# 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)

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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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Chapter 2: The Cost Function

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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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Cost Management

EXERCISES

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

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

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

D D I D D D D

D I I I I D D

I I I I I D D

the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. TC = $10.000 0 100 200 Number of Units 300 400
The cost function includes the following assumptions: • Operations are within a relevant range of activity • Within the relevant range of activity: o Fixed costs will remain fixed o Variable cost per unit will remain constant
. In a service business such as this.000 $8. CPAs do keep detailed time records.00*Q Graph of Cost Function
$14. the tax partner probably spends some time in non-billable activities.000 Total Cost $12. For the firm to make this cost direct for the personal returns cost object.000 + $8. The time records that the tax partner maintains support this cost as a direct cost. 2.000 $13.13 Linear. Stepwise Linear.000 $11. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.000 $10. and Piecewise Linear Cost Functions A.Chapter 2: The Cost Function
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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. 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. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. Of course.000 $9.

000 $60.000 4.000)/(12.000 $0 0 1. Convert the average costs to total costs for each production level: Total cost at 10.000 Total cost at 12.000 Graph of Cost Function
$80. it is first necessary to estimate the cost function.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 Calculate the variable cost per unit using the Two-Point method:
Change in cost Change in volume
= ($528.$390.2-6
Cost Management B.000)
= $78.000 TC = $35.000 – 10.000/2.000 3.000 units: $450.000 = $60.000 F = $450.$450.000 $70.000 = F + $39*10.000 units = 10.00*Q.000 $30. for Q ≤ 2.000 Number of Units
C.000 + $8.000 + $8.000 * $45 = $450.000 * $44 = $528.00*Q.000 $20.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 units = 12.000 .000 $10.000 Total Cost $50.000 $40. for Q > 2. To estimate the costs at another production level. TC = $25.000 2.000 + $39*Q
.000 .

000/15.000 $45.000 units: TC = $60.000 = $60.000 = $9.500 2.00) + $9.000 $65.14 Piecewise Linear Cost Function A.000: TC = $50.000 $70. total cost is estimated as: TC = $5.000 + 45%*$10.00*Q.000 + $9.000) TC = $50.000 $50.Chapter 2: The Cost Function Estimated total cost at 15.000 + $585.000 + $10.00*Q
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Graph of Cost Function
$75.000 + (1.000 $60.000 Estimated cost per unit = $645.000 = $43 D.000 + $10.000 in revenues into the cost function.000 Number of Units
Slope is $10 per unit Slope is $9 per unit
Total Cost
.000 For Q > 1. Inserting $10.000 * $10.500 2.00*Q .000 + $9.000 0 500 1.000 $55.000 = $645.000 + $39*15.$9. for Q < 1.000 1. TC = $50.00*(Q-1.000 TC = $51.

3. 2.00*Q.8 hours (average time for each of the next two returns) B.3219 Y = 6 hours*2-0.
Graph of Learning Curve
Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared
.000 + $10.000 units. This cost function would provide reasonable estimates for Q > 1.000 units but would underestimate total cost for Q ≤ 1.3219 Y = 4.3 and 2A. then the cost function would be some mixture of the functions for the two relevant ranges. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. There are three general situations: 1. If all of the data estimation points occurred when Q was ≤ 1.000 units.000 units. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.15 Tax Plus A. This cost function would provide reasonable estimates for Q ≤ 1.000 units but would overestimate total cost for Q > 1. then the cost function would appear to be: TC = $51.00*Q.
2. Hours for two returns would be determined as follows. the cost function mismeasurement depends on the values of Q.000 + $9.4. If all of the data estimation points occurred when Q was > 1. then the cost function would appear to be: TC = $50.80/ln2) = −0. If the accountant did not detect that there were two different relevant ranges. If the data estimation points occurred across the two relevant ranges.2-8
Cost Management B.000 units.

this particular cost function assumes that variable costs are driven by sales. Assuming that the cost of clay can be traced to each bowl. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls.
2. the cost function is: TC = $20. that is.000 + 25%*Total sales B. Total clay cost will vary with the number of bowls made. and their productivity rate will remain stable.25. Wages are fixed because they remain constant (the employee always works 40 hours). However. D or I.000. their productivity increases.000 = 0.000 on total sales of $32. it is a common cost of production for all of the bowls that are heat-treated in the kiln.16 Bison Sandwiches A. 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. making it a fixed cost.] A. Note: Depreciation using a method such as declining balance is not constant over time. it is a direct cost. wages are a direct cost. In addition. Assumptions: Fixed costs remain fixed within the relevant range. If total variable costs were $8. V C. then variable cost per dollar of revenue is calculated as follows: $8. D. if time is not traced to individual bowls (for example.Chapter 2: The Cost Function
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As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. 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. as their performance improves. then wages would be an indirect cost. it improves less quickly for the next return. Eventually their learning will plateau. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). 2.000/$32. but would still be considered fixed because it does not vary with production volume.
B. or 25% of sales Combining fixed and variable costs. F Assuming that employee time can be traced to each bowl. However.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. I. and variable costs remain constant within the relevant range. F
.

making it a fixed cost. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume. it might not be traced to individual bowls. It might be fixed or mixed. I. This cost is also discretionary. then this cost could be indirect. because the production area may need more cleaning as volumes increase. I. if the cost is too small to justify tracing them). Advertising is not directly related to production. F The business license is not related to production.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. it is most likely traced to individual bowls.
H. making it an indirect cost. V or F Brushes for the glaze are most likely used for multiple bowls. If the packing materials are not traced (for example. 2. E. If it is an hourly charge. I. Packing costs are most likely variable because they will increase as production increases. so it is treated as fixed. V Assuming that the cost of packing materials is traced to each bowl. I.2-10 Cost Management D. I.300 Variable $4. making it a direct and variable cost. if the cost is small it might be grouped with overhead costs (variable).000 2. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. They might be fixed or variable. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. this is a direct cost. depending on what causes the cost to vary.] A. If the cost of glaze is very small. V If the glaze is expensive and therefore a relatively large cost. J. it is probably a mixed cost. D or I. making it an indirect cost.300 $3.500
. part of the cost might vary proportionately with volume.000 in sales $1.500 ______ $4. If the kiln is electric. Also.
F. F
I. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. making it an indirect cost. making them a common cost for multiple units and an indirect cost. depending on whether they are “used up” after a certain quantity of production. G. D or I.

In this type of situation. they are more likely related to time on the boat than pounds of fish. F. V. because of uncertainty in the success of each fishing expedition. C. Benefits might include mandated items such as social security. D. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. costs vary with dollars of revenue. 2. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. D.] A.500/$9. employees are likely scheduled in advance on a fixed schedule. The cost of rent is irrelevant because it will not change with either alternative. Some may be sent home if business is very slow.50.300 + 50%*Total revenue C. FB. B. and unemployment insurance.Chapter 2: The Cost Function 2-11 B. or 50% of revenue Combining fixed and variable costs.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. these costs would be mixed with a large proportion of the cost fixed. as well as voluntary items such as health insurance and retirement benefits. In many organizations. B. so they would tend to be fixed or mixed (see Item A above). F. E. workers’ compensation. Benefit costs often vary with level of wages or salaries. In the pizza shop. There most likely would not be any ingredients in a fishing boat business. B. PS. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. In the fishing boat business.000 = 0. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. F There would be no reason to incur fishing equipment costs in a pizza business. While hourly wages may be related to number of fish caught. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired).
. F or M Employee benefits occur in any business in which employees are hired. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. the cost function is: TC = $3. Therefore. and the cost would vary with number of pizzas produced. V Ingredients are used in making pizzas.

69/8) 0. Because advertising costs tend to be discretionary.1619 10. there might be some utility costs for the fishing operation and for a business office.0053 0. F or M Any type of business will have insurance costs.59/16) 0. F Most pizza shops incur advertising costs such as flyers. PS. B. F.000) * 4] 0.29/12) 0.79/150) 0.0148 6. If the fishing boat is for tourists.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 1.1619 0. Hamburger patty ($1.59/40) 0. they are treated as fixed costs. Cost of plain burger = $0. depending on how the insurance cost is calculated. Mustard ($. G. For the fishing boat business.0863 5. Lettuce ($. The cost might be fixed or mixed. and yellow pages advertisements.0863 0.0198 9. In general.49/(16 x 4)] 0.69/7) $0.0198 0.2-12 Cost Management E.1075 3. Hamburger bun ($1.6815 A. B.5196 Suggested selling price: 300% * $0. It will be a fixed cost if it is a flat amount. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.5195 = $1. the utility costs for these two businesses would tend to be fixed (would not vary with production).0179 0. advertising costs would be incurred.2414 $0.2414 $0. Dill pickles [($8.1075 0.1075 0.$0. however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship. Onions ($.0033 0. newspaper advertisements.95/2.0233 0.3489 $0. Catsup ($. Cost of burger with everything except cheese = ($0.15/45) 0.0053 8. 2.3489 (calculated above) B. Cheese ($2.6815 . but it might be mixed if a portion of the cost relates to levels of business activity. Tomato ($. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.99/50) 0.0148 0.56
.0033 $0.2414 2.0179 4.0233 7.1619) = $0. Mayonnaise [$1.

Fixed
. If Ms.Mixed. Clerical wages – Fixed unless overtime is regularly scheduled.$0. if her prices are too low.79 Some students will view this higher price as "unfair. B. Professional dues. she foregoes profits and people may believe there could be quality problems with her food. B. Therefore. Long is able to differentiate her hamburgers from others in the market.Fixed F. This means that her costs need to be below the competitive price. Professional subscriptions. mostly variable G. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. Selling price of cheeseburger with everything: 300% * $0.04 Therefore. Alternatively. that is. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. In the current business environment. Alternatively." However. If there is part time help. 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.Fixed and discretionary I. The Step 2 questions (A. and then mixed C. they set prices considering their competitors’ prices. Licenses. Property taxes.Mostly fixed and discretionary H. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. if Ms.] A. the price of the plain hamburger should be: $2. there is no moral obligation to maintain a 300% markup on each item. It is just a general guideline. However staff are often salaried. and F) are the ones requiring significant assumptions to generate an answer.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.6815 = $2.25 = $1.Fixed D. most organizations are price takers. Office supplies . Long’s prices are too high. 2. that cost would be variable.04 . she needs to know what competitors charge for a similar quality sandwich and price hers competitively. D. Insurance.Chapter 2: The Cost Function 2-13 C. Market forces will dictate achievable prices.Fixed E. Rent . in which case the total cost would be primarily fixed.

2. Other Potential Cost Drivers A.] The data for this problem can be found on the datasets file for chapter 2. number of advertisements placed. available on both the Instructor and Student web sites for the textbook (available at www.wiley. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. it is possible that marketing costs are discretionary. If this is the case. For example. Therefore. the cost is discretionary and will be set through the negotiating process. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management. The cost analyst needs to gather information about how marketing costs are set each year.35*units sold.com/college/eldenburg).) B. the variation in units sold explains about 61% of the variation in marketing department cost. the fixed cost is set at zero.com/college/eldenburg).2-14 Cost Management
K. Advertising – Fixed and discretionary 2.22 Cost Function Using Regression. In this problem.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. or profits. Other possible cost drivers for marketing department costs could be revenue. C. In addition.wiley.
. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero.

113687834
Intercept Output
t Stat 5.582691
P-value 6.761602 4.61765897 0.000 $500 $0 0 500 1000 Output 1500 2000
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.026826 0.58824812 182.000 $1.58E-05 0.52099624 Standard Error 153.Chapter 2: The Cost Function 2-15 A.78591283 0.119724 15 Coefficient s 884.500 Maintenance Costs $2.4342166 0.000514
. Potential Cost Driver: Output
Maintenance Costs Against Output
$2.500 $1.

457384 3.60187065 0.31319046 235.000 $1.291084 2.02569657 Standard Error 261.500 $1.36224828 0.113464425
Intercept Direct Labor Hours
t Stat 3.210849 15 Coefficient s 861.005847 0.717372
P-value 0.7549386 1.017601
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$2.000 $500 $0 0 50 100 150 200 250 300 350 Direct Labor Hours
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 Maintenance Costs $2.

97410583 0. In a scatter plot.94495003 66.96E-10
B. In Part A.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.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups
Maintenance Costs Against Machine Set-Ups
$2.500 Maintenance Costs $2.197755 8. all three potential cost drivers appear to be positively related to maintenance costs. For example. the trend line for machine setups looks as if the intercept could be zero or very close to zero.94888217 0.6778973 0.357393 15. a good cost driver would present a linear or football-shaped positive slope or trend. However. Sometimes a cost that is mostly variable can be identified from a scatter plot.5343
P-value 0.5913391 15 Standard Error 93.000 $1.500 $1.
. the cost driver does not explain the variation in cost and either it is the wrong driver. This indicates that the cost could be totally variable.815737 29. or the cost is mostly fixed. If the observations are widely scattered.910475729
Intercept Machine Setups
t Stat 1. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver.42597461 1.

2-18 Cost Management C. This provides confidence that the variable cost part of the cost function is not zero. R-Square 0.
. the cost is likely to be totally variable.025*Direct Labor Hours TC = $29. D.945 Cost Function TC = $884 + $0. the t-statistic is significant for the independent variable but not for the intercept. so it is excluded from the cost function.313 0. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. This means that variation in setups explains about 95% of the variation in cost. The use of past cost data to predict the future assumes that future resource costs and volumes of activities will remain the same as in the past.588 0.945. In the machine setups regression. Changes in many factors such as resource prices. and technology can cause future costs to be different than estimated.68* Machine Setups
The machine setups intercept coefficient is not significant. E. Therefore. the economic environment. business processes. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. The regression using machine setups has the highest adjusted R-Square of 0.521*Output TC = $861 +$3.

. the cost function is calculated using the highest and lowest values of the cost driver.132.333)/($1. First.132. That means that the cost function might not represent the actual cost.$56.605 = $11.100 F = $68.100) = $25.Chapter 2: The Cost Function 2-19
PROBLEMS
2.000/$500.000 = 0.24 Big Jack Burgers A.333 – $43. that is. the total cost function is: TC = $11. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. which could be outliers. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.05.728 Thus. The high low method uses the most extreme cost driver values.333 .100 – $632. the variable cost is calculated: ($68.333 = F + 5%*$1.728 + 5%*Sales B. this cost function might provide poor estimates of future costs. Therefore. not represent the cost most of the time. on average. Under the high-low method.

000 $600. Following is the regression output.000
Administrative Costs
$60.162.000 $900. If this cost pool includes items such as salaries and other fixed costs (insurance.172. Based on the p-value. Alternatively.800 + 4. the regression intercept can be used as an estimate of the fixed costs. etc). fixed costs are likely to be zero and would be excluded from the cost function. In that case. Notice that the t-statistic for the intercept coefficient is 2. Because this regression has few observations. Then. Chart of data with trend line added by Excel. there is a 16% probability that the intercept (fixed cost) is not different from zero.000 $0 $0 $300. Then.000
Sales
It appears that the cost is most likely mixed. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.2-20 Cost Management C. the cost function would be TC = $16.5% x sales
.5% x sales. analysis at the account level might indicate that there are few fixed costs. Analysis at the account level can be used to increase the understanding of this cost. the cost function would be: TC = 4.000 $20. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line
$80.000 $1.000 $40. the p-value result for the tstatistic is atypical. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. but the p-value is greater than 10% at 0. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. The upward slope of the line indicates that there are variable costs. D.200.

Using the regression results. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. and possible changes in costs such as those described in Part E are ignored. especially because so few observations were used in the estimation. However. There might be a large discretionary component in administrative costs.17205158 5. Because of unforeseen changes in cost behavior. Sales might not be the activity that drives administrative costs. then both methods may be unsuitable for estimating future costs.04466925 0.365 + 0.93711636 0.Chapter 2: The Cost Function 2-21
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. 2. the high-low method may be the best option available. a cost function may not provide a good estimate for the next month’s costs. Sales does not appear to explain much of the variation in research and development costs. The adjusted R-Square statistic is very low at 0. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost. causing fluctuations in cost that are unrelated to any cost driver.82%*Sales C. The plot shows costs that are widely scattered. Therefore.73545 0. there does appear to be a general upward trend. The past costs used for estimation might not be representative.
. If there are more data points. both of these methods assume that the data points are representative of future costs. regression analysis incorporates all of the observations into the analysis.45937486 P-value 0. Cost Function Using Regression A.0319523
Intercept X Variable 1
E.9680477 0.00818212 t Stat 2. on average. This means that variation in sales explains only about 18% of the variation in research and development cost. the results rely on more complete information and provide a better estimate. The cons of the high-low method as an estimation technique were discussed in Part B above.4038 4 Coefficients Standard Error 16800. If there are only two or three data points. This method can be used in cases where there is not enough data to perform regression. the cost function is: TC = $50.2444 7734. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. B.16197623 0. Unusual cost items are assumed to continue in the future.25 Scatter Plot.90567454 3293. however. F.186. In addition. If these assumptions do not hold. Both methods assume that the cost function is linear and that all data points come from a single relevant range.

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

00 $20.00 $20. It is possible that the managers under.00 + (600-500)*$0. Many cellular telephone bills do not list the calls made.00 $20. If her calls are over 400 minutes or under 600 minutes.05 $0. so Susan may need to maintain her own records if she wishes to trace telephone usage. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. In
.04 $0. Hours per batch would be determined as follows.27 Fancy Furniture A.1 hours (average time for the first four batches) B. Here are some of the reasons. There are many different reasons that the time could be different from the amount determined above. In most businesses.067 $0.Chapter 2: The Cost Function 2-23 consulting jobs. 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.10 = $40.90/ln2) = −0. especially if she usually calls less than 500 minutes a month • Below is Susan’s average cost per minute at different levels of calls per month. telephone costs are viewed as an indirect cost.00 Average Cost $0. students may think of others.057
The average cost is lowest at exactly 500 minutes per month.152 Y = 10 hours*4-0.05 $0.10 = $30.or overestimated the amount of hand work performed. she will pay a very high rate of 10 cents per minute 2. In this case the learning rate would be wrong and so the time would also be wrong.152 Y = 8. Cons • If Susan has a number of projects in her local area or will be traveling a lot. Minutes 300 400 500 600 700 Total Cost $20.00 $20. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls).00 + (700-500)*$0. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. her phone bill will be less than it would be at a rate 5 cents per minute.

If a worker is absent one day. or 40% or revenue Combining fixed and variable costs. and the University surcharge is specifically based on sales. if managers believe that 25% of the work is done by hand. Thus.000 5.2-24 Cost Management addition.500 $47.28 Wildcat Lair A.000 + 40%*80.000 = $79.000
Variable $21. then the cost would be overestimated.000 1.000 Profit = Revenues – Total costs = $80.$79. or has a great deal of experience on the machine.40. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals
Fixed $ 30.000
.000 .000 using the cost function is: TC = $47.000 _______ $28.000 = $1.000 + 40%*Total revenue D.000/$70.000 = 0. 2. the rate will change if the replacement employee has never worked on this machine. 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. and B.000
7. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000
Total revenue is the most likely cost driver for both variable costs. the cost function is: TC = $47. Because revenue is the cost driver for both variable costs. The estimate of total costs given revenues of $80. then this chart suggests that the learning curve will be slower than the 90% estimate. C. if managers believe that more than 25% of the work is done by hand. However. If these values are used in a regression to estimate a cost function. D. it is possible that different types of wood affect the rate at which chairs can be produced. C. Food costs are likely to vary proportionately with sales. they would be higher than the labor costs in later periods.500 10. then the chart suggests that the learning rate estimate is reasonable.

000 increase in revenues. However. Item D will be VERY difficult for most students. so the estimated profit in August is $1. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning). but this is not considered a cost driver (a business activity that causes variations in total variable cost). Electricity costs also vary with changes in electricity rates. so the trend would be the opposite of this plot.000)+the university surcharge of $7.] A. Variable food costs are estimated to be 30% ($21. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. C. it would lose the revenues.000 .000
.000. In a retail business.000 increase in revenues is expected to be $6. To estimate the opportunity cost for August.000). If the university were to close the Lair.000 + 30%*Total revenue During August. B. Thus. for July the opportunity cost would have been $2. The shop is most likely a seasonal business. less the fixed costs and the variable food costs.000+$6.000) Net 2.Chapter 2: The Cost Function 2-25 E. costs would be higher when there were fewer sales.000 ($10. So.$4. In July there was a loss of $5.000— the operating loss of $(5. it might even close when the ski area shuts down. the variable cost part of the cost function can be adjusted. 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). Lair’s fixed costs are assumed to be unchanged with the $10.000). A shop located near a ski area is likely to incur high heating costs during the winter. Because the university surcharge is an allocation within the university.000. the additional profit from a $10.000 ($10.000) of revenues.000*40%). F. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. and the increase is estimated to be 40% of the increase in revenues. So.000 (-$5.29 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) (24.000 (47. the shop might experience very little business activity.) The adjusted cost function is: TC = $47.000/$70. generating most its sales around the ski season (fall and winter). if the bathing suit shop is located in a geographic region $80.000) $ 9. During the spring and summer months. Only total variable costs are expected to increase. total variable costs are expected to increase by $4.

and new office furniture or equipment.69 x 5 = $1. However.5 = $152. special promotions. D.50 = $1.67 1.542. higher profits generally occur during periods when activity is high. correlation does not necessarily mean causation.69 (average cost for each of the 5 units) Total cost = $205.85/ln2) = 0.22
Firm B set its selling price based on the average cost. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.89 (average cost for each of the 100 units produced) Given a 50% markup on cost. A correlation may appear in a scatter plot or regression analysis. 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.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.028. a 50% markup on total cost will cause sales to be: $1. then the highest sales might coincide with the highest electricity costs.45 $ 514.2345 Y = $101. 2. given a 100 unit production level: Y = α Xr Y = $300*100-0.67 Firm A's income for last year was: Sales Costs Income $1.028.2345 Y = $300*5-0. For example.542. firm B's selling price is: $101.89 x 1.45 Although each customer paid a different price.45 x 1.84
.028. generally mean there is more money available to spend on administrative travel. in turn. Many costs can be related to volume of activity. employee training. they are discretionary expenditures and not caused by the level of activity. Higher profits.2345 Y = $205.

028.926.50/150 units = $64.28 $23.97) 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 $1.528.85 x 1.45 $1. assuming an 85% learning effect would be: Y = $300*150-0.84) Costs (150 x $ 92.50
.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.727.00 13.50
Firm B's calculation for its selling price is as follows: Y = $300*300-0.50 $ 9.84) = $1.528.727.85 Thus Firm B's selling price this year was $64.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.625.384.897.356.2345 Y= $78. Total cumulative production cost (300 x $78.50 $ 9.2345 Y = $92.00 13.897.356.10 $ 172.40 1.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.2345 (notice that the cumulative units produced is 15) Y = $158.75) Total costs to produce the first 150 (from last year’s income statement) Total costs of this year’s production (150 units) Average cost per unit = $9.65) Income Firm A's revenues for this year are: (10 x $152.40 Firm A's costs may be computed as follows: Y = $300*15-0.50 = $97.Chapter 2: The Cost Function 2-27 Firm B's costs.55 1.028.10 $22.30 $2.

356.000 $135. and most of the observations appear to have a fairly linear trend.500.wiley.000 $155.500.000 $5.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.592. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.000 $145.
.wiley. Scatter Plot of Marketing Costs Against Sales
$175.000
$8.000
$7.727.000
$6. 2.28) Costs (150 x $64.50 $ 4.61. such extreme differences in cost can occur.com/college/eldenburg).500.000
Sales
B. There is a positive slope. Costs
$165.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97. available on both the Instructor and Student web sites for the textbook (available at www. A.864.28 is lower than Firm A's average cost per unit: $1.85) Income $14.500.000
Marketing Dept. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.50
Note that Firm B's selling price for this year of $97.com/college/eldenburg).00 9.10/10 = $135. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.

Assuming that profits are more likely to increase when sales increase. the cost function is: TC = $65. Even if marketing department costs are discretionary.86656716 Standard Error 4015.7600071 P-value 2. usually annually. there would be a positive correlation between marketing department costs and sales. F.93336396 R Square 0. sales may go up.34%*Sales D.Chapter 2: The Cost Function 2-29 C.584 + 1. the decision maker(s) should be asked what next year’s cost will be. Here is the regression output.08144 Observations 30 Coefficients 65584. E. In addition.4501E-10 5. it is economically plausible for sales to be a cost driver. the cost estimate should not be based on past costs. discretionary costs such as marketing are often increased when profits increase.00097028 t Stat 9.2608 0.
. using regression or any other technique. When more money is spent on marketing.87116829 Adjusted R Square 0. Discretionary costs are set by decision.63816 0. Therefore. If the variable portion of the marketing cost is sales commissions.01335108 Standard Error 6844.
Regression Statistics Multiple R 0.58184484 13.5289E-14
Intercept X Variable 1
Based on the regression results. Instead. they may be positively correlated with sales.

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.000 $120.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $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.wiley.000 $0 0 300 600 900 1200 1500 Machine Hours
. A.
Manufacturing Overhead Against Labor Hours
Manufacturing Overhead Cost $200.com/college/eldenburg).000 $40.com/college/eldenburg).000 $160.000 $80.000 $40.wiley.000 $80.000 $160.

but the plot for labor hours appears to have the least trend.000 $160.600936029
Intercept Labor Hours
t Stat 10.11279932 R Square 0. Sometimes a cost that is mostly variable. C.02253618 Standard Error 11114. None of the plots show a definite trend. Labor Hours Regression:
Regression Statistics Multiple R 0.8173 Observations Coefficient s 150410.600712
P-value 6. D. Costs and potential cost driver data are plotted to determine whether further analysis is necessary. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. the cost driver does not explain the variation in cost. labor hours could be deleted as a potential cost driver. Based only on the cost plots.682 4.000 $0 0 100 200 300 400 500 600 700 Raw Materials
B. If the observations are widely scattered.01272369 Adjusted R Square -0.50852 7. The plots help determine whether regression analysis should be performed using any of the potential drivers. either the driver is wrong or the cost is mostly fixed.000 $40.1543 0.56597156 30 Standard Error 14812.000 $80.000 $120.552864
.86E-11 0.Chapter 2: The Cost Function 2-31
Manufacturing Overhead Against Raw Materials
Manufacturing Overhead Cost $200.

9786 Observations 30 Coefficient s 126216.68E-12 0.11E-12 0.22* Raw materials
. so the cost function is estimated as: TC = $126.411 Machine Hours Regression:
Regression Statistics Multiple R 0.56778 19. so the cost function is estimated as: TC = $117.215128 Standard Error 10853.3746211 Adjusted R Square 0.095468
P-value 4.217192 Standard Error 10291.599 + $38.47803 9.331580777
Intercept Machine Hours
t Stat 11.53627459
Intercept Raw Materials
t Stat 11.082222
P-value 3.67 38.4268 4. so the cost function is estimated as: TC = $150.004579
Both the intercept and slope coefficients are significant.1555 Observations 30 Coefficient s 117598.5033241 R Square 0.2-32 Cost Management Only the intercept term is significantly different from zero.62907 3.22*Machine hours Raw Materials Regression:
Regression Statistics Multiple R 0.2266685 Standard Error 9665.217 + $60.2533351 Adjusted R Square 0.612063 R Square 0.000325
Both the intercept and slope coefficients are significant.3522862 Standard Error 8846.91 60.

2349 3. however. 2. F.08E-08
.953575 1.9092294 R Square 0.291558412 10.wiley.com/college/eldenburg).5558 Observations 30 Coefficient s 60988. available on both the Instructor and Student web sites for the textbook (available at www.3E-06 0.12E-09 1.com/college/eldenburg).8067018 Standard Error 4832.333162437 5. The coefficients for each of the other potential cost drivers are significantly different from zero.Chapter 2: The Cost Function 2-33 E.218173 8.489 -0. A. Yes.210187
P-value 3.778501 82.886218 -0.976635 Standard Error 10361. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.1959303 48. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression. this driver explains only 35% of the variation in cost.10654585
Intercept Labor Hours Machine Hours Raw Materials
t Stat 5.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2. Multiple regression with all three potential cost drivers:
Regression Statistics Multiple R 0.226
Based on the simple regression results.05878 9.8266982 Adjusted R Square 0. machine hours appears to do the best job of explaining manufacturing overhead costs. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.352 0.wiley.

55) $38.78 (<0.001) $-0. Thus.98 (<0.391636
P-value 1.352 and 0.664851 5.93*Raw materials D.352 0.157604083 9.450561 8.20 (0. machine hours and raw materials explain different activity
.001)
B.954) $48. its coefficient is not significantly different from zero in either regression.001)
$4.5902 48.411 (<0. In this example.90921678 R Square 0.74*Machine hours + $82. Also.001) $60. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.5348 Observations Coefficient s 60677.001) $126.71E-10 5. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.226) for these two cost drivers.29E-09
The cost function is: TC = $60.599 (<0.22 (<0.881964042
Intercept Machine Hours Raw Materials
t Stat 6.939606 9. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression. Manufacturing can be a complex activity requiring a number of different tasks.925842 30 Standard Error 8743. labor hours can be eliminated as a potential cost driver.001) $60.678 + $48. The adjusted RSquare is far higher in the multiple regression (0.022 0.806) than in either of the simple regressions (0.82667515 Adjusted R Square 0.86E-07 4.2-34 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.005) $82. Costs for these activities are likely related to specific cost drivers.001) $117.226 0.988 (<0.22 (0.81383627 Standard Error 4742. Each task includes different activities.217 (<0.57 (0. its coefficient is negative rather than positive in the multiple regression.7422519 82.806
$150. R2
Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression
0. Multiple regression using machine hours and raw materials as cost drivers:
Regression Statistics Multiple R 0. C.

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

000 $0 50 100 150 200 250 300 350
Maintenance Hours Worked
Scatter Plot of Maintenance Costs Against Number of Students
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.2-36 Cost Management 2. B.000 $5.
Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked
Maint. Dept. square feet cleaned.com/college/eldenburg).000 $20.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.000 $10. Costs
$25.000 $5. number of hours students attend school.wiley.
. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. or number of classes and activities per period.000 $10.000 $15. A.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2. Costs
$25. number of hours the building is open.000 $15. available on both the Instructor and Student web sites for the textbook (available at www.wiley. Dept.000 $0 528 530 532 534 536 538 540 542
Number of Students
C. Other cost drivers for total maintenance cost could be number of rooms cleaned.000 $20.

875134 35.796328319
Intercept X Variable 1
Coefficients 9134. However. it is considered fixed.74733262
t Stat 9.03271 Standard Error 3019. providing high confidence that both the intercept and slope are different from zero.832184392 Standard Error 1217. The total cost function is: TC = $9. Therefore. it is logical to expect a strong relation between hours worked and cost.68624 0. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.36 The Elder Clinic A and B Salaries are always fixed. maintenance hours is a reasonable cost driver.807201
P-value 0. E.06772 Observations 12 Standard Error 965. The most current value is used to
. An unidentified cost driver could have a higher R-Square.173 Observations 12 Coefficient s -89867 197.438328
According to the R Square statistics.0261 Standard Error 130954. and rent for this type of facility is usually fixed. From the analyses performed.Chapter 2: The Cost Function 2-37 D. 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.920565237 R Square 0.9 244.847440356 Adjusted R Square 0.135 + $35.247329 R Square 0.461245 7.061172 Adjusted R Square -0. Regression results for maintenance cost and number of maintenance hours worked:
Regression Statistics Multiple R 0. Utilities cost varies with season not visits.63E-06 2.18E-05
Regression output for maintenance cost and number of students:
Regression Statistics Multiple R 0. 2. The p-values on the Tstatistics are very small.0857
Intercept X Variable 1
t Stat -0.453062
P-value 2.508157 0. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.74*maintenance hours worked.5045837 4.

49 Cost Driver Patient-visits Mixed X
2.182 . to find fixed: $3. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14.
.$2.934)/(849 – 778). or there are changes in treatment procedures for certain illnesses.412 1. each patient requires a certain number of supplies.182 = F + $3. Use March. Here are some of the reasons: • The managers will not know how many visits they will receive. such as tongue depressors. **Using high-low. Visits are affected by season.07*patient-visits C.736 Variable $3. Use the same method for other expenses. • Prices of all inputs could change (usually increase).49*849. There is no one answer to this part.115 219 3. E. medical supplies is a mixed cost.wiley. other facilities may open or close.com/college/eldenburg). 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. must be kept on hand whether or not they are used. variable cost is $3. gloves.58 $6. At 940 patient-visits.80 D. and costs go up as patient-visits increase. weather. • Treatments and related costs may change as new drugs are available. and so on. Some supplies.2-38 Cost Management predict next period’s utilities. July expenses are estimated to be: TC = $19. and so on. Medical supplies vary with number of patient-visits.07
Patient-visits
X
* The value in June is used for fixed costs because the increase in salaries will hold into the future. Given the preceding computations and cost summary.736 + $6. Therefore. Other expenses appear to increase and decrease with number of patientvisits. current illnesses that are circulating in the area.100 226 664 $19. These would be variable. so this cost is classified as a mixed cost. new equipment is acquired. but not proportionately.07*940 = $25.49 ($3. Also. such as snake anti-venom. high point of medical supplies cost and patient data. the cost function is: TC = $19. These would be fixed.736 + $6. This analysis suggests that there are some of the other expenses are variable costs and some fixed. There are many possible reasons that could be listed.441. affecting the number of visits at this clinic.

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

750 68.10.750 .wiley.310 70.596 73.686 71. available on both the Instructor and Student web sites for the textbook (available at www. A.83/mo.750.200
+$2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.2-40 Cost Management 2.
.150 73. 1/2 of August 5 payroll goes to July: 5.236 69. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. July’s result is an outlier and should be removed from the data.800
41.500 38.250 May June July Aug Sept Oct Nov
1
Property Tax(a) +$500 + 500 + 500 + 500 -3.850 2 .com/college/eldenburg).350 68.com/college/eldenburg). the first month is adjusted even though it is not an actual cost: 4.500 x 1/2 = 2. Because of the large difference between these values and the values in other months.300/10 x 12 = 35.000 + 500 + 500 + 500 + 500 + 500
Depreciation(b) +$36 1 + 36 -4.790 80.8 x 6. these are correctly handled. as shown in the scatter plot below.wiley.200 Apr 71.4.286 68.736
To predict future overhead.800.800 .376 65.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36
Other
Payroll3
Adjusted Cost $68. No adjustments are needed for items (c) and (d).39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. The miscellaneous supplies account also looks suspicious. 80% of September 2 payroll to August: . the trend line is likely to distort costs. Operations in the month of July are not typical of the rest of the time period. B.2. (rounded to $36) 2 Note IB-4's power added to Dept.486 68. IP-14 3 Payroll paid every two weeks.736 67.036
68. If these observations are included in the regression analysis. Similarly. but there is insufficient information to make an adjustment.750 + 4.000 = 4.

000 $40.086126
Based on the t-statistic and p-value for the intercept.000
Overhead Costs
$70. According to the details provided for August and September. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.000 6.500 5.314163 1980.641981 0.789722
t Stat 0. Thus.000 9.000 2. Monthly overhead costs for supplies may be significantly overstated or understated
.000 $55.775388 0.47 8 Standard Error 29406.050976
P-value 0. Here are the regression results:
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 8.412139 0.26 3.310484
Intercept X Variable 1
Coefficient s 8777.000 $45.000 3. they are most likely recorded at the time of purchase rather than at the time of use. the fixed cost does not appear to be different from zero.000 $60. the cost function is estimated as: Overhead cost = $6. Therefore.500
Outlier
Direct Labor Hours
C. D.Chapter 2: The Cost Function 2-41
Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours
$75. Based on the variation in dates at which supplies are recorded. supplies were a large proportion of overhead cost.298502 2.000 $50.000 $65.79 * 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).818 6.

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

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

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

957296 Standard Error 6710.04 13. Because of the annual pay increases. the cost function was estimated by regressing actual labor costs on number of chairs produced. However. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.3147402
P-value 3. the regression explains only about 59% of the variation in labor costs. A.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. In prior years.848277 8. B.6004687 Adjusted R Square 0.] The data for this problem can be found on the datasets file for chapter 2.5917832 Standard Error 6216.com/college/eldenburg). The cost function is estimated as: Labor cost = $133.96 x number of chairs produced However. students are likely to struggle interpreting and choosing a method (Parts E and F). Here are the simple regression results:
Regression Statistics Multiple R 0.7995 Observations 48 Coefficient s 133194.com/college/eldenburg).194 + $13. Considerable variation in labor costs is not explained by changes in the volume of production.437E-24 1.
.02E-10
Based on the regression results.7748991 R Square 0.678620854
Intercept X Variable 1
t Stat 19.609693 1.Chapter 2: The Cost Function 2-45 2. the degree of downward bias is higher for older data than for more recent data. available on both the Instructor and Student web sites for the textbook (available at www.wiley. 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. using monthly data for the prior 4 years. Also.

which is reasonable given the increase in wage rates over time. Also.54295 Standard Error 5689. the fixed cost and the variable cost per unit are each positive and statistically different from zero.863839 Standard Error 3742. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203. approximately 26% of the variation in labor costs is still unexplained. this cost function would result in a higher estimate for future costs.05E-27 2.864722 R Square 0.742261 Standard Error 5148.96 to $16.35E-15
Based on the regression results.869633 Adjusted R Square 0. D.390275
Intercept X Variable 1
t Stat 24.347 x 1.2-46 Cost Management C.06236 11.23 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 0.8 16.00872
Intercept X Variable 1 X Variable 2
t Stat 18.905 Observations 48 Coefficient s 133736 16.57E-23 2.486389
P-value 4.23439 Standard Error 5557. The fixed cost is nearly the same.74).492 1.67711
P-value 1. Nevertheless.93821 16. here are the regression results:
Regression Statistics Multiple R 0.010513 1.91E-08
. Here are the multiple regression results:
Regression Statistics Multiple R 0.73E-20 5.26499 6.347 Calculation $203.736 + $16.02 Adjusted Labor Cost $220.533 x (1.311 200.747745 Adjusted R Square 0.23 per chair.932541 R Square 0. The cost function is estimated as: Labor cost = $133.02)4 $196.533 Dec 20X4 196.274
Using the adjusted labor cost data.09577 6.891 1. but the variable cost increased from $13.411 Observations 48 Coefficient s 107748.

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