Chapter 2 The Cost Function

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

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

2-2

Cost Management

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

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

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

Of course.000 $8. 2.000 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 . Stepwise Linear.000 $13. The time records that the tax partner maintains support this cost as a direct cost. In a service business such as this.000 $11.000 Total Cost $12. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns.000 + $8. Now notice that the tax partner's salary is considered a direct cost for all three cost objects. For the firm to make this cost direct for the personal returns cost object. the tax partner probably spends some time in non-billable activities. TC = $10.13 Linear. and Piecewise Linear Cost Functions A.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.000 $10. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained.000 $9.00*Q Graph of Cost Function $14. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. the CPA's time is the product being sold.

000 + $39*Q .000 – 10.000 .000 $40.000 $0 0 1.000 Total cost at 12.000 $30. for Q > 2.000 units: $450.000 4.000 + $8. TC = $25.000 Total Cost $50.000 = F + $39*10. To estimate the costs at another production level.000 = $60.000/2.000 $60.000 * $45 = $450.000 Number of Units C.000 + $8.000 units = 12.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 units = 10.000 * $44 = $528.000) = $78.000 .000 $70.000 $10.000 Combining the fixed and variable costs to create the cost function: TC = $60. it is first necessary to estimate the cost function.000 Graph of Cost Function $80.00*Q.$390.$450.000 TC = $35. for Q ≤ 2.000 3.2-6 Cost Management B. Convert the average costs to total costs for each production level: Total cost at 10.000 F = $450.000 2.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.00*Q.000)/(12.000 $20.

000 $60.000 $55.000 units: TC = $60. total cost is estimated as: TC = $5. TC = $50.000 + $10.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 + 45%*$10.000 + (1.000 For Q > 1.00*(Q-1.00*Q 2-7 Graph of Cost Function $75.000: TC = $50.000 + $9.Chapter 2: The Cost Function Estimated total cost at 15.000 $45.000 Estimated cost per unit = $645.000 $70.000 = $645.00*Q.000 = $60.000 0 500 1.000 + $585. Inserting $10.000 = $43 D.000 in revenues into the cost function.000/15.00) + $9.000 1.500 2.500 2.$9.000 TC = $51.000 + $39*15. for Q < 1.000 = $9.000 * $10.00*Q .000 + $10.14 Piecewise Linear Cost Function A.000) TC = $50.000 + $9.000 $50.000 $65.

80/ln2) = −0. If the accountant did not detect that there were two different relevant ranges.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 .3219 Y = 4.000 units but would overestimate total cost for Q > 1.000 units but would underestimate total cost for Q ≤ 1. This cost function would provide reasonable estimates for Q > 1.000 units.000 units. If all of the data estimation points occurred when Q was ≤ 1.00*Q. then the cost function would appear to be: TC = $50. 3. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.000 units. If all of the data estimation points occurred when Q was > 1.2-8 Cost Management B.000 + $10.00*Q. This cost function would provide reasonable estimates for Q ≤ 1.000 units. 2. There are three general situations: 1.3 and 2A.000 + $9. then the cost function would appear to be: TC = $51. Hours for two returns would be determined as follows. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.8 hours (average time for each of the next two returns) B. 2.15 Tax Plus A. then the cost function would be some mixture of the functions for the two relevant ranges.4. If the data estimation points occurred across the two relevant ranges. the cost function mismeasurement depends on the values of Q.

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

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

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

Onions ($.0198 0.1075 3. newspaper advertisements. Cost of plain burger = $0.79/150) 0.0033 $0.15/45) 0.0053 8.49/(16 x 4)] 0. Hamburger patty ($1. For the fishing boat business.1075 0.000) * 4] 0. Catsup ($.2414 $0.0179 4. 2.0863 0. F Most pizza shops incur advertising costs such as flyers.0148 6.0233 0.6815 . B. Mustard ($.0198 9. Because advertising costs tend to be discretionary.0053 0. and yellow pages advertisements.59/40) 0. PS.3489 $0.0179 0.29/12) 0.59/16) 0.2-12 Cost Management E.5196 Suggested selling price: 300% * $0.0033 0. advertising costs would be incurred. It will be a fixed cost if it is a flat amount. 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.2414 2.0148 0.1619 10.1075 0.2414 $0.6815 A. B. there might be some utility costs for the fishing operation and for a business office. G.$0. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.69/7) $0. Lettuce ($. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop. Cost of burger with everything except cheese = ($0. depending on how the insurance cost is calculated.1619) = $0.99/50) 0. they are treated as fixed costs.5195 = $1. Cheese ($2. If the fishing boat is for tourists.95/2. The cost might be fixed or mixed. In general.1619 0. Hamburger bun ($1.69/8) 0. F or M Any type of business will have insurance costs. Mayonnaise [$1.56 . the utility costs for these two businesses would tend to be fixed (would not vary with production).3489 (calculated above) B. Dill pickles [($8. F. but it might be mixed if a portion of the cost relates to levels of business activity.20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1. Tomato ($.0863 5.0233 7.

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

35*units sold. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero.) B. . the fixed cost is set at zero.wiley. the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management. Advertising – Fixed and discretionary 2. Other possible cost drivers for marketing department costs could be revenue. For example.22 Cost Function Using Regression.] The data for this problem can be found on the datasets file for chapter 2.2-14 Cost Management K. Other Potential Cost Drivers A.com/college/eldenburg). number of advertisements placed. C.wiley. In addition. available on both the Instructor and Student web sites for the textbook (available at www. In this problem. Therefore. If this is the case. TC = $222. it is possible that marketing costs are discretionary.23 Central Industries [Note about problem complexity: Item B is not coded as Step 1 because it is fairly clear which cost driver appears to be best.com/college/eldenburg). The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. the cost is discretionary and will be set through the negotiating process. the variation in units sold explains about 61% of the variation in marketing department cost. 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. or profits. The cost analyst needs to gather information about how marketing costs are set each year.

026826 0.582691 P-value 6.000514 .500 Maintenance Costs $2.4342166 0.000 $1.761602 4.119724 15 Coefficient s 884.61765897 0.58E-05 0.Chapter 2: The Cost Function 2-15 A.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 $1.52099624 Standard Error 153.78591283 0. Potential Cost Driver: Output Maintenance Costs Against Output $2.58824812 182.113687834 Intercept Output t Stat 5.

005847 0.7549386 1.210849 15 Coefficient s 861.31319046 235.500 $1.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.717372 P-value 0.017601 .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 $2.36224828 0.000 $1.113464425 Intercept Direct Labor Hours t Stat 3.291084 2.457384 3.60187065 0.02569657 Standard Error 261.

the trend line for machine setups looks as if the intercept could be zero or very close to zero.6778973 0.197755 8.815737 29. all three potential cost drivers appear to be positively related to maintenance costs.000 $1.500 Maintenance Costs $2. Sometimes a cost that is mostly variable can be identified from a scatter plot. or the cost is mostly fixed. 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 126.94888217 0. If the observations are widely scattered. a good cost driver would present a linear or football-shaped positive slope or trend. .42597461 1. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. This indicates that the cost could be totally variable. For example.5913391 15 Standard Error 93.97410583 0.94495003 66.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2. the cost driver does not explain the variation in cost and either it is the wrong driver. However.910475729 Intercept Machine Setups t Stat 1.357393 15.96E-10 B. In a scatter plot.5343 P-value 0.500 $1.

The use of past cost data to predict the future assumes that future resource costs and volumes of activities will remain the same as in the past. R-Square 0. The regression using machine setups has the highest adjusted R-Square of 0. business processes. the economic environment.588 0. and technology can cause future costs to be different than estimated.68* Machine Setups The machine setups intercept coefficient is not significant.521*Output TC = $861 +$3.945 Cost Function TC = $884 + $0. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. the cost is likely to be totally variable. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. This means that variation in setups explains about 95% of the variation in cost. Changes in many factors such as resource prices.025*Direct Labor Hours TC = $29. the t-statistic is significant for the independent variable but not for the intercept.945.2-18 Cost Management C. D. This provides confidence that the variable cost part of the cost function is not zero.313 0. . Therefore. E. so it is excluded from the cost function. In the machine setups regression.

The high low method uses the most extreme cost driver values.333 = F + 5%*$1.000/$500. Under the high-low method. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. the variable cost is calculated: ($68. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.24 Big Jack Burgers A.728 + 5%*Sales B. that is.728 Thus.333 – $43.132.Chapter 2: The Cost Function 2-19 PROBLEMS 2.100 F = $68.132.333 . the total cost function is: TC = $11. on average.100) = $25. the cost function is calculated using the highest and lowest values of the cost driver. That means that the cost function might not represent the actual cost. this cost function might provide poor estimates of future costs. First.$56. which could be outliers. Therefore.333)/($1.05.605 = $11.000 = 0. not represent the cost most of the time. .100 – $632.

172. Following is the regression output.000 Administrative Costs $60. analysis at the account level might indicate that there are few fixed costs. etc). Notice that the t-statistic for the intercept coefficient is 2. Alternatively. the cost function would be: TC = 4. Analysis at the account level can be used to increase the understanding of this cost. Chart of data with trend line added by Excel. fixed costs are likely to be zero and would be excluded from the cost function.000 Sales It appears that the cost is most likely mixed.000 $40.800 + 4. Based on the p-value. the cost function would be TC = $16.000 $900.162. Then. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function.000 $1.5% x sales. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. but the p-value is greater than 10% at 0. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.200.2-20 Cost Management C.000 $600. Because this regression has few observations. In that case. D.000 $20. there is a 16% probability that the intercept (fixed cost) is not different from zero. The upward slope of the line indicates that there are variable costs. the regression intercept can be used as an estimate of the fixed costs. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80.5% x sales . If this cost pool includes items such as salaries and other fixed costs (insurance. the p-value result for the tstatistic is atypical. Then.000 $0 $0 $300.

the cost function is: TC = $50. The past costs used for estimation might not be representative.17205158 5.2444 7734. the high-low method may be the best option available. Unusual cost items are assumed to continue in the future.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.93711636 0. The plot shows costs that are widely scattered.45937486 P-value 0. There might be a large discretionary component in administrative costs. If these assumptions do not hold. the results rely on more complete information and provide a better estimate.16197623 0. especially because so few observations were used in the estimation. However. Using the regression results.365 + 0. . If there are only two or three data points. B. The adjusted R-Square statistic is very low at 0. a cost function may not provide a good estimate for the next month’s costs.00818212 t Stat 2. The cons of the high-low method as an estimation technique were discussed in Part B above. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost. Both methods assume that the cost function is linear and that all data points come from a single relevant range. This method can be used in cases where there is not enough data to perform regression. and possible changes in costs such as those described in Part E are ignored. This means that variation in sales explains only about 18% of the variation in research and development cost. Sales does not appear to explain much of the variation in research and development costs. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. If there are more data points. both of these methods assume that the data points are representative of future costs.73545 0. however. Because of unforeseen changes in cost behavior. Sales might not be the activity that drives administrative costs. regression analysis incorporates all of the observations into the analysis.0319523 Intercept X Variable 1 E. there does appear to be a general upward trend.82%*Sales C. then both methods may be unsuitable for estimating future costs. 2.9680477 0.90567454 3293. causing fluctuations in cost that are unrelated to any cost driver. Cost Function Using Regression A. In addition. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver.04466925 0.25 Scatter Plot. on average.4038 4 Coefficients Standard Error 16800.186. Therefore. F.

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

using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. It is possible that the managers under. Many cellular telephone bills do not list the calls made.04 $0.10 = $40.00 $20. Hours per batch would be determined as follows.05 $0. 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. Cons • If Susan has a number of projects in her local area or will be traveling a lot. her phone bill will be less than it would be at a rate 5 cents per minute. In this case the learning rate would be wrong and so the time would also be wrong. Minutes 300 400 500 600 700 Total Cost $20.or overestimated the amount of hand work performed. I. so Susan may need to maintain her own records if she wishes to trace telephone usage.27 Fancy Furniture A.00 $20. There are many different reasons that the time could be different from the amount determined above.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.00 + (700-500)*$0. In most businesses. In . she will pay a very high rate of 10 cents per minute 2. students may think of others. especially if she usually calls less than 500 minutes a month • Below is Susan’s average cost per minute at different levels of calls per month.10 = $30.05 $0.00 $20.90/ln2) = −0. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. If her calls are over 400 minutes or under 600 minutes.057 The average cost is lowest at exactly 500 minutes per month.00 $20. Here are some of the reasons.152 Y = 10 hours*4-0.152 Y = 8. telephone costs are viewed as an indirect cost.1 hours (average time for the first four batches) B.00 + (600-500)*$0.00 Average Cost $0.

500 10. Thus. If a worker is absent one day.40.000 + 40%*80. and B.000 Variable $21.000 Total revenue is the most likely cost driver for both variable costs. or 40% or revenue Combining fixed and variable costs.000 _______ $28. D. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. The estimate of total costs given revenues of $80. 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. 2.000 . C. Food costs are likely to vary proportionately with sales. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 = $79. C. if managers believe that more than 25% of the work is done by hand. If these values are used in a regression to estimate a cost function. or has a great deal of experience on the machine. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28.000 7. then the cost would be overestimated.28 Wildcat Lair A.2-24 Cost Management addition.000 . then the chart suggests that the learning rate estimate is reasonable.000 = $1. then this chart suggests that the learning curve will be slower than the 90% estimate. it is possible that different types of wood affect the rate at which chairs can be produced. Because revenue is the cost driver for both variable costs. and the University surcharge is specifically based on sales.000 1. they would be higher than the labor costs in later periods.000 5. the cost function is: TC = $47.000/$70. if managers believe that 25% of the work is done by hand.000 Profit = Revenues – Total costs = $80.000 + 40%*Total revenue D.$79.000 using the cost function is: TC = $47. However.500 $47.000 = 0.

but this is not considered a cost driver (a business activity that causes variations in total variable cost). the shop might experience very little business activity. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. To estimate the opportunity cost for August.000 ($10. B. the additional profit from a $10. The shop is most likely a seasonal business.000) (24. it would lose the revenues. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000 . If the university were to close the Lair.000). costs would be higher when there were fewer sales.000 + 30%*Total revenue During August.] A. for July the opportunity cost would have been $2. During the spring and summer months. total variable costs are expected to increase by $4.000)+the university surcharge of $7.000/$70. C. and the increase is estimated to be 40% of the increase in revenues.000*40%).000— the operating loss of $(5. However. In a retail business.000. so the estimated profit in August is $1. so the trend would be the opposite of this plot. generating most its sales around the ski season (fall and winter).000. the variable cost part of the cost function can be adjusted.000 increase in revenues is expected to be $6. 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).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.$4. less the fixed costs and the variable food costs. F.000 . Lair’s fixed costs are assumed to be unchanged with the $10.000) $ 9.000 (47.000 ($10.000). Thus.Chapter 2: The Cost Function 2-25 E. Only total variable costs are expected to increase.000 (-$5. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.) The adjusted cost function is: TC = $47. if the bathing suit shop is located in a geographic region $80. A shop located near a ski area is likely to incur high heating costs during the winter. Variable food costs are estimated to be 30% ($21. So. Because the university surcharge is an allocation within the university. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. it might even close when the ski area shuts down.000) of revenues. So. Electricity costs also vary with changes in electricity rates.000 increase in revenues. Item D will be VERY difficult for most students.000+$6. In July there was a loss of $5.000) Net 2.

542.89 x 1. generally mean there is more money available to spend on administrative travel.2345 Y = $205.2345 Y = $101.84 .85/ln2) = 0.028. firm B's selling price is: $101. employee training. However. they are discretionary expenditures and not caused by the level of activity. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.50 = $1.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.542.45 $ 514. and new office furniture or equipment.89 (average cost for each of the 100 units produced) Given a 50% markup on cost. For example.028.22 Firm B set its selling price based on the average cost. then the highest sales might coincide with the highest electricity costs.67 1.2345 Y = $300*5-0.45 Although each customer paid a different price. 2. given a 100 unit production level: Y = α Xr Y = $300*100-0.5 = $152. Higher profits.67 Firm A's income for last year was: Sales Costs Income $1.69 (average cost for each of the 5 units) Total cost = $205. correlation does not necessarily mean causation.69 x 5 = $1.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. Although these expenditures are made because more money is available. D. A correlation may appear in a scatter plot or regression analysis. special promotions. Many costs can be related to volume of activity.028. a 50% markup on total cost will cause sales to be: $1. in turn.45 x 1. higher profits generally occur during periods when activity is high.

897.40 1.2345 (notice that the cumulative units produced is 15) Y = $158.00 13.2345 Y= $78.10 $22.926.50 = $97.625.356.028.85 Thus Firm B's selling price this year was $64.356. assuming an 85% learning effect would be: Y = $300*150-0.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.50 $ 9.528.50 $ 9.30 $2.028.727.Chapter 2: The Cost Function 2-27 Firm B's costs.28 $23.45 $1.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.528.50 .85 x 1.10 $ 172.84) = $1.97) 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 $1.50/150 units = $64.727. Total cumulative production cost (300 x $78.384.897.84) Costs (150 x $ 92.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.00 13.40 Firm A's costs may be computed as follows: Y = $300*15-0.55 1.75) 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 = $9.2345 Y = $92.65) Income Firm A's revenues for this year are: (10 x $152.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.

There is a positive slope. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.85) Income $14.000 $135.00 9.000 $8. and most of the observations appear to have a fairly linear trend.10/10 = $135.000 $155.com/college/eldenburg). such extreme differences in cost can occur.wiley.356. available on both the Instructor and Student web sites for the textbook (available at www.000 Marketing Dept. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.000 $6.000 $145. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes. 2.50 $ 4. .2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97. A. Scatter Plot of Marketing Costs Against Sales $175.592.50 Note that Firm B's selling price for this year of $97.727.500.000 Sales B.500.500.61.500.wiley.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.864.000 $7.com/college/eldenburg).28) Costs (150 x $64. Costs $165.000 $5.28 is lower than Firm A's average cost per unit: $1.

discretionary costs such as marketing are often increased when profits increase.Chapter 2: The Cost Function 2-29 C. sales may go up. Discretionary costs are set by decision.5289E-14 Intercept X Variable 1 Based on the regression results.87116829 Adjusted R Square 0.34%*Sales D. the cost estimate should not be based on past costs. Therefore. Instead.58184484 13.86656716 Standard Error 4015.2608 0. Here is the regression output.08144 Observations 30 Coefficients 65584.63816 0. When more money is spent on marketing. there would be a positive correlation between marketing department costs and sales.93336396 R Square 0. If the variable portion of the marketing cost is sales commissions. it is economically plausible for sales to be a cost driver.4501E-10 5. using regression or any other technique. Even if marketing department costs are discretionary. the cost function is: TC = $65.584 + 1. E. usually annually. the decision maker(s) should be asked what next year’s cost will be. Assuming that profits are more likely to increase when sales increase.01335108 Standard Error 6844. In addition. . F.00097028 t Stat 9.7600071 P-value 2. they may be positively correlated with sales. Regression Statistics Multiple R 0.

com/college/eldenburg).000 $0 0 300 600 900 1200 1500 Machine Hours . available on both the Instructor and Student web sites for the textbook (available at www. A. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $80.000 $40.000 $40.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $120.000 $80.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $160.com/college/eldenburg).000 $160.000 $120.wiley.2-30 Cost Management 2.wiley.

01272369 Adjusted R Square -0.000 $0 0 100 200 300 400 500 600 700 Raw Materials B.000 $120.50852 7. labor hours could be deleted as a potential cost driver.600936029 Intercept Labor Hours t Stat 10. None of the plots show a definite trend. The plots help determine whether regression analysis should be performed using any of the potential drivers. D.02253618 Standard Error 11114.11279932 R Square 0. If the observations are widely scattered. the cost driver does not explain the variation in cost. C.000 $160.1543 0.552864 . Sometimes a cost that is mostly variable.86E-11 0.56597156 30 Standard Error 14812.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.600712 P-value 6. either the driver is wrong or the cost is mostly fixed.682 4. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.8173 Observations Coefficient s 150410. Based only on the cost plots.000 $80. but the plot for labor hours appears to have the least trend. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. Labor Hours Regression: Regression Statistics Multiple R 0.000 $40.

53627459 Intercept Raw Materials t Stat 11.004579 Both the intercept and slope coefficients are significant.217192 Standard Error 10291.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.68E-12 0.22* Raw materials . so the cost function is estimated as: TC = $126.612063 R Square 0.62907 3.11E-12 0.331580777 Intercept Machine Hours t Stat 11.095468 P-value 4.56778 19.411 Machine Hours Regression: Regression Statistics Multiple R 0.217 + $60.47803 9.5033241 R Square 0.215128 Standard Error 10853. so the cost function is estimated as: TC = $117.3522862 Standard Error 8846.67 38.4268 4.3746211 Adjusted R Square 0. so the cost function is estimated as: TC = $150.9786 Observations 30 Coefficient s 126216.082222 P-value 3.2-32 Cost Management Only the intercept term is significantly different from zero.1555 Observations 30 Coefficient s 117598.2266685 Standard Error 9665.91 60.2533351 Adjusted R Square 0.599 + $38.000325 Both the intercept and slope coefficients are significant.

886218 -0.8266982 Adjusted R Square 0. 2.08E-08 . A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.291558412 10.333162437 5.210187 P-value 3.8067018 Standard Error 4832. A.226 Based on the simple regression results. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).05878 9. available on both the Instructor and Student web sites for the textbook (available at www. F.489 -0.2349 3. Yes.9092294 R Square 0.1959303 48.Chapter 2: The Cost Function 2-33 E.com/college/eldenburg).3E-06 0. machine hours appears to do the best job of explaining manufacturing overhead costs.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5. this driver explains only 35% of the variation in cost.953575 1.976635 Standard Error 10361.778501 82.wiley.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.wiley. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.12E-09 1.218173 8. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.352 0. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.com/college/eldenburg). The coefficients for each of the other potential cost drivers are significantly different from zero.5558 Observations 30 Coefficient s 60988. however.

Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0. Costs for these activities are likely related to specific cost drivers.78 (<0.93*Raw materials D. Manufacturing can be a complex activity requiring a number of different tasks.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.81383627 Standard Error 4742.806) than in either of the simple regressions (0.001) $126.5902 48.74*Machine hours + $82. Each task includes different activities. machine hours and raw materials explain different activity .939606 9.450561 8.5348 Observations Coefficient s 60677.001) $60. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.86E-07 4. labor hours can be eliminated as a potential cost driver.22 (0. Also.352 0.29E-09 The cost function is: TC = $60. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.7422519 82.001) $60.001) B.20 (0. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.391636 P-value 1. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.599 (<0.57 (0.90921678 R Square 0.217 (<0.226 0.98 (<0.022 0.352 and 0.881964042 Intercept Machine Hours Raw Materials t Stat 6.664851 5.925842 30 Standard Error 8743.157604083 9.411 (<0.001) $117.988 (<0. Thus.226) for these two cost drivers.005) $82.71E-10 5.001) $4.806 $150.678 + $48.22 (<0.001) $-0.954) $48.82667515 Adjusted R Square 0. its coefficient is not significantly different from zero in either regression. its coefficient is negative rather than positive in the multiple regression. The adjusted RSquare is far higher in the multiple regression (0. C. In this example.55) $38.

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

000 $10.2-36 Cost Management 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. Costs $25. Costs $25.000 $10. or number of classes and activities per period.000 $20.com/college/eldenburg).000 $0 528 530 532 534 536 538 540 542 Number of Students C. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint. .35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2. A.000 $5. Dept. Other cost drivers for total maintenance cost could be number of rooms cleaned.000 $15. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.wiley. square feet cleaned.000 $20.wiley. number of hours the building is open.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. B. number of hours students attend school. Dept.000 $5. available on both the Instructor and Student web sites for the textbook (available at www.000 $15.com/college/eldenburg).

The p-values on the Tstatistics are very small. 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. E. Utilities cost varies with season not visits. and rent for this type of facility is usually fixed. Therefore.9 244. The most current value is used to .796328319 Intercept X Variable 1 Coefficients 9134.Chapter 2: The Cost Function 2-37 D. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.0261 Standard Error 130954.135 + $35.0857 Intercept X Variable 1 t Stat -0.438328 According to the R Square statistics.461245 7.508157 0. maintenance hours is a reasonable cost driver. From the analyses performed.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.74*maintenance hours worked.875134 35.74733262 t Stat 9.453062 P-value 2.832184392 Standard Error 1217.807201 P-value 0.247329 R Square 0. 2. However. providing high confidence that both the intercept and slope are different from zero.847440356 Adjusted R Square 0. it is logical to expect a strong relation between hours worked and cost.68624 0. it is considered fixed.63E-06 2. An unidentified cost driver could have a higher R-Square.06772 Observations 12 Standard Error 965. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0. The total cost function is: TC = $9.173 Observations 12 Coefficient s -89867 197.36 The Elder Clinic A and B Salaries are always fixed. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.920565237 R Square 0.061172 Adjusted R Square -0.03271 Standard Error 3019.5045837 4.

variable cost is $3. • Treatments and related costs may change as new drugs are available. must be kept on hand whether or not they are used. Therefore. Other expenses appear to increase and decrease with number of patientvisits.49 ($3. and so on. July expenses are estimated to be: TC = $19. 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. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. Here are some of the reasons: • The managers will not know how many visits they will receive. There is no one answer to this part. There are many possible reasons that could be listed. Some supplies.736 Variable $3.com/college/eldenburg). each patient requires a certain number of supplies.58 $6. current illnesses that are circulating in the area. Use the same method for other expenses. the cost function is: TC = $19. affecting the number of visits at this clinic. other facilities may open or close. weather. such as snake anti-venom.115 219 3. so this cost is classified as a mixed cost. These would be variable.07*940 = $25. These would be fixed.412 1. or there are changes in treatment procedures for certain illnesses. E. such as tongue depressors.49 Cost Driver Patient-visits Mixed X 2. Given the preceding computations and cost summary. high point of medical supplies cost and patient data.07*patient-visits C.80 D.736 + $6.49*849. Visits are affected by season. to find fixed: $3. and so on. Medical supplies vary with number of patient-visits.736 + $6. Also. • Prices of all inputs could change (usually increase). gloves. new equipment is acquired.2-38 Cost Management predict next period’s utilities.934)/(849 – 778). medical supplies is a mixed cost.100 226 664 $19. **Using high-low.wiley. .441.$2.182 = F + $3. This analysis suggests that there are some of the other expenses are variable costs and some fixed.182 . and costs go up as patient-visits increase.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. At 940 patient-visits. but not proportionately. Use March.

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

83/mo.200 +$2.750. as shown in the scatter plot below. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.4. (rounded to $36) 2 Note IB-4's power added to Dept. Operations in the month of July are not typical of the rest of the time period.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68.036 68.486 68. available on both the Instructor and Student web sites for the textbook (available at www. .com/college/eldenburg).686 71.790 80.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.000 = 4.800. B.2-40 Cost Management 2. but there is insufficient information to make an adjustment.310 70.850 2 .750 + 4. the trend line is likely to distort costs.500 x 1/2 = 2.376 65.750 .39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.8 x 6.736 To predict future overhead. 80% of September 2 payroll to August: . The miscellaneous supplies account also looks suspicious. 1/2 of August 5 payroll goes to July: 5. Because of the large difference between these values and the values in other months. If these observations are included in the regression analysis. the first month is adjusted even though it is not an actual cost: 4. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.500 38. No adjustments are needed for items (c) and (d). A.286 68.150 73.800 .300/10 x 12 = 35. Similarly. these are correctly handled.200 Apr 71.236 69.350 68.wiley.wiley.com/college/eldenburg).736 67.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.10.750 68. IP-14 3 Payroll paid every two weeks. July’s result is an outlier and should be removed from the data.800 41.2.596 73.

298502 2.500 Outlier Direct Labor Hours C.000 $60.000 $50. Therefore.000 Overhead Costs $70.412139 0.000 $65.775388 0.000 $55.641981 0.26 3.314163 1980.000 $40.086126 Based on the t-statistic and p-value for the intercept.000 3. the cost function is estimated as: Overhead cost = $6.050976 P-value 0. they are most likely recorded at the time of purchase rather than at the time of use. Thus. Monthly overhead costs for supplies may be significantly overstated or understated . Based on the variation in dates at which supplies are recorded.47 8 Standard Error 29406. According to the details provided for August and September.789722 t Stat 0. the fixed cost does not appear to be different from zero.500 8.000 2.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.500 5. supplies were a large proportion of overhead cost. D.818 6. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 $45.000 6.310484 Intercept X Variable 1 Coefficient s 8777. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.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 9.

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

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

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

the degree of downward bias is higher for older data than for more recent data.96 x number of chairs produced However. using monthly data for the prior 4 years. In prior years.7995 Observations 48 Coefficient s 133194.Chapter 2: The Cost Function 2-45 2. B. Also.437E-24 1.6004687 Adjusted R Square 0. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs. the cost function was estimated by regressing actual labor costs on number of chairs produced.3147402 P-value 3.957296 Standard Error 6710. .wiley. available on both the Instructor and Student web sites for the textbook (available at www. students are likely to struggle interpreting and choosing a method (Parts E and F).678620854 Intercept X Variable 1 t Stat 19.04 13. the regression explains only about 59% of the variation in labor costs. Because of the annual pay increases. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. A.609693 1.41 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.wiley. However.] The data for this problem can be found on the datasets file for chapter 2.194 + $13.02E-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).848277 8. Here are the simple regression results: Regression Statistics Multiple R 0. Considerable variation in labor costs is not explained by changes in the volume of production. The cost function is estimated as: Labor cost = $133.com/college/eldenburg).5917832 Standard Error 6216.

23439 Standard Error 5557. Nevertheless.91E-08 .2-46 Cost Management C.863839 Standard Error 3742.35E-15 Based on the regression results.09577 6.05E-27 2.96 to $16. which is reasonable given the increase in wage rates over time. Here are the multiple regression results: Regression Statistics Multiple R 0.274 Using the adjusted labor cost data.533 Dec 20X4 196.010513 1.533 x (1.8 16.747745 Adjusted R Square 0. D.486389 P-value 4. approximately 26% of the variation in labor costs is still unexplained. The fixed cost is nearly the same.74).93821 16.311 200.02)4 $196.73E-20 5.00872 Intercept X Variable 1 X Variable 2 t Stat 18.742261 Standard Error 5148.23 per chair.736 + $16.23 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. the fixed cost and the variable cost per unit are each positive and statistically different from zero.02 Adjusted Labor Cost $220.390275 Intercept X Variable 1 t Stat 24.932541 R Square 0.347 x 1.06236 11.67711 P-value 1. Also. here are the regression results: Regression Statistics Multiple R 0. but the variable cost increased from $13.411 Observations 48 Coefficient s 107748.57E-23 2. The cost function is estimated as: Labor cost = $133. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.347 Calculation $203.492 1.864722 R Square 0.869633 Adjusted R Square 0.26499 6.891 1.54295 Standard Error 5689.905 Observations 48 Coefficient s 133736 16. this cost function would result in a higher estimate for future costs.

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

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