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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

so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. the CPA's time is the product being sold.000 + $8. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. 2.000 $9.13 Linear. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.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 . CPAs do keep detailed time records. In a service business such as this. The time records that the tax partner maintains support this cost as a direct cost.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. For the firm to make this cost direct for the personal returns cost object.000 Total Cost $12. Stepwise Linear.000 $11. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns.000 $8. TC = $10.000 $13.000 $10. the tax partner probably spends some time in non-billable activities. Of course. and Piecewise Linear Cost Functions A.00*Q Graph of Cost Function $14.

000 + $39*Q .000 .000 $70.000 – 10.000 $0 0 1.000 Number of Units C.000 $20.000 + $8.000) = $78.000 TC = $35.000 $10.00*Q. Convert the average costs to total costs for each production level: Total cost at 10.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 $60.000 $40. for Q > 2.000/2.000 Graph of Cost Function $80.000 + $8.000 4. it is first necessary to estimate the cost function.000 = $60.000 3.000 units: $450.000 Total cost at 12.000 $30.000 2.000 * $44 = $528.2-6 Cost Management B.$390.000 units = 10.$450. To estimate the costs at another production level.000 = F + $39*10. TC = $25.000 * $45 = $450.000 .000)/(12.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528. for Q ≤ 2.000 Total Cost $50.000 units = 12.000 F = $450.00*Q.

000 + 45%*$10.000 + $10.14 Piecewise Linear Cost Function A.000 $60.000 $70.Chapter 2: The Cost Function Estimated total cost at 15.000 in revenues into the cost function. Inserting $10.000 For Q > 1.000 * $10.500 2.000 $50.000/15.00*Q 2-7 Graph of Cost Function $75.000 $45. TC = $50.000 0 500 1.000 = $645.000 = $60. for Q < 1.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost . total cost is estimated as: TC = $5.000 Estimated cost per unit = $645.00*Q.000 TC = $51.000 units: TC = $60.000 $65.00*(Q-1.000 = $43 D.000 + $9.000 + $39*15.000 + $9.000 + (1.000 1.000 = $9.000 $55.000 + $585.00) + $9.$9.00*Q .000 + $10.500 2.000) TC = $50.000: TC = $50.

This cost function would provide reasonable estimates for Q ≤ 1.000 + $9.000 units.3219 Y = 6 hours*2-0.3 and 2A. 3. If all of the data estimation points occurred when Q was > 1. 2.000 + $10.2-8 Cost Management B. then the cost function would appear to be: TC = $51.15 Tax Plus A.000 units.80/ln2) = −0. the cost function mismeasurement depends on the values of Q.8 hours (average time for each of the next two returns) B. If the data estimation points occurred across the two relevant ranges. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A. Hours for two returns would be determined as follows. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared . If the accountant did not detect that there were two different relevant ranges.00*Q. then the cost function would appear to be: TC = $50.3219 Y = 4.00*Q. 2. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. There are three general situations: 1.000 units but would overestimate total cost for Q > 1. This cost function would provide reasonable estimates for Q > 1.4. then the cost function would be some mixture of the functions for the two relevant ranges.000 units. If all of the data estimation points occurred when Q was ≤ 1.000 units.000 units but would underestimate total cost for Q ≤ 1.

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

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

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

It will be a fixed cost if it is a flat amount.59/16) 0.15/45) 0.0863 0.2-12 Cost Management E. The cost might be fixed or mixed.0198 0.0033 0. they are treated as fixed costs. If the fishing boat is for tourists. For the fishing boat business. Tomato ($.3489 (calculated above) B. Mustard ($.000) * 4] 0.69/7) $0. Mayonnaise [$1. F or M Any type of business will have insurance costs. Dill pickles [($8.1075 0.79/150) 0.6815 A.99/50) 0.1619 10. but it might be mixed if a portion of the cost relates to levels of business activity.3489 $0.2414 2.0233 0.95/2.$0. Cost of plain burger = $0. Because advertising costs tend to be discretionary. B. G. F. F Most pizza shops incur advertising costs such as flyers. newspaper advertisements.59/40) 0. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. Cost of burger with everything except cheese = ($0.1619) = $0.0179 4. 2.56 .20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1. Lettuce ($. PS. Cheese ($2. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.49/(16 x 4)] 0. advertising costs would be incurred. B. Hamburger patty ($1.0233 7.5196 Suggested selling price: 300% * $0. however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship.0179 0.0033 $0.1075 0.69/8) 0. there might be some utility costs for the fishing operation and for a business office.0053 8. Onions ($. Catsup ($.29/12) 0. In general.2414 $0.0148 6. and yellow pages advertisements. depending on how the insurance cost is calculated. the utility costs for these two businesses would tend to be fixed (would not vary with production).1075 3. Hamburger bun ($1.0148 0.1619 0.0053 0.5195 = $1.2414 $0.6815 .0863 5.0198 9.

FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J.$0. Therefore. Licenses. However staff are often salaried. if her prices are too low. Professional subscriptions.6815 = $2. Staff wages – Could be variable or mixed (salary + overtime) for regular staff." However. D. and then mixed C. If there is part time help.04 . Office supplies . If Ms.Fixed D. It is just a general guideline.] A. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. 2. This means that her costs need to be below the competitive price. Clerical wages – Fixed unless overtime is regularly scheduled.Fixed F. In the current business environment. mostly variable G. that is.Fixed . Selling price of cheeseburger with everything: 300% * $0.21 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. Long is able to differentiate her hamburgers from others in the market. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. Alternatively. she foregoes profits and people may believe there could be quality problems with her food. Property taxes.25 = $1.Mostly fixed and discretionary H.Fixed E.04 Therefore. and F) are the ones requiring significant assumptions to generate an answer. 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.Chapter 2: The Cost Function 2-13 C. Market forces will dictate achievable prices. B. that cost would be variable. Long’s prices are too high. Professional dues. Rent . Alternatively.Mixed. if Ms. in which case the total cost would be primarily fixed. they set prices considering their competitors’ prices. most organizations are price takers. there is no moral obligation to maintain a 300% markup on each item. the price of the plain hamburger should be: $2.Fixed and discretionary I. Insurance. The Step 2 questions (A.79 Some students will view this higher price as "unfair. B.

) B.2-14 Cost Management K. number of advertisements placed. In this problem. available on both the Instructor and Student web sites for the textbook (available at www.22 Cost Function Using Regression. If this is the case. For example.] The data for this problem can be found on the datasets file for chapter 2.wiley. The cost analyst needs to gather information about how marketing costs are set each year.wiley. 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. Other Potential Cost Drivers A. Other possible cost drivers for marketing department costs could be revenue. .com/college/eldenburg). Advertising – Fixed and discretionary 2.35*units sold. 2. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. In addition. Therefore. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero. C. or profits. it is possible that marketing costs are discretionary.com/college/eldenburg). the variation in units sold explains about 61% of the variation in marketing department cost. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. the cost is discretionary and will be set through the negotiating process.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. TC = $222.

Potential Cost Driver: Output Maintenance Costs Against Output $2.119724 15 Coefficient s 884.4342166 0.113687834 Intercept Output t Stat 5.000 $1.61765897 0.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.761602 4.500 $1.58E-05 0.58824812 182.500 Maintenance Costs $2.78591283 0.026826 0.000514 .52099624 Standard Error 153.582691 P-value 6.Chapter 2: The Cost Function 2-15 A.

60187065 0.017601 .02569657 Standard Error 261.500 $1.31319046 235.7549386 1.717372 P-value 0.210849 15 Coefficient s 861.36224828 0.291084 2.113464425 Intercept Direct Labor Hours t Stat 3.500 Maintenance Costs $2.457384 3.000 $1.005847 0.000 $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 0.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.

However.500 $1.910475729 Intercept Machine Setups t Stat 1. In Part A.42597461 1. If the observations are widely scattered. 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.500 Maintenance Costs $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 126.6778973 0.815737 29.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2.94495003 66. . a good cost driver would present a linear or football-shaped positive slope or trend.357393 15. For example.96E-10 B.197755 8.97410583 0. In a scatter plot.5343 P-value 0.000 $1. the trend line for machine setups looks as if the intercept could be zero or very close to zero. or the cost is mostly fixed. all three potential cost drivers appear to be positively related to maintenance costs. This indicates that the cost could be totally variable.94888217 0. the cost driver does not explain the variation in cost and either it is the wrong driver.5913391 15 Standard Error 93.

This means that variation in setups explains about 95% of the variation in cost. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. 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. R-Square 0. Changes in many factors such as resource prices. and technology can cause future costs to be different than estimated.025*Direct Labor Hours TC = $29. so it is excluded from the cost function. In the machine setups regression. the t-statistic is significant for the independent variable but not for the intercept. E.521*Output TC = $861 +$3. the economic environment. D.68* Machine Setups The machine setups intercept coefficient is not significant.588 0. This provides confidence that the variable cost part of the cost function is not zero.313 0. Therefore. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero.2-18 Cost Management C. The regression using machine setups has the highest adjusted R-Square of 0. business processes. . the cost is likely to be totally variable.945.945 Cost Function TC = $884 + $0.

on average. . or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. this cost function might provide poor estimates of future costs.728 + 5%*Sales B.333 = F + 5%*$1. Therefore.Chapter 2: The Cost Function 2-19 PROBLEMS 2. the cost function is calculated using the highest and lowest values of the cost driver.24 Big Jack Burgers A. That means that the cost function might not represent the actual cost. First.333)/($1. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.05. Under the high-low method. not represent the cost most of the time.132.728 Thus. the total cost function is: TC = $11.605 = $11.100 – $632.100 F = $68. The high low method uses the most extreme cost driver values.000/$500.132.000 = 0. that is.333 – $43. which could be outliers. the variable cost is calculated: ($68.100) = $25.$56.333 .

analysis at the account level might indicate that there are few fixed costs. the regression intercept can be used as an estimate of the fixed costs. the cost function would be TC = $16.000 $1. Chart of data with trend line added by Excel. etc).200.2-20 Cost Management C. In that case.5% x sales . The upward slope of the line indicates that there are variable costs.000 $600. Then. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. D.000 $900. fixed costs are likely to be zero and would be excluded from the cost function.800 + 4. Because this regression has few observations. If this cost pool includes items such as salaries and other fixed costs (insurance.000 $40.172. but the p-value is greater than 10% at 0.000 Sales It appears that the cost is most likely mixed. Analysis at the account level can be used to increase the understanding of this cost. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. the cost function would be: TC = 4.000 $20. Following is the regression output.000 $0 $0 $300. there is a 16% probability that the intercept (fixed cost) is not different from zero. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function.162. Then. the p-value result for the tstatistic is atypical.000 Administrative Costs $60. Notice that the t-statistic for the intercept coefficient is 2. Alternatively. Based on the p-value.5% x sales.

This method can be used in cases where there is not enough data to perform regression. the high-low method may be the best option available. If these assumptions do not hold. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. a cost function may not provide a good estimate for the next month’s costs. Therefore. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.365 + 0. If there are more data points. Using the regression results. the cost function is: TC = $50.73545 0.16197623 0. This means that variation in sales explains only about 18% of the variation in research and development cost. The past costs used for estimation might not be representative. However. especially because so few observations were used in the estimation. There might be a large discretionary component in administrative costs. 2. Both methods assume that the cost function is linear and that all data points come from a single relevant range. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. B. The plot shows costs that are widely scattered. there does appear to be a general upward trend. Sales does not appear to explain much of the variation in research and development costs. Sales might not be the activity that drives administrative costs. .0319523 Intercept X Variable 1 E. and possible changes in costs such as those described in Part E are ignored. The adjusted R-Square statistic is very low at 0.00818212 t Stat 2.2444 7734. Because of unforeseen changes in cost behavior.17205158 5. however.45937486 P-value 0. The cons of the high-low method as an estimation technique were discussed in Part B above.82%*Sales C. then both methods may be unsuitable for estimating future costs. F. both of these methods assume that the data points are representative of future costs.186.93711636 0. on average. In addition. Unusual cost items are assumed to continue in the future. If there are only two or three data points. regression analysis incorporates all of the observations into the analysis.9680477 0.90567454 3293.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. Cost Function Using Regression A.4038 4 Coefficients Standard Error 16800.04466925 0.25 Scatter Plot. the results rely on more complete information and provide a better estimate. causing fluctuations in cost that are unrelated to any cost driver.

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

Here are some of the reasons.00 + (600-500)*$0.152 Y = 8. Hours per batch would be determined as follows.10 = $40. Cons • If Susan has a number of projects in her local area or will be traveling a lot. so Susan may need to maintain her own records if she wishes to trace telephone usage.05 $0. Pros: • Susan might prefer the convenience of not switching telephone companies • If Susan is happy with her current quality of service she might prefer to stay with the same company and not investigate other companies’ plans • Susan may be able to predict her cost better. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. There are many different reasons that the time could be different from the amount determined above.90/ln2) = −0. telephone costs are viewed as an indirect cost.04 $0.00 $20. she will pay a very high rate of 10 cents per minute 2.00 $20.00 $20.10 = $30.1 hours (average time for the first four batches) B.00 $20. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. Minutes 300 400 500 600 700 Total Cost $20. In . students may think of others. her phone bill will be less than it would be at a rate 5 cents per minute. It is possible that the managers under. I. 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. In most businesses. If her calls are over 400 minutes or under 600 minutes.Chapter 2: The Cost Function 2-23 consulting jobs. In this case the learning rate would be wrong and so the time would also be wrong.27 Fancy Furniture A. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls).05 $0.067 $0.152 Y = 10 hours*4-0.00 Average Cost $0. Many cellular telephone bills do not list the calls made.00 + (700-500)*$0.or overestimated the amount of hand work performed.

000 1.000 + 40%*Total revenue D. C. If a worker is absent one day. and the University surcharge is specifically based on sales. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. However. D. Thus.500 10. or has a great deal of experience on the machine. they would be higher than the labor costs in later periods.000 Total revenue is the most likely cost driver for both variable costs.000 = $1. the cost function is: TC = $47.500 $47.000 using the cost function is: TC = $47.000 7. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28.000 Variable $21.$79.000 Profit = Revenues – Total costs = $80.000 . then the cost would be overestimated.000 = 0.000 + 40%*80. C.000 5. Because revenue is the cost driver for both variable costs. then this chart suggests that the learning curve will be slower than the 90% estimate.2-24 Cost Management addition. or 40% or revenue Combining fixed and variable costs.000 . Food costs are likely to vary proportionately with sales.000 = $79.000 _______ $28. 2. the rate will change if the replacement employee has never worked on this machine. and B. if managers believe that 25% of the work is done by hand. If these values are used in a regression to estimate a cost function.000/$70.28 Wildcat Lair A.40. if managers believe that more than 25% of the work is done by hand. it is possible that different types of wood affect the rate at which chairs can be produced. 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. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized. The estimate of total costs given revenues of $80. then the chart suggests that the learning rate estimate is reasonable.

the shop might experience very little business activity.000— the operating loss of $(5. In July there was a loss of $5. A shop located near a ski area is likely to incur high heating costs during the winter. Item D will be VERY difficult for most students. for July the opportunity cost would have been $2.Chapter 2: The Cost Function 2-25 E. B.000) of revenues. the additional profit from a $10.000)+the university surcharge of $7. During the spring and summer months. but this is not considered a cost driver (a business activity that causes variations in total variable cost). Only total variable costs are expected to increase.000 (47. costs would be higher when there were fewer sales.$4.000) (24. Electricity costs also vary with changes in electricity rates. C. Because the university surcharge is an allocation within the university. if the bathing suit shop is located in a geographic region $80.000).000) Net 2. Variable food costs are estimated to be 30% ($21.000 (-$5. To estimate the opportunity cost for August. the variable cost part of the cost function can be adjusted.000).000+$6.] A.000 + 30%*Total revenue During August. The shop is most likely a seasonal business. So. less the fixed costs and the variable food costs.) The adjusted cost function is: TC = $47. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000.000*40%).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.000. Lair’s fixed costs are assumed to be unchanged with the $10. so the trend would be the opposite of this plot. and the increase is estimated to be 40% of the increase in revenues.000/$70. total variable costs are expected to increase by $4. If the university were to close the Lair. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold.000 .000) $ 9.000 . it would lose the revenues. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. 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). So. it might even close when the ski area shuts down. F. so the estimated profit in August is $1. Thus.000 increase in revenues is expected to be $6.000 ($10. In a retail business. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues. generating most its sales around the ski season (fall and winter).000 ($10. However.000 increase in revenues.

84 .67 1. Higher profits.69 x 5 = $1. given a 100 unit production level: Y = α Xr Y = $300*100-0. a 50% markup on total cost will cause sales to be: $1. generally mean there is more money available to spend on administrative travel. correlation does not necessarily mean causation.542.45 Although each customer paid a different price. then the highest sales might coincide with the highest electricity costs. 2. higher profits generally occur during periods when activity is high. However. and new office furniture or equipment. For example.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.5 = $152.2345 Y = $101.22 Firm B set its selling price based on the average cost.85/ln2) = 0. Although these expenditures are made because more money is available.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. Many costs can be related to volume of activity.028. employee training.2345 Y = $300*5-0.542. A correlation may appear in a scatter plot or regression analysis. in turn.89 x 1.45 $ 514.028. special promotions.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning. D.69 (average cost for each of the 5 units) Total cost = $205. they are discretionary expenditures and not caused by the level of activity. firm B's selling price is: $101.2345 Y = $205. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.67 Firm A's income for last year was: Sales Costs Income $1.45 x 1.028.50 = $1.

50/150 units = $64.97) Less costs from last year’s income statement for first five units Cost to produce the 10 units for this year Thus Firm A's income statement for this year is Sales Costs Income $1.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.00 13.356.028.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.356.84) = $1.28 $23.50 = $97.50 $ 9.55 1.Chapter 2: The Cost Function 2-27 Firm B's costs.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.84) Costs (150 x $ 92.10 $22.65) Income Firm A's revenues for this year are: (10 x $152.50 .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 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.727.2345 Y = $92.40 Firm A's costs may be computed as follows: Y = $300*15-0.30 $2. Total cumulative production cost (300 x $78.2345 (notice that the cumulative units produced is 15) Y = $158.50 $ 9.897.625.384.897.85 x 1.528.10 $ 172.727.028. assuming an 85% learning effect would be: Y = $300*150-0.45 $1.926.2345 Y= $78.40 1.00 13.85 Thus Firm B's selling price this year was $64.

Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.wiley.50 $ 4.500.000 $5.000 $6. Costs $165.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000 $8.com/college/eldenburg).2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.356.00 9.727.000 $7.000 $135.000 $145. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales. There is a positive slope. such extreme differences in cost can occur. .28 is lower than Firm A's average cost per unit: $1.592.com/college/eldenburg).28) Costs (150 x $64. A. and most of the observations appear to have a fairly linear trend.85) Income $14.500.864. available on both the Instructor and Student web sites for the textbook (available at www.50 Note that Firm B's selling price for this year of $97. 2.000 $155.500.wiley. Scatter Plot of Marketing Costs Against Sales $175.61.000 Sales B.10/10 = $135.500. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 Marketing Dept.

Here is the regression output. there would be a positive correlation between marketing department costs and sales. usually annually. they may be positively correlated with sales.86656716 Standard Error 4015. In addition. the cost estimate should not be based on past costs. Discretionary costs are set by decision. Instead. Therefore. it is economically plausible for sales to be a cost driver. discretionary costs such as marketing are often increased when profits increase. using regression or any other technique.08144 Observations 30 Coefficients 65584.584 + 1.34%*Sales D.87116829 Adjusted R Square 0. E.00097028 t Stat 9. sales may go up. Regression Statistics Multiple R 0. the cost function is: TC = $65.5289E-14 Intercept X Variable 1 Based on the regression results.63816 0.2608 0.4501E-10 5.01335108 Standard Error 6844.Chapter 2: The Cost Function 2-29 C. the decision maker(s) should be asked what next year’s cost will be. When more money is spent on marketing. F.93336396 R Square 0. . Assuming that profits are more likely to increase when sales increase.58184484 13.7600071 P-value 2. If the variable portion of the marketing cost is sales commissions. Even if marketing department costs are discretionary.

wiley.000 $80. A.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $40.000 $160.com/college/eldenburg).000 $80. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200. available on both the Instructor and Student web sites for the textbook (available at www.wiley.000 $40.000 $120.000 $120.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.2-30 Cost Management 2. 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.com/college/eldenburg).000 $160.

600936029 Intercept Labor Hours t Stat 10.000 $80.000 $0 0 100 200 300 400 500 600 700 Raw Materials B.8173 Observations Coefficient s 150410. Based only on the cost plots.50852 7.000 $160. 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. the cost driver does not explain the variation in cost.02253618 Standard Error 11114. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.682 4.1543 0. None of the plots show a definite trend. but the plot for labor hours appears to have the least trend. Costs and potential cost driver data are plotted to determine whether further analysis is necessary. If the observations are widely scattered. D.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.11279932 R Square 0. C.600712 P-value 6. labor hours could be deleted as a potential cost driver.01272369 Adjusted R Square -0.000 $120.000 $40.56597156 30 Standard Error 14812. Labor Hours Regression: Regression Statistics Multiple R 0. Sometimes a cost that is mostly variable.552864 .86E-11 0.

2266685 Standard Error 9665.47803 9.67 38.9786 Observations 30 Coefficient s 126216.217 + $60.000325 Both the intercept and slope coefficients are significant. so the cost function is estimated as: TC = $150.3746211 Adjusted R Square 0. so the cost function is estimated as: TC = $126.1555 Observations 30 Coefficient s 117598.082222 P-value 3.599 + $38.331580777 Intercept Machine Hours t Stat 11.5033241 R Square 0.095468 P-value 4.2-32 Cost Management Only the intercept term is significantly different from zero.2533351 Adjusted R Square 0.91 60.11E-12 0. so the cost function is estimated as: TC = $117.4268 4.68E-12 0.3522862 Standard Error 8846.411 Machine Hours Regression: Regression Statistics Multiple R 0.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.215128 Standard Error 10853.53627459 Intercept Raw Materials t Stat 11.22* Raw materials .62907 3.612063 R Square 0.004579 Both the intercept and slope coefficients are significant.56778 19.217192 Standard Error 10291.

976635 Standard Error 10361.953575 1.com/college/eldenburg).778501 82. however.wiley.05878 9.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.2349 3.352 0.333162437 5. F.1959303 48.12E-09 1.wiley. A. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.8266982 Adjusted R Square 0. Yes.3E-06 0.886218 -0.com/college/eldenburg).08E-08 . available on both the Instructor and Student web sites for the textbook (available at www.5558 Observations 30 Coefficient s 60988. machine hours appears to do the best job of explaining manufacturing overhead costs.9092294 R Square 0.8067018 Standard Error 4832. The coefficients for each of the other potential cost drivers are significantly different from zero.291558412 10. this driver explains only 35% of the variation in cost.489 -0. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.210187 P-value 3.Chapter 2: The Cost Function 2-33 E. 2.226 Based on the simple regression results. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.218173 8. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).

57 (0.005) $82. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.22 (0.806) than in either of the simple regressions (0. C.001) $60.71E-10 5. its coefficient is negative rather than positive in the multiple regression. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.81383627 Standard Error 4742.001) $60. The adjusted RSquare is far higher in the multiple regression (0.20 (0. its coefficient is not significantly different from zero in either regression.939606 9.82667515 Adjusted R Square 0.217 (<0.7422519 82.599 (<0.352 and 0.391636 P-value 1. Thus.022 0.55) $38.93*Raw materials D.29E-09 The cost function is: TC = $60. Each task includes different activities.2-34 Cost Management Comparison of simple and multiple regression results: Intercept t-stat (p-value) Independent Variables t-stat (p-value) Labor Machine Raw Hours Hours Materials Adj.001) B.226) for these two cost drivers. Manufacturing can be a complex activity requiring a number of different tasks.001) $117. Costs for these activities are likely related to specific cost drivers. machine hours and raw materials explain different activity .98 (<0.988 (<0.001) $4.86E-07 4.5902 48.5348 Observations Coefficient s 60677.352 0.78 (<0.806 $150.954) $48.22 (<0.925842 30 Standard Error 8743. In this example. labor hours can be eliminated as a potential cost driver. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.226 0.881964042 Intercept Machine Hours Raw Materials t Stat 6. Also.90921678 R Square 0.450561 8.411 (<0.001) $126.678 + $48. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.157604083 9.664851 5.74*Machine hours + $82.001) $-0.

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

000 $10. .000 $15. Dept.2-36 Cost Management 2.000 $0 528 530 532 534 536 538 540 542 Number of Students C. or number of classes and activities per period. Costs $25.000 $5. number of hours the building is open. Dept. 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 $5.com/college/eldenburg). Other cost drivers for total maintenance cost could be number of rooms cleaned. square feet cleaned. Students may have thought of other drivers that could be logically related to cleaning maintenance costs.000 $20.000 $20. A. B.wiley.000 $15.wiley. number of hours students attend school. available on both the Instructor and Student web sites for the textbook (available at www.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint.000 $10.com/college/eldenburg). A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2. Costs $25. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.

An unidentified cost driver could have a higher R-Square.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.173 Observations 12 Coefficient s -89867 197.0261 Standard Error 130954.63E-06 2.461245 7.Chapter 2: The Cost Function 2-37 D. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.875134 35. However. Utilities cost varies with season not visits. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0. it is rational to conclude that hours worked will provide a reasonable estimate of future costs. maintenance hours is a reasonable cost driver. E.74733262 t Stat 9.061172 Adjusted R Square -0.9 244.438328 According to the R Square statistics.68624 0. providing high confidence that both the intercept and slope are different from zero.832184392 Standard Error 1217.453062 P-value 2. it is logical to expect a strong relation between hours worked and cost.06772 Observations 12 Standard Error 965.920565237 R Square 0. Therefore. it is considered fixed.0857 Intercept X Variable 1 t Stat -0. The p-values on the Tstatistics are very small.5045837 4.847440356 Adjusted R Square 0.74*maintenance hours worked.796328319 Intercept X Variable 1 Coefficients 9134.135 + $35.508157 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. 2.807201 P-value 0. and rent for this type of facility is usually fixed.247329 R Square 0. The total cost function is: TC = $9.03271 Standard Error 3019. The most current value is used to . From the analyses performed.36 The Elder Clinic A and B Salaries are always fixed.

Therefore.934)/(849 – 778). These would be fixed.412 1. Medical supplies vary with number of patient-visits. the cost function is: TC = $19. July expenses are estimated to be: TC = $19. Use the same method for other expenses. affecting the number of visits at this clinic. . Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. Use March. new equipment is acquired. Some supplies.100 226 664 $19. • Prices of all inputs could change (usually increase).182 = F + $3.49 Cost Driver Patient-visits Mixed X 2.wiley. These would be variable. **Using high-low.441. so this cost is classified as a mixed cost. such as tongue depressors. or there are changes in treatment procedures for certain illnesses.58 $6. There is no one answer to this part.736 + $6. Also.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. to find fixed: $3. and so on.49 ($3. gloves.$2. 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. E. must be kept on hand whether or not they are used.07*patient-visits C. and costs go up as patient-visits increase. There are many possible reasons that could be listed.80 D. each patient requires a certain number of supplies. • Treatments and related costs may change as new drugs are available. weather. Here are some of the reasons: • The managers will not know how many visits they will receive. and so on. high point of medical supplies cost and patient data.07*940 = $25. Visits are affected by season. other facilities may open or close. variable cost is $3. such as snake anti-venom.com/college/eldenburg). Other expenses appear to increase and decrease with number of patientvisits. At 940 patient-visits.736 + $6.49*849. current illnesses that are circulating in the area.736 Variable $3. but not proportionately.182 .115 219 3. This analysis suggests that there are some of the other expenses are variable costs and some fixed. Given the preceding computations and cost summary.2-38 Cost Management predict next period’s utilities.

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

Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.83/mo. July’s result is an outlier and should be removed from the data.com/college/eldenburg). as shown in the scatter plot below. IP-14 3 Payroll paid every two weeks.750 .286 68.736 To predict future overhead.686 71. available on both the Instructor and Student web sites for the textbook (available at www.200 Apr 71. If these observations are included in the regression analysis.800 .800. 80% of September 2 payroll to August: .236 69.486 68.wiley. (rounded to $36) 2 Note IB-4's power added to Dept. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. A.850 2 .376 65.8 x 6.750. but there is insufficient information to make an adjustment. No adjustments are needed for items (c) and (d). 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 $68.750 + 4.200 +$2.wiley. .790 80. B. 1/2 of August 5 payroll goes to July: 5.com/college/eldenburg). the first month is adjusted even though it is not an actual cost: 4. Similarly.750 68. Operations in the month of July are not typical of the rest of the time period.350 68. these are correctly handled.10.500 38.300/10 x 12 = 35.310 70.500 x 1/2 = 2.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.4.800 41.2.000 = 4.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.036 68. The miscellaneous supplies account also looks suspicious.150 73.736 67.596 73.2-40 Cost Management 2. the trend line is likely to distort costs.

Monthly overhead costs for supplies may be significantly overstated or understated . Based on the variation in dates at which supplies are recorded. According to the details provided for August and September. they are most likely recorded at the time of purchase rather than at the time of use.086126 Based on the t-statistic and p-value for the intercept.000 $55.000 9.000 $60.641981 0.310484 Intercept X Variable 1 Coefficient s 8777. Thus.000 $65. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 8.000 2. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.26 3.47 8 Standard Error 29406.500 Outlier Direct Labor Hours C.298502 2.775388 0.412139 0.000 Overhead Costs $70.000 $45.500 5. supplies were a large proportion of overhead cost.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). D.818 6.314163 1980.000 3.000 $40. the fixed cost does not appear to be different from zero.050976 P-value 0. the cost function is estimated as: Overhead cost = $6. Therefore.789722 t Stat 0.000 $50.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.000 6.

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

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

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

6004687 Adjusted R Square 0.com/college/eldenburg). .com/college/eldenburg).678620854 Intercept X Variable 1 t Stat 19. B.3147402 P-value 3. students are likely to struggle interpreting and choosing a method (Parts E and F). A. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. available on both the Instructor and Student web sites for the textbook (available at www.5917832 Standard Error 6216.848277 8.96 x number of chairs produced However. using monthly data for the prior 4 years. the fixed cost and the variable cost per unit are each positive and statistically different from zero. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.wiley.7995 Observations 48 Coefficient s 133194.609693 1. the regression explains only about 59% of the variation in labor costs. In prior years. However.02E-10 Based on the regression results.437E-24 1. Considerable variation in labor costs is not explained by changes in the volume of production. the degree of downward bias is higher for older data than for more recent data. Because of the annual pay increases.04 13.Chapter 2: The Cost Function 2-45 2.wiley.194 + $13.957296 Standard Error 6710.] The data for this problem can be found on the datasets file for chapter 2. The cost function is estimated as: Labor cost = $133. the cost function was estimated by regressing actual labor costs on number of chairs produced.7748991 R Square 0. Also.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.

891 1.06236 11.347 x 1.863839 Standard Error 3742.00872 Intercept X Variable 1 X Variable 2 t Stat 18.905 Observations 48 Coefficient s 133736 16.09577 6.533 x (1.23 x number of chairs produced This regression provides a more reasonable cost function than the previous version because it explains a higher proportion of the variation in labor costs (adjusted R-square of 0.864722 R Square 0.57E-23 2. the fixed cost and the variable cost per unit are each positive and statistically different from zero.932541 R Square 0.347 Calculation $203.74).23 per chair.486389 P-value 4.02 Adjusted Labor Cost $220. Also. approximately 26% of the variation in labor costs is still unexplained.869633 Adjusted R Square 0. The cost function is estimated as: Labor cost = $133.96 to $16. here are the regression results: Regression Statistics Multiple R 0.73E-20 5.274 Using the adjusted labor cost data. Nevertheless. but the variable cost increased from $13. which is reasonable given the increase in wage rates over time.54295 Standard Error 5689.492 1.35E-15 Based on the regression results. Here are the multiple regression results: Regression Statistics Multiple R 0.533 Dec 20X4 196.2-46 Cost Management C.742261 Standard Error 5148.26499 6. The fixed cost is nearly the same.05E-27 2.91E-08 .8 16.02)4 $196.747745 Adjusted R Square 0. D.23439 Standard Error 5557. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.390275 Intercept X Variable 1 t Stat 24.93821 16.311 200.736 + $16.411 Observations 48 Coefficient s 107748. this cost function would result in a higher estimate for future costs.010513 1.67711 P-value 1.

each month’s labor costs are expected to increase by $6. In addition. On one hand. F. it often takes time for the company to hire qualified new workers. there may be some lag between the time that production volumes change and labor costs change. The second slope coefficient requires more thought.54 x prior month number of chairs produced The statistics suggest that this is a more reasonable cost function than the previous version because all coefficients are positive statistically different from zero. As explained in the problem.Chapter 2: The Cost Function 2-47 Based on the regression results.26 x current month number of chairs produced + $6. and to decrease the number of workers when production volumes decrease.26) is interpreted in a straight-forward way.749 + $16. and the managers often delay laying off employees when volumes decline. Conversely. if the prior month’s production was lower than this month’s production. E. each month’s labor costs are expected to increase by $16.54 for each chair produced during the prior month. then this month’s labor costs will reflect the higher level of labor cost. If the prior month’s production was higher than this month’s production.l6 for each chair produced during the month. Thus. The first slope coefficient ($16. The cost function is estimated as: Labor cost = $107. and they both have positive and statistically significant coefficients. 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. However. the two cost drivers together explain a very high proportion (86%) of the variation in past labor costs. the fixed cost and the variable cost per unit for each cost driver are all positive and statistically different from zero. it could be argued that some other cost driver might do a better job of predicting future labor costs. and this regression explains more of the variation in labor costs (86%). There is no one single answer to this question. . According to the multiple regression results. then this month’s labor costs will reflect a lower level of labor cost. On the other hand. the company’s policy is to increase the number of workers when production volumes increase.

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