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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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.

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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

the CPA's time is the product being sold.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 .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.13 Linear.000 Total Cost $12. 2.000 $10. and Piecewise Linear Cost Functions A. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. CPAs do keep detailed time records.000 $13. The time records that the tax partner maintains support this cost as a direct cost. TC = $10. In a service business such as this.000 + $8.000 $9.000 $8. For the firm to make this cost direct for the personal returns cost object. Of course. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. the tax partner probably spends some time in non-billable activities.00*Q Graph of Cost Function $14. Stepwise Linear.000 $11. 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.

000 + $8.000 3. for Q ≤ 2.000 Number of Units C.$450.000 . To estimate the costs at another production level.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 $40.000 Total cost at 12.000 = $60.000 $10.000 F = $450.000 units = 10.000 Graph of Cost Function $80.000 – 10.000 * $45 = $450.000 $30.000 2.000 units = 12.000 $20.$390.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 + $39*Q .000) = $78.000)/(12. for Q > 2.000 $60.000 + $8.000 * $44 = $528.00*Q. it is first necessary to estimate the cost function. Convert the average costs to total costs for each production level: Total cost at 10.00*Q.000 units: $450.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 $0 0 1.000 = F + $39*10.000 4.000 Total Cost $50. TC = $25.2-6 Cost Management B.000 .000/2.000 TC = $35.000 $70.

000 + $9.14 Piecewise Linear Cost Function A.000 Estimated cost per unit = $645.000 in revenues into the cost function.000 $60.500 2.00) + $9.00*Q .000 + (1.000 + 45%*$10.$9.000 = $645.000 0 500 1.000 $70. for Q < 1.000 $65.000 + $39*15.000 + $10.000 TC = $51.00*Q.000 units: TC = $60.000 + $10.000 = $60.000 For Q > 1.000) TC = $50.000 $50.000 = $43 D.000 1.000 + $9.500 2.000: TC = $50.00*Q 2-7 Graph of Cost Function $75.000 * $10.000 + $585.00*(Q-1.000 = $9.000 $45. TC = $50.000/15.Chapter 2: The Cost Function Estimated total cost at 15. Inserting $10.000 $55.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost . total cost is estimated as: TC = $5.

00*Q. then the cost function would appear to be: TC = $51. Hours for two returns would be determined as follows.80/ln2) = −0.000 units. This cost function would provide reasonable estimates for Q > 1. If all of the data estimation points occurred when Q was ≤ 1.000 units but would underestimate total cost for Q ≤ 1.000 + $10.3 and 2A. If all of the data estimation points occurred when Q was > 1.000 units. There are three general situations: 1. 2.4.3219 Y = 6 hours*2-0. This cost function would provide reasonable estimates for Q ≤ 1.000 units.000 units. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0.3219 Y = 4. 3.000 units but would overestimate total cost for Q > 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 .00*Q.8 hours (average time for each of the next two returns) B.15 Tax Plus A. If the accountant did not detect that there were two different relevant ranges. If the data estimation points occurred across the two relevant ranges.2-8 Cost Management B. 2. then the cost function would be some mixture of the functions for the two relevant ranges.000 + $9. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A. then the cost function would appear to be: TC = $50. the cost function mismeasurement depends on the values of Q.

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

D or I. if the cost is small it might be grouped with overhead costs (variable).500 . V or F Brushes for the glaze are most likely used for multiple bowls. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9.000 2. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. it is most likely traced to individual bowls. making it a fixed cost. G. Also. depending on what causes the cost to vary. if the cost is too small to justify tracing them). F The business license is not related to production. V If the glaze is expensive and therefore a relatively large cost. making it an indirect cost. F I. making it an indirect cost. making them a common cost for multiple units and an indirect cost. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. it is probably a mixed cost. I.500 ______ $4. E. If the cost of glaze is very small. making it an indirect cost. depending on whether they are “used up” after a certain quantity of production. This cost is also discretionary.000 in sales $1.300 Variable $4. It might be fixed or mixed.2-10 Cost Management D. D or I. part of the cost might vary proportionately with volume. J. F.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. I. They might be fixed or variable.] A. H. If the packing materials are not traced (for example.300 $3. so it is treated as fixed. I. it might not be traced to individual bowls. If it is an hourly charge. V Assuming that the cost of packing materials is traced to each bowl. Advertising is not directly related to production. Packing costs are most likely variable because they will increase as production increases. because the production area may need more cleaning as volumes increase. If the kiln is electric. this is a direct cost. 2. I. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume. I. then this cost could be indirect. making it a direct and variable cost.

50. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. Therefore. While hourly wages may be related to number of fish caught. B.500/$9.000 = 0.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. because of uncertainty in the success of each fishing expedition. C.Chapter 2: The Cost Function 2-11 B. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. as well as voluntary items such as health insurance and retirement benefits. Benefits might include mandated items such as social security. FB. F or M Employee benefits occur in any business in which employees are hired. In this type of situation.300 + 50%*Total revenue C. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. D. F. or 50% of revenue Combining fixed and variable costs. E. workers’ compensation. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. V. PS. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). costs vary with dollars of revenue. There most likely would not be any ingredients in a fishing boat business. F.] A. In many organizations. B. The cost of rent is irrelevant because it will not change with either alternative. B. the cost function is: TC = $3. Some may be sent home if business is very slow. and unemployment insurance. In the pizza shop. V Ingredients are used in making pizzas. Benefit costs often vary with level of wages or salaries. F There would be no reason to incur fishing equipment costs in a pizza business. these costs would be mixed with a large proportion of the cost fixed. so they would tend to be fixed or mixed (see Item A above). employees are likely scheduled in advance on a fixed schedule. D. and the cost would vary with number of pizzas produced. 2. . In the fishing boat business. they are more likely related to time on the boat than pounds of fish. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing.

Hamburger bun ($1.0053 8. Onions ($.0053 0. If the fishing boat is for tourists. Mustard ($. Cheese ($2.5195 = $1.6815 A. It will be a fixed cost if it is a flat amount. Hamburger patty ($1.0033 $0. B. Because advertising costs tend to be discretionary. newspaper advertisements.3489 $0.2414 2.0863 5.0148 0.0179 4. G.1075 3.29/12) 0. Dill pickles [($8. the utility costs for these two businesses would tend to be fixed (would not vary with production). however it would be unusual for a commercial fishing boat business to incur advertising costs because the customers are most likely canneries and distributors with whom the fishermen have an ongoing relationship.59/40) 0. and yellow pages advertisements.15/45) 0. B. Tomato ($. The cost might be fixed or mixed.59/16) 0.0233 0.1075 0. there might be some utility costs for the fishing operation and for a business office.56 .0198 0. PS.$0.69/8) 0.69/7) $0.3489 (calculated above) B. F or M Any type of business will have insurance costs.99/50) 0. F. F Most pizza shops incur advertising costs such as flyers. 2.000) * 4] 0.6815 . Cost of burger with everything except cheese = ($0.1619) = $0.0033 0.2414 $0.1619 0. Lettuce ($.95/2.2-12 Cost Management E.0148 6. advertising costs would be incurred. In general. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.20 Hamburger Haven Following are calculations for the cost per unit of each ingredient and the cost of plan and cheeseburgers: Cheeseburger Cost per Unit Plain With Everything 1. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.1075 0. Mayonnaise [$1. Cost of plain burger = $0.0863 0.79/150) 0.1619 10. they are treated as fixed costs.5196 Suggested selling price: 300% * $0. but it might be mixed if a portion of the cost relates to levels of business activity.49/(16 x 4)] 0.0179 0. depending on how the insurance cost is calculated.0198 9. Catsup ($.0233 7. For the fishing boat business.2414 $0.

Long is able to differentiate her hamburgers from others in the market.Fixed D. Market forces will dictate achievable prices. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. Licenses. Long’s prices are too high.Fixed and discretionary I.04 .04 Therefore." However. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. Property taxes. However staff are often salaried.Mostly fixed and discretionary H. It is just a general guideline. If there is part time help. Professional dues. If Ms.25 = $1. mostly variable G.Fixed E. in which case the total cost would be primarily fixed. B. In the current business environment. D. The Step 2 questions (A. Therefore. and F) are the ones requiring significant assumptions to generate an answer. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. 2. Insurance. most organizations are price takers. if Ms.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.Mixed. she needs to know what competitors charge for a similar quality sandwich and price hers competitively. that is. Professional subscriptions.6815 = $2. they set prices considering their competitors’ prices. This means that her costs need to be below the competitive price. if her prices are too low.Fixed F.$0. she foregoes profits and people may believe there could be quality problems with her food.Fixed . Office supplies . the price of the plain hamburger should be: $2. that cost would be variable. B.] A. 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. Selling price of cheeseburger with everything: 300% * $0.79 Some students will view this higher price as "unfair. Alternatively. Rent .Chapter 2: The Cost Function 2-13 C. Clerical wages – Fixed unless overtime is regularly scheduled. Alternatively. there is no moral obligation to maintain a 300% markup on each item. and then mixed C.

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

58E-05 0.500 $1.500 Maintenance Costs $2.78591283 0.119724 15 Coefficient s 884.52099624 Standard Error 153.000514 . Potential Cost Driver: Output Maintenance Costs Against Output $2.4342166 0.026826 0.582691 P-value 6.58824812 182.113687834 Intercept Output t Stat 5.000 $1.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.Chapter 2: The Cost Function 2-15 A.761602 4.61765897 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 0.017601 .500 Maintenance Costs $2.457384 3.36224828 0.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.210849 15 Coefficient s 861.717372 P-value 0.02569657 Standard Error 261.291084 2.31319046 235.113464425 Intercept Direct Labor Hours t Stat 3.7549386 1.005847 0.500 $1.000 $1.60187065 0.

94495003 66. For example.5913391 15 Standard Error 93.94888217 0. If the observations are widely scattered.357393 15. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2. a good cost driver would present a linear or football-shaped positive slope or trend. This indicates that the cost could be totally variable.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 126.6778973 0. However. .197755 8. In Part A.96E-10 B. Sometimes a cost that is mostly variable can be identified from a scatter plot. In a scatter plot.5343 P-value 0.97410583 0.500 Maintenance Costs $2.42597461 1. or the cost is mostly fixed. the trend line for machine setups looks as if the intercept could be zero or very close to zero.910475729 Intercept Machine Setups t Stat 1. all three potential cost drivers appear to be positively related to maintenance costs.500 $1.000 $1.815737 29. the cost driver does not explain the variation in cost and either it is the wrong driver.

2-18 Cost Management C. Therefore. the cost is likely to be totally variable. 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.945. This provides confidence that the variable cost part of the cost function is not zero. E. 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. D. R-Square 0. Changes in many factors such as resource prices. . but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero.521*Output TC = $861 +$3. This means that variation in setups explains about 95% of the variation in cost.68* Machine Setups The machine setups intercept coefficient is not significant. the economic environment.025*Direct Labor Hours TC = $29. In the machine setups regression. and technology can cause future costs to be different than estimated.588 0.945 Cost Function TC = $884 + $0.313 0. so it is excluded from the cost function. The regression using machine setups has the highest adjusted R-Square of 0. business processes.

That means that the cost function might not represent the actual cost. that is. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. the total cost function is: TC = $11. The high low method uses the most extreme cost driver values. the variable cost is calculated: ($68. this cost function might provide poor estimates of future costs.132.000 = 0. First.333 – $43.728 Thus. the cost function is calculated using the highest and lowest values of the cost driver.000/$500. . on average.24 Big Jack Burgers A.333 = F + 5%*$1. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.100 F = $68.605 = $11.Chapter 2: The Cost Function 2-19 PROBLEMS 2.$56.333)/($1. Under the high-low method.100 – $632.728 + 5%*Sales B.333 . Therefore. which could be outliers.132. not represent the cost most of the time.05.100) = $25.

Then. analysis at the account level might indicate that there are few fixed costs. the cost function would be TC = $16.5% x sales. but the p-value is greater than 10% at 0.5% x sales . there is a 16% probability that the intercept (fixed cost) is not different from zero.200.000 Sales It appears that the cost is most likely mixed. In that case.000 $40. the regression intercept can be used as an estimate of the fixed costs. Alternatively. If this cost pool includes items such as salaries and other fixed costs (insurance.000 Administrative Costs $60. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. Then. D. the p-value result for the tstatistic is atypical.000 $0 $0 $300. The upward slope of the line indicates that there are variable costs.000 $900. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function.172. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. Notice that the t-statistic for the intercept coefficient is 2. Following is the regression output. Analysis at the account level can be used to increase the understanding of this cost.000 $1. Based on the p-value. Chart of data with trend line added by Excel. fixed costs are likely to be zero and would be excluded from the cost function.2-20 Cost Management C.000 $20.000 $600. etc). Because this regression has few observations.162. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.800 + 4. the cost function would be: TC = 4.

This means that variation in sales explains only about 18% of the variation in research and development cost.16197623 0. Sales does not appear to explain much of the variation in research and development costs. The plot shows costs that are widely scattered.9680477 0.17205158 5.0319523 Intercept X Variable 1 E. There might be a large discretionary component in administrative costs. the high-low method may be the best option available. However. there does appear to be a general upward trend. If these assumptions do not hold. . F. The cons of the high-low method as an estimation technique were discussed in Part B above. The past costs used for estimation might not be representative. causing fluctuations in cost that are unrelated to any cost driver. This method can be used in cases where there is not enough data to perform regression. Because of unforeseen changes in cost behavior. the results rely on more complete information and provide a better estimate.82%*Sales C.2444 7734. Cost Function Using Regression A. The adjusted R-Square statistic is very low at 0.186. B. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver.4038 4 Coefficients Standard Error 16800. especially because so few observations were used in the estimation. Sales might not be the activity that drives administrative 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. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.93711636 0. both of these methods assume that the data points are representative of future costs. on average. If there are only two or three data points. Unusual cost items are assumed to continue in the future.45937486 P-value 0.25 Scatter Plot.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. however. Both methods assume that the cost function is linear and that all data points come from a single relevant range.90567454 3293. the cost function is: TC = $50. Using the regression results. Therefore.04466925 0. regression analysis incorporates all of the observations into the analysis.365 + 0. If there are more data points. In addition. 2. a cost function may not provide a good estimate for the next month’s costs.00818212 t Stat 2. and possible changes in costs such as those described in Part E are ignored. then both methods may be unsuitable for estimating future costs.73545 0.

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

In this case the learning rate would be wrong and so the time would also be wrong. Cons • If Susan has a number of projects in her local area or will be traveling a lot.00 $20.1 hours (average time for the first four batches) B.00 + (700-500)*$0.05 $0.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. students may think of others. Here are some of the reasons.00 $20.04 $0. In . 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.or overestimated the amount of hand work performed.10 = $40.05 $0. Pros: • Susan might prefer the convenience of not switching telephone companies • If Susan is happy with her current quality of service she might prefer to stay with the same company and not investigate other companies’ plans • Susan may be able to predict her cost better.00 $20.00 $20. Minutes 300 400 500 600 700 Total Cost $20.00 Average Cost $0.152 Y = 8.27 Fancy Furniture A. I. In most businesses. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month.00 + (600-500)*$0.152 Y = 10 hours*4-0. If her calls are over 400 minutes or under 600 minutes. her phone bill will be less than it would be at a rate 5 cents per minute. Many cellular telephone bills do not list the calls made. telephone costs are viewed as an indirect cost.067 $0. It is possible that the managers under. she will pay a very high rate of 10 cents per minute 2.10 = $30. Hours per batch would be determined as follows.057 The average cost is lowest at exactly 500 minutes per month.90/ln2) = −0. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. 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.

it is possible that different types of wood affect the rate at which chairs can be produced.$79.000 5. then this chart suggests that the learning curve will be slower than the 90% estimate.000 _______ $28.28 Wildcat Lair A. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. 2.000 + 40%*Total revenue D.000/$70.500 $47.000 = $1.000 + 40%*80.000 .000 = 0. then the cost would be overestimated. the cost function is: TC = $47.000 7. C. they would be higher than the labor costs in later periods. The estimate of total costs given revenues of $80. Thus. and the University surcharge is specifically based on sales. 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. Food costs are likely to vary proportionately with sales.000 Profit = Revenues – Total costs = $80. D.000 using the cost function is: TC = $47. if managers believe that more than 25% of the work is done by hand.000 . if managers believe that 25% of the work is done by hand. or 40% or revenue Combining fixed and variable costs. However.40. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 Total revenue is the most likely cost driver for both variable costs.500 10.000 Variable $21. the rate will change if the replacement employee has never worked on this machine.000 = $79. then the chart suggests that the learning rate estimate is reasonable. Because revenue is the cost driver for both variable costs. and B. If a worker is absent one day. If these values are used in a regression to estimate a cost function. C.000 1.2-24 Cost Management addition. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30.

However. less the fixed costs and the variable food costs.000).000. In July there was a loss of $5. A shop located near a ski area is likely to incur high heating costs during the winter.000*40%).000 ($10.000 .] A. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80.000) Net 2.000)+the university surcharge of $7. Only total variable costs are expected to increase.$4.000— the operating loss of $(5. Item D will be VERY difficult for most students.000 + 30%*Total revenue During August. costs would be higher when there were fewer sales. so the trend would be the opposite of this plot. it might even close when the ski area shuts down. generating most its sales around the ski season (fall and winter).000) $ 9. C. 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).000 increase in revenues is expected to be $6. but this is not considered a cost driver (a business activity that causes variations in total variable cost). Electricity costs also vary with changes in electricity rates.000). The shop is most likely a seasonal business.000.29 Polar Bear Ski Wear [Notes about problem complexity: Item A is not coded as Step 2 because this is explicitly discussed in the chapter. B. the variable cost part of the cost function can be adjusted. it would lose the revenues. the shop might experience very little business activity. so the estimated profit in August is $1. for July the opportunity cost would have been $2. Lair’s fixed costs are assumed to be unchanged with the $10. In a retail business. So.000 (-$5. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues. If the university were to close the Lair.000/$70. and the increase is estimated to be 40% of the increase in revenues.000 (47.000 . To estimate the opportunity cost for August. So.Chapter 2: The Cost Function 2-25 E. Variable food costs are estimated to be 30% ($21. During the spring and summer months.000) of revenues. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning). F.) The adjusted cost function is: TC = $47. Thus. total variable costs are expected to increase by $4.000 increase in revenues.000+$6.000) (24.000 ($10. Because the university surcharge is an allocation within the university. 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.

2345 Y = $205.89 x 1.22 Firm B set its selling price based on the average cost.67 1.2345 Y = $101. higher profits generally occur during periods when activity is high.2345 Y = $300*5-0.028. a 50% markup on total cost will cause sales to be: $1. For example. then the highest sales might coincide with the highest electricity costs.84 . special promotions. A correlation may appear in a scatter plot or regression analysis. firm B's selling price is: $101.542. employee training. in turn.89 (average cost for each of the 100 units produced) Given a 50% markup on cost. and new office furniture or equipment.85/ln2) = 0.45 Although each customer paid a different price. generally mean there is more money available to spend on administrative travel. D. they are discretionary expenditures and not caused by the level of activity. Although these expenditures are made because more money is available.45 x 1.69 x 5 = $1.5 = $152. Many costs can be related to volume of activity. 2.67 Firm A's income for last year was: Sales Costs Income $1. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.542.45 $ 514.028. given a 100 unit production level: Y = α Xr Y = $300*100-0.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.50 = $1. Higher profits.69 (average cost for each of the 5 units) Total cost = $205.028.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. However. correlation does not necessarily mean causation.

10 $22.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158. assuming an 85% learning effect would be: Y = $300*150-0.2345 Y= $78.028.45 $1.2345 (notice that the cumulative units produced is 15) Y = $158.50/150 units = $64.30 $2.2345 Y = $92.897.10 $ 172.50 $ 9.528.75) 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 = $9.84) = $1.00 13.65) Income Firm A's revenues for this year are: (10 x $152.00 13.85 Thus Firm B's selling price this year was $64.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.528.028.727.Chapter 2: The Cost Function 2-27 Firm B's costs.356.926.40 Firm A's costs may be computed as follows: Y = $300*15-0.40 1.384.50 = $97.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.897.97) 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 $1.727.50 $ 9. Total cumulative production cost (300 x $78.356.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.28 $23.50 .625.55 1.85 x 1.84) Costs (150 x $ 92.

85) Income $14.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97. There is a positive slope.50 Note that Firm B's selling price for this year of $97.500. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.864.727.000 Sales B. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $5.10/10 = $135. Scatter Plot of Marketing Costs Against Sales $175. such extreme differences in cost can occur.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.00 9.28) Costs (150 x $64. A.000 Marketing Dept. Costs $165.000 $135.000 $155. .wiley.com/college/eldenburg). 2.500.000 $8.com/college/eldenburg).000 $145.000 $7.592.28 is lower than Firm A's average cost per unit: $1.50 $ 4. available on both the Instructor and Student web sites for the textbook (available at www.wiley.356.000 $6.61.500. and most of the observations appear to have a fairly linear trend.500.

4501E-10 5.7600071 P-value 2. If the variable portion of the marketing cost is sales commissions.58184484 13.08144 Observations 30 Coefficients 65584. Here is the regression output.63816 0. sales may go up. Regression Statistics Multiple R 0. the cost function is: TC = $65.00097028 t Stat 9. Assuming that profits are more likely to increase when sales increase. Therefore. it is economically plausible for sales to be a cost driver.93336396 R Square 0.86656716 Standard Error 4015.87116829 Adjusted R Square 0. the cost estimate should not be based on past costs. using regression or any other technique. When more money is spent on marketing.34%*Sales D. F. usually annually. the decision maker(s) should be asked what next year’s cost will be. they may be positively correlated with sales. Instead. E.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. In addition.584 + 1. Discretionary costs are set by decision.01335108 Standard Error 6844. there would be a positive correlation between marketing department costs and sales. discretionary costs such as marketing are often increased when profits increase.2608 0.

000 $40.000 $160. A.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.com/college/eldenburg).000 $120.com/college/eldenburg).2-30 Cost Management 2.000 $80.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $120. available on both the Instructor and Student web sites for the textbook (available at www. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200.000 $80.wiley.000 $0 0 300 600 900 1200 1500 Machine Hours .000 $160. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.000 $40.

000 $40.8173 Observations Coefficient s 150410. either the driver is wrong or the cost is mostly fixed. the cost driver does not explain the variation in cost.552864 . If the observations are widely scattered.01272369 Adjusted R Square -0.56597156 30 Standard Error 14812. The plots help determine whether regression analysis should be performed using any of the potential drivers.1543 0. Sometimes a cost that is mostly variable. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.600712 P-value 6.000 $80. D. Based only on the cost plots. C.000 $160.86E-11 0.02253618 Standard Error 11114. Labor Hours Regression: Regression Statistics Multiple R 0. Costs and potential cost driver data are plotted to determine whether further analysis is necessary.000 $120.11279932 R Square 0. but the plot for labor hours appears to have the least trend.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200. labor hours could be deleted as a potential cost driver. None of the plots show a definite trend.50852 7.000 $0 0 100 200 300 400 500 600 700 Raw Materials B.600936029 Intercept Labor Hours t Stat 10.682 4.

11E-12 0.331580777 Intercept Machine Hours t Stat 11.53627459 Intercept Raw Materials t Stat 11.2533351 Adjusted R Square 0.56778 19.4268 4.22* Raw materials . so the cost function is estimated as: TC = $126.2-32 Cost Management Only the intercept term is significantly different from zero.67 38.5033241 R Square 0.082222 P-value 3.47803 9.2266685 Standard Error 9665.3746211 Adjusted R Square 0.411 Machine Hours Regression: Regression Statistics Multiple R 0.215128 Standard Error 10853.217192 Standard Error 10291.217 + $60.3522862 Standard Error 8846. so the cost function is estimated as: TC = $150.68E-12 0.599 + $38.612063 R Square 0.095468 P-value 4.9786 Observations 30 Coefficient s 126216.91 60.1555 Observations 30 Coefficient s 117598.004579 Both the intercept and slope coefficients are significant.62907 3.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0. so the cost function is estimated as: TC = $117.000325 Both the intercept and slope coefficients are significant.

2349 3. A.1959303 48.218173 8.com/college/eldenburg). available on both the Instructor and Student web sites for the textbook (available at www. Yes.wiley. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.05878 9. however.976635 Standard Error 10361.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.226 Based on the simple regression results.wiley.953575 1. F. this driver explains only 35% of the variation in cost.08E-08 .3E-06 0.489 -0. 2. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).Chapter 2: The Cost Function 2-33 E.352 0.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2. machine hours appears to do the best job of explaining manufacturing overhead costs.778501 82.8067018 Standard Error 4832. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.com/college/eldenburg). The coefficients for each of the other potential cost drivers are significantly different from zero.886218 -0. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.9092294 R Square 0.333162437 5.210187 P-value 3.12E-09 1.8266982 Adjusted R Square 0. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.5558 Observations 30 Coefficient s 60988.291558412 10.

001) B.022 0.806 $150. its coefficient is not significantly different from zero in either regression.78 (<0.20 (0.954) $48. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone. Also.82667515 Adjusted R Square 0.988 (<0. Manufacturing can be a complex activity requiring a number of different tasks.7422519 82.71E-10 5. Each task includes different activities. C.55) $38. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.599 (<0.001) $60.352 0.925842 30 Standard Error 8743. In this example.157604083 9.001) $4. its coefficient is negative rather than positive in the multiple regression.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.806) than in either of the simple regressions (0.90921678 R Square 0.001) $-0. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0.5902 48.5348 Observations Coefficient s 60677.74*Machine hours + $82.29E-09 The cost function is: TC = $60.450561 8.81383627 Standard Error 4742.881964042 Intercept Machine Hours Raw Materials t Stat 6. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.664851 5.22 (<0. Thus. The adjusted RSquare is far higher in the multiple regression (0.391636 P-value 1.226 0.226) for these two cost drivers.001) $126.001) $60.93*Raw materials D.411 (<0.001) $117.005) $82.217 (<0.86E-07 4.678 + $48. machine hours and raw materials explain different activity .352 and 0.22 (0.939606 9. labor hours can be eliminated as a potential cost driver. Costs for these activities are likely related to specific cost drivers.98 (<0.57 (0. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.

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

Costs $25. Dept. available on both the Instructor and Student web sites for the textbook (available at www.000 $5. B. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.000 $0 528 530 532 534 536 538 540 542 Number of Students C.com/college/eldenburg). number of hours students attend school. A. square feet cleaned.000 $10. Other cost drivers for total maintenance cost could be number of rooms cleaned.000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint.wiley.000 $15.000 $10.000 $15. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint.wiley. Dept.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2.2-36 Cost Management 2.com/college/eldenburg). . Costs $25.000 $20. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. number of hours the building is open.000 $20. or number of classes and activities per period.000 $5.

453062 P-value 2. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.807201 P-value 0.875134 35. it is considered fixed.0857 Intercept X Variable 1 t Stat -0. Therefore.68624 0. The most current value is used to . However. The total cost function is: TC = $9. and rent for this type of facility is usually 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.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.173 Observations 12 Coefficient s -89867 197. it is logical to expect a strong relation between hours worked and cost.508157 0.061172 Adjusted R Square -0. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.74733262 t Stat 9.06772 Observations 12 Standard Error 965. maintenance hours is a reasonable cost driver.0261 Standard Error 130954.63E-06 2. From the analyses performed. providing high confidence that both the intercept and slope are different from zero.5045837 4. E. 2.796328319 Intercept X Variable 1 Coefficients 9134. An unidentified cost driver could have a higher R-Square.247329 R Square 0.461245 7.438328 According to the R Square statistics. Utilities cost varies with season not visits. The p-values on the Tstatistics are very small.847440356 Adjusted R Square 0.832184392 Standard Error 1217.Chapter 2: The Cost Function 2-37 D.920565237 R Square 0.9 244.36 The Elder Clinic A and B Salaries are always fixed.74*maintenance hours worked.03271 Standard Error 3019. it is rational to conclude that hours worked will provide a reasonable estimate of future costs.135 + $35.

These would be variable.49 Cost Driver Patient-visits Mixed X 2.182 = F + $3. must be kept on hand whether or not they are used. Here are some of the reasons: • The managers will not know how many visits they will receive. such as snake anti-venom.441. high point of medical supplies cost and patient data.58 $6.com/college/eldenburg).49*849.2-38 Cost Management predict next period’s utilities. Use the same method for other expenses. These would be fixed. Some supplies. to find fixed: $3. current illnesses that are circulating in the area.934)/(849 – 778). Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. and costs go up as patient-visits increase. There is no one answer to this part. Use March. and so on.07*patient-visits C. so this cost is classified as a mixed cost.412 1. affecting the number of visits at this clinic. new equipment is acquired. gloves.80 D.wiley. **Using high-low. or there are changes in treatment procedures for certain illnesses. Visits are affected by season. other facilities may open or close. Given the preceding computations and cost summary. This analysis suggests that there are some of the other expenses are variable costs and some fixed. 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. At 940 patient-visits.49 ($3. variable cost is $3. medical supplies is a mixed cost. each patient requires a certain number of supplies. July expenses are estimated to be: TC = $19. E.100 226 664 $19.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. but not proportionately.736 + $6. .07*940 = $25. • Treatments and related costs may change as new drugs are available. Also.115 219 3.182 .$2. Other expenses appear to increase and decrease with number of patientvisits. weather.736 Variable $3. Medical supplies vary with number of patient-visits. such as tongue depressors. and so on. Therefore.736 + $6. the cost function is: TC = $19. • Prices of all inputs could change (usually increase). There are many possible reasons that could be listed.

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

150 73.750 + 4.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4. available on both the Instructor and Student web sites for the textbook (available at www. 80% of September 2 payroll to August: .736 67. as shown in the scatter plot below.4. (rounded to $36) 2 Note IB-4's power added to Dept.2. the first month is adjusted even though it is not an actual cost: 4.486 68. No adjustments are needed for items (c) and (d). Because of the large difference between these values and the values in other months.300/10 x 12 = 35.wiley.2-40 Cost Management 2.wiley.83/mo.800 .750 68.com/college/eldenburg).376 65. If these observations are included in the regression analysis.750. A.036 68.750 .236 69.com/college/eldenburg). these are correctly handled. .500 38.790 80. Similarly.800 41.500 x 1/2 = 2.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. the trend line is likely to distort costs.350 68. The miscellaneous supplies account also looks suspicious.10.800.850 2 .250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3. July’s result is an outlier and should be removed from the data.000 = 4. IP-14 3 Payroll paid every two weeks. 1/2 of August 5 payroll goes to July: 5.8 x 6.286 68. B.596 73.200 Apr 71. but there is insufficient information to make an adjustment.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68.686 71. Operations in the month of July are not typical of the rest of the time period.200 +$2.310 70. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.736 To predict future overhead.

the cost function is estimated as: Overhead cost = $6. they are most likely recorded at the time of purchase rather than at the time of use.000 $65. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. D. the fixed cost does not appear to be different from zero.789722 t Stat 0. supplies were a large proportion of overhead cost.050976 P-value 0.310484 Intercept X Variable 1 Coefficient s 8777.000 2. Based on the variation in dates at which supplies are recorded.26 3.775388 0.412139 0.086126 Based on the t-statistic and p-value for the intercept. Monthly overhead costs for supplies may be significantly overstated or understated .000 6.500 5.000 $50.000 $60.500 8.000 $45.000 9.000 Overhead Costs $70.79 * 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).641981 0.818 6. Thus. According to the details provided for August and September.000 $55.000 3.47 8 Standard Error 29406.314163 1980.000 $40. Therefore.500 Outlier Direct Labor Hours C.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.298502 2.

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

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

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

The cost function is estimated as: Labor cost = $133. B.7748991 R Square 0.3147402 P-value 3.02E-10 Based on the regression results.wiley. However. .609693 1. Considerable variation in labor costs is not explained by changes in the volume of production.com/college/eldenburg).] The data for this problem can be found on the datasets file for chapter 2.Chapter 2: The Cost Function 2-45 2.678620854 Intercept X Variable 1 t Stat 19. the cost function was estimated by regressing actual labor costs on number of chairs produced.848277 8. In prior years.957296 Standard Error 6710.7995 Observations 48 Coefficient s 133194. Here are the simple regression results: Regression Statistics Multiple R 0.04 13. Because of the annual pay increases.wiley. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.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. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.437E-24 1. available on both the Instructor and Student web sites for the textbook (available at www. Also.com/college/eldenburg). using monthly data for the prior 4 years. A. the degree of downward bias is higher for older data than for more recent data.5917832 Standard Error 6216. the regression explains only about 59% of the variation in labor costs. students are likely to struggle interpreting and choosing a method (Parts E and F).194 + $13.96 x number of chairs produced However.6004687 Adjusted R Square 0. the fixed cost and the variable cost per unit are each positive and statistically different from zero.

347 Calculation $203. Nevertheless.74).00872 Intercept X Variable 1 X Variable 2 t Stat 18.06236 11.411 Observations 48 Coefficient s 107748.486389 P-value 4.891 1.23439 Standard Error 5557.869633 Adjusted R Square 0. D.533 x (1.02)4 $196. Here are the multiple regression results: Regression Statistics Multiple R 0.23 per chair.905 Observations 48 Coefficient s 133736 16.863839 Standard Error 3742.23 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 0.91E-08 .05E-27 2.742261 Standard Error 5148.67711 P-value 1.96 to $16.26499 6.736 + $16.73E-20 5.54295 Standard Error 5689.57E-23 2. The fixed cost is nearly the same.274 Using the adjusted labor cost data. Also.390275 Intercept X Variable 1 t Stat 24.02 Adjusted Labor Cost $220. this cost function would result in a higher estimate for future costs.747745 Adjusted R Square 0. the fixed cost and the variable cost per unit are each positive and statistically different from zero. approximately 26% of the variation in labor costs is still unexplained. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203.8 16.93821 16.35E-15 Based on the regression results.311 200. but the variable cost increased from $13.932541 R Square 0.492 1. here are the regression results: Regression Statistics Multiple R 0. which is reasonable given the increase in wage rates over time.864722 R Square 0.010513 1.2-46 Cost Management C.347 x 1.09577 6. The cost function is estimated as: Labor cost = $133.533 Dec 20X4 196.

The second slope coefficient requires more thought. the two cost drivers together explain a very high proportion (86%) of the variation in past labor costs. then this month’s labor costs will reflect a lower level of labor cost. As explained in the problem. F. it could be argued that some other cost driver might do a better job of predicting future labor costs. the fixed cost and the variable cost per unit for each cost driver are all positive and statistically different from zero. If the prior month’s production was higher than this month’s production.l6 for each chair produced during the month. each month’s labor costs are expected to increase by $16. There is no one single answer to this question. the company’s policy is to increase the number of workers when production volumes increase. then this month’s labor costs will reflect the higher level of labor cost. each month’s labor costs are expected to increase by $6. Thus. In addition. According to the multiple regression results. and this regression explains more of the variation in labor costs (86%).26 x current month number of chairs produced + $6. Conversely. and to decrease the number of workers when production volumes decrease. However. On one hand. .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.Chapter 2: The Cost Function 2-47 Based on the regression results. it appears that both independent variables should be included in the cost function because they both have a logical cause-and-effect relationship with labor costs. The cost function is estimated as: Labor cost = $107. and they both have positive and statistically significant coefficients.26) is interpreted in a straight-forward way. if the prior month’s production was lower than this month’s production. On the other hand.54 for each chair produced during the prior month. and the managers often delay laying off employees when volumes decline. E. it often takes time for the company to hire qualified new workers. there may be some lag between the time that production volumes change and labor costs change. The first slope coefficient ($16.749 + $16.