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LEARNING OBJECTIVES

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

COMPLEXITY SYMBOLS

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

2-2

Cost Management

QUESTIONS

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

Total Cost

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

2.3

2.4

2.5

2.6

Chapter 2: The Cost Function

2-3

2.7

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

2.8

2.9

2.10

2-4

Cost Management

EXERCISES

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

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

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

D D I D D D D

D I I I I D D

I I I I I D D

2.000 $13.000 $11. Of course.000 $8.000 Total Cost $12. the CPA's time is the product being sold. the tax partner probably spends some time in non-billable activities.00*Q Graph of Cost Function $14.000 + $8.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.000 $9.13 Linear. TC = $10. For the firm to make this cost direct for the personal returns cost object. and Piecewise Linear Cost Functions A. CPAs do keep detailed time records. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects.000 $10. The time records that the tax partner maintains support this cost as a direct cost. In a service business such as this.000 0 100 200 Number of Units 300 400 The cost function includes the following assumptions: • Operations are within a relevant range of activity • Within the relevant range of activity: o Fixed costs will remain fixed o Variable cost per unit will remain constant . The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. Now notice that the tax partner's salary is considered a direct cost for all three cost objects. Stepwise Linear.

To estimate the costs at another production level.000 units = 12.000 $10. for Q ≤ 2.2-6 Cost Management B. Convert the average costs to total costs for each production level: Total cost at 10.000 = F + $39*10.000 + $8.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 4.000 + $8. it is first necessary to estimate the cost function.000 = $60.$450.000 Total cost at 12.000 $0 0 1.000 Graph of Cost Function $80.000 $70.000 units = 10.000 2.000 Total Cost $50.000 * $45 = $450.000 $40.00*Q. for Q > 2.000) = $78.000 – 10.$390.000 $20.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 .000/2.000 + $39*Q .000 * $44 = $528.000 $30.000 TC = $35.000 .00*Q.000 F = $450. TC = $25.000 $60.000 Number of Units C.000)/(12.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 3.000 units: $450.

Inserting $10.000 TC = $51.000 + $9.000 * $10.000 $55.000 = $645.000 $60.000 1.000 $50.000 + $585.00*Q 2-7 Graph of Cost Function $75.000 $70.14 Piecewise Linear Cost Function A.000 + (1.000 $45. TC = $50.000/15.$9.000 $65.Chapter 2: The Cost Function Estimated total cost at 15.000 0 500 1.000 + $10.000 For Q > 1.000 + $9.000 in revenues into the cost function.000 = $9.000 = $43 D.000) TC = $50. total cost is estimated as: TC = $5.000 + $10.00*Q .00*Q. for Q < 1.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 = $60.000 Estimated cost per unit = $645.000: TC = $50.00) + $9.500 2.000 + $39*15.00*(Q-1.000 + 45%*$10.000 units: TC = $60.500 2.

Hours for two returns would be determined as follows. This cost function would provide reasonable estimates for Q ≤ 1. then the cost function would be some mixture of the functions for the two relevant ranges. There are three general situations: 1. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared .000 units.000 + $10.4.00*Q.000 units.000 units.000 units but would overestimate total cost for Q > 1. 3. then the cost function would appear to be: TC = $51. 2. the cost function mismeasurement depends on the values of Q. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. If the accountant did not detect that there were two different relevant ranges. This cost function would provide reasonable estimates for Q > 1.15 Tax Plus A. If all of the data estimation points occurred when Q was > 1. 2.2-8 Cost Management B. If the data estimation points occurred across the two relevant ranges.3219 Y = 6 hours*2-0.3219 Y = 4.000 units. If all of the data estimation points occurred when Q was ≤ 1.8 hours (average time for each of the next two returns) B.80/ln2) = −0.000 units but would underestimate total cost for Q ≤ 1.3 and 2A. then the cost function would appear to be: TC = $50.00*Q. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A.000 + $9.

The cost probably does not depend on production volume (assuming depreciation is not based on units produced).25.] A. wages are a direct cost. B.000/$32. making it a fixed cost. or 25% of sales Combining fixed and variable costs. However. 2.16 Bison Sandwiches A. In addition.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. 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.000 = 0.000 on total sales of $32.000. 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. Assuming that the cost of clay can be traced to each bowl. D.000 + 25%*Total sales B. Eventually their learning will plateau. it is a common cost of production for all of the bowls that are heat-treated in the kiln. F Assuming that employee time can be traced to each bowl. Chapter 3 will point out another assumption for this cost function: the sales mix (the proportion of sales of different products) remains constant within the relevant range. If total variable costs were $8. this particular cost function assumes that variable costs are driven by sales. F . V C. and variable costs remain constant within the relevant range. the cost function is: TC = $20. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. that is. then variable cost per dollar of revenue is calculated as follows: $8. Wages are fixed because they remain constant (the employee always works 40 hours). but would still be considered fixed because it does not vary with production volume. as their performance improves. their productivity increases. it is a direct cost. if time is not traced to individual bowls (for example. However. I. then wages would be an indirect cost. Total clay cost will vary with the number of bowls made. D or I. 2. Note: Depreciation using a method such as declining balance is not constant over time. Assumptions: Fixed costs remain fixed within the relevant range. and their productivity rate will remain stable.

making it an indirect cost. if the cost is small it might be grouped with overhead costs (variable).500 .18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. They might be fixed or variable. D or I. making it an indirect cost.300 $3.500 ______ $4. I. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. If the packing materials are not traced (for example. making it a fixed cost.] A. F I. making it an indirect cost. H. I. part of the cost might vary proportionately with volume. D or I. 2. making it a direct and variable cost. making them a common cost for multiple units and an indirect cost. V Assuming that the cost of packing materials is traced to each bowl. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume. then this cost could be indirect. V If the glaze is expensive and therefore a relatively large cost. so it is treated as fixed. it is probably a mixed cost. F. It might be fixed or mixed. this is a direct cost. because the production area may need more cleaning as volumes increase. depending on whether they are “used up” after a certain quantity of production. Advertising is not directly related to production. G.300 Variable $4. If the cost of glaze is very small.000 in sales $1. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. If it is an hourly charge. If the kiln is electric. Packing costs are most likely variable because they will increase as production increases. E.000 2. J. I.2-10 Cost Management D. if the cost is too small to justify tracing them). it might not be traced to individual bowls. Also. depending on what causes the cost to vary. I. F The business license is not related to production. This cost is also discretionary. V or F Brushes for the glaze are most likely used for multiple bowls. I. it is most likely traced to individual bowls. F or M Electricity is an indirect cost because it cannot be traced to individual bowls.

The cost of rent is irrelevant because it will not change with either alternative. 2. these costs would be mixed with a large proportion of the cost fixed.300 + 50%*Total revenue C.Chapter 2: The Cost Function 2-11 B. or 50% of revenue Combining fixed and variable costs. B. and the cost would vary with number of pizzas produced. D. V Ingredients are used in making pizzas. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. F. F. . so they would tend to be fixed or mixed (see Item A above). While hourly wages may be related to number of fish caught. Some may be sent home if business is very slow. E.50. workers’ compensation. Benefit costs often vary with level of wages or salaries.500/$9. C. employees are likely scheduled in advance on a fixed schedule. F There would be no reason to incur fishing equipment costs in a pizza business. D. F or M Employee benefits occur in any business in which employees are hired.] A. Therefore. as well as voluntary items such as health insurance and retirement benefits. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. Benefits might include mandated items such as social security. In this type of situation.000 = 0. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. FB. V. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. B. There most likely would not be any ingredients in a fishing boat business. they are more likely related to time on the boat than pounds of fish. and unemployment insurance. because of uncertainty in the success of each fishing expedition. B. In the pizza shop. PS. In many organizations. the cost function is: TC = $3.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. costs vary with dollars of revenue. In the fishing boat business.

In general.0033 0. Catsup ($. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.0053 0. B.6815 . If the fishing boat is for tourists.2414 2. Tomato ($. B.0148 6. the utility costs for these two businesses would tend to be fixed (would not vary with production).0198 0.0863 5.56 .79/150) 0.0198 9.95/2. It will be a fixed cost if it is a flat amount.1619 0.3489 (calculated above) B. PS.3489 $0. Mayonnaise [$1. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.1075 0. newspaper advertisements.0148 0. The cost might be fixed or mixed.2414 $0. Cheese ($2. Hamburger patty ($1.0179 0. Because advertising costs tend to be discretionary.49/(16 x 4)] 0.0233 0. however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship. Cost of burger with everything except cheese = ($0.1075 3.69/7) $0.5196 Suggested selling price: 300% * $0.000) * 4] 0.99/50) 0.1619 10. Hamburger bun ($1. Dill pickles [($8.0863 0. F or M Any type of business will have insurance costs.69/8) 0.2-12 Cost Management E. depending on how the insurance cost is calculated.0179 4. there might be some utility costs for the fishing operation and for a business office.2414 $0.0033 $0. 2. F Most pizza shops incur advertising costs such as flyers. Onions ($.59/40) 0.5195 = $1. Mustard ($. Cost of plain burger = $0. they are treated as fixed costs. advertising costs would be incurred. For the fishing boat business. F.$0.29/12) 0.1075 0.0053 8.20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1. and yellow pages advertisements. but it might be mixed if a portion of the cost relates to levels of business activity.59/16) 0. Lettuce ($.1619) = $0.6815 A. G.0233 7.15/45) 0.

Fixed E. 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. she foregoes profits and people may believe there could be quality problems with her food. there is no moral obligation to maintain a 300% markup on each item. if Ms. In the current business environment. However staff are often salaried. It is just a general guideline. 2.04 .$0." However. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. D.6815 = $2.Mostly fixed and discretionary H. they set prices considering their competitors’ prices. Insurance. Long is able to differentiate her hamburgers from others in the market. that is.Fixed D.04 Therefore. Office supplies .Fixed F. Alternatively. Professional dues. and F) are the ones requiring significant assumptions to generate an answer.21 Spencer and Church [Note about problem complexity: These are difficult questions because students will need to first visualize the costs (with very little information) and then apply chapter concepts. the price of the plain hamburger should be: $2. most organizations are price takers.79 Some students will view this higher price as "unfair. If there is part time help. Licenses. Market forces will dictate achievable prices. in which case the total cost would be primarily fixed. Rent . Clerical wages – Fixed unless overtime is regularly scheduled. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. Therefore. The Step 2 questions (A. Alternatively. and then mixed C. Selling price of cheeseburger with everything: 300% * $0. B.Fixed and discretionary I. B. Property taxes.] A.Chapter 2: The Cost Function 2-13 C. This means that her costs need to be below the competitive price. If Ms. that cost would be variable.Fixed . Professional subscriptions. if her prices are too low. Long’s prices are too high.25 = $1. mostly variable G. 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.Mixed.

2-14 Cost Management K. For example.35*units sold. In addition. Other possible cost drivers for marketing department costs could be revenue.wiley. number of advertisements placed. or profits.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 variation in units sold explains about 61% of the variation in marketing department cost. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero. . C.) B.] The data for this problem can be found on the datasets file for chapter 2.wiley. 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. available on both the Instructor and Student web sites for the textbook (available at www. 2.22 Cost Function Using Regression. the fixed cost is set at zero. TC = $222. Therefore. 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. the cost is discretionary and will be set through the negotiating process. it is possible that marketing costs are discretionary. The cost analyst needs to gather information about how marketing costs are set each year. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold.com/college/eldenburg). In this problem.com/college/eldenburg). Other Potential Cost Drivers A.

119724 15 Coefficient s 884.000514 .78591283 0.Chapter 2: The Cost Function 2-15 A.026826 0.000 $1.761602 4.58E-05 0.52099624 Standard Error 153.4342166 0. Potential Cost Driver: Output Maintenance Costs Against Output $2.58824812 182.500 Maintenance Costs $2.113687834 Intercept Output t Stat 5.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.500 $1.582691 P-value 6.61765897 0.

291084 2.005847 0.31319046 235.500 Maintenance Costs $2.000 $1.113464425 Intercept Direct Labor Hours t Stat 3.017601 .36224828 0.000 $500 $0 0 50 100 150 200 250 300 350 Direct Labor Hours Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.210849 15 Coefficient s 861.457384 3.02569657 Standard Error 261.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.717372 P-value 0.7549386 1.500 $1.60187065 0.

the trend line for machine setups looks as if the intercept could be zero or very close to zero.5913391 15 Standard Error 93.910475729 Intercept Machine Setups t Stat 1.357393 15.500 Maintenance Costs $2. or the cost is mostly fixed. Sometimes a cost that is mostly variable can be identified from a scatter plot.815737 29.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2. .5343 P-value 0. In Part A.97410583 0. For example.96E-10 B.94888217 0. This indicates that the cost could be totally variable.197755 8. However.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. the cost driver does not explain the variation in cost and either it is the wrong driver. In a scatter plot. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. If the observations are widely scattered.42597461 1.000 $1.500 $1.6778973 0. a good cost driver would present a linear or football-shaped positive slope or trend. all three potential cost drivers appear to be positively related to maintenance costs.94495003 66.

business processes. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero. the t-statistic is significant for the independent variable but not for the intercept. so it is excluded from the cost function.945 Cost Function TC = $884 + $0. The use of past cost data to predict the future assumes that future resource costs and volumes of activities will remain the same as in the past. and technology can cause future costs to be different than estimated. In the machine setups regression. R-Square 0. This means that variation in setups explains about 95% of the variation in cost. The regression using machine setups has the highest adjusted R-Square of 0. the economic environment.313 0. D.2-18 Cost Management C. E.025*Direct Labor Hours TC = $29.945. Changes in many factors such as resource prices. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj.588 0. Therefore. .521*Output TC = $861 +$3.68* Machine Setups The machine setups intercept coefficient is not significant. the cost is likely to be totally variable. This provides confidence that the variable cost part of the cost function is not zero.

First.728 Thus.000 = 0. on average. the total cost function is: TC = $11.333 – $43. the variable cost is calculated: ($68.100 – $632. that is.132.333 = F + 5%*$1.728 + 5%*Sales B.05.100 F = $68.333)/($1.Chapter 2: The Cost Function 2-19 PROBLEMS 2.333 .605 = $11. which could be outliers. not represent the cost most of the time. The high low method uses the most extreme cost driver values.24 Big Jack Burgers A.100) = $25. this cost function might provide poor estimates of future costs. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver. 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. .132. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. Under the high-low method. Therefore.000/$500.$56.

the cost function would be TC = $16.000 $900. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.000 $600.000 $20. Chart of data with trend line added by Excel. the cost function would be: TC = 4. Then. analysis at the account level might indicate that there are few fixed costs. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. Because this regression has few observations.5% x sales . D. In that case. fixed costs are likely to be zero and would be excluded from the cost function. Alternatively. etc). Analysis at the account level can be used to increase the understanding of this cost. there is a 16% probability that the intercept (fixed cost) is not different from zero.000 Administrative Costs $60.200.162. Then. The upward slope of the line indicates that there are variable costs. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. Notice that the t-statistic for the intercept coefficient is 2.800 + 4. the regression intercept can be used as an estimate of the fixed costs.172.000 $1.2-20 Cost Management C.000 $0 $0 $300. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. If this cost pool includes items such as salaries and other fixed costs (insurance. the p-value result for the tstatistic is atypical. but the p-value is greater than 10% at 0.000 $40. Based on the p-value.5% x sales. Following is the regression output.000 Sales It appears that the cost is most likely mixed.

The adjusted R-Square statistic is very low at 0. This method can be used in cases where there is not enough data to perform regression. causing fluctuations in cost that are unrelated to any cost driver. There might be a large discretionary component in administrative costs. the results rely on more complete information and provide a better estimate. The past costs used for estimation might not be representative. 2. If there are only two or three data points.82%*Sales C. regression analysis incorporates all of the observations into the analysis. If these assumptions do not hold. 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.00818212 t Stat 2. Both methods assume that the cost function is linear and that all data points come from a single relevant range.186. Unusual cost items are assumed to continue in the future.04466925 0.365 + 0. However. a cost function may not provide a good estimate for the next month’s costs. 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. there does appear to be a general upward trend. B.16197623 0. especially because so few observations were used in the estimation. If there are more data points. Using the regression results. This means that variation in sales explains only about 18% of the variation in research and development cost.2444 7734.90567454 3293. the cost function is: TC = $50. Cost Function Using Regression A.25 Scatter Plot. the high-low method may be the best option available.0319523 Intercept X Variable 1 E.73545 0.45937486 P-value 0. then both methods may be unsuitable for estimating future costs.4038 4 Coefficients Standard Error 16800. on average. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. Therefore. In addition. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost. Because of unforeseen changes in cost behavior. F.93711636 0. both of these methods assume that the data points are representative of future costs. .9680477 0.17205158 5. The plot shows costs that are widely scattered. Sales might not be the activity that drives administrative costs. however.

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

10 = $30.057 The average cost is lowest at exactly 500 minutes per month. students may think of others. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). There are many different reasons that the time could be different from the amount determined above. I.00 + (600-500)*$0.152 Y = 10 hours*4-0. 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 2.05 $0.05 $0. In most businesses. Many cellular telephone bills do not list the calls made. It is possible that the managers under. 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.00 $20. In this case the learning rate would be wrong and so the time would also be wrong.00 Average Cost $0. telephone costs are viewed as an indirect cost.00 $20.10 = $40.or overestimated the amount of hand work performed. In . Minutes 300 400 500 600 700 Total Cost $20. If her calls are over 400 minutes or under 600 minutes.Chapter 2: The Cost Function 2-23 consulting jobs. so Susan may need to maintain her own records if she wishes to trace telephone usage. Hours per batch would be determined as follows.1 hours (average time for the first four batches) B.04 $0.90/ln2) = −0.00 $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. Here are some of the reasons.00 $20. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month. her phone bill will be less than it would be at a rate 5 cents per minute.067 $0.27 Fancy Furniture A. Cons • If Susan has a number of projects in her local area or will be traveling a lot.00 + (700-500)*$0.

40.000 1.000 Variable $21.500 $47. then the cost would be overestimated.000 = $1. then the chart suggests that the learning rate estimate is reasonable. it is possible that different types of wood affect the rate at which chairs can be produced. If these values are used in a regression to estimate a cost function. they would be higher than the labor costs in later periods.$79.000 _______ $28. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. and the University surcharge is specifically based on sales. 2. and B. then this chart suggests that the learning curve will be slower than the 90% estimate. C. if managers believe that 25% of the work is done by hand.000 using the cost function is: TC = $47. C. D. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000/$70. or 40% or revenue Combining fixed and variable costs.000 + 40%*80. Thus. However.2-24 Cost Management addition. The estimate of total costs given revenues of $80. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. or has a great deal of experience on the 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.000 7.000 .000 5.000 Total revenue is the most likely cost driver for both variable costs. the cost function is: TC = $47.000 = 0. the rate will change if the replacement employee has never worked on this machine.000 + 40%*Total revenue D.000 Profit = Revenues – Total costs = $80.28 Wildcat Lair A.500 10. if managers believe that more than 25% of the work is done by hand. If a worker is absent one day. Food costs are likely to vary proportionately with sales. Because revenue is the cost driver for both variable costs.000 = $79.000 .

000 ($10. 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). costs would be higher when there were fewer sales.000) (24. Because the university surcharge is an allocation within the university. F.000) of revenues. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. To estimate the opportunity cost for August.000 increase in revenues is expected to be $6.000 . and the increase is estimated to be 40% of the increase in revenues. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.000/$70. generating most its sales around the ski season (fall and winter). Lair’s fixed costs are assumed to be unchanged with the $10. it might even close when the ski area shuts down.000.000)+the university surcharge of $7. Item D will be VERY difficult for most students.000) Net 2. total variable costs are expected to increase by $4.000— the operating loss of $(5. Variable food costs are estimated to be 30% ($21. the shop might experience very little business activity.000 (47. So. So. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).000). In July there was a 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. A shop located near a ski area is likely to incur high heating costs during the winter.Chapter 2: The Cost Function 2-25 E.000+$6.) The adjusted cost function is: TC = $47. Electricity costs also vary with changes in electricity rates. the variable cost part of the cost function can be adjusted. less the fixed costs and the variable food costs. it would lose the revenues.000) $ 9.000).000*40%).000 ($10. During the spring and summer months. Thus. If the university were to close the Lair. so the trend would be the opposite of this plot.000 increase in revenues. B.000 . In a retail business.000.000 (-$5.$4. However. C. so the estimated profit in August is $1. The shop is most likely a seasonal business. but this is not considered a cost driver (a business activity that causes variations in total variable cost). if the bathing suit shop is located in a geographic region $80. Only total variable costs are expected to increase. for July the opportunity cost would have been $2. the additional profit from a $10.000 + 30%*Total revenue During August.] A.

67 1. Higher profits. given a 100 unit production level: Y = α Xr Y = $300*100-0.85/ln2) = 0. a 50% markup on total cost will cause sales to be: $1.22 Firm B set its selling price based on the average cost. A correlation may appear in a scatter plot or regression analysis.542.2345 Y = $205.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.028. firm B's selling price is: $101. higher profits generally occur during periods when activity is high.45 x 1.69 (average cost for each of the 5 units) Total cost = $205.89 (average cost for each of the 100 units produced) Given a 50% markup on cost. employee training.5 = $152. Although these expenditures are made because more money is available. in turn. For example. they are discretionary expenditures and not caused by the level of activity.84 . and new office furniture or equipment.50 = $1.2345 Y = $101. However.45 Although each customer paid a different price. D.89 x 1. generally mean there is more money available to spend on administrative travel.028.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. special promotions.69 x 5 = $1. then the highest sales might coincide with the highest electricity costs.028.542.2345 Y = $300*5-0. 2. Many costs can be related to volume of activity.45 $ 514.67 Firm A's income for last year was: Sales Costs Income $1. correlation does not necessarily mean causation.

028.84) = $1.2345 Y= $78.85 Thus Firm B's selling price this year was $64.50 $ 9.00 13.50/150 units = $64.84) Costs (150 x $ 92.40 Firm A's costs may be computed as follows: Y = $300*15-0.10 $ 172.55 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 $1.528.2345 (notice that the cumulative units produced is 15) Y = $158. Total cumulative production cost (300 x $78.10 $22.356.45 $1.30 $2.50 .384.00 13.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.Chapter 2: The Cost Function 2-27 Firm B's costs.625.028.40 1.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.2345 Y = $92.727.75) 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*150-0.28 $23.85 x 1.897.926.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.897.356.727.50 = $97.528.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.50 $ 9.65) Income Firm A's revenues for this year are: (10 x $152.

2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.000 $145.500.wiley.000 Sales B. Costs $165.10/10 = $135.500.592.wiley.31 Belford’s The data for this problem can be found on the datasets file for chapter 2. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.000 Marketing Dept.000 $135.500.500. . 2.000 $155.000 $6. A.61.50 $ 4. available on both the Instructor and Student web sites for the textbook (available at www.com/college/eldenburg). such extreme differences in cost can occur.com/college/eldenburg).00 9.50 Note that Firm B's selling price for this year of $97. and most of the observations appear to have a fairly linear trend.356.000 $8.727.28 is lower than Firm A's average cost per unit: $1. There is a positive slope.864. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $7.000 $5.28) Costs (150 x $64.85) Income $14. Scatter Plot of Marketing Costs Against Sales $175.

63816 0. F.4501E-10 5.00097028 t Stat 9. sales may go up.2608 0. Therefore. Here is the regression output.Chapter 2: The Cost Function 2-29 C.34%*Sales D. Assuming that profits are more likely to increase when sales increase. there would be a positive correlation between marketing department costs and sales.86656716 Standard Error 4015. the cost function is: TC = $65. usually annually.584 + 1.93336396 R Square 0.08144 Observations 30 Coefficients 65584.5289E-14 Intercept X Variable 1 Based on the regression results.87116829 Adjusted R Square 0. Instead. Regression Statistics Multiple R 0.7600071 P-value 2. If the variable portion of the marketing cost is sales commissions. they may be positively correlated with sales. it is economically plausible for sales to be a cost driver.01335108 Standard Error 6844. In addition. using regression or any other technique. . Even if marketing department costs are discretionary. the cost estimate should not be based on past costs.58184484 13. E. Discretionary costs are set by decision. the decision maker(s) should be asked what next year’s cost will be. When more money is spent on marketing. discretionary costs such as marketing are often increased when profits increase.

000 $120.wiley.000 $120.com/college/eldenburg).000 $80.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $160. available on both the Instructor and Student web sites for the textbook (available at www. A.wiley.000 $40. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $80.000 $40. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $160.2-30 Cost Management 2.com/college/eldenburg).32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.

000 $80. None of the plots show a definite trend. Sometimes a cost that is mostly variable. Labor Hours Regression: Regression Statistics Multiple R 0.56597156 30 Standard Error 14812. If the observations are widely scattered.01272369 Adjusted R Square -0. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. Based only on the cost plots.50852 7.11279932 R Square 0.600712 P-value 6.000 $120. but the plot for labor hours appears to have the least trend. labor hours could be deleted as a potential cost driver. D.600936029 Intercept Labor Hours t Stat 10. the cost driver does not explain the variation in cost.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200. C.86E-11 0.000 $0 0 100 200 300 400 500 600 700 Raw Materials B. either the driver is wrong or the cost is mostly fixed.02253618 Standard Error 11114.1543 0.682 4. The plots help determine whether regression analysis should be performed using any of the potential drivers. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.000 $160.552864 .8173 Observations Coefficient s 150410.000 $40.

2-32 Cost Management Only the intercept term is significantly different from zero.217192 Standard Error 10291.082222 P-value 3.3746211 Adjusted R Square 0.5033241 R Square 0.53627459 Intercept Raw Materials t Stat 11.62907 3.411 Machine Hours Regression: Regression Statistics Multiple R 0.1555 Observations 30 Coefficient s 117598.68E-12 0.11E-12 0.67 38. so the cost function is estimated as: TC = $117.004579 Both the intercept and slope coefficients are significant.56778 19.331580777 Intercept Machine Hours t Stat 11.095468 P-value 4. so the cost function is estimated as: TC = $126.2266685 Standard Error 9665.599 + $38. so the cost function is estimated as: TC = $150.217 + $60.000325 Both the intercept and slope coefficients are significant.4268 4.3522862 Standard Error 8846.22* Raw materials .47803 9.612063 R Square 0.215128 Standard Error 10853.2533351 Adjusted R Square 0.9786 Observations 30 Coefficient s 126216.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.91 60.

machine hours appears to do the best job of explaining manufacturing overhead costs.2349 3. Yes.08E-08 .5558 Observations 30 Coefficient s 60988.com/college/eldenburg).9092294 R Square 0.210187 P-value 3. available on both the Instructor and Student web sites for the textbook (available at www.wiley.com/college/eldenburg).886218 -0.226 Based on the simple regression results. A.8266982 Adjusted R Square 0. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.778501 82.Chapter 2: The Cost Function 2-33 E.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5. this driver explains only 35% of the variation in cost. The coefficients for each of the other potential cost drivers are significantly different from zero. however.wiley.352 0.291558412 10.12E-09 1.218173 8.05878 9. 2. F.3E-06 0.953575 1.976635 Standard Error 10361.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.8067018 Standard Error 4832.489 -0.333162437 5. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.1959303 48.

450561 8.217 (<0.001) $4.001) $117.678 + $48. Manufacturing can be a complex activity requiring a number of different tasks.22 (<0.157604083 9.22 (0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.226) for these two cost drivers.391636 P-value 1.98 (<0.29E-09 The cost function is: TC = $60.90921678 R Square 0.939606 9.93*Raw materials D.599 (<0.74*Machine hours + $82.022 0.001) $60.925842 30 Standard Error 8743.55) $38.001) $126. its coefficient is negative rather than positive in the multiple regression.57 (0. Costs for these activities are likely related to specific cost drivers.806 $150.2-34 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. Also.005) $82.81383627 Standard Error 4742.5348 Observations Coefficient s 60677.82667515 Adjusted R Square 0. labor hours can be eliminated as a potential cost driver.001) $60. In this example. Each task includes different activities.86E-07 4.7422519 82.352 and 0. C.806) than in either of the simple regressions (0.664851 5.881964042 Intercept Machine Hours Raw Materials t Stat 6. machine hours and raw materials explain different activity .5902 48.001) B.001) $-0. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.954) $48. The adjusted RSquare is far higher in the multiple regression (0.20 (0. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.71E-10 5. its coefficient is not significantly different from zero in either regression.411 (<0. Thus. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.988 (<0. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.226 0.352 0.78 (<0.

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

000 $15. number of hours the building is open.000 $15. . Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint. Dept. Dept.000 $20. B. Other cost drivers for total maintenance cost could be number of rooms cleaned. or number of classes and activities per period.000 $5.wiley.2-36 Cost Management 2. 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. Costs $25.com/college/eldenburg). number of hours students attend school.000 $0 528 530 532 534 536 538 540 542 Number of Students C. A.com/college/eldenburg).wiley. Costs $25.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2.000 $10.000 $5.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. 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. square feet cleaned.000 $10.000 $20.

The most current value is used to .173 Observations 12 Coefficient s -89867 197. An unidentified cost driver could have a higher R-Square.453062 P-value 2. The total cost function is: TC = $9.847440356 Adjusted R Square 0. providing high confidence that both the intercept and slope are different from zero.247329 R Square 0.36 The Elder Clinic A and B Salaries are always fixed.807201 P-value 0.875134 35. From the analyses performed.03271 Standard Error 3019.796328319 Intercept X Variable 1 Coefficients 9134. 2. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.74*maintenance hours worked.5045837 4.461245 7.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.438328 According to the R Square statistics. The p-values on the Tstatistics are very small. Therefore. However.0261 Standard Error 130954. and rent for this type of facility is usually fixed.0857 Intercept X Variable 1 t Stat -0.9 244. maintenance hours is a reasonable cost driver.63E-06 2. it is considered fixed.920565237 R Square 0.74733262 t Stat 9.832184392 Standard Error 1217. it is logical to expect a strong relation between hours worked and cost.061172 Adjusted R Square -0.68624 0.06772 Observations 12 Standard Error 965. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.508157 0. 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.Chapter 2: The Cost Function 2-37 D.135 + $35. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none. Utilities cost varies with season not visits.

current illnesses that are circulating in the area. Medical supplies vary with number of patient-visits. and costs go up as patient-visits increase.934)/(849 – 778).wiley. This analysis suggests that there are some of the other expenses are variable costs and some fixed. such as snake anti-venom. E. At 940 patient-visits. variable cost is $3. 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.49*849. each patient requires a certain number of supplies. and so on.49 Cost Driver Patient-visits Mixed X 2. gloves. such as tongue depressors. • Prices of all inputs could change (usually increase). high point of medical supplies cost and patient data. There is no one answer to this part.736 + $6. 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.736 + $6.115 219 3.412 1. weather. the cost function is: TC = $19.2-38 Cost Management predict next period’s utilities. . There are many possible reasons that could be listed. **Using high-low. or there are changes in treatment procedures for certain illnesses. to find fixed: $3. and so on.80 D.441. Also.49 ($3. but not proportionately.182 = F + $3.736 Variable $3. These would be variable. Use the same method for other expenses. affecting the number of visits at this clinic.07*patient-visits C. Some supplies.182 .58 $6. Visits are affected by season.$2.07*940 = $25.com/college/eldenburg). These would be fixed. • Treatments and related costs may change as new drugs are available.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. Therefore. July expenses are estimated to be: TC = $19. Given the preceding computations and cost summary. so this cost is classified as a mixed cost. new equipment is acquired. must be kept on hand whether or not they are used. Other expenses appear to increase and decrease with number of patientvisits. Use March. other facilities may open or close.100 226 664 $19. medical supplies is a mixed cost.

Number of calls might have to be tracked by employees or by the telephone system. If the service is housed in a common building.Chapter 2: The Cost Function 2-39 2. or it might need to be estimated if it has not been tracked in the past. and D. could be used to identify costs for building and occupancy costs. department heads. If enough data points are available. If the help line is housed in its own building. C. The choice of information sources depends on how the past cost information is to be used. and others could be interviewed to identify any potential cost increases or other expected changes in cost behavior from prior periods. D. regression analysis would probably be the best choice. analysis at the account level could be used to develop a cost function using information from the general ledger. C. Possible cost drivers include number of calls handled. If not. supplies. This data could be found in the accounting system. Regression analysis makes use of all data points and is more accurate than twopoint methods. E. B.g. The answers to these questions depend on the individual student’s data and cost behavior. with representative points selected from a scatter plot. The cost object is the help line. Number of customers is part of the revenue accounting records.. cost allocation records could be used to identify past costs. a two point method might be best. assuming a linear cost function. Number of work stations might come from the department head. rent). prepaid insurance schedules. Some costs are discretionary. or total number of Internet customers. etc. Information about number of employees and hours worked is found in the payroll accounting system. Other costs are highly uncertain and subject to external factors that cannot be controlled. and other miscellaneous costs. Accounting records could be accessed to determine the wage rates and time worked for help support staff and supervisors. Vendors. Analysis of general ledger entries could be used to determine past costs for phone service. 2.37 Cost function Judgment and Method A. It would be useful to obtain several years of monthly data from which to prepare scatter plots and run regression analysis. Some future costs can be estimated with high accuracy based on prior commitments (e. In some ways. number of hours worked.38 Personal Cost Function A. number of work stations. depreciation schedules. a personal budget estimation problem is similar to the cost estimation problem for a business. number of employees. Alternatively. B. .

the trend line is likely to distort costs.83/mo.750 + 4. these are correctly handled.500 x 1/2 = 2.750 .800 .800 41.686 71.790 80.200 +$2.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68. 1/2 of August 5 payroll goes to July: 5.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. . (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.310 70. as shown in the scatter plot below.800.376 65.4.com/college/eldenburg).736 To predict future overhead. A. but there is insufficient information to make an adjustment. The miscellaneous supplies account also looks suspicious.350 68. If these observations are included in the regression analysis. IP-14 3 Payroll paid every two weeks. Similarly.wiley. No adjustments are needed for items (c) and (d).500 38. Because of the large difference between these values and the values in other months.850 2 .036 68.10.150 73.596 73.8 x 6.736 67. 80% of September 2 payroll to August: . the first month is adjusted even though it is not an actual cost: 4. available on both the Instructor and Student web sites for the textbook (available at www. July’s result is an outlier and should be removed from the data. B.486 68.236 69.000 = 4.286 68.750.2.2-40 Cost Management 2.com/college/eldenburg).wiley.750 68.300/10 x 12 = 35. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.200 Apr 71.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.

considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. Monthly overhead costs for supplies may be significantly overstated or understated . they are most likely recorded at the time of purchase rather than at the time of use.314163 1980.000 Overhead Costs $70. According to the details provided for August and September.818 6.47 8 Standard Error 29406. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.789722 t Stat 0. Based on the variation in dates at which supplies are recorded.775388 0. the cost function is estimated as: Overhead cost = $6.310484 Intercept X Variable 1 Coefficient s 8777.500 Outlier Direct Labor Hours C.641981 0.412139 0.086126 Based on the t-statistic and p-value for the intercept.000 2. Thus.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 $50.26 3. supplies were a large proportion of overhead cost. Therefore.000 $40.000 6.000 $45.298502 2.000 3. D.500 8.000 9.500 5.050976 P-value 0.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.000 $65. the fixed cost does not appear to be different from zero.000 $55.000 $60.

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

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

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

96 x number of chairs produced However. Considerable variation in labor costs is not explained by changes in the volume of production.3147402 P-value 3. However.957296 Standard Error 6710.7995 Observations 48 Coefficient s 133194.678620854 Intercept X Variable 1 t Stat 19.com/college/eldenburg).7748991 R Square 0. B. the regression explains only about 59% of the variation in labor costs.437E-24 1.02E-10 Based on the regression results. A. Here are the simple regression results: Regression Statistics Multiple R 0. the degree of downward bias is higher for older data than for more recent data. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley. Because of the annual pay increases.04 13.com/college/eldenburg). The cost function is estimated as: Labor cost = $133.5917832 Standard Error 6216.wiley. . the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.609693 1. using monthly data for the prior 4 years. available on both the Instructor and Student web sites for the textbook (available at www. the cost function was estimated by regressing actual labor costs on number of chairs produced.] The data for this problem can be found on the datasets file for chapter 2.194 + $13.6004687 Adjusted R Square 0. students are likely to struggle interpreting and choosing a method (Parts E and F). the fixed cost and the variable cost per unit are each positive and statistically different from zero.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.Chapter 2: The Cost Function 2-45 2. In prior years. Also.848277 8.

57E-23 2.26499 6.02 Adjusted Labor Cost $220.347 x 1. this cost function would result in a higher estimate for future costs.23 per chair.863839 Standard Error 3742.74). The fixed cost is nearly the same.869633 Adjusted R Square 0. Here are the multiple regression results: Regression Statistics Multiple R 0. approximately 26% of the variation in labor costs is still unexplained. The cost function is estimated as: Labor cost = $133.864722 R Square 0.93821 16.91E-08 .2-46 Cost Management C.00872 Intercept X Variable 1 X Variable 2 t Stat 18.23439 Standard Error 5557. D.742261 Standard Error 5148. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.390275 Intercept X Variable 1 t Stat 24.533 Dec 20X4 196.06236 11.905 Observations 48 Coefficient s 133736 16.67711 P-value 1. the fixed cost and the variable cost per unit are each positive and statistically different from zero.891 1.23 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 0.492 1.35E-15 Based on the regression results.486389 P-value 4.747745 Adjusted R Square 0.8 16. Nevertheless. which is reasonable given the increase in wage rates over time. here are the regression results: Regression Statistics Multiple R 0.274 Using the adjusted labor cost data.736 + $16.932541 R Square 0.010513 1. Also.73E-20 5. but the variable cost increased from $13.02)4 $196.09577 6.311 200.96 to $16.533 x (1.54295 Standard Error 5689.411 Observations 48 Coefficient s 107748.347 Calculation $203.05E-27 2.

On one hand. Thus. The second slope coefficient requires more thought. E. If the prior month’s production was higher than this month’s production. According to the multiple regression results. the two cost drivers together explain a very high proportion (86%) of the variation in past labor costs. there may be some lag between the time that production volumes change and labor costs change. F. the company’s policy is to increase the number of workers when production volumes increase. The cost function is estimated as: Labor cost = $107. and this regression explains more of the variation in labor costs (86%).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.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. then this month’s labor costs will reflect the higher level of labor cost. As explained in the problem.26 x current month number of chairs produced + $6. and the managers often delay laying off employees when volumes decline. it often takes time for the company to hire qualified new workers. if the prior month’s production was lower than this month’s production. and they both have positive and statistically significant coefficients. The first slope coefficient ($16. . There is no one single answer to this question. Conversely.l6 for each chair produced during the month. it could be argued that some other cost driver might do a better job of predicting future labor costs. then this month’s labor costs will reflect a lower level of labor cost. However. and to decrease the number of workers when production volumes decrease. In addition. On the other hand. 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. each month’s labor costs are expected to increase by $6. each month’s labor costs are expected to increase by $16.54 for each chair produced during the prior month.749 + $16.26) is interpreted in a straight-forward way.

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