# Chapter 2 The Cost Function

LEARNING OBJECTIVES

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

COMPLEXITY SYMBOLS

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

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Cost Management

QUESTIONS

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

Total Cost

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

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Chapter 2: The Cost Function

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2.7

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

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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

Chapter 2: The Cost Function
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Explanation for Parts D and E: Notice that the wages of the tax department administrative assistant are considered a direct cost when the cost object is the entire tax department but are considered indirect for the other two cost objects.13 Linear. the tax partner probably spends some time in non-billable activities.000 + $8.000 $13. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects.000 $11. TC = $10.00*Q Graph of Cost Function
$14.000 $10. 2. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.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. In a service business such as this. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. For the firm to make this cost direct for the personal returns cost object. The time records that the tax partner maintains support this cost as a direct cost.000 $9. CPAs do keep detailed time records. Of course.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
. and Piecewise Linear Cost Functions A.000 $8. the CPA's time is the product being sold. Stepwise Linear.

$450. for Q ≤ 2.$390.00*Q.000 $70.000 TC = $35.000 + $39*Q
. it is first necessary to estimate the cost function.000 Total cost at 12.000)
= $78.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 F = $450. TC = $25.000 . To estimate the costs at another production level.000 $40.000 – 10.000 units: $450.000 = F + $39*10.00*Q. Convert the average costs to total costs for each production level: Total cost at 10.000 $10.000 $60. for Q > 2.000 Graph of Cost Function
$80.2-6
Cost Management B.000 = $60.000 * $45 = $450.000 units = 10.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 Number of Units
C.000 $30.000 Calculate the variable cost per unit using the Two-Point method:
Change in cost Change in volume
= ($528.000 .000 + $8.000 2.000 3.000 * $44 = $528.000 $20.000 $0 0 1.000/2.000 + $8.000 units = 12.000 Total Cost $50.000 4.000)/(12.

000 = $9.$9.000 $55.000 = $60.000 $60. Inserting $10.000 = $43 D.500 2. TC = $50. for Q < 1.000/15.000 Number of Units
Slope is $10 per unit Slope is $9 per unit
Total Cost
.000 $70.000 1.000 TC = $51.000 + (1.000 For Q > 1.000 + $9.000 in revenues into the cost function.000 units: TC = $60.000 $65.500 2.000 = $645.14 Piecewise Linear Cost Function A.00*Q . total cost is estimated as: TC = $5.000 + $585.00*Q.00) + $9.00*(Q-1.00*Q
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Graph of Cost Function
$75.000 + 45%*$10.000 + $9.000 + $10.000 + $39*15.000) TC = $50.000 $45.000 $50.000 0 500 1.Chapter 2: The Cost Function Estimated total cost at 15.000 * $10.000: TC = $50.000 + $10.000 Estimated cost per unit = $645.

8 hours (average time for each of the next two returns) B.15 Tax Plus A. If the data estimation points occurred across the two relevant ranges. If all of the data estimation points occurred when Q was ≤ 1. then the cost function would appear to be: TC = $50.000 units but would overestimate total cost for Q > 1.
2.3 and 2A. then the cost function would appear to be: TC = $51.4. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 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
. This cost function would provide reasonable estimates for Q > 1. 3. 2.000 units. If all of the data estimation points occurred when Q was > 1.00*Q. Hours for two returns would be determined as follows.000 units. This cost function would provide reasonable estimates for Q ≤ 1.000 units.000 units.3219 Y = 4. the cost function mismeasurement depends on the values of Q. then the cost function would be some mixture of the functions for the two relevant ranges. There are three general situations: 1.2-8
Cost Management B.000 + $10.00*Q.80/ln2) = −0. If the accountant did not detect that there were two different relevant ranges. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.3219 Y = 6 hours*2-0.000 units but would underestimate total cost for Q ≤ 1.000 + $9.

it is a direct cost. V C.Chapter 2: The Cost Function
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As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns.000 = 0.000. but would still be considered fixed because it does not vary with production volume.000/$32. then wages would be an indirect cost.] A. making it a fixed cost. 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. If total variable costs were $8. 2.16 Bison Sandwiches A. However. or 25% of sales Combining fixed and variable costs. I. F
. Eventually their learning will plateau. it is a common cost of production for all of the bowls that are heat-treated in the kiln. In addition. as their performance improves. wages are a direct cost. Assumptions: Fixed costs remain fixed within the relevant range.25. D. 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. 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. Total clay cost will vary with the number of bowls made. F Assuming that employee time can be traced to each bowl.
B. if time is not traced to individual bowls (for example.
2. and variable costs remain constant within the relevant range. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. it improves less quickly for the next return. and their productivity rate will remain stable.000 on total sales of $32. this particular cost function assumes that variable costs are driven by sales. Assuming that the cost of clay can be traced to each bowl. their productivity increases. Note: Depreciation using a method such as declining balance is not constant over time. that is. Wages are fixed because they remain constant (the employee always works 40 hours).17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization.000 + 25%*Total sales B. D or I. However.

E. making it a direct and variable cost. then this cost could be indirect. making it an indirect cost. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. V or F Brushes for the glaze are most likely used for multiple bowls. D or I.000 in sales $1. If the packing materials are not traced (for example. if the cost is too small to justify tracing them). making it a fixed cost. it is most likely traced to individual bowls. I. making it an indirect cost. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9.000 2. it is probably a mixed cost. depending on whether they are “used up” after a certain quantity of production. making it an indirect cost. making them a common cost for multiple units and an indirect cost. because the production area may need more cleaning as volumes increase. part of the cost might vary proportionately with volume.
H. Also. It might be fixed or mixed.2-10 Cost Management D.500 ______ $4. I. If it is an hourly charge. so it is treated as fixed. D or I. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume.300 $3. it might not be traced to individual bowls. V If the glaze is expensive and therefore a relatively large cost.300 Variable $4. Packing costs are most likely variable because they will increase as production increases. depending on what causes the cost to vary.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. this is a direct cost. I. 2. They might be fixed or variable.
F. If the cost of glaze is very small. V Assuming that the cost of packing materials is traced to each bowl.500
.] A. I. Advertising is not directly related to production. G. if the cost is small it might be grouped with overhead costs (variable). F or M Electricity is an indirect cost because it cannot be traced to individual bowls. F
I. This cost is also discretionary. J. I. If the kiln is electric. F The business license is not related to production.

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

Because advertising costs tend to be discretionary. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.0863 5.2414 $0. F. Mustard ($. there might be some utility costs for the fishing operation and for a business office. B.0179 0. Lettuce ($. 2. Mayonnaise [$1.79/150) 0.1619 0.0148 6. If the fishing boat is for tourists.1619 10.0198 0. newspaper advertisements.0233 7.1075 0. they are treated as fixed costs. 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. depending on how the insurance cost is calculated. Cost of burger with everything except cheese = ($0.0148 0. Cost of plain burger = $0. PS.0033 0.2-12 Cost Management E. Catsup ($.5195 = $1.0033 $0.0863 0.5196 Suggested selling price: 300% * $0. Dill pickles [($8. The cost might be fixed or mixed. advertising costs would be incurred.0053 8. Onions ($.0179 4.59/16) 0. but it might be mixed if a portion of the cost relates to levels of business activity.3489 (calculated above) B. F Most pizza shops incur advertising costs such as flyers.3489 $0.69/8) 0.$0. It will be a fixed cost if it is a flat amount.29/12) 0.0053 0.0233 0.69/7) $0. F or M Any type of business will have insurance costs. For the fishing boat business.2414 $0.95/2.6815 A.59/40) 0. Hamburger bun ($1.1619) = $0.1075 3.000) * 4] 0. Cheese ($2. and yellow pages advertisements.2414 2. In general.15/45) 0. the utility costs for these two businesses would tend to be fixed (would not vary with production). B.49/(16 x 4)] 0. G.6815 .20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1.99/50) 0. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop. Tomato ($.0198 9.56
. Hamburger patty ($1.1075 0.

there is no moral obligation to maintain a 300% markup on each item.Mostly fixed and discretionary H. In the current business environment. most organizations are price takers. they set prices considering their competitors’ prices. B. If there is part time help. This means that her costs need to be below the competitive price. If Ms. Alternatively. Licenses. and then mixed C. Professional dues.Mixed. Rent .04 Therefore.Fixed D. B.04 . if Ms. It is just a general guideline." However. that is.25 = $1. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. Clerical wages – Fixed unless overtime is regularly scheduled. Selling price of cheeseburger with everything: 300% * $0. 2.Fixed
.79 Some students will view this higher price as "unfair. However staff are often salaried.] A. D. if her prices are too low.Fixed and discretionary I. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. 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. that cost would be variable. Long’s prices are too high.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. the price of the plain hamburger should be: $2. Market forces will dictate achievable prices. Professional subscriptions. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. she foregoes profits and people may believe there could be quality problems with her food. mostly variable G. Long is able to differentiate her hamburgers from others in the market.Fixed E.Fixed F. Insurance. Therefore. The Step 2 questions (A. and F) are the ones requiring significant assumptions to generate an answer. in which case the total cost would be primarily fixed.$0.6815 = $2. Alternatively. Property taxes. Office supplies .Chapter 2: The Cost Function 2-13 C.

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

000 $1.58E-05 0.113687834
Intercept Output
t Stat 5.4342166 0.61765897 0.Chapter 2: The Cost Function 2-15 A.000514
. Potential Cost Driver: Output
Maintenance Costs Against Output
$2.582691
P-value 6.78591283 0.761602 4.500 $1.52099624 Standard Error 153.58824812 182.000 $500 $0 0 500 1000 Output 1500 2000
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.026826 0.119724 15 Coefficient s 884.500 Maintenance Costs $2.

31319046 235.36224828 0.500 Maintenance Costs $2.005847 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 0.717372
P-value 0.291084 2.7549386 1.500 $1.457384 3.113464425
Intercept Direct Labor Hours
t Stat 3.210849 15 Coefficient s 861.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours
$2.000 $1.60187065 0.02569657 Standard Error 261.

This indicates that the cost could be totally variable. In Part A.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups
Maintenance Costs Against Machine Set-Ups
$2.42597461 1.5343
P-value 0.94888217 0.
. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver.910475729
Intercept Machine Setups
t Stat 1.197755 8.96E-10
B. or the cost is mostly fixed. If the observations are widely scattered.000 $1. However. the trend line for machine setups looks as if the intercept could be zero or very close to zero.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 126.5913391 15 Standard Error 93. For example. a good cost driver would present a linear or football-shaped positive slope or trend.357393 15. the cost driver does not explain the variation in cost and either it is the wrong driver.97410583 0.94495003 66. Sometimes a cost that is mostly variable can be identified from a scatter plot.500 Maintenance Costs $2. all three potential cost drivers appear to be positively related to maintenance costs.815737 29.500 $1. In a scatter plot.6778973 0.

R-Square 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. the economic environment.68* Machine Setups
The machine setups intercept coefficient is not significant. and technology can cause future costs to be different than estimated. so it is excluded from the cost function.521*Output TC = $861 +$3. This means that variation in setups explains about 95% of the variation in cost. D. business processes.945.2-18 Cost Management C.945 Cost Function TC = $884 + $0. Therefore. Changes in many factors such as resource prices.313 0. E. This provides confidence that the variable cost part of the cost function is not zero. The regression using machine setups has the highest adjusted R-Square of 0.025*Direct Labor Hours TC = $29.588 0. the cost is likely to be totally variable. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj. the t-statistic is significant for the independent variable but not for the intercept. In the machine setups regression.

which could be outliers.333)/($1. That means that the cost function might not represent the actual cost. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver. this cost function might provide poor estimates of future costs.
. that is.132.100 – $632.$56.605 = $11.000 = 0.333 = F + 5%*$1. the total cost function is: TC = $11.132.Chapter 2: The Cost Function 2-19
PROBLEMS
2. The high low method uses the most extreme cost driver values.05.100 F = $68. Under the high-low method. Therefore.728 Thus.24 Big Jack Burgers A.333 – $43.728 + 5%*Sales B. on average. not represent the cost most of the time. First. the cost function is calculated using the highest and lowest values of the cost driver.000/$500.100) = $25. the variable cost is calculated: ($68.333 .

There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.5% x sales
. Alternatively. Based on the p-value. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.000 $20. but the p-value is greater than 10% at 0.000
Administrative Costs
$60. D. the cost function would be TC = $16.5% x sales. Because this regression has few observations.000 $600.800 + 4. Then. the p-value result for the tstatistic is atypical. Notice that the t-statistic for the intercept coefficient is 2.000 $1. Chart of data with trend line added by Excel. Following is the regression output. etc).000 $40.000 $0 $0 $300. the cost function would be: TC = 4. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. fixed costs are likely to be zero and would be excluded from the cost function. Then. Analysis at the account level can be used to increase the understanding of this cost. the regression intercept can be used as an estimate of the fixed costs.200. If this cost pool includes items such as salaries and other fixed costs (insurance.2-20 Cost Management C. 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.000 $900.172.000
Sales
It appears that the cost is most likely mixed. In that case. analysis at the account level might indicate that there are few fixed costs.162. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line
$80.

Therefore. Unusual cost items are assumed to continue in the future. If these assumptions do not hold. the high-low method may be the best option available. Using the regression results. Because of unforeseen changes in cost behavior. If there are only two or three data points. the results rely on more complete information and provide a better estimate. There might be a large discretionary component in administrative costs. regression analysis incorporates all of the observations into the analysis.2444 7734. In addition. The cons of the high-low method as an estimation technique were discussed in Part B above. and possible changes in costs such as those described in Part E are ignored.16197623 0.186. The past costs used for estimation might not be representative. Cost Function Using Regression A. 2. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.04466925 0. The adjusted R-Square statistic is very low at 0.00818212 t Stat 2.17205158 5. a cost function may not provide a good estimate for the next month’s costs.93711636 0. especially because so few observations were used in the estimation.25 Scatter Plot. causing fluctuations in cost that are unrelated to any cost driver. on average. The plot shows costs that are widely scattered. B.Chapter 2: The Cost Function 2-21
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.90567454 3293. Sales does not appear to explain much of the variation in research and development costs. However. however. This means that variation in sales explains only about 18% of the variation in research and development cost.365 + 0.4038 4 Coefficients Standard Error 16800. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. If there are more data points. This method can be used in cases where there is not enough data to perform regression.73545 0.82%*Sales C. both of these methods assume that the data points are representative of future costs.9680477 0. Both methods assume that the cost function is linear and that all data points come from a single relevant range. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. the cost function is: TC = $50.0319523
Intercept X Variable 1
E. there does appear to be a general upward trend. then both methods may be unsuitable for estimating future costs. F.
.45937486 P-value 0. Sales might not be the activity that drives administrative costs.

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

Cons • If Susan has a number of projects in her local area or will be traveling a lot.05 $0.067 $0. In
.152 Y = 10 hours*4-0. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. so Susan may need to maintain her own records if she wishes to trace telephone usage. I.00 $20. In most businesses. 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. students may think of others.27 Fancy Furniture A. In this case the learning rate would be wrong and so the time would also be wrong.90/ln2) = −0.00 $20.10 = $30.Chapter 2: The Cost Function 2-23 consulting jobs.1 hours (average time for the first four batches) B. It is possible that the managers under. Here are some of the reasons.or overestimated the amount of hand work performed. Hours per batch would be determined as follows. telephone costs are viewed as an indirect cost. Many cellular telephone bills do not list the calls made.10 = $40.00 Average Cost $0. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. she will pay a very high rate of 10 cents per minute 2.00 $20. If her calls are over 400 minutes or under 600 minutes.057
The average cost is lowest at exactly 500 minutes per month. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). Minutes 300 400 500 600 700 Total Cost $20. 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.152 Y = 8. There are many different reasons that the time could be different from the amount determined above.00 $20.05 $0.00 + (700-500)*$0.04 $0.00 + (600-500)*$0. her phone bill will be less than it would be at a rate 5 cents per minute.

total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28.000 = $1.2-24 Cost Management addition.000 . and B. 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
. However.000 using the cost function is: TC = $47. or has a great deal of experience on the machine.$79. or 40% or revenue Combining fixed and variable costs. 2. C. then the chart suggests that the learning rate estimate is reasonable.000 _______ $28. if managers believe that 25% of the work is done by hand.000 1.40.000 Profit = Revenues – Total costs = $80. Because revenue is the cost driver for both variable costs. Thus.000
Variable $21. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 = 0. it is possible that different types of wood affect the rate at which chairs can be produced.500 10. then the cost would be overestimated.000
Total revenue is the most likely cost driver for both variable costs.000 + 40%*Total revenue D. the cost function is: TC = $47. D. Food costs are likely to vary proportionately with sales. The estimate of total costs given revenues of $80.000
7. the rate will change if the replacement employee has never worked on this machine.000 5. if managers believe that more than 25% of the work is done by hand. and the University surcharge is specifically based on sales.500 $47.28 Wildcat Lair A. C.000 = $79. If these values are used in a regression to estimate a cost function. they would be higher than the labor costs in later periods.000/$70.000 + 40%*80. then this chart suggests that the learning curve will be slower than the 90% estimate. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals
Fixed $ 30. If a worker is absent one day.

000) Net 2.000— the operating loss of $(5.29 Polar Bear Ski Wear [Notes about problem complexity: Item A is not coded as Step 2 because this is explicitly discussed in the chapter. F.000 .] A. but this is not considered a cost driver (a business activity that causes variations in total variable cost).000 increase in revenues.$4. In a retail business.000) (24. the shop might experience very little business activity. Lair’s fixed costs are assumed to be unchanged with the $10. it might even close when the ski area shuts down. During the spring and summer months. C. If the university were to close the Lair. Only total variable costs are expected to increase.000+$6. B. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. the additional profit from a $10. if the bathing suit shop is located in a geographic region $80. costs would be higher when there were fewer sales.) The adjusted cost function is: TC = $47.000 + 30%*Total revenue During August.000). 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). Thus.000*40%).000).000. Electricity costs also vary with changes in electricity rates. However. To estimate the opportunity cost for August.000 ($10.000) of revenues. The shop is most likely a seasonal business. So.000 increase in revenues is expected to be $6. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.000
.000 (-$5. it would lose the revenues. In July there was a loss of $5. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. less the fixed costs and the variable food costs. so the trend would be the opposite of this plot.000/$70. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000. the variable cost part of the cost function can be adjusted. Because the university surcharge is an allocation within the university.000 ($10.000 (47. and the increase is estimated to be 40% of the increase in revenues. So. Item D will be VERY difficult for most students. so the estimated profit in August is $1. total variable costs are expected to increase by $4. Variable food costs are estimated to be 30% ($21. generating most its sales around the ski season (fall and winter).000) $ 9.Chapter 2: The Cost Function 2-25 E. A shop located near a ski area is likely to incur high heating costs during the winter. for July the opportunity cost would have been $2.000)+the university surcharge of $7.

correlation does not necessarily mean causation. A correlation may appear in a scatter plot or regression analysis.67 1.2345 Y = $300*5-0. Many costs can be related to volume of activity.89 x 1. higher profits generally occur during periods when activity is high.45 x 1.45 $ 514. they are discretionary expenditures and not caused by the level of activity. generally mean there is more money available to spend on administrative travel. and new office furniture or equipment. For example.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows.2345 Y = $205.85/ln2) = 0.2345 Y = $101.50 = $1.69 x 5 = $1.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning. given a 100 unit production level: Y = α Xr Y = $300*100-0. employee training.542. However. special promotions. in turn.69 (average cost for each of the 5 units) Total cost = $205.45 Although each customer paid a different price. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.028. firm B's selling price is: $101.5 = $152. Although these expenditures are made because more money is available.028.22
Firm B set its selling price based on the average cost. 2.542. D.67 Firm A's income for last year was: Sales Costs Income $1. a 50% markup on total cost will cause sales to be: $1. Higher profits. then the highest sales might coincide with the highest electricity costs.028.84
.

926.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.00 13.356.10 $22.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.84) Costs (150 x $ 92.55 1.65) Income Firm A's revenues for this year are: (10 x $152.50
.727.50 $ 9.84) = $1.028.75) 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. assuming an 85% learning effect would be: Y = $300*150-0.625.50 $ 9.528.50/150 units = $64.50
Firm B's calculation for its selling price is as follows: Y = $300*300-0.85 Thus Firm B's selling price this year was $64.2345 (notice that the cumulative units produced is 15) Y = $158.528.40 Firm A's costs may be computed as follows: Y = $300*15-0.45 $1.28 $23.30 $2.2345 Y = $92.028.50 = $97.897.10 $ 172. Total cumulative production cost (300 x $78.00 13.384.40 1.85 x 1.Chapter 2: The Cost Function 2-27 Firm B's costs.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 $1.356.2345 Y= $78.727.897.

28) Costs (150 x $64.000 $135.500. There is a positive slope.61.000
$8.864.85) Income $14. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.000
$7.500. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. available on both the Instructor and Student web sites for the textbook (available at www.592.00 9.50 $ 4. Scatter Plot of Marketing Costs Against Sales
$175.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.000
$6.000
Marketing Dept.10/10 = $135.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.356. and most of the observations appear to have a fairly linear trend.com/college/eldenburg). A.500.50
Note that Firm B's selling price for this year of $97.com/college/eldenburg). such extreme differences in cost can occur.727.000 $145. Costs
$165. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.28 is lower than Firm A's average cost per unit: $1.wiley. 2.
.000
Sales
B.000 $155.000 $5.wiley.500.

Here is the regression output.93336396 R Square 0.2608 0. using regression or any other technique.4501E-10 5. the cost function is: TC = $65. In addition. they may be positively correlated with sales. Instead. E.00097028 t Stat 9. there would be a positive correlation between marketing department costs and sales. it is economically plausible for sales to be a cost driver.Chapter 2: The Cost Function 2-29 C.5289E-14
Intercept X Variable 1
Based on the regression results. Even if marketing department costs are discretionary. discretionary costs such as marketing are often increased when profits increase. sales may go up.87116829 Adjusted R Square 0.58184484 13. Assuming that profits are more likely to increase when sales increase. Discretionary costs are set by decision.86656716 Standard Error 4015.34%*Sales D.01335108 Standard Error 6844.
Regression Statistics Multiple R 0. F. usually annually. Therefore. the decision maker(s) should be asked what next year’s cost will be.63816 0. If the variable portion of the marketing cost is sales commissions. When more money is spent on marketing.08144 Observations 30 Coefficients 65584. the cost estimate should not be based on past costs.
.584 + 1.7600071 P-value 2.

000 $0 0 500 1000 1500 2000 2500 Labor Hours
Manufacturing Overhead Against Machine Hours
Manufacturing Overhead Cost $200.wiley.000 $40.000 $120.000 $40.com/college/eldenburg). A.000 $80.wiley. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $160.2-30 Cost Management 2.000 $160.000 $80.000 $0 0 300 600 900 1200 1500 Machine Hours
. available on both the Instructor and Student web sites for the textbook (available at www.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.com/college/eldenburg).000 $120.
Manufacturing Overhead Against Labor Hours
Manufacturing Overhead Cost $200.

If the observations are widely scattered.86E-11 0.1543 0. Sometimes a cost that is mostly variable.50852 7.600712
P-value 6.682 4. either the driver is wrong or the cost is mostly fixed. the cost driver does not explain the variation in cost. Labor Hours Regression:
Regression Statistics Multiple R 0.000 $80.11279932 R Square 0. labor hours could be deleted as a potential cost driver.02253618 Standard Error 11114.Chapter 2: The Cost Function 2-31
Manufacturing Overhead Against Raw Materials
Manufacturing Overhead Cost $200. C. D.600936029
Intercept Labor Hours
t Stat 10. but the plot for labor hours appears to have the least trend.000 $0 0 100 200 300 400 500 600 700 Raw Materials
B. The plots help determine whether regression analysis should be performed using any of the potential drivers. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.56597156 30 Standard Error 14812.8173 Observations Coefficient s 150410.000 $120.000 $160.01272369 Adjusted R Square -0.552864
. Based only on the cost plots.000 $40. Costs and potential cost driver data are plotted to determine whether further analysis is necessary. None of the plots show a definite trend.

217192 Standard Error 10291.3746211 Adjusted R Square 0. so the cost function is estimated as: TC = $150.000325
Both the intercept and slope coefficients are significant.612063 R Square 0.331580777
Intercept Machine Hours
t Stat 11.411 Machine Hours Regression:
Regression Statistics Multiple R 0.22*Machine hours Raw Materials Regression:
Regression Statistics Multiple R 0.9786 Observations 30 Coefficient s 126216.217 + $60.215128 Standard Error 10853.1555 Observations 30 Coefficient s 117598.3522862 Standard Error 8846.22* Raw materials
.62907 3. so the cost function is estimated as: TC = $126.2266685 Standard Error 9665.5033241 R Square 0. so the cost function is estimated as: TC = $117.004579
Both the intercept and slope coefficients are significant.2533351 Adjusted R Square 0.67 38.082222
P-value 3.53627459
Intercept Raw Materials
t Stat 11.47803 9.91 60.56778 19.2-32 Cost Management Only the intercept term is significantly different from zero.095468
P-value 4.11E-12 0.599 + $38.68E-12 0.4268 4.

however.291558412 10.9092294 R Square 0.976635 Standard Error 10361. 2.886218 -0. machine hours appears to do the best job of explaining manufacturing overhead costs. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). available on both the Instructor and Student web sites for the textbook (available at www. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.953575 1.210187
P-value 3.12E-09 1.wiley.333162437 5.8266982 Adjusted R Square 0.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.1959303 48.218173 8. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.com/college/eldenburg).10654585
Intercept Labor Hours Machine Hours Raw Materials
t Stat 5.8067018 Standard Error 4832.05878 9. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.778501 82. Yes.226
Based on the simple regression results.5558 Observations 30 Coefficient s 60988. Multiple regression with all three potential cost drivers:
Regression Statistics Multiple R 0. A.2349 3.Chapter 2: The Cost Function 2-33 E.wiley.08E-08
.489 -0.com/college/eldenburg). this driver explains only 35% of the variation in cost.352 0.3E-06 0. The coefficients for each of the other potential cost drivers are significantly different from zero. F.

450561 8.954) $48.806) than in either of the simple regressions (0.806
$150. Multiple regression using machine hours and raw materials as cost drivers:
Regression Statistics Multiple R 0.988 (<0.71E-10 5.664851 5.217 (<0.20 (0.29E-09
The cost function is: TC = $60.57 (0.22 (0.001) $-0.001)
B.7422519 82.5348 Observations Coefficient s 60677.98 (<0. its coefficient is not significantly different from zero in either regression. C.001)
$4.022 0.939606 9.352 and 0. Thus.5902 48. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.93*Raw materials D. Costs for these activities are likely related to specific cost drivers.78 (<0.74*Machine hours + $82.001) $60.22 (<0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.352 0.226) for these two cost drivers. The adjusted RSquare is far higher in the multiple regression (0. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.005) $82.925842 30 Standard Error 8743. In this example. machine hours and raw materials explain different activity
.411 (<0.001) $126. its coefficient is negative rather than positive in the multiple regression.678 + $48.881964042
Intercept Machine Hours Raw Materials
t Stat 6.157604083 9. Each task includes different activities. R2
Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression
0.55) $38.86E-07 4.226 0. labor hours can be eliminated as a potential cost driver.001) $117. Manufacturing can be a complex activity requiring a number of different tasks. Also.82667515 Adjusted R Square 0.001) $60.599 (<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.90921678 R Square 0.391636
P-value 1.81383627 Standard Error 4742.

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

number of hours the building is open.000 $5. Dept.000 $15. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $5.
. Students may have thought of other drivers that could be logically related to cleaning maintenance costs.000 $20.000 $10. Dept. B.000 $15.
Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked
Maint. or number of classes and activities per period.000 $10. Costs
$25.com/college/eldenburg).000 $0 50 100 150 200 250 300 350
Maintenance Hours Worked
Scatter Plot of Maintenance Costs Against Number of Students
Maint. Other cost drivers for total maintenance cost could be number of rooms cleaned. A. available on both the Instructor and Student web sites for the textbook (available at www.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2.wiley. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.2-36 Cost Management 2.wiley.000 $20. Costs
$25. number of hours students attend school. square feet cleaned.com/college/eldenburg).000 $0 528 530 532 534 536 538 540 542
Number of Students
C.

247329 R Square 0.9 244. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none. The most current value is used to
.63E-06 2. Therefore. The total cost function is: TC = $9. From the analyses performed.920565237 R Square 0. it is logical to expect a strong relation between hours worked and cost. Utilities cost varies with season not visits.832184392 Standard Error 1217. and rent for this type of facility is usually fixed.847440356 Adjusted R Square 0.061172 Adjusted R Square -0.796328319
Intercept X Variable 1
Coefficients 9134.68624 0.74*maintenance hours worked.508157 0. 2.74733262
t Stat 9.461245 7.173 Observations 12 Coefficient s -89867 197.03271 Standard Error 3019.0261 Standard Error 130954.135 + $35. An unidentified cost driver could have a higher R-Square. The p-values on the Tstatistics are very small.5045837 4.Chapter 2: The Cost Function 2-37 D. However.807201
P-value 0. it is considered fixed. 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.36 The Elder Clinic A and B Salaries are always fixed.18E-05
Regression output for maintenance cost and number of students:
Regression Statistics Multiple R 0.875134 35. providing high confidence that both the intercept and slope are different from zero.438328
According to the R Square statistics. maintenance hours is a reasonable cost driver.453062
P-value 2. Regression results for maintenance cost and number of maintenance hours worked:
Regression Statistics Multiple R 0.0857
Intercept X Variable 1
t Stat -0.06772 Observations 12 Standard Error 965. E. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.

There is no one answer to this part. Use March. At 940 patient-visits.412 1. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www. Medical supplies vary with number of patient-visits. medical supplies is a mixed cost.wiley.115 219 3. such as tongue depressors. high point of medical supplies cost and patient data.100 226 664 $19.07*940 = $25. July expenses are estimated to be: TC = $19. **Using high-low.736 + $6.07
Patient-visits
X
* The value in June is used for fixed costs because the increase in salaries will hold into the future. This analysis suggests that there are some of the other expenses are variable costs and some fixed. and so on.80 D.736 + $6. Use the same method for other expenses. These would be fixed. or there are changes in treatment procedures for certain illnesses. other facilities may open or close.182 = F + $3. variable cost is $3. to find fixed: $3.736 Variable $3. and so on. Visits are affected by season. new equipment is acquired.58 $6. weather.49 ($3. affecting the number of visits at this clinic. E. must be kept on hand whether or not they are used. but not proportionately. gloves. each patient requires a certain number of supplies. and costs go up as patient-visits increase. Some supplies. current illnesses that are circulating in the area.182 .934)/(849 – 778). Here are some of the reasons: • The managers will not know how many visits they will receive.com/college/eldenburg). so this cost is classified as a mixed cost. such as snake anti-venom.441. Given the preceding computations and cost summary.49*849. • Prices of all inputs could change (usually increase).$2. • Treatments and related costs may change as new drugs are available.
.2-38 Cost Management predict next period’s utilities. Therefore. These would be variable. There are many possible reasons that could be listed.07*patient-visits C. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. the cost function is: TC = $19. Other expenses appear to increase and decrease with number of patientvisits.49 Cost Driver Patient-visits Mixed X
2. Also.

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

The miscellaneous supplies account also looks suspicious.8 x 6.500 x 1/2 = 2.250 May June July Aug Sept Oct Nov
1
Property Tax(a) +$500 + 500 + 500 + 500 -3. the trend line is likely to distort costs.000 = 4.com/college/eldenburg).736
To predict future overhead.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. Similarly. A.4.800 .376 65. as shown in the scatter plot below.750. 80% of September 2 payroll to August: .686 71. If these observations are included in the regression analysis.750 .000 + 500 + 500 + 500 + 500 + 500
Depreciation(b) +$36 1 + 36 -4. (rounded to $36) 2 Note IB-4's power added to Dept. B.300/10 x 12 = 35.com/college/eldenburg). but there is insufficient information to make an adjustment.736 67.800.500 38.350 68. the first month is adjusted even though it is not an actual cost: 4. Operations in the month of July are not typical of the rest of the time period.83/mo.486 68. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.150 73. available on both the Instructor and Student web sites for the textbook (available at www.800
41.750 + 4.10.wiley.236 69.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36
Other
Payroll3
Adjusted Cost $68. July’s result is an outlier and should be removed from the data. IP-14 3 Payroll paid every two weeks.750 68.850 2 . Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. 1/2 of August 5 payroll goes to July: 5.310 70.200
+$2. these are correctly handled.200 Apr 71.286 68.036
68. Because of the large difference between these values and the values in other months. No adjustments are needed for items (c) and (d).596 73.2-40 Cost Management 2.2.790 80.
.

500
Outlier
Direct Labor Hours
C. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. they are most likely recorded at the time of purchase rather than at the time of use.000 $55.086126
Based on the t-statistic and p-value for the intercept.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).500 8.000 3.000 9. the fixed cost does not appear to be different from zero.000 $45. D.310484
Intercept X Variable 1
Coefficient s 8777.314163 1980.000
Overhead Costs
$70.26 3. the cost function is estimated as: Overhead cost = $6.47 8 Standard Error 29406.818 6.000 $65.000 $40.Chapter 2: The Cost Function 2-41
Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours
$75.000 2.789722
t Stat 0. Therefore.050976
P-value 0.412139 0.000 $50.775388 0.500 5. According to the details provided for August and September. Monthly overhead costs for supplies may be significantly overstated or understated
. supplies were a large proportion of overhead cost.641981 0. Here are the regression results:
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 6.298502 2. Based on the variation in dates at which supplies are recorded.000 $60. Thus.

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

the best choice of estimation technique. Fixed costs are often irrelevant to decisions. Suppose a cost function is measured for the purpose of estimating future costs. then simple regression is inappropriate.Chapter 2: The Cost Function 2-43
BUILD YOUR PROFESSIONAL COMPETENCIES
2. and reliable measure for estimating a cost function because of uncertainties about: data availability. B. It is often difficult to identify an appropriate. for example. For example. it is necessary to use judgment when choosing and applying measurement methods. 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. b. C. Chapter 2 introduced the following measurement methods for estimating a cost function: Engineered estimate of cost. whether past cost behaviors will continue in the future. 1.40 Focus on Professional Competency: Measurement A. a cost function should distinguish between fixed and variable costs. 2. It is also necessary to evaluate the quality of measurement results when using accounting information. two-point method. and how to interpret computational results. c. and multiple regression (Appendix 2A). and they prevent complete accuracy in making accounting measurements. relevant. A measurement is appropriate if it is suitable for the purpose. 3. which typically involved creating a cost function for one or more individual costs. Uncertainties prevent identification of single “correct” measurement methods.17 for the pros and cons of each method. When estimating a cost function: a. A measurement is relevant if the resulting cost function information helps decision makers choose between alternative courses of action. in Chapter 2 pointed out that a cost function is estimated within a relevant range of activity. A cost function estimated from past cost data may be unreliable if future operating activities are expected to occur in a different relevant range. whereas variable costs are often relevant. If the cost is believed to be nonlinear. In Chapter 2. The costs and benefits of alternative measures should also be considered. See Exhibit 2. analysis at the account level. Thus. variable or mixed. A measurement is reliable if it if it is reasonably free from error and bias. which factors drive variable costs. sometimes the cost of obtaining a better measure exceeds the benefits. the main focus was on measuring costs for a cost object. For example. 4. simple regression. how to categorize costs as fixed.
. high-low method.

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

the degree of downward bias is higher for older data than for more recent data.com/college/eldenburg).7748991 R Square 0.
.04 13.5917832 Standard Error 6216.] The data for this problem can be found on the datasets file for chapter 2.6004687 Adjusted R Square 0.96 x number of chairs produced However.194 + $13. students are likely to struggle interpreting and choosing a method (Parts E and F). Also.437E-24 1. Here are the simple regression results:
Regression Statistics Multiple R 0. the fixed cost and the variable cost per unit are each positive and statistically different from zero. using monthly data for the prior 4 years. the cost function was estimated by regressing actual labor costs on number of chairs produced.848277 8. B.678620854
Intercept X Variable 1
t Stat 19. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.7995 Observations 48 Coefficient s 133194. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs. Considerable variation in labor costs is not explained by changes in the volume of production.com/college/eldenburg).3147402
P-value 3.41 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 regression explains only about 59% of the variation in labor costs. Because of the annual pay increases.Chapter 2: The Cost Function 2-45 2.wiley.957296 Standard Error 6710. available on both the Instructor and Student web sites for the textbook (available at www. In prior years. A.02E-10
Based on the regression results.609693 1. The cost function is estimated as: Labor cost = $133.

73E-20 5.533 x (1. Here are the multiple regression results:
Regression Statistics Multiple R 0.00872
Intercept X Variable 1 X Variable 2
t Stat 18. which is reasonable given the increase in wage rates over time. this cost function would result in a higher estimate for future costs.2-46 Cost Management C. The cost function is estimated as: Labor cost = $133.390275
Intercept X Variable 1
t Stat 24.74).23439 Standard Error 5557.891 1.35E-15
Based on the regression results.747745 Adjusted R Square 0.93821 16.347 Calculation $203.96 to $16. the fixed cost and the variable cost per unit are each positive and statistically different from zero.347 x 1. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.411 Observations 48 Coefficient s 107748. D.54295 Standard Error 5689.06236 11.8 16.02)4 $196.492 1.57E-23 2.91E-08
.09577 6.486389
P-value 4.274
Using the adjusted labor cost data.010513 1.05E-27 2.932541 R Square 0. but the variable cost increased from $13.905 Observations 48 Coefficient s 133736 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 0.869633 Adjusted R Square 0.533 Dec 20X4 196.742261 Standard Error 5148.23 per chair.26499 6. Nevertheless.863839 Standard Error 3742. The fixed cost is nearly the same. Also.02 Adjusted Labor Cost $220. here are the regression results:
Regression Statistics Multiple R 0.864722 R Square 0.67711
P-value 1. approximately 26% of the variation in labor costs is still unexplained.736 + $16.311 200.

the two cost drivers together explain a very high proportion (86%) of the variation in past labor costs. and to decrease the number of workers when production volumes decrease. there may be some lag between the time that production volumes change and labor costs change. it often takes time for the company to hire qualified new workers. Thus.26 x current month number of chairs produced + $6. The first slope coefficient ($16. On the other hand. As explained in the problem.
. There is no one single answer to this question. it appears that both independent variables should be included in the cost function because they both have a logical cause-and-effect relationship with labor costs. if the prior month’s production was lower than this month’s production. and this regression explains more of the variation in labor costs (86%). then this month’s labor costs will reflect the higher level of labor cost. On one hand. The cost function is estimated as: Labor cost = $107.749 + $16. In addition. each month’s labor costs are expected to increase by $6.54 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. F. However. and they both have positive and statistically significant coefficients. it could be argued that some other cost driver might do a better job of predicting future labor costs. The second slope coefficient requires more thought. each month’s labor costs are expected to increase by $16. and the managers often delay laying off employees when volumes decline. According to the multiple regression results. then this month’s labor costs will reflect a lower level of labor cost.54 for each chair produced during the prior month. Conversely. the company’s policy is to increase the number of workers when production volumes increase.26) is interpreted in a straight-forward way.Chapter 2: The Cost Function 2-47 Based on the regression results. the fixed cost and the variable cost per unit for each cost driver are all positive and statistically different from zero.l6 for each chair produced during the month. If the prior month’s production was higher than this month’s production. E.