarily mean causation.45 x 1. Higher profits.89 x 1.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.

356.10 $22. assuming an 85% learning effect would be: Y = $300*150-0.50 $ 9.10 $ 172.40 Firm A's costs may be computed as follows: Y = $300*15-0.727.384.84) Costs (150 x $ 92.727.50 $ 9.50 = $97.45 $1.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.85 x 1.528.625.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.55 1.85 Thus Firm B's selling price this year was $64.2345 Y= $78.Chapter 2: The Cost Function 2-27 Firm B's costs.00 13.2345 Y = $92.356.028.65) Income Firm A's revenues for this year are: (10 x $152.028. Total cumulative production cost (300 x $78.84) = $1.40 1.50 .50/150 units = $64.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.897.528.75) Total costs to produce the first 150 (from last year’s income statement) Total costs of this year’s production (150 units) Average cost per unit = $9.97) 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 $1.28 $23.2345 (notice that the cumulative units produced is 15) Y = $158.926.30 $2.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.897.00 13.

500.864. Costs $165. A.00 9. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $6.com/college/eldenburg). Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales. available on both the Instructor and Student web sites for the textbook (available at www.000 $8.com/college/eldenburg).28) Costs (150 x $64. and most of the observations appear to have a fairly linear trend.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.727.61.500.000 $135.500.000 Marketing Dept.wiley.356. such extreme differences in cost can occur. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.000 $145. .10/10 = $135.000 $5. There is a positive slope.85) Income $14.000 $7.50 $ 4.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.28 is lower than Firm A's average cost per unit: $1.500.000 Sales B.50 Note that Firm B's selling price for this year of $97. Scatter Plot of Marketing Costs Against Sales $175.592. 2.000 $155.wiley.

. they may be positively correlated with sales.86656716 Standard Error 4015.01335108 Standard Error 6844. Instead. Therefore. E.34%*Sales D.08144 Observations 30 Coefficients 65584. Discretionary costs are set by decision. F. discretionary costs such as marketing are often increased when profits increase. the cost function is: TC = $65. If the variable portion of the marketing cost is sales commissions. the cost estimate should not be based on past costs.93336396 R Square 0. using regression or any other technique.4501E-10 5. Regression Statistics Multiple R 0. usually annually.5289E-14 Intercept X Variable 1 Based on the regression results.Chapter 2: The Cost Function 2-29 C. Here is the regression output. Assuming that profits are more likely to increase when sales increase. Even if marketing department costs are discretionary.584 + 1.63816 0.2608 0. there would be a positive correlation between marketing department costs and sales. the decision maker(s) should be asked what next year’s cost will be. When more money is spent on marketing.58184484 13. sales may go up. it is economically plausible for sales to be a cost driver.00097028 t Stat 9. In addition.7600071 P-value 2.87116829 Adjusted R Square 0.

000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.000 $40.com/college/eldenburg).000 $40.000 $160.2-30 Cost Management 2.com/college/eldenburg).wiley.000 $80.000 $0 0 300 600 900 1200 1500 Machine Hours . A.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $160. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.wiley. available on both the Instructor and Student web sites for the textbook (available at www.000 $120. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $120.000 $80.

552864 . If the observations are widely scattered. Sometimes a cost that is mostly variable. but the plot for labor hours appears to have the least trend.02253618 Standard Error 11114. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.000 $0 0 100 200 300 400 500 600 700 Raw Materials B. The plots help determine whether regression analysis should be performed using any of the potential drivers.000 $40.11279932 R Square 0.56597156 30 Standard Error 14812.600712 P-value 6.000 $80. None of the plots show a definite trend. Labor Hours Regression: Regression Statistics Multiple R 0.1543 0.86E-11 0.000 $160.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200. the cost driver does not explain the variation in cost.8173 Observations Coefficient s 150410. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.600936029 Intercept Labor Hours t Stat 10. either the driver is wrong or the cost is mostly fixed.50852 7.000 $120. labor hours could be deleted as a potential cost driver. C. Based only on the cost plots.01272369 Adjusted R Square -0. D.682 4.

9786 Observations 30 Coefficient s 126216.004579 Both the intercept and slope coefficients are significant.5033241 R Square 0.217 + $60. so the cost function is estimated as: TC = $150.2266685 Standard Error 9665.91 60. so the cost function is estimated as: TC = $117.2-32 Cost Management Only the intercept term is significantly different from zero.331580777 Intercept Machine Hours t Stat 11.599 + $38.2533351 Adjusted R Square 0.217192 Standard Error 10291.56778 19.53627459 Intercept Raw Materials t Stat 11.612063 R Square 0.11E-12 0.67 38.000325 Both the intercept and slope coefficients are significant.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.4268 4.095468 P-value 4.62907 3.082222 P-value 3.411 Machine Hours Regression: Regression Statistics Multiple R 0. so the cost function is estimated as: TC = $126.3522862 Standard Error 8846.215128 Standard Error 10853.47803 9.3746211 Adjusted R Square 0.1555 Observations 30 Coefficient s 117598.68E-12 0.22* Raw materials .

wiley.953575 1. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.352 0. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.com/college/eldenburg).218173 8.wiley.2349 3.210187 P-value 3.8067018 Standard Error 4832.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.5558 Observations 30 Coefficient s 60988. The coefficients for each of the other potential cost drivers are significantly different from zero.9092294 R Square 0. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. machine hours appears to do the best job of explaining manufacturing overhead costs.886218 -0. 2.08E-08 .226 Based on the simple regression results. however. F.8266982 Adjusted R Square 0.976635 Standard Error 10361.com/college/eldenburg).05878 9.489 -0. available on both the Instructor and Student web sites for the textbook (available at www.333162437 5.778501 82.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0. A.Chapter 2: The Cost Function 2-33 E. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).3E-06 0. this driver explains only 35% of the variation in cost.1959303 48.12E-09 1.291558412 10. Yes.

7422519 82. In this example.806) than in either of the simple regressions (0.411 (<0.98 (<0. Costs for these activities are likely related to specific cost drivers.226) for these two cost drivers.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. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0. C.988 (<0. Manufacturing can be a complex activity requiring a number of different tasks.57 (0. its coefficient is not significantly different from zero in either regression.81383627 Standard Error 4742.664851 5.954) $48.022 0.678 + $48. Each task includes different activities.20 (0.55) $38. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.352 and 0.881964042 Intercept Machine Hours Raw Materials t Stat 6.93*Raw materials D.22 (<0.74*Machine hours + $82. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.939606 9.001) $117.5348 Observations Coefficient s 60677.71E-10 5.226 0.82667515 Adjusted R Square 0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.217 (<0.001) $126. Thus. The adjusted RSquare is far higher in the multiple regression (0.001) $60. Also.29E-09 The cost function is: TC = $60.391636 P-value 1.001) $4.001) B.5902 48.352 0.599 (<0.450561 8.925842 30 Standard Error 8743. labor hours can be eliminated as a potential cost driver.22 (0. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.157604083 9. machine hours and raw materials explain different activity .005) $82.001) $-0.806 $150.86E-07 4.78 (<0.90921678 R Square 0. its coefficient is negative rather than positive in the multiple regression.001) $60.

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

Dept. Costs $25. Costs $25.com/college/eldenburg). Dept. Other cost drivers for total maintenance cost could be number of rooms cleaned.wiley. number of hours students attend school.wiley. 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 $0 528 530 532 534 536 538 540 542 Number of Students C.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2.000 $5.000 $20. number of hours the building is open.000 $20.000 $10.000 $15. B. or number of classes and activities per period. square feet cleaned.000 $15.2-36 Cost Management 2. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. available on both the Instructor and Student web sites for the textbook (available at www.000 $10.com/college/eldenburg). A.000 $5. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. .

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.03271 Standard Error 3019. The p-values on the Tstatistics are very small.0857 Intercept X Variable 1 t Stat -0.461245 7.74733262 t Stat 9.247329 R Square 0. maintenance hours is a reasonable cost driver. providing high confidence that both the intercept and slope are different from zero.438328 According to the R Square statistics.832184392 Standard Error 1217. E. From the analyses performed.135 + $35. However.453062 P-value 2.Chapter 2: The Cost Function 2-37 D. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.920565237 R Square 0. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.68624 0.74*maintenance hours worked.796328319 Intercept X Variable 1 Coefficients 9134.36 The Elder Clinic A and B Salaries are always fixed. An unidentified cost driver could have a higher R-Square. Utilities cost varies with season not visits.9 244.5045837 4.875134 35.06772 Observations 12 Standard Error 965.173 Observations 12 Coefficient s -89867 197. and rent for this type of facility is usually fixed.847440356 Adjusted R Square 0. it is logical to expect a strong relation between hours worked and cost.63E-06 2.807201 P-value 0. Therefore.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.061172 Adjusted R Square -0.508157 0. it is considered fixed. 2. The total cost function is: TC = $9.0261 Standard Error 130954. The most current value is used to .

and so on. Here are some of the reasons: • The managers will not know how many visits they will receive. gloves. so this cost is classified as a mixed cost. 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. medical supplies is a mixed cost. This analysis suggests that there are some of the other expenses are variable costs and some fixed. each patient requires a certain number of supplies. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. .100 226 664 $19. • Prices of all inputs could change (usually increase).115 219 3. July expenses are estimated to be: TC = $19.182 .441.182 = F + $3. the cost function is: TC = $19. Some supplies. must be kept on hand whether or not they are used. Other expenses appear to increase and decrease with number of patientvisits. variable cost is $3.$2. weather. At 940 patient-visits. Medical supplies vary with number of patient-visits.934)/(849 – 778). and so on.49 Cost Driver Patient-visits Mixed X 2. affecting the number of visits at this clinic.49 ($3. or there are changes in treatment procedures for certain illnesses.com/college/eldenburg). other facilities may open or close. These would be variable.80 D.07*940 = $25. • Treatments and related costs may change as new drugs are available. high point of medical supplies cost and patient data. and costs go up as patient-visits increase. Also. Therefore. such as snake anti-venom.736 + $6.wiley.412 1.736 + $6. new equipment is acquired. Visits are affected by season. There is no one answer to this part. E. There are many possible reasons that could be listed. **Using high-low. such as tongue depressors. These would be fixed. Use the same method for other expenses.2-38 Cost Management predict next period’s utilities.07*patient-visits C. Given the preceding computations and cost summary.736 Variable $3.49*849. but not proportionately. to find fixed: $3. current illnesses that are circulating in the area. Use March.58 $6.

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

350 68.200 Apr 71.376 65.790 80.4. Because of the large difference between these values and the values in other months.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68. these are correctly handled. as shown in the scatter plot below.750. July’s result is an outlier and should be removed from the data.750 + 4. No adjustments are needed for items (c) and (d).com/college/eldenburg).736 To predict future overhead. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.800 41. but there is insufficient information to make an adjustment. IP-14 3 Payroll paid every two weeks. the first month is adjusted even though it is not an actual cost: 4.10.500 x 1/2 = 2. A. (rounded to $36) 2 Note IB-4's power added to Dept.83/mo.236 69.com/college/eldenburg).250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.036 68. If these observations are included in the regression analysis.800 .750 68.8 x 6. B. The miscellaneous supplies account also looks suspicious. 80% of September 2 payroll to August: .486 68.000 = 4.686 71.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.2.736 67.286 68. Operations in the month of July are not typical of the rest of the time period. available on both the Instructor and Student web sites for the textbook (available at www.wiley.150 73. the trend line is likely to distort costs. 1/2 of August 5 payroll goes to July: 5.300/10 x 12 = 35.800.500 38.750 .2-40 Cost Management 2.wiley.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.200 +$2. . Similarly. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.596 73.850 2 .310 70.

500 Outlier Direct Labor Hours C.314163 1980.050976 P-value 0.26 3.775388 0. the cost function is estimated as: Overhead cost = $6.47 8 Standard Error 29406.310484 Intercept X Variable 1 Coefficient s 8777.412139 0. Therefore.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). Based on the variation in dates at which supplies are recorded.000 $55. Thus.000 $65.000 $50.298502 2.000 9.500 8.000 2.789722 t Stat 0. D.000 $45. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 3.086126 Based on the t-statistic and p-value for the intercept.641981 0.000 6. the fixed cost does not appear to be different from zero.000 $60.000 $40. According to the details provided for August and September.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75. supplies were a large proportion of overhead cost. Monthly overhead costs for supplies may be significantly overstated or understated . they are most likely recorded at the time of purchase rather than at the time of use.818 6.000 Overhead Costs $70.500 5.

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

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

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

Here are the simple regression results: Regression Statistics Multiple R 0. the fixed cost and the variable cost per unit are each positive and statistically different from zero. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.] The data for this problem can be found on the datasets file for chapter 2. the degree of downward bias is higher for older data than for more recent data. Also. However.com/college/eldenburg). Considerable variation in labor costs is not explained by changes in the volume of production.957296 Standard Error 6710.6004687 Adjusted R Square 0. A.02E-10 Based on the regression results.com/college/eldenburg).wiley. available on both the Instructor and Student web sites for the textbook (available at www. In prior years.437E-24 1. .96 x number of chairs produced However. using monthly data for the prior 4 years.3147402 P-value 3.04 13.wiley.41 Integrating Across the Curriculum: Statistics [Note about problem complexity: This homework problem was written with adequate instructions so that students should be able to perform the various regression analyses that are called for. The cost function is estimated as: Labor cost = $133. the cost function was estimated by regressing actual labor costs on number of chairs produced.194 + $13. students are likely to struggle interpreting and choosing a method (Parts E and F).5917832 Standard Error 6216.7748991 R Square 0. B.848277 8. the regression explains only about 59% of the variation in labor costs. Because of the annual pay increases. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.Chapter 2: The Cost Function 2-45 2.609693 1.678620854 Intercept X Variable 1 t Stat 19.7995 Observations 48 Coefficient s 133194.

approximately 26% of the variation in labor costs is still unexplained. D.869633 Adjusted R Square 0.23 per chair.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 0.736 + $16. which is reasonable given the increase in wage rates over time. The fixed cost is nearly the same.74).932541 R Square 0.57E-23 2.23439 Standard Error 5557. but the variable cost increased from $13.91E-08 .905 Observations 48 Coefficient s 133736 16.010513 1.93821 16.67711 P-value 1.390275 Intercept X Variable 1 t Stat 24.311 200.864722 R Square 0.891 1. here are the regression results: Regression Statistics Multiple R 0. Here are the multiple regression results: Regression Statistics Multiple R 0. Also.347 x 1.02 Adjusted Labor Cost $220.533 x (1.96 to $16.73E-20 5.26499 6.35E-15 Based on the regression results.486389 P-value 4. Nevertheless.05E-27 2. The cost function is estimated as: Labor cost = $133.54295 Standard Error 5689.274 Using the adjusted labor cost data.742261 Standard Error 5148.09577 6.06236 11. this cost function would result in a higher estimate for future costs.863839 Standard Error 3742.02)4 $196.411 Observations 48 Coefficient s 107748.492 1.2-46 Cost Management C.347 Calculation $203.00872 Intercept X Variable 1 X Variable 2 t Stat 18.747745 Adjusted R Square 0. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.8 16. the fixed cost and the variable cost per unit are each positive and statistically different from zero.533 Dec 20X4 196.

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

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