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LEARNING OBJECTIVES

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

COMPLEXITY SYMBOLS

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

2-2

Cost Management

QUESTIONS

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

Total Cost

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

2.3

2.4

2.5

2.6

Chapter 2: The Cost Function

2-3

2.7

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

2.8

2.9

2.10

2-4

Cost Management

EXERCISES

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

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

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

D D I D D D D

D I I I I D D

I I I I I D D

13 Linear. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. 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 .000 $8.000 $9. the CPA's time is the product being sold. TC = $10. 2.00*Q Graph of Cost Function $14.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. CPAs do keep detailed time records. Stepwise Linear. the tax partner probably spends some time in non-billable activities.000 $11.000 $13. For the firm to make this cost direct for the personal returns cost object. and Piecewise Linear Cost Functions A. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. In a service business such as this.000 + $8. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. Of course.000 Total Cost $12. The time records that the tax partner maintains support this cost as a direct cost.000 $10.

000 F = $450.000 $60.000 * $45 = $450.000 3.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528. it is first necessary to estimate the cost function.000 .000 * $44 = $528. for Q > 2.000)/(12.00*Q.000 units = 12.000 – 10.000 TC = $35.00*Q. for Q ≤ 2.000 = $60.000 + $8.000 .000 $70.000) = $78.$450.000 $40.000 Total cost at 12.000 $10.000 units = 10. TC = $25.$390.000 Total Cost $50.000 $30.000 $20.000 Graph of Cost Function $80.000 Combining the fixed and variable costs to create the cost function: TC = $60. To estimate the costs at another production level.000/2. Convert the average costs to total costs for each production level: Total cost at 10.000 + $39*Q .000 units: $450.2-6 Cost Management B.000 Number of Units C.000 2.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 4.000 = F + $39*10.000 $0 0 1.000 + $8.

for Q < 1.000 Estimated cost per unit = $645.500 2.00) + $9.000: TC = $50.000 + $10.000 = $645.$9.000 For Q > 1.500 2.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost . TC = $50.000 0 500 1.00*Q 2-7 Graph of Cost Function $75.000 $50.000 $45.000 = $9.000 + $9. total cost is estimated as: TC = $5.000 + $9.00*Q.000 + 45%*$10. Inserting $10.14 Piecewise Linear Cost Function A.000 $65.000 TC = $51.000 in revenues into the cost function.000 * $10.000 units: TC = $60.000 $60.000) TC = $50.00*(Q-1.00*Q .000 + $585.000 + $10.000 $70.000/15.000 + $39*15.000 1.000 = $43 D.000 $55.000 + (1.Chapter 2: The Cost Function Estimated total cost at 15.000 = $60.

00*Q.3219 Y = 6 hours*2-0.000 units but would underestimate total cost for Q ≤ 1.3219 Y = 4.3 and 2A. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared .8 hours (average time for each of the next two returns) B.000 units but would overestimate total cost for Q > 1. This cost function would provide reasonable estimates for Q > 1. then the cost function would be some mixture of the functions for the two relevant ranges.80/ln2) = −0. the cost function mismeasurement depends on the values of Q. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. 3. If all of the data estimation points occurred when Q was > 1.2-8 Cost Management B.000 units. Hours for two returns would be determined as follows.00*Q. This cost function would provide reasonable estimates for Q ≤ 1. then the cost function would appear to be: TC = $51. then the cost function would appear to be: TC = $50. If the data estimation points occurred across the two relevant ranges.15 Tax Plus A. 2.4. If the accountant did not detect that there were two different relevant ranges.000 + $10.000 units. If all of the data estimation points occurred when Q was ≤ 1. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.000 + $9.000 units.000 units. There are three general situations: 1. 2.

then wages would be an indirect cost. then variable cost per dollar of revenue is calculated as follows: $8.000 + 25%*Total sales B. Wages are fixed because they remain constant (the employee always works 40 hours). Chapter 3 will point out another assumption for this cost function: the sales mix (the proportion of sales of different products) remains constant within the relevant range. if time is not traced to individual bowls (for example.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns.16 Bison Sandwiches A. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). it improves less quickly for the next return. D. it is a direct cost. Note: Depreciation using a method such as declining balance is not constant over time. F Assuming that employee time can be traced to each bowl.25.000/$32.000 on total sales of $32. making it a fixed cost. B. F . 2. their productivity increases. this particular cost function assumes that variable costs are driven by sales. D or I. V C. Total clay cost will vary with the number of bowls made. In addition.000. 2. as their performance improves. If total variable costs were $8. 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.000 = 0. that is. Assuming that the cost of clay can be traced to each bowl. and variable costs remain constant within the relevant range. However. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. but would still be considered fixed because it does not vary with production volume.] A. I.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. and their productivity rate will remain stable. Eventually their learning will plateau. it is a common cost of production for all of the bowls that are heat-treated in the kiln. However. wages are a direct cost. Assumptions: Fixed costs remain fixed within the relevant range. the cost function is: TC = $20.

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

E. 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. F. as well as voluntary items such as health insurance and retirement benefits. 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. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. F or M Employee benefits occur in any business in which employees are hired.] A. V Ingredients are used in making pizzas.50. Benefit costs often vary with level of wages or salaries.000 = 0. B. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. or 50% of revenue Combining fixed and variable costs. The cost of rent is irrelevant because it will not change with either alternative. In the fishing boat business. Therefore. . There most likely would not be any ingredients in a fishing boat business. F. In the pizza shop. In many organizations. because of uncertainty in the success of each fishing expedition. PS. C.500/$9. the cost function is: TC = $3. V. B. FB. D. D. these costs would be mixed with a large proportion of the cost fixed. workers’ compensation. B. so they would tend to be fixed or mixed (see Item A above). they are more likely related to time on the boat than pounds of fish. and unemployment insurance. Benefits might include mandated items such as social security. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). employees are likely scheduled in advance on a fixed schedule.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C.Chapter 2: The Cost Function 2-11 B. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4.300 + 50%*Total revenue C. 2. costs vary with dollars of revenue. and the cost would vary with number of pizzas produced. In this type of situation. Some may be sent home if business is very slow.

1619) = $0. Tomato ($.0198 9.0033 0.1619 10. Lettuce ($. Cost of burger with everything except cheese = ($0. they are treated as fixed costs. B. Catsup ($.6815 .59/40) 0.1075 0. In general.2414 $0.0053 0.2414 $0. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.49/(16 x 4)] 0.69/7) $0. but it might be mixed if a portion of the cost relates to levels of business activity. and yellow pages advertisements. 2.0053 8. newspaper advertisements. there might be some utility costs for the fishing operation and for a business office.15/45) 0.0233 0. PS. Hamburger bun ($1.0148 0. Mustard ($.0233 7.20 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. F or M Any type of business will have insurance costs.95/2.000) * 4] 0. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship. Because advertising costs tend to be discretionary.2-12 Cost Management E. F.5195 = $1.0148 6.1619 0.56 .0179 0.1075 3. Mayonnaise [$1. It will be a fixed cost if it is a flat amount.0863 5.0033 $0. Cost of plain burger = $0. B.59/16) 0. The cost might be fixed or mixed.3489 (calculated above) B. If the fishing boat is for tourists.0863 0. Onions ($. depending on how the insurance cost is calculated. Dill pickles [($8.29/12) 0.0179 4. F Most pizza shops incur advertising costs such as flyers.$0.69/8) 0. the utility costs for these two businesses would tend to be fixed (would not vary with production).5196 Suggested selling price: 300% * $0. G.2414 2. advertising costs would be incurred.0198 0.3489 $0. Hamburger patty ($1.79/150) 0. Cheese ($2.6815 A.99/50) 0.1075 0. For the fishing boat business.

Mostly fixed and discretionary H. Market forces will dictate achievable prices.25 = $1.04 Therefore.Chapter 2: The Cost Function 2-13 C. 2. Professional subscriptions. Therefore.79 Some students will view this higher price as "unfair. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. Professional dues. if her prices are too low. if Ms.04 .Fixed . that is. and then mixed C. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. Property taxes. Clerical wages – Fixed unless overtime is regularly scheduled. 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. Alternatively. Rent . and F) are the ones requiring significant assumptions to generate an answer.6815 = $2. It is just a general guideline. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. that cost would be variable.] A. If Ms.Fixed F.Fixed and discretionary I. Office supplies .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. However staff are often salaried. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. she foregoes profits and people may believe there could be quality problems with her food. Long is able to differentiate her hamburgers from others in the market. In the current business environment.Fixed E. in which case the total cost would be primarily fixed. D.Mixed. there is no moral obligation to maintain a 300% markup on each item. they set prices considering their competitors’ prices. Alternatively. mostly variable G. Long’s prices are too high. Selling price of cheeseburger with everything: 300% * $0. most organizations are price takers. the price of the plain hamburger should be: $2. This means that her costs need to be below the competitive price. B.Fixed D. The Step 2 questions (A. B.$0. Insurance. If there is part time help. Licenses." However.

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

Chapter 2: The Cost Function 2-15 A.78591283 0.113687834 Intercept Output t Stat 5.582691 P-value 6.52099624 Standard Error 153. Potential Cost Driver: Output Maintenance Costs Against Output $2.500 Maintenance Costs $2.500 $1.58E-05 0.000 $1.000514 .026826 0.119724 15 Coefficient s 884.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.61765897 0.58824812 182.761602 4.4342166 0.

500 Maintenance Costs $2.500 $1.017601 .717372 P-value 0.60187065 0.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.02569657 Standard Error 261.000 $1.291084 2.31319046 235.457384 3.005847 0.210849 15 Coefficient s 861.113464425 Intercept Direct Labor Hours t Stat 3.36224828 0.000 $500 $0 0 50 100 150 200 250 300 350 Direct Labor Hours Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.7549386 1.

94888217 0.000 $500 $0 0 20 40 Machine Set-Ups 60 80 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations Coefficient s 126.96E-10 B. the cost driver does not explain the variation in cost and either it is the wrong driver. the trend line for machine setups looks as if the intercept could be zero or very close to zero. For example.42597461 1.500 $1. all three potential cost drivers appear to be positively related to maintenance costs. This indicates that the cost could be totally variable.357393 15.97410583 0.000 $1.94495003 66.815737 29.5913391 15 Standard Error 93. .500 Maintenance Costs $2. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. Sometimes a cost that is mostly variable can be identified from a scatter plot.5343 P-value 0. If the observations are widely scattered.910475729 Intercept Machine Setups t Stat 1.6778973 0. a good cost driver would present a linear or football-shaped positive slope or trend.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2. However. In Part A. or the cost is mostly fixed.197755 8. In a scatter plot.

E. business processes. D. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. Therefore. This provides confidence that the variable cost part of the cost function is not zero. This means that variation in setups explains about 95% of the variation in cost. the economic environment.521*Output TC = $861 +$3. In the machine setups regression. .945 Cost Function TC = $884 + $0.945.025*Direct Labor Hours TC = $29.588 0. The regression using machine setups has the highest adjusted R-Square of 0. Changes in many factors such as resource prices. the cost is likely to be totally variable. the t-statistic is significant for the independent variable but not for the intercept. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. R-Square 0.2-18 Cost Management C.313 0. The use of past cost data to predict the future assumes that future resource costs and volumes of activities will remain the same as in the past. and technology can cause future costs to be different than estimated.68* Machine Setups The machine setups intercept coefficient is not significant. so it is excluded from the cost function.

that is.100 – $632.333 = F + 5%*$1. First.333 – $43.100 F = $68. That means that the cost function might not represent the actual cost. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver. on average.333 .Chapter 2: The Cost Function 2-19 PROBLEMS 2. this cost function might provide poor estimates of future costs. The high low method uses the most extreme cost driver values.000/$500.132.100) = $25. Therefore.728 Thus.24 Big Jack Burgers A. Under the high-low method.$56. the cost function is calculated using the highest and lowest values of the cost driver.728 + 5%*Sales B. . the variable cost is calculated: ($68. the total cost function is: TC = $11. not represent the cost most of the time.605 = $11.05.333)/($1.000 = 0. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.132. which could be outliers.

Because this regression has few observations. Based on the p-value. If this cost pool includes items such as salaries and other fixed costs (insurance.172. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. Notice that the t-statistic for the intercept coefficient is 2.000 $1. there is a 16% probability that the intercept (fixed cost) is not different from zero. Then. Following is the regression output.000 $900. The upward slope of the line indicates that there are variable costs. Analysis at the account level can be used to increase the understanding of this cost.800 + 4. the cost function would be TC = $16.000 $40.000 $0 $0 $300. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function.162.5% x sales . the cost function would be: TC = 4. analysis at the account level might indicate that there are few fixed costs. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. Alternatively.5% x sales.000 $600. In that case.2-20 Cost Management C. the p-value result for the tstatistic is atypical.200. Chart of data with trend line added by Excel.000 Administrative Costs $60.000 $20.000 Sales It appears that the cost is most likely mixed. but the p-value is greater than 10% at 0. fixed costs are likely to be zero and would be excluded from the cost function. D. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. etc). the regression intercept can be used as an estimate of the fixed costs. Then.

Sales does not appear to explain much of the variation in research and development costs.73545 0. If there are only two or three data points. The plot shows costs that are widely scattered. If these assumptions do not hold. There might be a change in business operations or in the economy that would cause future costs to be different than in the past.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.25 Scatter Plot.186. on average.9680477 0. Both methods assume that the cost function is linear and that all data points come from a single relevant range. and possible changes in costs such as those described in Part E are ignored.45937486 P-value 0. The cons of the high-low method as an estimation technique were discussed in Part B above. However. the results rely on more complete information and provide a better estimate. Sales might not be the activity that drives administrative costs.90567454 3293.00818212 t Stat 2. B. both of these methods assume that the data points are representative of future costs. F. 2. there does appear to be a general upward trend.16197623 0. This means that variation in sales explains only about 18% of the variation in research and development cost.17205158 5. a cost function may not provide a good estimate for the next month’s costs. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.93711636 0. The past costs used for estimation might not be representative. Therefore. Using the regression results. .04466925 0.82%*Sales C.365 + 0. The adjusted R-Square statistic is very low at 0. the high-low method may be the best option available. If there are more data points. There might be a large discretionary component in administrative costs. the cost function is: TC = $50. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. causing fluctuations in cost that are unrelated to any cost driver.0319523 Intercept X Variable 1 E. regression analysis incorporates all of the observations into the analysis. Unusual cost items are assumed to continue in the future. especially because so few observations were used in the estimation. however. This method can be used in cases where there is not enough data to perform regression. Because of unforeseen changes in cost behavior.4038 4 Coefficients Standard Error 16800. Cost Function Using Regression A. then both methods may be unsuitable for estimating future costs.2444 7734. In addition.

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

05 $0. There are many different reasons that the time could be different from the amount determined above.00 Average Cost $0. If her calls are over 400 minutes or under 600 minutes. so Susan may need to maintain her own records if she wishes to trace telephone usage.152 Y = 10 hours*4-0. Cons • If Susan has a number of projects in her local area or will be traveling a lot.or overestimated the amount of hand work performed.10 = $30.27 Fancy Furniture A.90/ln2) = −0. Hours per batch would be determined as follows.00 $20. she will pay a very high rate of 10 cents per minute 2. students may think of others.05 $0.00 + (600-500)*$0.1 hours (average time for the first four batches) B. I. In .Chapter 2: The Cost Function 2-23 consulting jobs.00 $20.00 $20. especially if she usually calls less than 500 minutes a month • Below is Susan’s average cost per minute at different levels of calls per month.10 = $40.00 + (700-500)*$0. In most businesses. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls).067 $0. her phone bill will be less than it would be at a rate 5 cents per minute. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. 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. In this case the learning rate would be wrong and so the time would also be wrong. Here are some of the reasons. Minutes 300 400 500 600 700 Total Cost $20.152 Y = 8. It is possible that the managers under.04 $0. telephone costs are viewed as an indirect cost.00 $20.057 The average cost is lowest at exactly 500 minutes per month. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. Many cellular telephone bills do not list the calls made.

the rate will change if the replacement employee has never worked on this machine.000 + 40%*80. if managers believe that more than 25% of the work is done by hand. Because revenue is the cost driver for both variable costs. Food costs are likely to vary proportionately with sales. C.000 Profit = Revenues – Total costs = $80.000 Variable $21.500 10. and the University surcharge is specifically based on sales.500 $47. and B.000 _______ $28. then this chart suggests that the learning curve will be slower than the 90% estimate. 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.000 5.2-24 Cost Management addition.000 + 40%*Total revenue D.000 Total revenue is the most likely cost driver for both variable costs.28 Wildcat Lair A.000 using the cost function is: TC = $47. 2.000 1. The estimate of total costs given revenues of $80. or has a great deal of experience on the machine. it is possible that different types of wood affect the rate at which chairs can be produced.000 . the cost function is: TC = $47.000/$70.000 = 0.000 = $79.000 = $1.40. If these values are used in a regression to estimate a cost function. then the chart suggests that the learning rate estimate is reasonable. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. C.000 . Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. If a worker is absent one day. or 40% or revenue Combining fixed and variable costs.000 7.$79. Thus. However. D. they would be higher than the labor costs in later periods. then the cost would be overestimated. if managers believe that 25% of the work is done by hand. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.

] A. total variable costs are expected to increase by $4.000). During the spring and summer months.000+$6.000). so the estimated profit in August is $1.000 ($10.) The adjusted cost function is: TC = $47.000. Thus.000 ($10. Electricity costs also vary with changes in electricity rates. If the university were to close the Lair.000/$70. generating most its sales around the ski season (fall and winter).$4.000. so the trend would be the opposite of this plot. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues. it would lose the revenues. for July the opportunity cost would have been $2. Lair’s fixed costs are assumed to be unchanged with the $10. F. C. In a retail business. However.000) $ 9.000 (-$5. Because the university surcharge is an allocation within the university. So.000) (24. less the fixed costs and the variable food costs.000 + 30%*Total revenue During August.000 (47. B.000— the operating loss of $(5. it might even close when the ski area shuts down. but this is not considered a cost driver (a business activity that causes variations in total variable cost).000 . the additional profit from a $10. In July there was a loss of $5. if the bathing suit shop is located in a geographic region $80. Only total variable costs are expected to increase. The shop is most likely a seasonal business.000) Net 2. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).Chapter 2: The Cost Function 2-25 E. Item D will be VERY difficult for most students.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 . Variable food costs are estimated to be 30% ($21. To estimate the opportunity cost for August.000) of revenues. A shop located near a ski area is likely to incur high heating costs during the winter.000*40%). the shop might experience very little business activity. the variable cost part of the cost function can be adjusted.000 increase in revenues is expected to be $6.000 increase in revenues.000)+the university surcharge of $7. 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. this surcharge should be ignored when computing the university’s opportunity cost (assuming that the charge does not relate to any variable costs for the university that arise because of the Lair). So. costs would be higher when there were fewer sales.

45 x 1.5 = $152.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.2345 Y = $205. they are discretionary expenditures and not caused by the level of activity. generally mean there is more money available to spend on administrative travel.45 $ 514. Many costs can be related to volume of activity. 2. then the highest sales might coincide with the highest electricity costs.542. For example.2345 Y = $300*5-0. D. Although these expenditures are made because more money is available. a 50% markup on total cost will cause sales to be: $1. given a 100 unit production level: Y = α Xr Y = $300*100-0.22 Firm B set its selling price based on the average cost.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.50 = $1. correlation does not necessarily mean causation. in turn.85/ln2) = 0. A correlation may appear in a scatter plot or regression analysis.67 Firm A's income for last year was: Sales Costs Income $1. special promotions.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows.69 x 5 = $1.69 (average cost for each of the 5 units) Total cost = $205.028.2345 Y = $101.028.542. However.67 1.45 Although each customer paid a different price. Higher profits. higher profits generally occur during periods when activity is high.84 .028. employee training. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.89 x 1. and new office furniture or equipment. firm B's selling price is: $101.

625. assuming an 85% learning effect would be: Y = $300*150-0.10 $ 172.50 $ 9.40 Firm A's costs may be computed as follows: Y = $300*15-0.30 $2.384.028.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.356.028. Total cumulative production cost (300 x $78.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.00 13.2345 Y = $92.97) 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 $1.85 Thus Firm B's selling price this year was $64.84) Costs (150 x $ 92.50 = $97.84) = $1.50 $ 9.Chapter 2: The Cost Function 2-27 Firm B's costs.727.897.10 $22.65) Income Firm A's revenues for this year are: (10 x $152.55 1.897.528.50 .50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.00 13.528.926.40 1.727.2345 Y= $78.85 x 1.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.45 $1.356.2345 (notice that the cumulative units produced is 15) Y = $158.50/150 units = $64.28 $23.75) 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.

000 $5.000 $135. Costs $165. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.85) Income $14.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.50 $ 4.wiley.500.000 $155.000 Marketing Dept. There is a positive slope.000 $6.500.727.28) Costs (150 x $64.000 Sales B.000 $7.500.28 is lower than Firm A's average cost per unit: $1. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.wiley.com/college/eldenburg).000 $145.000 $8.00 9.com/college/eldenburg). and most of the observations appear to have a fairly linear trend. A. 2.31 Belford’s The data for this problem can be found on the datasets file for chapter 2. .356.10/10 = $135.50 Note that Firm B's selling price for this year of $97.864.500. such extreme differences in cost can occur. Scatter Plot of Marketing Costs Against Sales $175. available on both the Instructor and Student web sites for the textbook (available at www. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.61.592.

F.93336396 R Square 0. Instead.63816 0.2608 0. the decision maker(s) should be asked what next year’s cost will be.86656716 Standard Error 4015. it is economically plausible for sales to be a cost driver. E. Here is the regression output. sales may go up. usually annually. Regression Statistics Multiple R 0.01335108 Standard Error 6844. the cost estimate should not be based on past costs.08144 Observations 30 Coefficients 65584.00097028 t Stat 9. the cost function is: TC = $65. In addition. Therefore.87116829 Adjusted R Square 0.584 + 1. Assuming that profits are more likely to increase when sales increase.7600071 P-value 2.5289E-14 Intercept X Variable 1 Based on the regression results. When more money is spent on marketing. using regression or any other technique.34%*Sales D. discretionary costs such as marketing are often increased when profits increase. Even if marketing department costs are discretionary. . they may be positively correlated with sales. there would be a positive correlation between marketing department costs and sales.4501E-10 5.Chapter 2: The Cost Function 2-29 C.58184484 13. Discretionary costs are set by decision. If the variable portion of the marketing cost is sales commissions.

available on both the Instructor and Student web sites for the textbook (available at www. A.000 $160. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.com/college/eldenburg).000 $40.000 $80.wiley.2-30 Cost Management 2.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $120.000 $120.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.com/college/eldenburg).000 $160.000 $80.wiley.000 $40. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.

552864 . C.682 4.86E-11 0.50852 7.56597156 30 Standard Error 14812.000 $40.600936029 Intercept Labor Hours t Stat 10. Labor Hours Regression: Regression Statistics Multiple R 0.1543 0. the cost driver does not explain the variation in cost.000 $160. The plots help determine whether regression analysis should be performed using any of the potential drivers. None of the plots show a definite trend.11279932 R Square 0. labor hours could be deleted as a potential cost driver. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. Sometimes a cost that is mostly variable. but the plot for labor hours appears to have the least trend. either the driver is wrong or the cost is mostly fixed.8173 Observations Coefficient s 150410.01272369 Adjusted R Square -0. D.000 $80.000 $120. Costs and potential cost driver data are plotted to determine whether further analysis is necessary. If the observations are widely scattered.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.600712 P-value 6.000 $0 0 100 200 300 400 500 600 700 Raw Materials B. Based only on the cost plots.02253618 Standard Error 11114.

3522862 Standard Error 8846.612063 R Square 0.599 + $38. so the cost function is estimated as: TC = $150.331580777 Intercept Machine Hours t Stat 11.095468 P-value 4.000325 Both the intercept and slope coefficients are significant.215128 Standard Error 10853.217192 Standard Error 10291.2266685 Standard Error 9665.4268 4.56778 19.47803 9. so the cost function is estimated as: TC = $126.411 Machine Hours Regression: Regression Statistics Multiple R 0.11E-12 0.1555 Observations 30 Coefficient s 117598.68E-12 0.2-32 Cost Management Only the intercept term is significantly different from zero.5033241 R Square 0. so the cost function is estimated as: TC = $117.9786 Observations 30 Coefficient s 126216.62907 3.2533351 Adjusted R Square 0.004579 Both the intercept and slope coefficients are significant.217 + $60.53627459 Intercept Raw Materials t Stat 11.22* Raw materials .22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.91 60.3746211 Adjusted R Square 0.67 38.082222 P-value 3.

machine hours appears to do the best job of explaining manufacturing overhead costs. Yes.489 -0. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.8266982 Adjusted R Square 0.1959303 48.3E-06 0. The coefficients for each of the other potential cost drivers are significantly different from zero. 2.226 Based on the simple regression results.210187 P-value 3.com/college/eldenburg).8067018 Standard Error 4832.wiley.352 0. however.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.08E-08 .33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2. A.12E-09 1. available on both the Instructor and Student web sites for the textbook (available at www. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).05878 9.9092294 R Square 0. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. this driver explains only 35% of the variation in cost.953575 1.com/college/eldenburg).976635 Standard Error 10361.wiley.Chapter 2: The Cost Function 2-33 E.778501 82. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.291558412 10.333162437 5. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.5558 Observations 30 Coefficient s 60988.2349 3.886218 -0.218173 8. F.

20 (0. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.226 0.664851 5.217 (<0.939606 9.881964042 Intercept Machine Hours Raw Materials t Stat 6.352 and 0. Costs for these activities are likely related to specific cost drivers.57 (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.001) $117. machine hours and raw materials explain different activity .022 0.78 (<0.71E-10 5. its coefficient is not significantly different from zero in either regression.7422519 82.86E-07 4.352 0.450561 8. Thus.411 (<0. The adjusted RSquare is far higher in the multiple regression (0. Manufacturing can be a complex activity requiring a number of different tasks. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.55) $38.29E-09 The cost function is: TC = $60. Each task includes different activities.988 (<0.391636 P-value 1. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.93*Raw materials D.599 (<0.001) B.22 (<0.81383627 Standard Error 4742.90921678 R Square 0.001) $126.5348 Observations Coefficient s 60677.001) $4.226) for these two cost drivers.98 (<0.82667515 Adjusted R Square 0.806) than in either of the simple regressions (0.806 $150.001) $-0. its coefficient is negative rather than positive in the multiple regression.954) $48. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.678 + $48. Also.001) $60. In this example.157604083 9.22 (0.005) $82.001) $60. C. labor hours can be eliminated as a potential cost driver.5902 48.74*Machine hours + $82.925842 30 Standard Error 8743.

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

available on both the Instructor and Student web sites for the textbook (available at www. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.2-36 Cost Management 2. square feet cleaned.wiley.000 $10. Dept. Costs $25.000 $0 528 530 532 534 536 538 540 542 Number of Students C. Dept.000 $20.com/college/eldenburg). Other cost drivers for total maintenance cost could be number of rooms cleaned. Costs $25. number of hours the building is open. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.000 $10. Students may have thought of other drivers that could be logically related to cleaning maintenance costs.000 $15.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2.000 $5.000 $5.000 $15.wiley. A. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.com/college/eldenburg). or number of classes and activities per period. number of hours students attend school. .000 $20.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. B.

74*maintenance hours worked. E.796328319 Intercept X Variable 1 Coefficients 9134. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.Chapter 2: The Cost Function 2-37 D. Utilities cost varies with season not visits. 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. The total cost function is: TC = $9.68624 0.875134 35. providing high confidence that both the intercept and slope are different from zero.0261 Standard Error 130954.03271 Standard Error 3019.06772 Observations 12 Standard Error 965.508157 0.9 244. However.0857 Intercept X Variable 1 t Stat -0.63E-06 2. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.832184392 Standard Error 1217.461245 7.135 + $35.247329 R Square 0.453062 P-value 2. it is considered fixed.847440356 Adjusted R Square 0.173 Observations 12 Coefficient s -89867 197.807201 P-value 0. From the analyses performed.061172 Adjusted R Square -0.5045837 4.36 The Elder Clinic A and B Salaries are always fixed. and rent for this type of facility is usually fixed. maintenance hours is a reasonable cost driver. An unidentified cost driver could have a higher R-Square.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. 2. Therefore.438328 According to the R Square statistics. The most current value is used to .18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. it is logical to expect a strong relation between hours worked and cost.74733262 t Stat 9. The p-values on the Tstatistics are very small.

At 940 patient-visits.115 219 3. must be kept on hand whether or not they are used.$2. These would be fixed. This analysis suggests that there are some of the other expenses are variable costs and some fixed.58 $6. E. weather. so this cost is classified as a mixed cost. Also.49 Cost Driver Patient-visits Mixed X 2. the cost function is: TC = $19. each patient requires a certain number of supplies. current illnesses that are circulating in the area. other facilities may open or close. There is no one answer to this part. These would be variable. but not proportionately. such as snake anti-venom. high point of medical supplies cost and patient data.07*940 = $25.736 + $6. or there are changes in treatment procedures for certain illnesses.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future.80 D. variable cost is $3. Use March.49 ($3. Here are some of the reasons: • The managers will not know how many visits they will receive.182 = F + $3. such as tongue depressors. and costs go up as patient-visits increase. 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.441.736 + $6. Medical supplies vary with number of patient-visits.2-38 Cost Management predict next period’s utilities. new equipment is acquired.com/college/eldenburg). affecting the number of visits at this clinic. medical supplies is a mixed cost. and so on.100 226 664 $19. Given the preceding computations and cost summary. Use the same method for other expenses. **Using high-low.412 1.182 . to find fixed: $3. gloves. and so on.wiley.07*patient-visits C. There are many possible reasons that could be listed. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. Other expenses appear to increase and decrease with number of patientvisits. July expenses are estimated to be: TC = $19. • Treatments and related costs may change as new drugs are available.934)/(849 – 778). Therefore. Visits are affected by season. Some supplies.736 Variable $3.49*849. • Prices of all inputs could change (usually increase). .

Number of work stations might come from the department head. etc. Some future costs can be estimated with high accuracy based on prior commitments (e. If enough data points are available. assuming a linear cost function. Accounting records could be accessed to determine the wage rates and time worked for help support staff and supervisors.g. rent). Other costs are highly uncertain and subject to external factors that cannot be controlled.Chapter 2: The Cost Function 2-39 2.38 Personal Cost Function A. The choice of information sources depends on how the past cost information is to be used. C. Number of calls might have to be tracked by employees or by the telephone system. cost allocation records could be used to identify past costs. If the service is housed in a common building.. The answers to these questions depend on the individual student’s data and cost behavior. E. number of work stations. and others could be interviewed to identify any potential cost increases or other expected changes in cost behavior from prior periods. Regression analysis makes use of all data points and is more accurate than twopoint methods. If not. D. The cost object is the help line. number of employees. Possible cost drivers include number of calls handled. and other miscellaneous costs. and D. It would be useful to obtain several years of monthly data from which to prepare scatter plots and run regression analysis. Vendors. Some costs are discretionary. with representative points selected from a scatter plot. B. number of hours worked. could be used to identify costs for building and occupancy costs. analysis at the account level could be used to develop a cost function using information from the general ledger. This data could be found in the accounting system. B. department heads. Alternatively. If the help line is housed in its own building. 2. C. regression analysis would probably be the best choice. Number of customers is part of the revenue accounting records. Information about number of employees and hours worked is found in the payroll accounting system. or total number of Internet customers. a two point method might be best. or it might need to be estimated if it has not been tracked in the past. In some ways. a personal budget estimation problem is similar to the cost estimation problem for a business.37 Cost function Judgment and Method A. prepaid insurance schedules. supplies. Analysis of general ledger entries could be used to determine past costs for phone service. depreciation schedules. .

IP-14 3 Payroll paid every two weeks.200 Apr 71. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.4.com/college/eldenburg). Operations in the month of July are not typical of the rest of the time period.wiley.150 73.350 68. the trend line is likely to distort costs. Because of the large difference between these values and the values in other months.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.2. but there is insufficient information to make an adjustment.750 . (rounded to $36) 2 Note IB-4's power added to Dept. 1/2 of August 5 payroll goes to July: 5.500 38.376 65.000 = 4. If these observations are included in the regression analysis.750.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.686 71.83/mo. The miscellaneous supplies account also looks suspicious.736 To predict future overhead. July’s result is an outlier and should be removed from the data.036 68.wiley.850 2 .200 +$2.8 x 6.500 x 1/2 = 2. No adjustments are needed for items (c) and (d).800.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.com/college/eldenburg).596 73. . as shown in the scatter plot below.736 67. B.236 69. available on both the Instructor and Student web sites for the textbook (available at www.800 .486 68. the first month is adjusted even though it is not an actual cost: 4. these are correctly handled. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.310 70.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68. Similarly.790 80.10.2-40 Cost Management 2. A. 80% of September 2 payroll to August: .286 68.750 68.750 + 4.300/10 x 12 = 35.800 41.

Monthly overhead costs for supplies may be significantly overstated or understated . the cost function is estimated as: Overhead cost = $6.298502 2. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.000 6.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.000 3. Based on the variation in dates at which supplies are recorded.310484 Intercept X Variable 1 Coefficient s 8777.79 * 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).000 $55. D. According to the details provided for August and September. Therefore. they are most likely recorded at the time of purchase rather than at the time of use.500 8.789722 t Stat 0. supplies were a large proportion of overhead cost.000 9. Thus.000 2.818 6.47 8 Standard Error 29406.500 5.000 $40.641981 0.000 $60.000 $65.412139 0.26 3.000 $45.086126 Based on the t-statistic and p-value for the intercept.775388 0.000 $50.314163 1980. the fixed cost does not appear to be different from zero.500 Outlier Direct Labor Hours C. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.050976 P-value 0.000 Overhead Costs $70.

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

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

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

609693 1. . A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.] The data for this problem can be found on the datasets file for chapter 2. the regression explains only about 59% of the variation in labor costs. However. A.194 + $13.04 13.6004687 Adjusted R Square 0.848277 8.957296 Standard Error 6710. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.437E-24 1. Also.02E-10 Based on the regression results. the fixed cost and the variable cost per unit are each positive and statistically different from zero.7748991 R Square 0.com/college/eldenburg). The cost function is estimated as: Labor cost = $133.Chapter 2: The Cost Function 2-45 2. Here are the simple regression results: Regression Statistics Multiple R 0.wiley.678620854 Intercept X Variable 1 t Stat 19.com/college/eldenburg). Because of the annual pay increases. available on both the Instructor and Student web sites for the textbook (available at www.wiley.41 Integrating Across the Curriculum: Statistics [Note about problem complexity: This homework problem was written with adequate instructions so that students should be able to perform the various regression analyses that are called for. Considerable variation in labor costs is not explained by changes in the volume of production. B.3147402 P-value 3. students are likely to struggle interpreting and choosing a method (Parts E and F).5917832 Standard Error 6216. the cost function was estimated by regressing actual labor costs on number of chairs produced. using monthly data for the prior 4 years.7995 Observations 48 Coefficient s 133194.96 x number of chairs produced However. In prior years. the degree of downward bias is higher for older data than for more recent data.

8 16.00872 Intercept X Variable 1 X Variable 2 t Stat 18.93821 16.96 to $16.347 x 1. D. here are the regression results: Regression Statistics Multiple R 0.02 Adjusted Labor Cost $220.57E-23 2. this cost function would result in a higher estimate for future costs. the fixed cost and the variable cost per unit are each positive and statistically different from zero.390275 Intercept X Variable 1 t Stat 24.869633 Adjusted R Square 0.35E-15 Based on the regression results.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. approximately 26% of the variation in labor costs is still unexplained.736 + $16. which is reasonable given the increase in wage rates over time.23439 Standard Error 5557. Also.486389 P-value 4.91E-08 . Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.932541 R Square 0.23 per chair.09577 6.905 Observations 48 Coefficient s 133736 16.74). Nevertheless.67711 P-value 1.26499 6. but the variable cost increased from $13.864722 R Square 0.274 Using the adjusted labor cost data.54295 Standard Error 5689.747745 Adjusted R Square 0.06236 11. The fixed cost is nearly the same.010513 1.2-46 Cost Management C. The cost function is estimated as: Labor cost = $133.533 Dec 20X4 196.492 1. Here are the multiple regression results: Regression Statistics Multiple R 0.05E-27 2.891 1.73E-20 5.311 200.742261 Standard Error 5148.347 Calculation $203.02)4 $196.411 Observations 48 Coefficient s 107748.863839 Standard Error 3742.533 x (1.

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

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