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COST ESTIMATION

ANSWERS TO REVIEW QUESTIONS

3.1 (a) Cost estimation: the process of determining how a particular cost behaves.

(b) Cost behaviour: the relationship between cost and the level of activity (that is, cost

driver).

(c) Cost prediction: using knowledge of cost behaviour to forecast the level of a cost at a

particular level of activity.

Cost estimation is the process used to determine what the cost behaviour is for a particular

cost item. The cost behaviour pattern is used to make a cost prediction about the cost at a

particular level of activity.

3.2 A cost driver is an activity or factor that causes costs to be incurred. In identifying cost

behaviour, the management accountant identifies the relationship between a particular cost

and the level of its cost driver (also called level of activity when the cost driver relates to

an activity).

3.3 Volume-based cost drivers are used in conventional management accounting systems. This

assumes that variable costs vary in proportion to production volume and that fixed costs do

not change with production volume. ABC allows a range of cost driverssuch as unit level,

batch level, product level, and facility levelso that for these various types of cost there is a

more realistic link between the cost and its cost driver. The conventional approach only

examines variability with production volumethat is, at the unit level.

3.4 The hierarchy of costs is a way of grouping costs on the basis of them having similar

behaviour patterns. They have similar behaviour patterns because they have the same, or

related, cost drivers. Unit level costs have cost drivers that change with the number of units

of output (for example, units of production, number of direct labour hours, amount of direct

material used, the number of cheques a bank employee processes, the number of operations

in an operating theatre and so on). Batch level costs have cost drivers that are associated

with the number of batches and will vary roughly with the number of batches. Product -

sustaining costs do not change with the number of products but exist because an individual

product is produced. There is no reason why the product-sustaining costs for one product

should be the same as those for a different product. Hence they are probably better referred

to as product-sustaining rather than product level costs. Clearly facility-sustaining costs are

incurred to provide the capability to produce but are not caused by any individual product.

At Holden Engine Company (HEC) an analysis of costs identified these four cost drivers,

plus a fifth cost driver, which was described as administration. Thus, HECs activity-based

costing system identified five different cost behaviour patterns due to five clearly different

causes of costs. The separate recognition of administration costs will also draw attention to

what drives these costs, the value of them to the organisation, and the best ways of

managing them.

3.5 BP targeted certain costs that needed better management. We can see in the Real Life that,

in order to reduce discretionary costs, BP identified activities that did not adequately add

value to the business. Examples are the regular preparation of reports that were rarely (if

ever) used, unnecessary travel (both domestic and international), outsourcing tasks to

consultants, and maintaining excessive layers of management. These four root-cause cost

drivers were better managed to reduce costs.

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3.6 As the level of activity (or cost driver) decreases, total variable cost decreases

proportionately and the variable cost per unit remains constant.

3.7 As the level of activity (cost driver) decreases, total fixed cost remains constant. However,

the fixed cost per unit of activity increases as activity decreases. Examples include factory

rent, managers salaries, straight-line depreciation and property taxes.

3.8 As the level of activity (cost driver) increases, total fixed cost remains constant. However,

the fixed cost per unit of activity declines as activity increases, and the fixed cost per unit

of activity increases as activity decreases. This change in the average fixed cost per unit

may not be understood by a decision making manager who has been presented with product

costs that include unitised fixed costs.

When product costs include unitised fixed costs, managers can mistakenly treat them as

totally variable for decision making. These managers may believe that:

any short term sales that do not cover the unitised fixed costs may result in losing

money, not realising that those sales would help cover fixed costs;

a 20% reduction in production will reduce costs by 20% of the total product costs, not

realising that the fixed costs will not reduce at all (within the relevant range);

making 1000 more products will increase costs by one thousand times the product

cost, not realising that the extra cost will be less than that since total fixed costs will

not change if production is still within the relevant range.

3.9 (a) Variable cost, assuming that rubber is the only direct material used in the

manufacturing process.

(c) The number of tyres produced determines the quantity of rubber used in production

and therefore the total direct material cost. If only the quantity of rubber used is the

cost driver, it ignores any abnormal wastage incurred in the process, or the effects of

changing supply and/or demand on rubber prices. To identify the cost driver from a

cost management perspective, it is necessary to identify the underlying causes of the

direct material cost.

3.10 There are a number of ways in which the behaviour of costs may change over an extended

range of activity. Let us first consider some fixed costs. We would expect rent to change if

activity increases to the extent that extra premises are required, and depreciation would rise

in a large step if we acquired extra equipment to meet growing demand for a product. Hence

we say that fixed costs are only fixed over a particular range. With fixed costs, outside that

range we would expect there to be a large step in the cost, which would then be fixed over

another range.

If we consider variable costs, we must recognise that they are often not perfectly linear. A

simple example would be direct material. There are often discounts when large volumes of

material are purchased, and there can be transportation savings for larger orders. The

assumption of a defined linear relationship between cost and production levels will therefore

only be valid over a particular range.

Outside that range discounts may be obtained or lost and transport charges may change per

unit. In the chapter the example of curvilinear electricity costs in Tasty Bread demonstrates

that efficiencies of scale may only apply up to a particular level and then unit costs can

begin to increase again.

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3.11 The cost analyst should respond by pointing out that in most cases a cost behaviour pattern

should be limited to the relevant range of activity. When the firms electricity cost was

shown as a semivariable cost, it is likely that only some portion in the middle of the graph

would fall within the relevant range.

Within the relevant range, the firms electricity cost can be approximated reasonably closely

by a semivariable cost behaviour pattern. However, outside that range (including an activity

level of zero) the semivariable cost behaviour pattern should not be used as an

approximation of the cost.

3.12 1 Annual cost of maintaining a national highway: committed cost. (Once the highway

has been built, it must be maintained. The transportation authorities are largely

committed to spending the necessary funds to maintain the highway adequately.)

3.13 There are a number of issues to draw out in a discussion about the variability of direct

labour.

Historically direct labour was a variable cost. Now there are different employment

agreements and many workers are on a set income.

Some firms have a basic workforce that can be supplemented by hourly or daily

paid workers on an on call basis. This effectively makes direct labour a variable

cost.

Even when all workers are on contracted incomes, there is an argument that

moving workers from working on one product to another effectively makes the

direct labour cost to that product a variable cost.

3.14 The account classification method of cost estimation involves identifying costs as being of a

particular type and analysing their past behaviour to understand the expected cost in the

future. For example, a manager may identify the costs that will not change with changing

production levels (the fixed costs), and separately address the costs that change with the

levels of production (both variable costs and semi-variable costs). This way the estimation

of costs is based on expected cost behaviour, especially in relation to levels of activity such

as production volumes.

3.15 Some of the possible reasons that approximations are used in estimating cost functions

include the following:

lack of data

the resultant cost functions may be regarded as accurate enough for the firms needs.

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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3.16 The chief drawback of the high-low method of cost estimation is that it uses only two data

points, and ignores all other observations. The rest of the data are ignored. An outlier can

cause a significant problem when the high-low method is used, if one of the two data points

happens to be an outlier. In other words, if the high activity level happens to be associated

with a cost that is not representative of the data, the resulting cost line may also not be

representative of the cost behaviour pattern.

3.17 Regression analysis is a statistical method that measures the average amount of change in the

dependent variable that is associated with a unit change in one or more independent variables.

Simple regression analysis estimates the relationship between the dependent variable and a

single independent variable, while multiple regression estimates the relationship between the

dependent variable and multiple independent variables. Multiple regression can help

management determine more accurate cost estimates because it is able to recognise the effects

of two or more factors that influence total costs, and therefore is more economically plausible.

Assume that a rug manufacturer is trying to estimate the indirect labour cost associated with

the manufacture of rugs, when production on one batch of rugs is stopped and another batch

started. Management believes that, in addition to machine hours, indirect labour costs are

also affected by the number of different batches worked on during the period (a batch-level

cost driver).

3.18 A particular least squares regression line may be evaluated on the basis of criteria such as

economic plausibility and the goodness of fit. The coefficient of determination, represented

by the R2 statistic, is used to evaluate the goodness of fit of the regression line. It indicates

the extent to which the pattern of variability of the dependent variable imitates the pattern of

variability of the independent variable. The more closely they vary (or move together), the

greater the fit between the two variables. This indicates the degree to which the change in

the dependent variable can be explained by the change in the independent variable.

The proportion of change in the dependent variable that can be explained by the change in

the independent variable is what we measure with the coefficient of determination (R2). The

higher the R2, the better the fit.

3.19 Some of the problems often encountered when collecting data for cost estimation include:

outliers which need to be detected and eliminated from the data set

3.20 A learning curve reflects how production efficiency increases with increased production. An

experience curve shows how product costs from across the value chain decrease with

increased production.

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SOLUTIONS TO EXERCISES

EXERCISE 3.21 (15 minutes) Cost drivers: service firm

A number of different answers are possible here.

Branch managers salary Number of customer enquiries In practice, fixed for a wide range

of activity, usually one per branch

Number of staff

Number of staff hours worked

(full-time and casual)

Full-time customer service staff Number of customer enquiries In practice, step-fixed as it is

salaries /quotes contractually fixed for a wide range

of activity, until an additional full-

Number of bookings

time staff member is required

Number of staff

Number of full-time staff hours

worked

Casual customer service staff Number of customers Variable, casual labour

wages

Number of journeys quoted

Number of flight, accommodation

and car bookings made

Number of hours worked

Computer expenses Number of bookings processed Step-fixed, each computer can only

process a given number of enquiries

Number of desks

and bookings before an additional

Number of hours worked computer is required

Number of customers' quotes

provided

Telephone expenses Number of bookings processed A wide range of contracts are

available. In practice, this may be

Number of desks/telephones

fixed for a wide range of activity

Number of hours worked before additional charges are made

Number of customers' quotes

provided

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EXERCISE 3.22 (15 minutes) Variable and fixed costs; graphical and tabular

analyses: manufacturer

1 Graph of raw materials cost:

Total raw

material cost

$1 800 000

$1 200 000

$600 000

Balls Produced

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3 Graph of fixed production cost:

Total

Fixed cost

$80 000

$60 000

$40 000

$20 000

Balls Produced

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EXERCISE 3.23 (40 minutes) Graphing cost behaviour patterns: hospital

1 Cost of food:

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3 Laboratory costs:

4 Cost of electricity:

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5 Nursing costs

Actual Estimated

2 (a) The approximation is very accurate in the range of 40 000 to 60 000 km per month.

(b) The approximation is less accurate in the extremes of the longer range of 20 000 to

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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EXERCISE 3.25 (15 minutes) Account classification method; manufacturer.

1 (a) Fixed; does not change for different levels of production.

produced.

produced

(e) Semivariable (or mixed): includes a fixed element ($4000 per month) and a

variable element ($0.20 per kilogram of sausages produced).

$2.00 = $1.10 + $0.70 + $0.20

manufacturer

61500 - 31500

Variable cost at 61 500 machine hours (61 500 $0.10 per machine hour) 6 150

Cost equation:

Total utilities cost = $30 000 + $0.10X, where X denotes machine hours.

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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EXERCISE 3.27 (45 minutes) Estimating cost behaviour; regression

analysis: manufacturer

1 The calculations to estimate the companys utilities cost behaviour are shown below,

using Excel. Some of the figures have been rounded.

Regression Statistics

R 0.78833

R Square 0.62147

S 1 592.9189

ANOVA

d.f. SS MS F p-level

Coefficients

Intercept 26 306.25

Y = a + bX, where:

This can be expressed as total cost = fixed costs of $26 306.25 plus $0.192 per machine

hour. For comparison, this gives a cost at 39 000 machine hours:

2 Given that this question does not assume knowledge of the appendix, the evaluation will

focus on R2. In this case, the figure for R20.6215suggests that 62 per cent of the

variability of utility costs can be explained by changes in the machine hours. The higher the

R2 figure, the more confident the accountant can be that changes in the dependent variable

can be explained in terms of changes in the independent variable. In this case 38 per cent of

the variability of utility costs remained unexplained.

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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EXERCISE 3.28 (15 minutes) Regression analysis: health services firm

1 The calculations to estimate the companys cost behaviour are shown below, using Excel.

Some of the figures have been rounded.

Regression Statistics

R 0.98105

R Square 0.96245

S 2 191.16457

Total number of

observations 12

ANOVA

d.f. SS MS F p-level

costs is as follows:

Y = a + bX, where:

This can be expressed as total cost = fixed costs of $29 568 plus $10.0957 per blood test

completed.

3 When 5500 tests are performed in a month the total monthly costs are predicted to be:

Note that this is very similar to the recorded cost for 5300 blood tests in the data provided

($87 000). With an R2 of 0.96245 (and an adjusted R2 of 0.9587), it appears that the number

of blood tests completed is the major factor in explaining the costs in the diagnostic blood

laboratory of Plasma Pathology.

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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EXERCISE 3.29 (45 minutes) Estimating cost behaviour using multiple

methods: retailer

1 Variable electricity cost per hour = $3800 $2600 = $4 per hour

700 400

Cost formula: Monthly electricity cost = $1000 + $4 X, where X denotes hours of operation.

2 Regression analysis:

Using Excel

Regression statistics

Multiple R 0.975590116

R square 0.951776075

Observations 6

Cost formula:

(b) Regression:

* rounded

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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EXERCISE 3.30 (10 minutes) (appendix) Learning curve; high technology:

manufacturer

1 (a) Average time for 4 satellites 130 hours

3 Learning curves indicate how labour costs will change as the company gains experience

with the production process. Since labour time and costs must be predicted for both

budgeting and setting cost standards, the learning curve is a valuable tool.

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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SOLUTIONS TO PROBLEMS

PROBLEM 3.31 (20 minutes) Cost drivers: service firm

Answers to this question will vary. Rather than looking for a right answer, instructors should seek

an understanding of the concepts.

(a) This is a fixed cost and, therefore, has no obvious cost driver in the short run. It is a facility

level cost. In the long run one cost driver may be the number of patients, because the larger

and busier the hospice, the more skilled (and, therefore, highly salaried) the administrator

will need to be, although the salary is unlikely to vary in proportion to the number of

patients.

Location of patients may be a cost driver as the dispersion may create extra travelling time

(but there is unlikely to be a proportional relationship here) (unit level).

(c) Depends whether the physiotherapist is paid by the hour or by the clinic. If paid hourly, the

length of time of a clinic and the number of patients are possible cost drivers (unit level). If

paid per clinic, the number of clinics held is the cost driver (batch level).

(d) Refer to (c) above. Perhaps the number of patients (unit level), severity of patient

conditions and the number of visits (batch level).

(e) Likely to be a fixed cost (product level, as it relates only to outpatients). It is a committed

cost with no obvious cost driver, although the cost of the lease may be affected by the size

of the cars and the length of time they can be kept.

(g) The depreciation cost is a fixed cost per pump but the total depreciation cost will vary with

the number of pumps, which is likely to vary with the number of patients (unit level).

(i) Number of shifts worked, which will vary to some degree, with the number of patients. At

a maximum capacity, where three shifts are worked every day, this becomes a fixed cost.

(j) While the amount of cleaning may vary with the number of patients, the contract is for a set

payment. Therefore, this is a fixed cost (facility level).

1 h 5 b 9 d

2 i 6 g 10 j

3 f 7 c 11 l

4 e 8 a

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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PROBLEM 3.33 (25 minutes) Cost behaviour; engineered cost; committed

and discretionary costs: manufacturer

Variable Committed /

Discretionary

a Cost of daily radio Fixed Discretionary Cost arising from management

advertising on the local decision relating to advertising

community radio station expenditure, easy to change in short

term

b Cost of the fabric used to Variable Engineered Cost of fabric has a direct physical

make T-shirts relationship to the number of

T-shirts manufactured

c Cost of the ink used in the Variable Engineered Cost of ink has a direct physical

designs relationship to the number of

T-shirts manufactured

d Salary of the managing Fixed Committed Management salary cost is part of

director organisations basic structure,

difficult to change in short term

e Wages of the production Variable Engineered Cost with clear direct physical

employees who sew and relationship to the level of output

print the T-shirts

f Cost of movie tickets Fixed Discretionary Cost arising from managements

provided for Employee of decision, easy to change/vary in

the Month award each short term

month

g Depreciation on the Variable Engineered Cost with clear direct physical

sewing machine, relationship to the level of output

calculated on a units of

production basis

h Cost of electricity used in Variable Engineered Cost of electricity consumed in

the factory building production is directly related to the

level of manufacturing activity

i Rent of the factory Fixed Committed Cost resulting from organisations

building use of premises, difficult to change

in short term

j Wages of the staff who Variable Engineered Cost of packaging directly related

package the finished T- to the level of output produced

shirts

k Cost of sewing machine Fixed Discretionary Cost arising from managements

maintenance decision regarding maintenance,

easy to change/vary in short term

l Cost of a new company Fixed Discretionary Cost arising from management

advertising sign placed in decision relating to advertising

front of the factory expenditure, easy to change in short

term

m Cost of company car used Fixed Discretionary Cost arising from managements

by the managing director decision, easy to change/vary in

short term

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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PROBLEM 3.34 (15 minutes) Account classification; cost drivers: school

Answers to this question will vary. Rather than looking for a right answer, instructors should seek

an understanding of the concepts.

a The cost of paper used in The Sunshine Times is a variable cost. If the number of pages

varied for each edition, the number of pages would be an appropriate cost driver. However

since the number of pages for each edition is constant, the cost varies per newspaper

printedthe cost driver is units of production.

b The number of business cards printed is the cost driver for this variable cost.

d The number of units of production is the cost driver of this variable cost.

f If each set up consumes the same amount of resources the cost driver would be the number

of set ups. As the set ups are for different kinds of jobs it is likely that set up time would be

a suitable cost driver for this variable cost.

g A semi-variable cost, partly fixed (lease charge) and partly driven by the distance travelled

or number of deliveries.

i A variable cost; the cost driver is the number of business card designs undertaken.

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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PROBLEM 3.35 Cost estimation: high low; regression: wholesaler

1 Scatter diagram:

Shipping Department

costs

$25 000

$24 000

$23 000

$22 000

$21 000

$20 000

$19 000

kilograms of

The lower part of the vertical axis has been supplies

shortened

2 Highlow method:

Variable cost per unit of cost driver $24 240 - $20 400

=

5200 - 2000

loaded/unloaded

driver (5200 $1.20) 6 240

=

month

where X denotes the number of kilograms of supplies loaded/unloaded during the month

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3 Cost when 4500 kgs are moved:

4 Estimating the fixed and variable cost components using regression analysis can be

determined by using Excel and StatPlus, the output from which is reproduced below.

Regression statistics

R 0.77355

R Square 0.59838

S 796.98293

Standard

Coefficients Error

5 The formula to explain the behaviour of the Shipping Departments costs is as follows.

Y = a + bX,

where:

X = the independent variable (the kilograms of supplies handled for one month)

This can be expressed as total cost = fixed costs of $19 885.66 plus $0.885 per kilogram of

supplies handled.

7 On the basis of using the highlow method and regression analysis, the Shipping

Departments monthly cost behaviour was estimated as follows:

Using the highlow method, the following cost estimate was obtained:

Material-handling cost per month = $18 000 + $1.20 per unit of cost driver

Using regression analysis = $19 885.66 + $0.885 per unit of cost driver

The two methods yield different estimates because the highlow method uses only two data

points, ignoring the rest of the information. Regression analysis, on the other hand, is a

statistical technique that can be used to estimate the relationship between the dependent

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variable (cost) and the independent variable (quantity of supplies handled). Regression

analysis uses all of the data points to determine the line of best fit.

In this case, the two data points used by the highlow method do not appear to be

representative of the entire set of data. Hence, I suggest that the cost line determined using

regression analysis be utilised.

costs; highlow method: Mining company

1 Straight-line depreciation committed fixed

The mining labour costs with on costs are considered as variable, because the labour cost is

$225 per tonne of ore extracted. This labour rate is the same when

315 000

1400 tonnes are extracted (labour rate = = $225) or when

1400

607 500

2700 tonnes are extracted (labour rate = = $225).

2700

2 Given the assumption that royalties is semi-variable we could use the high-low method to

identify its fixed and variable components.

Variable cost per unit of cost driver $224 500 $140 000

=

2700 1400

driver (2700 $65) 175 500

= ($30 000 + $0 + $49 000 + $280 000) + (($225 + 65) x 1 650) = $837 500

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3 OMLs trucking and hauling costs increase from $240 000 to $280 000 when the hauling

capacity reaches 1500 tonnes. This seems to indicate that OML is not cost effective in

handling 1500 tonnes of ore. It costs $40 000 less to truck 1499 tonnes than it does 1500

tonnes. This may reflect OMLs commercial arrangement with trucking and hauling

equipment, as the production capacity reaches 1500 tonnes, the costs related to trucking and

hauling equipment escalate to a new level.

The cost effectiveness in utilising the trucking and hauling equipment can be improved by

planning the monthly production level so that the output is always slightly below the

maximum output (1500, 1900 and 2300 tonnes) of each step-fixed cost range.

4 The committed fixed costs refer to the facilities owned or used by the business as the bare

necessity of a basic organisation structure. As the name indicates, they cannot be avoided.

On the other hand, the discretionary fixed costs arise as a result of the management decision

to spend a particular amount of money for some purpose. For example, OMLs charitable

contribution is only managements decision.

In times of economic downturn, the management would be likely to cut the discretionary

fixed costs. This is because a discretionary cost can be avoidable. However, the cutting of

discretionary costs can cause long-term problems. For example, reducing discretionary costs

such as machine maintenance, employee training and advertising can lead to equipment

breakdowns, poorly used equipment, lack of knowledge about new software and reduced

sales. The decision to reduce these discretionary costs should not be undertaken lightly,

rather it should be a last resort and managers underspending in these areas should be

monitored.

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PROBLEM 3.37 (45 minutes) Multiple regression analysis: service firm

1 Because there are two independent variables, it is necessary to use multiple regression

analysis. The following data is provided.

Regression Statistics

R 0.993371

R Square 0.986785

S 242.405

Standard

Coefficients Error

Hours of maintenance

service 7.345228 0.285104

The coefficients for the regression are in the lower panel of output. The constant, or intercept, is

$1298.843, and the coefficients of the two variables are the number of photocopies and the number

of hours of maintenance. The regression equation can be expressed as follows:

2 The R2 for the equation is 0.987 (rounded), which means that 98.7 per cent of the variation

in the monthly maintenance cost can be explained by the variation in the numbers of hours

of maintenance and the number of photocopies produced. Given that the number of

observations (12) and the number of independent variables (2) are on the borderline for an

acceptable sample size, the adjusted R2 should be used (this measures the coefficient of

determination after adjusting for a relatively small number of observations). In this example,

an adjusted R2 of 0.984 (rounded) occurs, thus, there is little change in the outcome.

The fixed cost per hour is a misleading amount because it will change as the number of

hours change. For example, at 600 hours of maintenance, the fixed cost per hour is $0.72

($432.95/600 hours).

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

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PROBLEM 3.38 (40 minutes) Interpreting regression analysis in cost

estimation: catering company

1 The original method was simply the average overhead per hour for the last 12 months and

did not distinguish between fixed and variable costs. Dana divided total overhead by total

labour hours, which effectively treated all overhead as variable. Regression analysis

measures the behaviour of the overhead costs in relation to labour hours and is a model that

distinguishes between fixed and variable costs within the relevant range of 2500 to 7500

labour hours.

Regression Statistics

Multiple R 0.980976

R Square 0.962313

Adjusted R

Square 0.958544

Observations 12

Coefficients Error t Stat P-value Lower 95% 95% 95.0% 95.0%

Labour

hours 3.94936 0.247152 15.97946 1.9E-08 3.39867 4.500049 3.39867 4.500049

Using the regression results the variable cost per person is:

Total $28.37

* Rounded.

3 The minimum bid for a 250-person cocktail party would be $7093. The amount is calculated

by multiplying the variable cost per person of $28.37 by 250 people. At any price above the

variable cost, Dana will be earning a contribution toward his fixed costs.

4 Other factors that Dana should consider in developing a bid include the following:

capacity, other work would have to be sacrificed at some opportunity cost

analysis of the competition. If competition is rigorous, Dana may not have much

bargaining power

a determination of whether or not Danas bid will set a precedent for lower prices

the realisation that regression analysis is based on historical data, and that any

anticipated changes in the cost structure should be considered.

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PROBLEM 3.39 (45 minutes) Evaluation of cost estimation models: retailer

1 Method A:

= 0.93 + (0.0936)(11)

= $1.9596 million

= $1 959 600

Method B:

= 0.5597 + (0.02219)(60)

= $1.8911 million

= $1 891 100

Method C:

= $2.172932 million

= $2 172 932

where 1.445 = average annual rent expense for the 10-year period from

Year 1 to Year 10

39.9 = average annual revenue for the 10-year period from Year 1 to

Year 10

way to take into consideration all possible factors that may be influencing the dependent

variable during each period of time. A disadvantage of Method A is that there is no causal

relationship between years and rental expense beyond mere inflationary pressure.

An advantage of Method B is that this method is logical because as revenues increase, the

stores increase, and thus rental expense increases. A disadvantage of Method B is that a

prediction of revenues is required.

An advantage of Method C is that the calculations are relatively easy and the method is

easy to understand. A disadvantage of Method C is that the arithmetic average is an

oversimplification that does not recognise any relationship between the variables.

3 Motomation should select Method B, because the relationship between revenue and rental

expense is causally based and it has economic plausibility.

4 The use of multiple regression analysis on the data provided would allow the inclusion of

all causal factors and should give a greater degree of accuracy to the projections.

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PROBLEM 3.40 (30 minutes) (appendix) Learning curve: manufacturer

1 The initial batch took 10 hours for 10 ($200/$20 per hour) or 1 hour each. When the

cumulative output is increased from 10 to 20 the average labour time per unit for the 20

tables should reduce to 0.8 hours per table. The 20 tables should take 16 hours, so the

second batch will take 6 hours (16 hours for the total output of 20 tables minus the 10 hours

for the first 10).

3 No. Labour is becoming increasingly skilled at making the tables. The hours taken is an

average of the batches and the first one produced of the first batch would take more than 10

hours, and the last of the second batch would take less than 6 hours.

4 Cumulative production is now 20, so the time taken to produce the next batch of 60 can be

estimated as follows:

Cumulative time taken for 80 tables = 80 (0.8 hours 80% 80%) = 40.96 hrs

5 The direct labour cost, per table, for the batch of 60 is:

Over time, tables will appear to get cheaper. Perhaps Austral needs to take a more long-run

view of their pricing, to stimulate early demand so that they can move quickly along the

learning curve.

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SOLUTIONS TO CASES

CASE 3.41 (45 minutes) Cost estimations: hospital

1 Scatter diagram

Administrative Cost

(2)

relevant

range

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3 This analysis is based on the costs and activity within the relevant range, that is between 600

and 1200 patients.

Variable cost per unit cost of driver = ($11100 $8300) $4.667 per patient*

(1200 600)

*(rounded)

= $5600 (rounded)

However, it is not appropriate to use this cost function to estimate the administrative costs at

300 patients, as this is well below the relevant range.

procedures cost

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6 (a) If only patient load is considered as a determinant of administration costs and only the

historical patient load data that falls within the relevant range (patient load between 600 and

1200) are considered, then simple regression can be used, utilising Excel. The output is

reproduced below:

Regression Statistics

Multiple R 0.927088078

R Square 0.859492304

Observations 6

ANOVA

df SS MS F Significance F

8

Intercept 6 181.36646 730.0175478 8.467422 0.0010661 4 154.51281 208.220107

Y = a + bX, where:

Y = $6181 + $3.84X

This can be expressed as total cost = fixed costs of $6181 plus $3.84 per patient

(b) The clinics administrative cost during the month when 800 patients visit the hospital would

be $6181 + $3.84 x 800 = $9253

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(c) When both patient load and the number of emergency procedures are considered as

determinants of administrative cost, multiple regression must be used. Utilising Excel, the

regression statistics are reproduced below.

Regression Statistics

Multiple R 0.92919029

R Square 0.86339459

Observations 6

ANOVA

df SS MS F Significance F

Upper

Coefficients Error t Stat P-value 95% 95% 95.0% 95.0%

X1= the independent variable (the number of emergency procedures for one month)

that is, Administrative cost = $5944 + $24.91 per emergency procedure + $3.81 per patient

(d) Clinics administrative cost during the month when 800 patients visit the hospital and 12

emergency procedures taken place would be $9291

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7 When patient load is used as the sole independent variable, the figure for R2 is 0.859 as per

the above calculations. This suggests that 86 per cent of the variability of administrative costs

can be explained by changes in patient load. An R2 figure of 86 per cent indicates that 14 per

cent of the variability in administrative costs is not explained by patient load. With only 6

observations and one independent variable, it is more appropriate to use the adjusted R 2,

which is slightly lower at 0.824.

When patient load and emergency procedures are used as independent variables R2 increases

only marginally to 0.863 and the adjusted R2 is 0.772 per the above calculations. Thus the

adjusted R2 indicates that the addition of emergency procedures reduces rather than

increases the explanatory power.

The real problem is that, once we limit the analysis to observations within the relevant

range, there are only 6 observations, which undermines the effectiveness of the regression

analysis.

8 The equation from highlow method is based on only two observations and therefore should

be viewed with caution. However, as discussed above, even though both the regression cost

models have a high R2 and therefore high explanatory power, there are too few observations

to rely on the results of these regression models.

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CASE 3.42 (45 minutes) Interpreting regression analysis; activity-based

costing: service firm

1 Drakes preliminary estimate for overhead of $18.00 per direct labour hour does not

distinguish between fixed and variable overhead. This preliminary rate is applicable only to

the activity level at which it was computed (36 000 direct labour hours per year) and may

not be used to predict total overhead at other activity levels.

The overhead rate developed from the least-squares regression recognises the relationship

between cost and volume in the data. The regression suggests that there is a component of

the cost ($26 201 per month) that is unrelated to total direct labour hours. This cost

component is the intercept on the vertical axis and is often considered to be the fixed cost as

long as the activity level is within the relevant range. Thus, the least-squares regression

results in a cost function with two components: fixed cost per month and variable cost per

direct labour hour. This cost formula can be used to predict total overhead at any activity

level within the relevant range.

* DLH denotes direct labour hours.

3 The minimum bid should include the following incremental costs of the project:

4 Yes, Greenscape Pty Ltd can rely on the formula as long as Drake recognises that there are

some shortcomings. The fact that least-squares regression estimates cost behaviour increases

the usefulness of rates calculated from cost data. However, the regression is based on

historical costs that may change in the future, and Drake must assess whether the cost

equation would need to be revised for future cost increases or decreases.

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5 (a)

(b)

(c) The two scenarios in (a) and (b) differ in terms of the activities to be undertaken. Scenario

(a) involves a large amount of seeding activity and relatively little planting activity. Scenario

(b) involves considerably less seeding activity, but a great deal more planting activity. An

activity-based costing system accounts for the different costs in projects involving different

mixes of activity.

Case 3.42)

The combined data from this case plus Case 3.42 is reproduced below so that the information is

clear.

overhead cost labour hours of turf plantings

$

(DLH) (STS) (PL)

Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd

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1 The output data from the multiple regression equation using Excel and StatPlus is shown

below.

Regression Statistics

R 0.9706

R Square 0.9421

S 1 747.948

ANOVA

p-

d.f. SS MS F level

p- H0 (2%)

Coefficients Std Error LCL UCL t Stat level rejected?

Total overhead = $11 188 + $6.16 per direct labour hour + $0.216 per square metre of turf +

$32.17 per planting.

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2 As shown in (1), the adjusted R2 for this equation is 0.9204. When DLH is used as the sole

independent variable (as in Case 3.42) the R2 is lower (0.8597), although the standard error

of the coefficient is better, as shown below. At this point it would be appropriate in some

classes to discuss the sample size and predictive ability of the regression model. For

example, twelve observations would normally be considered adequate for one variable, as

with just DLH, but not for three variables (and only borderline for two variables in (3)).

Regression Statistics

Multiple R 0.927176006

R Square 0.859655346

Adjusted R

Square 0.845620881

Observations 12

ANOVA

df SS MS F Significance F

Total 11 422000000

Coefficients Error Stat value 95% 95% 95.0% 95.0%

3 Regression functions for the various combinations of cost drivers are shown below. These

results suggest that, when considered individually, DL hours is the best of the three cost

drivers. (STS lacks economic plausibility with a negative intercept and PL has low R2.)

When combined, the three independent variable model performs the best, although DLH

combined with either STS or PL seems to be almost as effective. However, before

reaching a final conclusion on the relative performance of these models, a more detailed

analysis should be completed, considering factors such as the standard error of the

coefficients and the F statistics.

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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COMPARISONS OF RESULTS: SUMMARY OUTPUT

For all Variables For DLH only

Observations 12 Observations 12

Coefficients Coefficients

(DLH) 5.036231834

(STS) 0.31914144

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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For STS and PL

Regression Statistics

Multiple R 0.926434568

R Square 0.858281008

Observations 12

Coefficients

Intercept 5437.381336

(STS) 0.59887704

(PL) 4.02114619

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e

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