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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

TC = $10. Stepwise Linear. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. 2.000 $13.000 $11.000 $10. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. the tax partner probably spends some time in non-billable activities. The time records that the tax partner maintains support this cost as a direct cost. the CPA's time is the product being sold.00*Q Graph of Cost Function $14. Of course.000 $8.000 0 100 200 Number of Units 300 400 The cost function includes the following assumptions: • Operations are within a relevant range of activity • Within the relevant range of activity: o Fixed costs will remain fixed o Variable cost per unit will remain constant .000 + $8. In a service business such as this. For the firm to make this cost direct for the personal returns cost object. and Piecewise Linear Cost Functions A.Chapter 2: The Cost Function 2-5 Explanation for Parts D and E: Notice that the wages of the tax department administrative assistant are considered a direct cost when the cost object is the entire tax department but are considered indirect for the other two cost objects. Now notice that the tax partner's salary is considered a direct cost for all three cost objects.000 $9. CPAs do keep detailed time records.13 Linear.000 Total Cost $12. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns.

000 $70.000 Total Cost $50. To estimate the costs at another production level. for Q > 2.000 $10.000 Total cost at 12.000 = F + $39*10.000 Graph of Cost Function $80.000 . TC = $25.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 TC = $35.000 + $8.000 $60.000 + $39*Q .$450.000 $40.2-6 Cost Management B.000 units: $450.000 units = 10.00*Q.000 * $44 = $528.000)/(12.00*Q.000 units = 12.000 = $60.000/2.000 3. it is first necessary to estimate the cost function.000 $20.000 Calculate the variable cost per unit using the Two-Point method: Change in cost Change in volume = ($528.000 + $8.000 .000 F = $450.000 Number of Units C.000 – 10.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 $30. Convert the average costs to total costs for each production level: Total cost at 10.000) = $78.000 * $45 = $450.$390.000 2.000 4.000 $0 0 1. for Q ≤ 2.

00*(Q-1. TC = $50.000 TC = $51.000 = $60.000/15.000 + $9.00*Q .000 + $585.000 $55.500 2.000 + $10.000 + $9.000 + 45%*$10.000 $60.000 units: TC = $60.14 Piecewise Linear Cost Function A. Inserting $10.000 0 500 1.000 $45.000 * $10.000 + $10.000 $65.000: TC = $50.00) + $9.500 2.000 = $43 D.000 + $39*15.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .00*Q 2-7 Graph of Cost Function $75.000 $70.Chapter 2: The Cost Function Estimated total cost at 15.000 in revenues into the cost function.000) TC = $50.00*Q.000 For Q > 1. for Q < 1.000 = $645.$9.000 + (1. total cost is estimated as: TC = $5.000 Estimated cost per unit = $645.000 1.000 $50.000 = $9.

2. If all of the data estimation points occurred when Q was > 1.000 + $10. This cost function would provide reasonable estimates for Q > 1. using the learning curve equation Y = α Xr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. then the cost function would be some mixture of the functions for the two relevant ranges.8 hours (average time for each of the next two returns) B.000 + $9. There are three general situations: 1.15 Tax Plus A.000 units.000 units but would overestimate total cost for Q > 1.000 units. 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 = $50.4.80/ln2) = −0.3219 Y = 4.2-8 Cost Management B. the cost function mismeasurement depends on the values of Q. If the data estimation points occurred across the two relevant ranges. If all of the data estimation points occurred when Q was ≤ 1.3 and 2A. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared .000 units but would underestimate total cost for Q ≤ 1.3219 Y = 6 hours*2-0. Hours for two returns would be determined as follows.00*Q.000 units. If the accountant did not detect that there were two different relevant ranges. 2. This cost function would provide reasonable estimates for Q ≤ 1.000 units. then the cost function would appear to be: TC = $51.00*Q. 3.

but would still be considered fixed because it does not vary with production volume. if time is not traced to individual bowls (for example. Assumptions: Fixed costs remain fixed within the relevant range. However. it is a common cost of production for all of the bowls that are heat-treated in the kiln. then variable cost per dollar of revenue is calculated as follows: $8.16 Bison Sandwiches A. Assuming that the cost of clay can be traced to each bowl. it improves less quickly for the next return. F . In addition. wages are a direct cost.000 = 0.25. 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. Note: Depreciation using a method such as declining balance is not constant over time.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization. that is. and their productivity rate will remain stable. their productivity increases. the cost function is: TC = $20. B. 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. and variable costs remain constant within the relevant range. it is a direct cost.] A. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). then wages would be an indirect cost. 2. If total variable costs were $8. D. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. or 25% of sales Combining fixed and variable costs. D or I.000 on total sales of $32. as their performance improves. Total clay cost will vary with the number of bowls made. making it a fixed cost. this particular cost function assumes that variable costs are driven by sales. However. I. Wages are fixed because they remain constant (the employee always works 40 hours). Eventually their learning will plateau.000 + 25%*Total sales B.Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns. 2. V C. F Assuming that employee time can be traced to each bowl.000/$32.000.

Also.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. H.300 Variable $4. 2.500 ______ $4. making it an indirect cost. Packing costs are most likely variable because they will increase as production increases. I. V or F Brushes for the glaze are most likely used for multiple bowls. F I. Advertising is not directly related to production. They might be fixed or variable. If it is an hourly charge. making it an indirect cost. because the production area may need more cleaning as volumes increase. depending on what causes the cost to vary. if the cost is too small to justify tracing them).] A. J. D or I. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. F. 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. part of the cost might vary proportionately with volume. it is probably a mixed cost. If the packing materials are not traced (for example. it might not be traced to individual bowls. this is a direct cost.2-10 Cost Management D. F The business license is not related to production. depending on whether they are “used up” after a certain quantity of production. It might be fixed or mixed. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. I. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume.000 2. E. I. D or I. making it a fixed cost. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. if the cost is small it might be grouped with overhead costs (variable). G.300 $3. making it a direct and variable cost. it is most likely traced to individual bowls. This cost is also discretionary. I. If the kiln is electric.000 in sales $1. If the cost of glaze is very small. so it is treated as fixed. V If the glaze is expensive and therefore a relatively large cost. then this cost could be indirect. I. making it an indirect cost.500 .

they are more likely related to time on the boat than pounds of fish. In this type of situation. F.300 + 50%*Total revenue C. V Ingredients are used in making pizzas. 2. Benefits might include mandated items such as social security. The cost of rent is irrelevant because it will not change with either alternative. the cost function is: TC = $3. In many organizations. PS. In the fishing boat business. D. B. . because of uncertainty in the success of each fishing expedition. V. as well as voluntary items such as health insurance and retirement benefits. B. or 50% of revenue Combining fixed and variable costs. B. so they would tend to be fixed or mixed (see Item A above).000 = 0. E. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. There most likely would not be any ingredients in a fishing boat business. this cost would most likely be fixed because the cost would not vary within a relevant range of activity. In the pizza shop. F or M Employee benefits occur in any business in which employees are hired. and unemployment insurance. workers’ compensation. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired).] A.50.500/$9. C. employees are likely scheduled in advance on a fixed schedule. Some may be sent home if business is very slow. The opportunity cost is the contribution margin from the products sold with the flavor that has been replaced. F There would be no reason to incur fishing equipment costs in a pizza business. F.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. FB. While hourly wages may be related to number of fish caught. and the cost would vary with number of pizzas produced.Chapter 2: The Cost Function 2-11 B. costs vary with dollars of revenue. Benefit costs often vary with level of wages or salaries. these costs would be mixed with a large proportion of the cost fixed. D. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. Therefore.

Mustard ($.99/50) 0. For the fishing boat business.0053 8. 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. The cost might be fixed or mixed.5195 = $1.1619 0.2414 2. Catsup ($. Dill pickles [($8. PS.0198 0. It will be a fixed cost if it is a flat amount.2-12 Cost Management E. B.49/(16 x 4)] 0.3489 $0. F Some type of utility costs (such as water and electricity) would be incurred in both types of business. Because advertising costs tend to be discretionary. Cheese ($2. Lettuce ($.0148 6. advertising costs would be incurred.79/150) 0. G.56 .0198 9.69/8) 0.20 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. Mayonnaise [$1. F.1619 10. Onions ($.59/40) 0.2414 $0. F or M Any type of business will have insurance costs.2414 $0.0148 0.95/2.6815 A.0863 5. depending on how the insurance cost is calculated. In general. If the fishing boat is for tourists. Cost of burger with everything except cheese = ($0. Tomato ($. and yellow pages advertisements.3489 (calculated above) B.$0.0033 $0.6815 . Hamburger bun ($1. Cost of plain burger = $0.0179 4. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.0233 7. but it might be mixed if a portion of the cost relates to levels of business activity. they are treated as fixed costs. there might be some utility costs for the fishing operation and for a business office. the utility costs for these two businesses would tend to be fixed (would not vary with production). Hamburger patty ($1.1619) = $0.5196 Suggested selling price: 300% * $0.59/16) 0.1075 0. 2.0033 0.1075 0.29/12) 0.0863 0.15/45) 0.000) * 4] 0.0053 0.69/7) $0. B. F Most pizza shops incur advertising costs such as flyers.1075 3. newspaper advertisements.0179 0.0233 0.

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

In addition. Other possible cost drivers for marketing department costs could be revenue. In this problem.com/college/eldenburg). Therefore. number of advertisements placed.wiley. TC = $222. . the variation in units sold explains about 61% of the variation in marketing department cost. Other Potential Cost Drivers A.2-14 Cost Management K. or profits. The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. If this is the case. For example. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero. the cost is discretionary and will be set through the negotiating process.com/college/eldenburg).wiley.22 Cost Function Using Regression. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. available on both the Instructor and Student web sites for the textbook (available at www. 2. C. Advertising – Fixed and discretionary 2.23 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.35*units sold. it is possible that marketing costs are discretionary. the fixed cost is set at zero.] The data for this problem can be found on the datasets file for chapter 2. the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management.) B. The cost analyst needs to gather information about how marketing costs are set each year.

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 0.61765897 0.500 $1.Chapter 2: The Cost Function 2-15 A.4342166 0.58824812 182.119724 15 Coefficient s 884.026826 0.500 Maintenance Costs $2.582691 P-value 6.58E-05 0.52099624 Standard Error 153. Potential Cost Driver: Output Maintenance Costs Against Output $2.000514 .78591283 0.761602 4.

457384 3.7549386 1.000 $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 .02569657 Standard Error 261.31319046 235.005847 0.60187065 0.210849 15 Coefficient s 861.291084 2.717372 P-value 0.113464425 Intercept Direct Labor Hours t Stat 3.500 Maintenance Costs $2.000 $1.36224828 0.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.500 $1.

000 $1. For example. the trend line for machine setups looks as if the intercept could be zero or very close to zero. Sometimes a cost that is mostly variable can be identified from a scatter plot.357393 15. In Part A.197755 8.6778973 0.500 $1. .500 Maintenance Costs $2.97410583 0. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. a good cost driver would present a linear or football-shaped positive slope or trend.42597461 1. If the observations are widely scattered.910475729 Intercept Machine Setups t Stat 1. the cost driver does not explain the variation in cost and either it is the wrong driver.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 126.5343 P-value 0. However.815737 29.5913391 15 Standard Error 93. In a scatter plot.96E-10 B.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2. or the cost is mostly fixed.94888217 0.94495003 66. all three potential cost drivers appear to be positively related to maintenance costs. This indicates that the cost could be totally variable.

D. The regression using machine setups has the highest adjusted R-Square of 0. . R-Square 0. so it is excluded from the cost function. Changes in many factors such as resource prices. business processes. E. This provides confidence that the variable cost part of the cost function is not zero. but does not provide confidence that the intercept (fixed cost) part of the cost function is different from zero.945.2-18 Cost Management C. the economic environment. In the machine setups regression. This means that variation in setups explains about 95% of the variation in cost.025*Direct Labor Hours TC = $29. and technology can cause future costs to be different than estimated.521*Output TC = $861 +$3.945 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. the t-statistic is significant for the independent variable but not for the intercept.313 0.588 0. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj.68* Machine Setups The machine setups intercept coefficient is not significant. the cost is likely to be totally variable. Therefore.

Therefore. First.728 + 5%*Sales B.000 = 0.$56. That means that the cost function might not represent the actual cost. Under the high-low method.132.333 = F + 5%*$1. on average. the variable cost is calculated: ($68. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.728 Thus.333 .132. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68.100 F = $68. this cost function might provide poor estimates of future costs.100 – $632.333 – $43.100) = $25.Chapter 2: The Cost Function 2-19 PROBLEMS 2. .333)/($1. the cost function is calculated using the highest and lowest values of the cost driver. not represent the cost most of the time. that is.24 Big Jack Burgers A. the total cost function is: TC = $11.605 = $11.05. which could be outliers. The high low method uses the most extreme cost driver values.000/$500.

Chart of data with trend line added by Excel. Notice that the t-statistic for the intercept coefficient is 2. Then. Analysis at the account level can be used to increase the understanding of this cost.2-20 Cost Management C. the cost function would be: TC = 4.000 $20.5% x sales . Then. In that case. Based on the p-value.162.000 Administrative Costs $60.200. the p-value result for the tstatistic is atypical. Because this regression has few observations.5% x sales.000 $40. etc).000 $1.800 + 4. D. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80. the cost function would be TC = $16. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function. Alternatively. fixed costs are likely to be zero and would be excluded from the cost function.172.000 $600. the regression intercept can be used as an estimate of the fixed costs. but the p-value is greater than 10% at 0.000 Sales It appears that the cost is most likely mixed.000 $0 $0 $300. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost.000 $900. Following is the regression output. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. The upward slope of the line indicates that there are variable costs. there is a 16% probability that the intercept (fixed cost) is not different from zero. analysis at the account level might indicate that there are few fixed costs. If this cost pool includes items such as salaries and other fixed costs (insurance.

Because of unforeseen changes in cost behavior. the high-low method may be the best option available.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.17205158 5. 2. B. both of these methods assume that the data points are representative of future 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. In addition. causing fluctuations in cost that are unrelated to any cost driver. The cons of the high-low method as an estimation technique were discussed in Part B above. however.365 + 0. This means that variation in sales explains only about 18% of the variation in research and development cost. Both methods assume that the cost function is linear and that all data points come from a single relevant range. Cost Function Using Regression A. F. Unusual cost items are assumed to continue in the future.04466925 0.186. the results rely on more complete information and provide a better estimate.73545 0.90567454 3293.16197623 0. especially because so few observations were used in the estimation. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.82%*Sales C. The past costs used for estimation might not be representative. there does appear to be a general upward trend.0319523 Intercept X Variable 1 E. There might be a large discretionary component in administrative costs. and possible changes in costs such as those described in Part E are ignored. Therefore. a cost function may not provide a good estimate for the next month’s costs. the cost function is: TC = $50. regression analysis incorporates all of the observations into the analysis. If these assumptions do not hold. Sales might not be the activity that drives administrative costs.2444 7734. The adjusted R-Square statistic is very low at 0.93711636 0. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. However. .9680477 0. then both methods may be unsuitable for estimating future costs.4038 4 Coefficients Standard Error 16800.00818212 t Stat 2. This method can be used in cases where there is not enough data to perform regression.25 Scatter Plot. The plot shows costs that are widely scattered. If there are more data points. If there are only two or three data points. Using the regression results. on average. Sales does not appear to explain much of the variation in research and development costs.45937486 P-value 0.

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

10 = $30.057 The average cost is lowest at exactly 500 minutes per month.152 Y = 10 hours*4-0. In most businesses. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). her phone bill will be less than it would be at a rate 5 cents per minute. so Susan may need to maintain her own records if she wishes to trace telephone usage.Chapter 2: The Cost Function 2-23 consulting jobs. Many cellular telephone bills do not list the calls made.00 $20.152 Y = 8. 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 $20.or overestimated the amount of hand work performed. If her calls are over 400 minutes or under 600 minutes. In this case the learning rate would be wrong and so the time would also be wrong.067 $0. In .05 $0. students may think of others. Cons • If Susan has a number of projects in her local area or will be traveling a lot.00 Average Cost $0. 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. Here are some of the reasons.10 = $40.00 + (700-500)*$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. telephone costs are viewed as an indirect cost.27 Fancy Furniture A. It is possible that the managers under. Hours per batch would be determined as follows.90/ln2) = −0. Minutes 300 400 500 600 700 Total Cost $20. I.1 hours (average time for the first four batches) B.00 $20. There are many different reasons that the time could be different from the amount determined above.05 $0.00 $20. she will pay a very high rate of 10 cents per minute 2.00 + (600-500)*$0. using the learning curve equation Y = α Xr α = 10 hours X (units produced) = 4 Learning rate = (ln 0.04 $0.

500 $47.000 Total revenue is the most likely cost driver for both variable costs. and B.000/$70. C. 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 Variable $21.000 Profit = Revenues – Total costs = $80. If a worker is absent one day.000 _______ $28.28 Wildcat Lair A. Thus. then the cost would be overestimated.500 10.000 . If these values are used in a regression to estimate a cost function.$79. or has a great deal of experience on the machine. if managers believe that more than 25% of the work is done by hand. Because revenue is the cost driver for both variable costs. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28.2-24 Cost Management addition.000 = $1. and the University surcharge is specifically based on sales. if managers believe that 25% of the work is done by hand. However. 2.000 = $79. The estimate of total costs given revenues of $80. Food costs are likely to vary proportionately with sales.40.000 7. Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. they would be higher than the labor costs in later periods. it is possible that different types of wood affect the rate at which chairs can be produced. C.000 + 40%*Total revenue D.000 + 40%*80. the rate will change if the replacement employee has never worked on this machine.000 .000 using the cost function is: TC = $47. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized.000 5. D. the cost function is: TC = $47.000 1. then this chart suggests that the learning curve will be slower than the 90% estimate. or 40% or revenue Combining fixed and variable costs. then the chart suggests that the learning rate estimate is reasonable.000 = 0.

C. but this is not considered a cost driver (a business activity that causes variations in total variable cost). However. it might even close when the ski area shuts down. To estimate the opportunity cost for August. it would lose the revenues.000) of revenues. less the fixed costs and the variable food costs. Because the university surcharge is an allocation within the university.000 (47.000 increase in revenues.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. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).$4.000.000*40%).000+$6. So.) The adjusted cost function is: TC = $47. generating most its sales around the ski season (fall and winter). and the increase is estimated to be 40% of the increase in revenues. If the university were to close the Lair. the additional profit from a $10. Thus.] A.000/$70. the shop might experience very little business activity.000) (24.000) Net 2. Item D will be VERY difficult for most students.000 increase in revenues is expected to be $6. B.000) $ 9. 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). The shop is most likely a seasonal business. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. Electricity costs also vary with changes in electricity rates.000).000). F.000)+the university surcharge of $7.000 + 30%*Total revenue During August. costs would be higher when there were fewer sales. total variable costs are expected to increase by $4. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold.000 .000 ($10. for July the opportunity cost would have been $2.000 (-$5. In a retail business.000.000 . In July there was a loss of $5. the variable cost part of the cost function can be adjusted.000— the operating loss of $(5. Lair’s fixed costs are assumed to be unchanged with the $10. Variable food costs are estimated to be 30% ($21.Chapter 2: The Cost Function 2-25 E. A shop located near a ski area is likely to incur high heating costs during the winter.000 ($10. During the spring and summer months. so the estimated profit in August is $1. So. so the trend would be the opposite of this plot. if the bathing suit shop is located in a geographic region $80. Only total variable costs are expected to increase.

D. generally mean there is more money available to spend on administrative travel. Higher profits.2-26 Cost Management where the highest electricity costs occur during the summer because of air conditioning.84 .89 x 1.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. given a 100 unit production level: Y = α Xr Y = $300*100-0. a 50% markup on total cost will cause sales to be: $1. employee training.2345 Y = $101. A correlation may appear in a scatter plot or regression analysis.50 = $1.5 = $152. For example. and new office furniture or equipment. in turn.542. correlation does not necessarily mean causation.542.45 x 1.45 Although each customer paid a different price. then the highest sales might coincide with the highest electricity costs. firm B's selling price is: $101. 2. using the learning curve equation Y = α Xr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.67 Firm A's income for last year was: Sales Costs Income $1.2345 Y = $205. higher profits generally occur during periods when activity is high. Many costs can be related to volume of activity.028.45 $ 514.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.22 Firm B set its selling price based on the average cost.2345 Y = $300*5-0.67 1.69 (average cost for each of the 5 units) Total cost = $205. Although these expenditures are made because more money is available.69 x 5 = $1.028. However. they are discretionary expenditures and not caused by the level of activity.85/ln2) = 0.028. special promotions.

356.926.897.85 Thus Firm B's selling price this year was $64.Chapter 2: The Cost Function 2-27 Firm B's costs.84) = $1.384.50 $ 9.028.897.55 1.50 = $97.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.85 x 1.65) Income Firm A's revenues for this year are: (10 x $152.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.84) Costs (150 x $ 92.528.356.10 $22.28 $23.97) 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 $1.00 13.50 $ 9.2345 Y = $92.00 13.40 Firm A's costs may be computed as follows: Y = $300*15-0.625.40 1.10 $ 172.528.2345 (notice that the cumulative units produced is 15) Y = $158. Total cumulative production cost (300 x $78.30 $2.727.50 .45 $1.028.727. assuming an 85% learning effect would be: Y = $300*150-0.75) 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 = $9.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.50/150 units = $64.2345 Y= $78.

727.000 $5.356.2-28 Cost Management Firm B's income statement for this year is Sales (150 x $97.500.50 $ 4.50 Note that Firm B's selling price for this year of $97.500.com/college/eldenburg).wiley. Costs $165. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.000 $135.000 $7.592.61. available on both the Instructor and Student web sites for the textbook (available at www.000 $8. and most of the observations appear to have a fairly linear trend.00 9.000 $145. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales.com/college/eldenburg). Scatter Plot of Marketing Costs Against Sales $175.000 Marketing Dept. A.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.864. .000 $155.28) Costs (150 x $64.500.500. There is a positive slope.28 is lower than Firm A's average cost per unit: $1.10/10 = $135.wiley.85) Income $14.000 Sales B. 2.000 $6. such extreme differences in cost can occur.

4501E-10 5. sales may go up. the cost estimate should not be based on past costs. If the variable portion of the marketing cost is sales commissions. F. the decision maker(s) should be asked what next year’s cost will be. Assuming that profits are more likely to increase when sales increase.7600071 P-value 2.34%*Sales D. Here is the regression output. Therefore. Regression Statistics Multiple R 0.Chapter 2: The Cost Function 2-29 C.63816 0. .87116829 Adjusted R Square 0. Instead. it is economically plausible for sales to be a cost driver.5289E-14 Intercept X Variable 1 Based on the regression results.58184484 13. they may be positively correlated with sales.86656716 Standard Error 4015.00097028 t Stat 9. usually annually. there would be a positive correlation between marketing department costs and sales. In addition. Discretionary costs are set by decision.2608 0.08144 Observations 30 Coefficients 65584. the cost function is: TC = $65.01335108 Standard Error 6844. Even if marketing department costs are discretionary.584 + 1. discretionary costs such as marketing are often increased when profits increase. When more money is spent on marketing. using regression or any other technique.93336396 R Square 0. E.

wiley.000 $120.com/college/eldenburg).000 $80.000 $120.000 $40. A.000 $160.000 $80.000 $160. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200. available on both the Instructor and Student web sites for the textbook (available at www.2-30 Cost Management 2. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.000 $0 0 300 600 900 1200 1500 Machine Hours .wiley.com/college/eldenburg).000 $40.

600712 P-value 6.02253618 Standard Error 11114.000 $80. Based only on the cost plots.000 $0 0 100 200 300 400 500 600 700 Raw Materials B. None of the plots show a definite trend.000 $160.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200.01272369 Adjusted R Square -0.56597156 30 Standard Error 14812.552864 . If the observations are widely scattered. the cost driver does not explain the variation in cost. 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.86E-11 0. Sometimes a cost that is mostly variable. labor hours could be deleted as a potential cost driver.8173 Observations Coefficient s 150410. Labor Hours Regression: Regression Statistics Multiple R 0. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.11279932 R Square 0.1543 0. but the plot for labor hours appears to have the least trend.50852 7.600936029 Intercept Labor Hours t Stat 10. either the driver is wrong or the cost is mostly fixed. D.682 4. C.000 $120.000 $40.

2533351 Adjusted R Square 0. so the cost function is estimated as: TC = $150.91 60.68E-12 0.411 Machine Hours Regression: Regression Statistics Multiple R 0.1555 Observations 30 Coefficient s 117598.4268 4.082222 P-value 3.599 + $38.217192 Standard Error 10291.095468 P-value 4.612063 R Square 0.217 + $60.47803 9.9786 Observations 30 Coefficient s 126216.5033241 R Square 0.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R 0.2-32 Cost Management Only the intercept term is significantly different from zero.22* Raw materials .3522862 Standard Error 8846.53627459 Intercept Raw Materials t Stat 11. so the cost function is estimated as: TC = $126.000325 Both the intercept and slope coefficients are significant.004579 Both the intercept and slope coefficients are significant.331580777 Intercept Machine Hours t Stat 11. so the cost function is estimated as: TC = $117.56778 19.3746211 Adjusted R Square 0.11E-12 0.215128 Standard Error 10853.62907 3.67 38.2266685 Standard Error 9665.

2. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.886218 -0.wiley.3E-06 0.1959303 48.2349 3.8266982 Adjusted R Square 0.976635 Standard Error 10361. A. F.com/college/eldenburg). A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.9092294 R Square 0.08E-08 .352 0. available on both the Instructor and Student web sites for the textbook (available at www. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression.05878 9. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).com/college/eldenburg).489 -0. this driver explains only 35% of the variation in cost.5558 Observations 30 Coefficient s 60988.wiley. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R 0.12E-09 1.8067018 Standard Error 4832. machine hours appears to do the best job of explaining manufacturing overhead costs.333162437 5.226 Based on the simple regression results.778501 82.10654585 Intercept Labor Hours Machine Hours Raw Materials t Stat 5.210187 P-value 3.218173 8. Yes.291558412 10. The coefficients for each of the other potential cost drivers are significantly different from zero.Chapter 2: The Cost Function 2-33 E. however.953575 1.

352 0.001) $-0.82667515 Adjusted R Square 0.7422519 82.98 (<0.22 (<0.001) $4.5902 48. Also.57 (0.005) $82.664851 5. In this example. Each task includes different activities.20 (0.157604083 9.939606 9.925842 30 Standard Error 8743.001) $117.001) $126.806 $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.217 (<0.001) $60.71E-10 5. C. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.22 (0.29E-09 The cost function is: TC = $60.001) B. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.93*Raw materials D.001) $60.678 + $48.78 (<0.74*Machine hours + $82.226 0.954) $48.55) $38.881964042 Intercept Machine Hours Raw Materials t Stat 6.90921678 R Square 0.411 (<0.226) for these two cost drivers. machine hours and raw materials explain different activity .022 0.5348 Observations Coefficient s 60677.391636 P-value 1. Costs for these activities are likely related to specific cost drivers. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R 0. its coefficient is negative rather than positive in the multiple regression.599 (<0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression. The adjusted RSquare is far higher in the multiple regression (0.352 and 0. labor hours can be eliminated as a potential cost driver.806) than in either of the simple regressions (0.86E-07 4.81383627 Standard Error 4742. its coefficient is not significantly different from zero in either regression. Thus.988 (<0. Manufacturing can be a complex activity requiring a number of different tasks. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.450561 8.

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

000 $20. square feet cleaned.000 $10.000 $0 528 530 532 534 536 538 540 542 Number of Students C. B. A.000 $5.000 $10. Costs $25. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. Dept. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.2-36 Cost Management 2.35 Brush Prairie High School The data for this problem can be found on the datasets file for chapter 2. Other cost drivers for total maintenance cost could be number of rooms cleaned. or number of classes and activities per period.000 $15.000 $15. number of hours the building is open.wiley. available on both the Instructor and Student web sites for the textbook (available at www.000 $5.wiley. number of hours students attend school.000 $20. I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.com/college/eldenburg).000 $0 50 100 150 200 250 300 350 Maintenance Hours Worked Scatter Plot of Maintenance Costs Against Number of Students Maint. Dept. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint. Costs $25.com/college/eldenburg). .

The most current value is used to .461245 7.247329 R Square 0.847440356 Adjusted R Square 0. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.Chapter 2: The Cost Function 2-37 D. E.508157 0. maintenance hours is a reasonable cost driver. An unidentified cost driver could have a higher R-Square.061172 Adjusted R Square -0. Utilities cost varies with season not visits.807201 P-value 0.9 244.18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0. providing high confidence that both the intercept and slope are different from zero.920565237 R Square 0.03271 Standard Error 3019.796328319 Intercept X Variable 1 Coefficients 9134.135 + $35.832184392 Standard Error 1217. and rent for this type of facility is usually fixed.875134 35.06772 Observations 12 Standard Error 965.438328 According to the R Square statistics. Therefore. it is rational to conclude that hours worked will provide a reasonable estimate of future costs. However. it is logical to expect a strong relation between hours worked and cost. The total cost function is: TC = $9.173 Observations 12 Coefficient s -89867 197.63E-06 2.74*maintenance hours worked.0857 Intercept X Variable 1 t Stat -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. From the analyses performed.68624 0. 2.36 The Elder Clinic A and B Salaries are always fixed. The p-values on the Tstatistics are very small.74733262 t Stat 9.453062 P-value 2.5045837 4. it is considered fixed. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.0261 Standard Error 130954.

736 + $6. high point of medical supplies cost and patient data. These would be variable.49 ($3. but not proportionately.412 1. other facilities may open or close. There is no one answer to this part.49*849. and so on. Medical supplies vary with number of patient-visits. affecting the number of visits at this clinic. each patient requires a certain number of supplies. E.934)/(849 – 778).182 = F + $3. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. such as snake anti-venom. Use the same method for other expenses. July expenses are estimated to be: TC = $19.441.com/college/eldenburg). Use March. or there are changes in treatment procedures for certain illnesses. These would be fixed.wiley.07*patient-visits C.$2.736 Variable $3. This analysis suggests that there are some of the other expenses are variable costs and some fixed.115 219 3. Therefore. 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.182 . and so on. There are many possible reasons that could be listed. **Using high-low. . Other expenses appear to increase and decrease with number of patientvisits. new equipment is acquired. Given the preceding computations and cost summary.80 D. • Treatments and related costs may change as new drugs are available. weather. Visits are affected by season. such as tongue depressors.58 $6.07*940 = $25. to find fixed: $3.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future. Also. Here are some of the reasons: • The managers will not know how many visits they will receive. so this cost is classified as a mixed cost. At 940 patient-visits. • Prices of all inputs could change (usually increase).49 Cost Driver Patient-visits Mixed X 2. medical supplies is a mixed cost. current illnesses that are circulating in the area.100 226 664 $19. and costs go up as patient-visits increase. must be kept on hand whether or not they are used.736 + $6. variable cost is $3. gloves. Some supplies.2-38 Cost Management predict next period’s utilities. the cost function is: TC = $19.

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

486 68.4.800 .236 69. Similarly.200 +$2.000 = 4.150 73.310 70.286 68. as shown in the scatter plot below. A.2-40 Cost Management 2.750 . July’s result is an outlier and should be removed from the data. 80% of September 2 payroll to August: .800 41. IP-14 3 Payroll paid every two weeks. these are correctly handled.300/10 x 12 = 35.10. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68.wiley. If these observations are included in the regression analysis. available on both the Instructor and Student web sites for the textbook (available at www.com/college/eldenburg).800.736 To predict future overhead.036 68.500 x 1/2 = 2. Operations in the month of July are not typical of the rest of the time period.750. B. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www. 1/2 of August 5 payroll goes to July: 5.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4. Because of the large difference between these values and the values in other months.350 68.39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2. No adjustments are needed for items (c) and (d).8 x 6.750 + 4. the first month is adjusted even though it is not an actual cost: 4.376 65.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68.com/college/eldenburg). The miscellaneous supplies account also looks suspicious.686 71.596 73.790 80. .736 67.2. (rounded to $36) 2 Note IB-4's power added to Dept.200 Apr 71.wiley.750 68.83/mo.850 2 . the trend line is likely to distort costs. but there is insufficient information to make an adjustment.500 38.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3.

the fixed cost does not appear to be different from zero.310484 Intercept X Variable 1 Coefficient s 8777.000 $45. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.26 3. Monthly overhead costs for supplies may be significantly overstated or understated . 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. supplies were a large proportion of overhead cost.000 $50.000 $65.79 * 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).775388 0. D.086126 Based on the t-statistic and p-value for the intercept.000 2.000 9.412139 0.500 5.000 $55.47 8 Standard Error 29406.000 Overhead Costs $70.000 6.000 $40.050976 P-value 0. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours. Therefore.641981 0.500 8.314163 1980. Thus.000 3.298502 2. According to the details provided for August and September. Based on the variation in dates at which supplies are recorded.818 6.000 $60.500 Outlier Direct Labor Hours C.789722 t Stat 0.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.

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

Suppose a cost function is measured for the purpose of estimating future costs. Fixed costs are often irrelevant to decisions. In Chapter 2. for example. 3. C. which factors drive variable costs. When estimating a cost function: a. and multiple regression (Appendix 2A). It is often difficult to identify an appropriate. Uncertainties prevent identification of single “correct” measurement methods. analysis at the account level. high-low method. how to categorize costs as fixed. and how to interpret computational results. variable or mixed. A measurement is relevant if the resulting cost function information helps decision makers choose between alternative courses of action. Thus. 1. simple regression. Chapter 2 introduced the following measurement methods for estimating a cost function: Engineered estimate of cost. A cost function estimated from past cost data may be unreliable if future operating activities are expected to occur in a different relevant range.40 Focus on Professional Competency: Measurement A. it is necessary to use judgment when choosing and applying measurement methods. A measurement method such as simple regression is appropriate if past cost patterns are expected to continue in the future and i the cost is linearly related to the cost driver. It is also necessary to evaluate the quality of measurement results when using accounting information. which typically involved creating a cost function for one or more individual costs. in Chapter 2 pointed out that a cost function is estimated within a relevant range of activity. If the cost is believed to be nonlinear. whereas variable costs are often relevant. the main focus was on measuring costs for a cost object. For example. B. then simple regression is inappropriate. See Exhibit 2. sometimes the cost of obtaining a better measure exceeds the benefits. a cost function should distinguish between fixed and variable costs.Chapter 2: The Cost Function 2-43 BUILD YOUR PROFESSIONAL COMPETENCIES 2. 4.17 for the pros and cons of each method. b. relevant. 2. and they prevent complete accuracy in making accounting measurements. A measurement is appropriate if it is suitable for the purpose. . A measurement is reliable if it if it is reasonably free from error and bias. whether past cost behaviors will continue in the future. c. the best choice of estimation technique. two-point method. and reliable measure for estimating a cost function because of uncertainties about: data availability. For example. The costs and benefits of alternative measures should also be considered.

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

com/college/eldenburg).com/college/eldenburg).7748991 R Square 0.Chapter 2: The Cost Function 2-45 2. the fixed cost and the variable cost per unit are each positive and statistically different from zero.437E-24 1.] The data for this problem can be found on the datasets file for chapter 2. the cost function was estimated by regressing actual labor costs on number of chairs produced.96 x number of chairs produced However.5917832 Standard Error 6216. Considerable variation in labor costs is not explained by changes in the volume of production. the regression explains only about 59% of the variation in labor costs. available on both the Instructor and Student web sites for the textbook (available at www.194 + $13. Also. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.957296 Standard Error 6710.02E-10 Based on the regression results. B.wiley.6004687 Adjusted R Square 0. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs. A. the degree of downward bias is higher for older data than for more recent data.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. However. students are likely to struggle interpreting and choosing a method (Parts E and F).04 13.wiley.3147402 P-value 3.848277 8.609693 1. Because of the annual pay increases. Here are the simple regression results: Regression Statistics Multiple R 0.7995 Observations 48 Coefficient s 133194. using monthly data for the prior 4 years. The cost function is estimated as: Labor cost = $133. In prior years.678620854 Intercept X Variable 1 t Stat 19. .

905 Observations 48 Coefficient s 133736 16. Here are the multiple regression results: Regression Statistics Multiple R 0.05E-27 2.2-46 Cost Management C. The fixed cost is nearly the same.09577 6.23 per chair.869633 Adjusted R Square 0.57E-23 2.742261 Standard Error 5148. here are the regression results: Regression Statistics Multiple R 0. which is reasonable given the increase in wage rates over time.492 1.93821 16.736 + $16.96 to $16.26499 6.533 Dec 20X4 196.35E-15 Based on the regression results.891 1.864722 R Square 0.533 x (1.274 Using the adjusted labor cost data.390275 Intercept X Variable 1 t Stat 24. Also.486389 P-value 4. Nevertheless. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Month Original Labor Cost Jan 20X1 $203. this cost function would result in a higher estimate for future costs.347 Calculation $203.411 Observations 48 Coefficient s 107748.010513 1.67711 P-value 1.347 x 1. approximately 26% of the variation in labor costs is still unexplained.73E-20 5.06236 11.23 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 0.863839 Standard Error 3742.747745 Adjusted R Square 0.8 16.02 Adjusted Labor Cost $220.00872 Intercept X Variable 1 X Variable 2 t Stat 18.02)4 $196. The cost function is estimated as: Labor cost = $133.311 200. but the variable cost increased from $13.932541 R Square 0. D.91E-08 .23439 Standard Error 5557.54295 Standard Error 5689. the fixed cost and the variable cost per unit are each positive and statistically different from zero.74).

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

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