Chapter 2 The Cost Function

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

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

2-2

Cost Management

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

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

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2.5

2.6

Chapter 2: The Cost Function

2-3

2.7

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

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2.9

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2-4

Cost Management

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

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

D D I D D D D

D I I I I D D

I I I I I D D

00*Q Graph of Cost Function $14. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects.000 $9.000 $8. 2. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. the CPA's time is the product being sold. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained.000 Total Cost $12. TC = $10.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.13 Linear. Of course. The time records that the tax partner maintains support this cost as a direct cost. 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 . the tax partner probably spends some time in non-billable activities. CPAs do keep detailed time records.000 $11. In a service business such as this.000 + $8. For the firm to make this cost direct for the personal returns cost object.000 $10. and Piecewise Linear Cost Functions A.000 $13. Stepwise Linear.

000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528. for Q ≤ 2. Convert the average costs to total costs for each production level: Total cost at 10.000 Graph of Cost Function $80.000 $40.000 .000 $20.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 + $8.000 $0 0 1.000 2.000)/(12.$450.000 Number of Units C.000) = $78. To estimate the costs at another production level.000/2. it is first necessary to estimate the cost function.000 units: $450.000 TC = $35.000 $60.000 units = 12.000 $70.000 = F + $39*10.000 Total cost at 12.000 3.000 units = 10.000 + $39*Q .000 = $60.2-6 Cost Management B. for Q > 2. TC = $25.000 4.000 * $44 = $528.000 $10.000 * $45 = $450.00*Q.000 F = $450.000 + $8.000 Total Cost $50.000 – 10.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 .00*Q.000 $30.$390.

500 2.000 + $9.000 1.000 + $585.14 Piecewise Linear Cost Function A.000 units: TC = $60.$9.000 in revenues into the cost function.000 $60.000) TC = $50.000: TC = $50.000 + $9. total cost is estimated as: TC = $5.000 * $10. for Q < 1.000 = $9.000 $55.000 $45.000 For Q > 1.000 + (1.000 + $10.000 + $10.000 $65. TC = $50.000/15.000 $70.500 2.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .00*Q 2-7 Graph of Cost Function $75.00) + $9.000 $50.00*(Q-1. Inserting $10.000 TC = $51.00*Q .000 Estimated cost per unit = $645.Chapter 2: The Cost Function Estimated total cost at 15.000 + $39*15.000 = $645.000 + 45%*$10.000 = $60.00*Q.000 0 500 1.000 = $43 D.

If the accountant did not detect that there were two different relevant ranges. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.000 + $10.000 units but would overestimate total cost for Q > 1. If all of the data estimation points occurred when Q was ≤ 1. then the cost function would be some mixture of the functions for the two relevant ranges. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.80/ln2) = −0.00*Q. This cost function would provide reasonable estimates for Q ≤ 1.000 units but would underestimate total cost for Q ≤ 1.00*Q.000 units.000 units.3219 Y = 4. If the data estimation points occurred across the two relevant ranges.3 and 2A.4.2-8 Cost Management B. Hours for two returns would be determined as follows. If all of the data estimation points occurred when Q was > 1.15 Tax Plus A.000 + $9.8 hours (average time for each of the next two returns) B. This cost function would provide reasonable estimates for Q > 1. 2.000 units. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared . 3. 2.000 units. then the cost function would appear to be: TC = $51. then the cost function would appear to be: TC = $50.3219 Y = 6 hours*2-0. the cost function mismeasurement depends on the values of Q. There are three general situations: 1.

000 = 0. F Assuming that employee time can be traced to each bowl. it is a direct cost. wages are a direct cost.] A. the cost function is: TC = $20. Chapter 3 will point out another assumption for this cost function: the sales mix (the proportion of sales of different products) remains constant within the relevant range. I. Assuming that the cost of clay can be traced to each bowl. B. V C. In addition. Eventually their learning will plateau. but would still be considered fixed because it does not vary with production volume. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. 2. if the employee performs different types of tasks and records are not kept of the types of work performed) or if the employee does not work directly in production. or 25% of sales Combining fixed and variable costs. then variable cost per dollar of revenue is calculated as follows: $8. this particular cost function assumes that variable costs are driven by sales. then wages would be an indirect cost.25. If total variable costs were $8. making it a fixed cost. it is a common cost of production for all of the bowls that are heat-treated in the kiln. 2. However. Wages are fixed because they remain constant (the employee always works 40 hours). as their performance improves. and their productivity rate will remain stable. D or I. Total clay cost will vary with the number of bowls made. D. Assumptions: Fixed costs remain fixed within the relevant range.000/$32. F . if time is not traced to individual bowls (for example.000 on total sales of $32.16 Bison Sandwiches A. However. their productivity increases.000 + 25%*Total sales B.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. it improves less quickly for the next return. and variable costs remain constant within the relevant range.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns.000. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). that is. Note: Depreciation using a method such as declining balance is not constant over time.

because the production area may need more cleaning as volumes increase. J.500 ______ $4. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. H. depending on whether they are “used up” after a certain quantity of production. Also. it might not be traced to individual bowls. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. this is a direct cost. so it is treated as fixed. depending on what causes the cost to vary. I. I. V Assuming that the cost of packing materials is traced to each bowl. making it a fixed cost. They might be fixed or variable. making them a common cost for multiple units and an indirect cost. Advertising is not directly related to production. F The business license is not related to production.000 in sales $1. V If the glaze is expensive and therefore a relatively large cost. it is probably a mixed cost. 2. D or I. If it is an hourly charge. making it an indirect cost. I. If the kiln is electric. Packing costs are most likely variable because they will increase as production increases.300 Variable $4.2-10 Cost Management D.300 $3. This cost is also discretionary. I. part of the cost might vary proportionately with volume. making it an indirect cost. V or F Brushes for the glaze are most likely used for multiple bowls. then this cost could be indirect.] A.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. E. making it a direct and variable cost. F I. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume. if the cost is small it might be grouped with overhead costs (variable). If the cost of glaze is very small. If the packing materials are not traced (for example. D or I. if the cost is too small to justify tracing them). F. it is most likely traced to individual bowls. making it an indirect cost.500 . I.000 2. It might be fixed or mixed. G.

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

0053 0.1075 3. Because advertising costs tend to be discretionary. For the fishing boat business. Cost of burger with everything except cheese = ($0.0198 0.2414 2. F.15/45) 0.2414 $0.000) * 4] 0. newspaper advertisements.6815 .0148 6. Catsup ($. B. Hamburger bun ($1.69/8) 0.3489 (calculated above) B. Cost of plain burger = $0.95/2.0863 5. they are treated as fixed costs. If the fishing boat is for tourists. The cost might be fixed or mixed.3489 $0.20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1. Onions ($.29/12) 0.2414 $0.59/16) 0.1619) = $0. It will be a fixed cost if it is a flat amount.49/(16 x 4)] 0.1075 0.56 . 2. and yellow pages advertisements.1619 10. Lettuce ($.5196 Suggested selling price: 300% * $0. Tomato ($. F or M Any type of business will have insurance costs. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.6815 A. PS.$0.0148 0. there might be some utility costs for the fishing operation and for a business office.59/40) 0. Mustard ($.0053 8. Mayonnaise [$1.1075 0.99/50) 0. depending on how the insurance cost is calculated. F Most pizza shops incur advertising costs such as flyers.0233 0.0033 0. but it might be mixed if a portion of the cost relates to levels of business activity. advertising costs would be incurred. Hamburger patty ($1.1619 0. In general.5195 = $1. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.0233 7.0179 4.0179 0.79/150) 0.0198 9. the utility costs for these two businesses would tend to be fixed (would not vary with production). G. B. Dill pickles [($8.2-12 Cost Management E.69/7) $0.0863 0.0033 $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. Cheese ($2.

volumes will drop because customers will go to other fast food restaurants that sell hamburgers.6815 = $2. B. that is. Professional dues.Fixed and discretionary I. and then mixed C.Fixed F. In the current business environment.Mixed. and F) are the ones requiring significant assumptions to generate an answer. B.79 Some students will view this higher price as "unfair.21 Spencer and Church [Note about problem complexity: These are difficult questions because students will need to first visualize the costs (with very little information) and then apply chapter concepts. Professional subscriptions.Fixed D. However staff are often salaried. they set prices considering their competitors’ prices.04 . mostly variable G. 2. Office supplies . there is no moral obligation to maintain a 300% markup on each item. Alternatively. D. if Ms. 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." However.$0. If there is part time help. Rent . Property taxes.Fixed .Mostly fixed and discretionary H. most organizations are price takers. Licenses. Alternatively. the price of the plain hamburger should be: $2.Fixed E. It is just a general guideline.25 = $1. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. Long is able to differentiate her hamburgers from others in the market.] A. Clerical wages – Fixed unless overtime is regularly scheduled. The Step 2 questions (A. This means that her costs need to be below the competitive price. Market forces will dictate achievable prices. Therefore.Chapter 2: The Cost Function 2-13 C. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. if her prices are too low.04 Therefore. Long’s prices are too high. she foregoes profits and people may believe there could be quality problems with her food. Selling price of cheeseburger with everything: 300% * $0. Insurance. in which case the total cost would be primarily fixed. that cost would be variable. If Ms.

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

026826 0.761602 4.58824812 182.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 Maintenance Costs $2.000514 .61765897 0.500 $1.119724 15 Coefficient s 884.113687834 Intercept Output t Stat 5.58E-05 0. Potential Cost Driver: Output Maintenance Costs Against Output $2.000 $1.582691 P-value 6.4342166 0.78591283 0.52099624 Standard Error 153.Chapter 2: The Cost Function 2-15 A.

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 0.36224828 0.500 $1.31319046 235.500 Maintenance Costs $2.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.717372 P-value 0.457384 3.113464425 Intercept Direct Labor Hours t Stat 3.7549386 1.017601 .000 $1.005847 0.291084 2.60187065 0.02569657 Standard Error 261.210849 15 Coefficient s 861.

Sometimes a cost that is mostly variable can be identified from a scatter plot. or the cost is mostly fixed.97410583 0. the trend line for machine setups looks as if the intercept could be zero or very close to zero.94495003 66. For example.96E-10 B.910475729 Intercept Machine Setups t Stat 1.6778973 0.5913391 15 Standard Error 93.000 $1.42597461 1.94888217 0. . If the observations are widely scattered.357393 15. In Part A.500 Maintenance Costs $2.197755 8.815737 29.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. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. However. all three potential cost drivers appear to be positively related to maintenance costs. In a scatter plot.5343 P-value 0. This indicates that the cost could be totally variable. the cost driver does not explain the variation in cost and either it is the wrong driver.500 $1. a good cost driver would present a linear or football-shaped positive slope or trend.

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. and technology can cause future costs to be different than estimated. the economic environment. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. the t-statistic is significant for the independent variable but not for the intercept. so it is excluded from the cost function.025*Direct Labor Hours TC = $29.521*Output TC = $861 +$3. In the machine setups regression. the cost is likely to be totally variable. This provides confidence that the variable cost part of the cost function is not zero. E. This means that variation in setups explains about 95% of the variation in cost.945.313 0. R-Square 0. The regression using machine setups has the highest adjusted R-Square of 0.945 Cost Function TC = $884 + $0. business processes. .68* Machine Setups The machine setups intercept coefficient is not significant. D. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. Changes in many factors such as resource prices. Therefore.588 0.2-18 Cost Management C.

333 .605 = $11.333 – $43.000 = 0. this cost function might provide poor estimates of future costs. the variable cost is calculated: ($68.000/$500. the total cost function is: TC = $11. Therefore. that is. which could be outliers. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.333)/($1. on average.132. That means that the cost function might not represent the actual cost. not represent the cost most of the time. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.728 Thus.$56. the cost function is calculated using the highest and lowest values of the cost driver.05.24 Big Jack Burgers A. .100) = $25.100 F = $68.100 – $632. First.728 + 5%*Sales B. The high low method uses the most extreme cost driver values. Under the high-low method.132.Chapter 2: The Cost Function 2-19 PROBLEMS 2.333 = F + 5%*$1.

000 $900.000 $600. the regression intercept can be used as an estimate of the fixed costs. the p-value result for the tstatistic is atypical.5% x sales. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. the cost function would be: TC = 4. Notice that the t-statistic for the intercept coefficient is 2.5% x sales . A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.800 + 4. Alternatively. Following is the regression output. the cost function would be TC = $16. fixed costs are likely to be zero and would be excluded from the cost function. In that case. Analysis at the account level can be used to increase the understanding of this cost. Then. Then.2-20 Cost Management C. etc). If this cost pool includes items such as salaries and other fixed costs (insurance.000 $1. Chart of data with trend line added by Excel.200. but the p-value is greater than 10% at 0. Because this regression has few observations.000 $0 $0 $300.000 Administrative Costs $60. D. analysis at the account level might indicate that there are few fixed costs. The upward slope of the line indicates that there are variable costs.172. Based on the p-value. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80.000 $40. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.000 Sales It appears that the cost is most likely mixed. there is a 16% probability that the intercept (fixed cost) is not different from zero.162.000 $20.

16197623 0. Because of unforeseen changes in cost behavior.25 Scatter Plot. The plot shows costs that are widely scattered. both of these methods assume that the data points are representative of future costs.9680477 0. There might be a large discretionary component in administrative costs.17205158 5. the cost function is: TC = $50. Both methods assume that the cost function is linear and that all data points come from a single relevant range. on average.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. causing fluctuations in cost that are unrelated to any cost driver. The cons of the high-low method as an estimation technique were discussed in Part B above. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost. If there are more data points. However. especially because so few observations were used in the estimation. the high-low method may be the best option available. The past costs used for estimation might not be representative. Unusual cost items are assumed to continue in the future. Sales does not appear to explain much of the variation in research and development costs. Therefore. B. This means that variation in sales explains only about 18% of the variation in research and development cost. 2. Cost Function Using Regression A. and possible changes in costs such as those described in Part E are ignored. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver.93711636 0.82%*Sales C.90567454 3293.04466925 0. This method can be used in cases where there is not enough data to perform regression. regression analysis incorporates all of the observations into the analysis.186.0319523 Intercept X Variable 1 E. If there are only two or three data points. If these assumptions do not hold.73545 0.00818212 t Stat 2. however.365 + 0.2444 7734. a cost function may not provide a good estimate for the next month’s costs. F. In addition.4038 4 Coefficients Standard Error 16800. there does appear to be a general upward trend. . Using the regression results. the results rely on more complete information and provide a better estimate. The adjusted R-Square statistic is very low at 0. Sales might not be the activity that drives administrative costs. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. then both methods may be unsuitable for estimating future costs.45937486 P-value 0.

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

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.10 = $30.152 Y = 10 hours*4-0.00 $20.00 Average Cost $0.00 $20.05 $0. In this case the learning rate would be wrong and so the time would also be wrong.00 $20.10 = $40. 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. I. her phone bill will be less than it would be at a rate 5 cents per minute. There are many different reasons that the time could be different from the amount determined above.00 + (600-500)*$0. If her calls are over 400 minutes or under 600 minutes. students may think of others.057 The average cost is lowest at exactly 500 minutes per month. In . she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. so Susan may need to maintain her own records if she wishes to trace telephone usage.067 $0. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls).or overestimated the amount of hand work performed. telephone costs are viewed as an indirect cost.1 hours (average time for the first four batches) B.04 $0. In most businesses. Many cellular telephone bills do not list the calls made. Cons • If Susan has a number of projects in her local area or will be traveling a lot.00 + (700-500)*$0. Here are some of the reasons. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. Hours per batch would be determined as follows.27 Fancy Furniture A.05 $0. It is possible that the managers under.90/ln2) = −0. Minutes 300 400 500 600 700 Total Cost $20.Chapter 2: The Cost Function 2-23 consulting jobs.00 $20.152 Y = 8. she will pay a very high rate of 10 cents per minute 2.

The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 _______ $28. then the chart suggests that the learning rate estimate is reasonable.40. and B. Thus. The estimate of total costs given revenues of $80. if managers believe that 25% of the work is done by hand. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30.500 10. D.000 7.000 Variable $21.000/$70. and the University surcharge is specifically based on sales.000 . 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.28 Wildcat Lair A. or has a great deal of experience on the machine.000 = $79.000 1.$79. then this chart suggests that the learning curve will be slower than the 90% estimate. if managers believe that more than 25% of the work is done by hand. 2.000 .2-24 Cost Management addition. C.000 Total revenue is the most likely cost driver for both variable costs. C. If a worker is absent one day.000 using the cost function is: TC = $47. they would be higher than the labor costs in later periods.000 = $1. Because revenue is the cost driver for both variable costs.500 $47. or 40% or revenue Combining fixed and variable costs. If these values are used in a regression to estimate a cost function. the cost function is: TC = $47.000 + 40%*Total revenue D. the rate will change if the replacement employee has never worked on this machine. However. Food costs are likely to vary proportionately with sales.000 5. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. it is possible that different types of wood affect the rate at which chairs can be produced. then the cost would be overestimated.000 Profit = Revenues – Total costs = $80.000 + 40%*80.000 = 0.

However. C.000) (24. F.000. so the trend would be the opposite of this plot. So.000 . If the university were to close the Lair. it might even close when the ski area shuts down. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. so the estimated profit in August is $1. Lair’s fixed costs are assumed to be unchanged with the $10.000) of revenues. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. In July there was a loss of $5. if the bathing suit shop is located in a geographic region $80. costs would be higher when there were fewer sales.000*40%). the additional profit from a $10. for July the opportunity cost would have been $2. this surcharge should be ignored when computing the university’s opportunity cost (assuming that the charge does not relate to any variable costs for the university that arise because of the Lair).000 (47. Thus. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.$4.Chapter 2: The Cost Function 2-25 E. generating most its sales around the ski season (fall and winter).000). electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000.000 ($10. and the increase is estimated to be 40% of the increase in revenues. it would lose the revenues.000 + 30%*Total revenue During August.] A.000 increase in revenues is expected to be $6. To estimate the opportunity cost for August. but this is not considered a cost driver (a business activity that causes variations in total variable cost).000/$70. total variable costs are expected to increase by $4.000 ($10. Item D will be VERY difficult for most students.000 (-$5. the shop might experience very little business activity. The shop is most likely a seasonal business.) The adjusted cost function is: TC = $47. Variable food costs are estimated to be 30% ($21. the variable cost part of the cost function can be adjusted.000— the operating loss of $(5.000 . less the fixed costs and the variable food costs.000 increase in revenues. So.000) $ 9. A shop located near a ski area is likely to incur high heating costs during the winter.000) Net 2. In a retail business.000).000+$6.000)+the university surcharge of $7. Because the university surcharge is an allocation within the university. Electricity costs also vary with changes in electricity rates.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. Only total variable costs are expected to increase. B. During the spring and summer months.

in turn. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.69 x 5 = $1.85/ln2) = 0.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.2345 Y = $205. and new office furniture or equipment.67 Firm A's income for last year was: Sales Costs Income $1.028. employee training. For example.67 1. then the highest sales might coincide with the highest electricity costs. Although these expenditures are made because more money is available. Many costs can be related to volume of activity. correlation does not necessarily mean causation.542. firm B's selling price is: $101.45 Although each customer paid a different price.45 $ 514.2345 Y = $300*5-0. generally mean there is more money available to spend on administrative travel. given a 100 unit production level: Y = α Xr Y = $300*100-0.89 x 1.028. 2. D. they are discretionary expenditures and not caused by the level of activity.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.5 = $152. higher profits generally occur during periods when activity is high. Higher profits.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. a 50% markup on total cost will cause sales to be: $1.028.2345 Y = $101.22 Firm B set its selling price based on the average cost.542.50 = $1. special promotions.45 x 1. A correlation may appear in a scatter plot or regression analysis.84 . However.69 (average cost for each of the 5 units) Total cost = $205.

50/150 units = $64. assuming an 85% learning effect would be: Y = $300*150-0.75) 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 $1.727.84) = $1.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.Chapter 2: The Cost Function 2-27 Firm B's costs.84) Costs (150 x $ 92.00 13.28 $23.10 $ 172.028.528.50 $ 9.10 $22.85 x 1.30 $2. Total cumulative production cost (300 x $78.2345 Y = $92.2345 Y= $78.50 = $97.897.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.50 .384.356.40 Firm A's costs may be computed as follows: Y = $300*15-0.926.65) Income Firm A's revenues for this year are: (10 x $152.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.897.625.028.528.356.85 Thus Firm B's selling price this year was $64.45 $1.50 $ 9.55 1.00 13.727.40 1.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.2345 (notice that the cumulative units produced is 15) Y = $158.

and most of the observations appear to have a fairly linear trend.356.000 $135.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.000 $5. available on both the Instructor and Student web sites for the textbook (available at www.28 is lower than Firm A's average cost per unit: $1.864.000 $155.727.000 $145.85) Income $14.50 $ 4.000 $6.10/10 = $135.000 Sales B. .000 $7.28) Costs (150 x $64.592.500. Scatter Plot of Marketing Costs Against Sales $175.wiley. 2.50 Note that Firm B's selling price for this year of $97.com/college/eldenburg). A.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000 Marketing Dept. There is a positive slope.500.500.61. Costs $165.000 $8. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.00 9.500. such extreme differences in cost can occur. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.wiley.com/college/eldenburg).

584 + 1.34%*Sales D. . Instead. Here is the regression output.7600071 P-value 2. usually annually. Therefore. the cost function is: TC = $65.2608 0. If the variable portion of the marketing cost is sales commissions. Regression Statistics Multiple R 0. When more money is spent on marketing.01335108 Standard Error 6844.4501E-10 5.87116829 Adjusted R Square 0.00097028 t Stat 9. sales may go up. there would be a positive correlation between marketing department costs and sales. discretionary costs such as marketing are often increased when profits increase.93336396 R Square 0.08144 Observations 30 Coefficients 65584. the cost estimate should not be based on past costs. it is economically plausible for sales to be a cost driver.5289E-14 Intercept X Variable 1 Based on the regression results. E. Assuming that profits are more likely to increase when sales increase.Chapter 2: The Cost Function 2-29 C. the decision maker(s) should be asked what next year’s cost will be. F. they may be positively correlated with sales. Discretionary costs are set by decision.63816 0.86656716 Standard Error 4015.58184484 13. Even if marketing department costs are discretionary. In addition. using regression or any other technique.

000 $0 0 300 600 900 1200 1500 Machine Hours .com/college/eldenburg).wiley.000 $160.000 $120.000 $160.000 $80.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. A.000 $40.000 $80.com/college/eldenburg).wiley.000 $120.2-30 Cost Management 2. available on both the Instructor and Student web sites for the textbook (available at www.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $40. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.

000 $0 0 100 200 300 400 500 600 700 Raw Materials B.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.600936029 Intercept Labor Hours t Stat 10.01272369 Adjusted R Square -0.1543 0. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.86E-11 0.000 $120.50852 7.000 $40. Labor Hours Regression: Regression Statistics Multiple R 0. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. labor hours could be deleted as a potential cost driver.600712 P-value 6. D.682 4. the cost driver does not explain the variation in cost.11279932 R Square 0. either the driver is wrong or the cost is mostly fixed. If the observations are widely scattered.56597156 30 Standard Error 14812. The plots help determine whether regression analysis should be performed using any of the potential drivers.000 $80. Sometimes a cost that is mostly variable.000 $160.8173 Observations Coefficient s 150410.02253618 Standard Error 11114. but the plot for labor hours appears to have the least trend. Based only on the cost plots. None of the plots show a definite trend.552864 . C.

599 + $38.67 38.22* Raw materials .2-32 Cost Management Only the intercept term is significantly different from zero.612063 R Square 0.217192 Standard Error 10291. so the cost function is estimated as: TC = $117.68E-12 0.1555 Observations 30 Coefficient s 117598.91 60.217 + $60.5033241 R Square 0.095468 P-value 4.9786 Observations 30 Coefficient s 126216.2266685 Standard Error 9665.3746211 Adjusted R Square 0.215128 Standard Error 10853.47803 9.3522862 Standard Error 8846.62907 3.082222 P-value 3.56778 19.411 Machine Hours Regression: Regression Statistics Multiple R 0.2533351 Adjusted R Square 0.4268 4.000325 Both the intercept and slope coefficients are significant.53627459 Intercept Raw Materials t Stat 11. so the cost function is estimated as: TC = $126.331580777 Intercept Machine Hours t Stat 11. so the cost function is estimated as: TC = $150.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.004579 Both the intercept and slope coefficients are significant.11E-12 0.

778501 82.08E-08 . and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.226 Based on the simple regression results.210187 P-value 3. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0. however. 2.489 -0.8067018 Standard Error 4832.wiley.1959303 48.2349 3.com/college/eldenburg).8266982 Adjusted R Square 0.953575 1.333162437 5.352 0. Yes.Chapter 2: The Cost Function 2-33 E. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.9092294 R Square 0.886218 -0.05878 9.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.218173 8. this driver explains only 35% of the variation in cost. The coefficients for each of the other potential cost drivers are significantly different from zero. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.wiley.3E-06 0. available on both the Instructor and Student web sites for the textbook (available at www.976635 Standard Error 10361. A.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.12E-09 1.com/college/eldenburg).291558412 10.5558 Observations 30 Coefficient s 60988. machine hours appears to do the best job of explaining manufacturing overhead costs. F.

157604083 9. machine hours and raw materials explain different activity .98 (<0. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression. its coefficient is not significantly different from zero in either regression. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0. The adjusted RSquare is far higher in the multiple regression (0.55) $38.001) $126.5902 48.71E-10 5.450561 8.352 and 0.001) $117.806 $150.78 (<0.226 0.005) $82.93*Raw materials D. Costs for these activities are likely related to specific cost drivers. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.954) $48.001) B.82667515 Adjusted R Square 0.217 (<0.678 + $48.22 (<0.20 (0.001) $4.988 (<0.57 (0.925842 30 Standard Error 8743.411 (<0.2-34 Cost Management Comparison of simple and multiple regression results: Intercept t-stat (p-value) Independent Variables t-stat (p-value) Labor Machine Raw Hours Hours Materials Adj.939606 9.001) $60. In this example.664851 5.86E-07 4.29E-09 The cost function is: TC = $60. Thus. Each task includes different activities.001) $-0. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0. Also. labor hours can be eliminated as a potential cost driver.881964042 Intercept Machine Hours Raw Materials t Stat 6.81383627 Standard Error 4742. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.022 0.391636 P-value 1.226) for these two cost drivers. Manufacturing can be a complex activity requiring a number of different tasks.90921678 R Square 0. its coefficient is negative rather than positive in the multiple regression.74*Machine hours + $82.7422519 82.22 (0.001) $60.5348 Observations Coefficient s 60677. C.599 (<0.352 0.806) than in either of the simple regressions (0.

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

000 $5. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. number of hours students attend school. .000 $10.wiley. B. Other cost drivers for total maintenance cost could be number of rooms cleaned. number of hours the building is open. Dept.000 $15.000 $20.000 $0 528 530 532 534 536 538 540 542 Number of Students C. 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. Costs $25. or number of classes and activities per period.2-36 Cost Management 2.000 $15. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. A.000 $10.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2.com/college/eldenburg). Dept.000 $5. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students. Costs $25.wiley.com/college/eldenburg). square feet cleaned.000 $20.

0261 Standard Error 130954.Chapter 2: The Cost Function 2-37 D.63E-06 2.9 244.135 + $35.03271 Standard Error 3019.453062 P-value 2. and rent for this type of facility is usually fixed. The p-values on the Tstatistics are very small.68624 0.875134 35.247329 R Square 0.796328319 Intercept X Variable 1 Coefficients 9134.36 The Elder Clinic A and B Salaries are always fixed. it is logical to expect a strong relation between hours worked and cost.173 Observations 12 Coefficient s -89867 197.847440356 Adjusted R Square 0.74733262 t Stat 9. 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.74*maintenance hours worked.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.0857 Intercept X Variable 1 t Stat -0. Therefore.832184392 Standard Error 1217.5045837 4.461245 7. The total cost function is: TC = $9. The most current value is used to . An unidentified cost driver could have a higher R-Square. maintenance hours is a reasonable cost driver.438328 According to the R Square statistics.06772 Observations 12 Standard Error 965. From the analyses performed. providing high confidence that both the intercept and slope are different from zero. Utilities cost varies with season not visits. 2. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.807201 P-value 0.508157 0. it is rational to conclude that hours worked will provide a reasonable estimate of future costs. it is considered fixed.920565237 R Square 0. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none. However.061172 Adjusted R Square -0. E.

Given the preceding computations and cost summary. This analysis suggests that there are some of the other expenses are variable costs and some fixed. Some supplies. such as snake anti-venom. Here are some of the reasons: • The managers will not know how many visits they will receive.49 ($3.$2.736 Variable $3. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www. the cost function is: TC = $19. Use March. Also.934)/(849 – 778).07*940 = $25. weather.2-38 Cost Management predict next period’s utilities.wiley.115 219 3.58 $6.736 + $6.182 .com/college/eldenburg). variable cost is $3. July expenses are estimated to be: TC = $19. gloves. Medical supplies vary with number of patient-visits.412 1.49 Cost Driver Patient-visits Mixed X 2. There are many possible reasons that could be listed.736 + $6. Visits are affected by season.100 226 664 $19. so this cost is classified as a mixed cost. Other expenses appear to increase and decrease with number of patientvisits. new equipment is acquired.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future.07*patient-visits C. . These would be variable. such as tongue depressors. These would be fixed.49*849. affecting the number of visits at this clinic. each patient requires a certain number of supplies. At 940 patient-visits. other facilities may open or close. but not proportionately.80 D. **Using high-low. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. There is no one answer to this part. Therefore. must be kept on hand whether or not they are used.441. • Treatments and related costs may change as new drugs are available. and so on. and costs go up as patient-visits increase. high point of medical supplies cost and patient data. Use the same method for other expenses.182 = F + $3. and so on. • Prices of all inputs could change (usually increase). to find fixed: $3. E. medical supplies is a mixed cost. current illnesses that are circulating in the area. or there are changes in treatment procedures for certain illnesses.

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

Because of the large difference between these values and the values in other months.736 67.500 38. July’s result is an outlier and should be removed from the data.790 80.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68. the trend line is likely to distort costs.686 71.8 x 6.236 69.310 70. as shown in the scatter plot below. 1/2 of August 5 payroll goes to July: 5.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.036 68. B. .2-40 Cost Management 2.500 x 1/2 = 2.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.200 +$2.350 68.800 41.376 65.83/mo.wiley. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. A.10.800 .150 73. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4. Similarly. No adjustments are needed for items (c) and (d).com/college/eldenburg).850 2 .750 + 4.286 68. the first month is adjusted even though it is not an actual cost: 4.300/10 x 12 = 35.000 = 4. If these observations are included in the regression analysis. (rounded to $36) 2 Note IB-4's power added to Dept.596 73.750 68. Operations in the month of July are not typical of the rest of the time period.486 68.750 .736 To predict future overhead.com/college/eldenburg). IP-14 3 Payroll paid every two weeks.750. available on both the Instructor and Student web sites for the textbook (available at www. 80% of September 2 payroll to August: .2.800. The miscellaneous supplies account also looks suspicious.4. but there is insufficient information to make an adjustment. these are correctly handled.200 Apr 71.wiley.

500 8.000 $55. Monthly overhead costs for supplies may be significantly overstated or understated .298502 2. the fixed cost does not appear to be different from zero.47 8 Standard Error 29406.000 $65. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 2.310484 Intercept X Variable 1 Coefficient s 8777.26 3.789722 t Stat 0.000 $60.79 * 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). According to the details provided for August and September.086126 Based on the t-statistic and p-value for the intercept. Therefore. they are most likely recorded at the time of purchase rather than at the time of use. supplies were a large proportion of overhead cost.314163 1980.000 6.775388 0.641981 0.000 9.000 $50.000 3. the cost function is estimated as: Overhead cost = $6.000 $40.412139 0.818 6.000 Overhead Costs $70.500 Outlier Direct Labor Hours C.000 $45. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. Based on the variation in dates at which supplies are recorded.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.500 5. D.050976 P-value 0. Thus.

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

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

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

194 + $13.5917832 Standard Error 6216. available on both the Instructor and Student web sites for the textbook (available at www. the regression explains only about 59% of the variation in labor costs. Because of the annual pay increases. B.848277 8.678620854 Intercept X Variable 1 t Stat 19. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs. students are likely to struggle interpreting and choosing a method (Parts E and F).6004687 Adjusted R Square 0. Here are the simple regression results: Regression Statistics Multiple R 0.com/college/eldenburg).] The data for this problem can be found on the datasets file for chapter 2.7995 Observations 48 Coefficient s 133194. In prior years.02E-10 Based on the regression results.437E-24 1.957296 Standard Error 6710.04 13.3147402 P-value 3. However.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.609693 1. using monthly data for the prior 4 years. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. Considerable variation in labor costs is not explained by changes in the volume of production.Chapter 2: The Cost Function 2-45 2.wiley.7748991 R Square 0. A. the degree of downward bias is higher for older data than for more recent data.wiley. The cost function is estimated as: Labor cost = $133. the cost function was estimated by regressing actual labor costs on number of chairs produced.96 x number of chairs produced However. . Also. the fixed cost and the variable cost per unit are each positive and statistically different from zero.com/college/eldenburg).

347 x 1.864722 R Square 0.54295 Standard Error 5689.742261 Standard Error 5148. D.57E-23 2. approximately 26% of the variation in labor costs is still unexplained.67711 P-value 1.486389 P-value 4.8 16.93821 16.347 Calculation $203.411 Observations 48 Coefficient s 107748. here are the regression results: Regression Statistics Multiple R 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. The cost function is estimated as: Labor cost = $133. but the variable cost increased from $13.869633 Adjusted R Square 0.010513 1.905 Observations 48 Coefficient s 133736 16.05E-27 2.2-46 Cost Management C.00872 Intercept X Variable 1 X Variable 2 t Stat 18.96 to $16. the fixed cost and the variable cost per unit are each positive and statistically different from zero.533 x (1. which is reasonable given the increase in wage rates over time. The fixed cost is nearly the same.02 Adjusted Labor Cost $220.06236 11. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203. Also.35E-15 Based on the regression results.863839 Standard Error 3742.09577 6.73E-20 5.311 200.891 1.274 Using the adjusted labor cost data.747745 Adjusted R Square 0.74). Nevertheless.91E-08 .533 Dec 20X4 196. this cost function would result in a higher estimate for future costs. Here are the multiple regression results: Regression Statistics Multiple R 0.23439 Standard Error 5557.26499 6.390275 Intercept X Variable 1 t Stat 24.492 1.932541 R Square 0.02)4 $196.

On the other hand. it could be argued that some other cost driver might do a better job of predicting future labor costs. The cost function is estimated as: Labor cost = $107. Conversely. The second slope coefficient requires more thought.26 x current month number of chairs produced + $6.l6 for each chair produced during the month.749 + $16. and this regression explains more of the variation in labor costs (86%). The first slope coefficient ($16. There is no one single answer to this question.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 company’s policy is to increase the number of workers when production volumes increase. the fixed cost and the variable cost per unit for each cost driver are all positive and statistically different from zero. and the managers often delay laying off employees when volumes decline. then this month’s labor costs will reflect a lower level of labor cost. As explained in the problem. Thus. it often takes time for the company to hire qualified new workers. However. F. each month’s labor costs are expected to increase by $6. On one hand.54 for each chair produced during the prior month. 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. if the prior month’s production was lower than this month’s production. there may be some lag between the time that production volumes change and labor costs change. each month’s labor costs are expected to increase by $16.26) is interpreted in a straight-forward way. If the prior month’s production was higher than this month’s production.Chapter 2: The Cost Function 2-47 Based on the regression results. E. then this month’s labor costs will reflect the higher level of labor cost. . and to decrease the number of workers when production volumes decrease. In addition. the two cost drivers together explain a very high proportion (86%) of the variation in past labor costs. According to the multiple regression results.

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