Chapter 3

Measurement of Cost Behavior

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be able to:

1. Explain management influences on cost behavior.

2. Measure and mathematically express cost functions and use them to predict costs.

3. Describe the importance of activity analysis for measuring cost functions.

4. Measure cost behavior using the engineering analysis, account analysis, high-low,
visual-fit, and least-squares regression methods.

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 CHAPTER 3: ASSIGNMENTS
CRITICAL THINKING EXERCISES

26. Committed and Discretionary Fixed Costs in Manufacturing

27. Cost Functions and Decision Making
28. Statistical Analysis and Cost Functions

EXERCISES

29. Plotting Data

30. Cost Function for Expedia
31. Predicting Costs
32. Identifying Discretionary and Committed Fixed Costs
33. Cost Effects of Technology
34. Mixed Cost, Choosing Cost Drivers, High-Low and Visual-Fit
Methods
35. Account Analysis
36. Linear Cost Functions
37. High-Low Method
38. Economic Plausibility of Regression Analysis Results

PROBLEMS

39. Controlling Risk, Capacity Decisions, Technology Decisions

40. Step Costs
41. Government Service Cost Analysis
42. Cost Analysis at US Airways
43. Separation of Drug Testing Laboratory Mixed Costs into Variable
and Fixed Components
44. School Cost Behavior
45. Activity Analysis
46. High-Low, Regression Analysis
47. Interpretation of Regression Analysis
48. Regression Analysis
49. Choice of Cost Driver
50. Use of Cost Functions for Pricing
51. Review of Chapters 2 and 3

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 CASES

52. Government Health Cost Behavior

53. Activity Analysis
54. Identifying Relevant Data
55. Nike 10k Problem: Step- and Mixed Cost Drivers

EXCEL APPLICATION EXERCISE

56. Fixed and Variable Cost Data

COLLABORATIVE LEARNING EXERCISE

57. Cost-Behavior Examples

INTERNET EXERCISE

58. Cost Behavior at Southwest Airlines

(http://www.southwest.com)

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CHAPTER 3: OUTLINE
I. Cost Drivers and Cost Behavior

Accountants and managers assume that cost behavior is linear over some relevant
range of activities or change in cost drivers. Linear-Cost Behavior—graphed with a
straight line when a cost changes proportionately with changes in a single cost
driver. Volume of a product produced or service provided is the primary driver for
some costs (e.g., printing labor, ink, paper, and binding costs of producing the
textbook). Other costs are more affected by activities not directly related to volume
and often have multiple cost drivers. These costs are not easily identified with or
traced to units of output (e.g., the salaries of the editorial staff of the publisher of the
text).

In practice, many organizations use a single cost driver to describe each cost even
though many have multiple causes. Careful use of linear-cost behavior with a single
cost driver often provides cost estimates that are accurate enough for most decisions,
though each cost may have a different cost driver. The use of linear cost behavior
may be justified on cost-benefit grounds. See EXHIBIT 3-1 for a graph of linear-
cost behavior, the relevant range, and an activity or resource cost driver level.

II. Management Influence on Cost Behavior {L. O. 1}

Managers can influence cost behavior through their decisions about such factors as
product or service attributes, capacity, technology, and policies to create incentives
to control costs.

A. Product and Service Decisions and the Value Chain—product mix,

design, performance, quality, features, distribution, and so on influence costs
(i.e., the value chain).

B. Capacity Decisions—strategic decisions about the scale and scope of

an organization’s activities result in fixed levels of capacity costs. Capacity
Costs are the fixed costs of being able to achieve a desired level of
production or service. Companies, such as Ford, must be careful in
controlling the level of capacity costs when they have long-term variation in
demand.

C. Committed Fixed Costs—usually arise from the possession of

facilities, equipment, and a basic organization. These are large, indivisible
chunks of cost that the organization is obligated to incur or usually would not
consider avoiding (e.g., mortgage or lease payments, interest payments on

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 long-term debt, property taxes, insurance, and salaries of key personnel).

D. Discretionary Fixed Costs—no obvious relationship to levels of

output activity but are determined as part of the periodic planning process.
Management decides that certain levels of these costs should be incurred to
meet the organization’s goals (e.g., advertising and promotion costs, public
relations, research and development costs, charitable donations, employee
training programs, and purchased management consulting services).
Discretionary fixed costs can be easily altered but become fixed until the next
planning period.

E. Technology Decisions (e.g., labor-intensive versus robotic

manufacturing or traditional banking services versus automated tellers)
position a company to meet current goals and to respond to changes in the
environment and affect the costs of products and services.

F. Cost-Control Incentives—created by management in order to have

employees control costs. Managers use their knowledge of cost behavior to
set expectations, and employees may receive compensation or other rewards
that are tied to meeting these expectations while maintaining quality and
service.

III. Cost Functions {L. O. 2}

Cost Measurement (or measuring cost behavior)—the first step in estimating or
predicting costs as a function of appropriate cost drivers. The second step is to use
these cost measures to estimate future costs at expected levels of the cost-driver
activity. Measuring costs without obvious links to cost drivers presents some
difficulty. Assumed relationships between costs and cost drivers are often used.

A. Form of Cost Functions. Cost Function—Algebraic equations that

describe the relationship between a cost and its cost driver(s). A typical cost
function equation is:

Y = F + VX where:
Y = Total cost

F = Fixed cost

V = Variable cost

X = Cost-driver

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 activity

When this mixed cost function is graphed, F is the intercept of the

vertical axis and V is the slope of the cost function. Sometimes two or more
cost drivers are used.

B. Developing Cost Functions

Two principles should be applied to obtain accurate and useful cost

functions: plausibility (i.e., believable) and reliability (conformity between a
cost function’s estimate of costs at actual levels of activity and actually
observed costs).

C. Choice of Cost Drivers: Activity Analysis {L. O. 3}

Activity Analysis—identifies appropriate cost drivers and their effects
on the costs of making a product or providing a service. The final product or
service may have a number of cost drivers because a number of separate
activities may be involved.

Cost Prediction—applies cost measures to expected future activity

levels to forecast future costs. Activity analysis is especially important for
measuring and predicting costs for which cost drivers are not obvious.

For many years, most organizations used only one cost driver: the
amount of direct labor. However, previously "hidden" activities greatly
influence cost behavior. Activities related to the complexity of performing
tasks affect costs more directly than labor usage or other volume-related
activity measures.

IV. Methods of Measuring Cost Functions {L. O. 4}

A. Engineering Analysis—measures cost behavior according to what
costs should be, not by what costs have been. It entails a systematic review of
materials, supplies, labor, support services, and facilities needed for products
and services. This can be used for existing products or for new products
similar to what has been produced before. Disadvantages are that it is
extremely costly and not timely.

B. Account Analysis—selects a volume-related cost driver and classifies

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 each account from the accounting records as a variable or fixed cost. The cost
analyst then looks at each cost account balance and estimates either the
variable cost per unit of cost driver activity or the periodic fixed cost.

C. High-Low, Visual Fit, and Least-Squares Methods

These methods rely on the use of past cost data to predict costs. These
methods may not be particularly useful in predicting costs for changing
organizations. If these methods are used, the cost analyst must be careful that
the historical data that is from a past environment is not obsolete. Historical
data may hide past inefficiencies that could be reduced if they are identified.

1. High-Low Method—makes use of the costs and

activity levels for the high and low activity levels in a set of data
(unless one of these levels is viewed as an outlier). The difference in
costs for the two activity levels is divided by the difference in activity
levels to determine the variable cost per unit of activity. Then, either
the high activity level and the cost at that activity level or the low
activity level and the cost at that activity are used to solve for the fixed
cost. Due to its reliance on just two data points, this method is rarely
used in practice (see EXHIBIT 3-3).

2. Visual-Fit Method—more reliable than the high-low

method because all the available data are used. In the visual fit
method, the cost analyst visually fits a straight line through a plot of all
of the available data. The line is extended back until it intersects the
vertical axis of the graph. The analyst measures where the line
intersects the cost axis to estimate the fixed cost. An activity level is
selected and the mixed cost at that activity level is used to determine
the variable cost per unit of activity by subtracting fixed cost from
mixed cost and dividing by the activity level. The subjectivity in
placing the line and in estimating the fixed and variable costs are
disadvantages of this method and is rarely used in practice (see
EXHIBIT 3-4).

3. Least-Squares Regression Method—(or simply

regression analysis) uses statistics to fit a cost function to all the data.
Using one cost driver requires simple regression, whereas using more
than one cost driver requires the use of multiple regression. Regression
analysis usually measures cost behavior more reliably than other cost
measurement methods. In addition, regression analysis yields
important statistical information about the reliability of cost estimates
so analysts can assess confidence in the cost measures and select the

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 best cost driver. Coefficient of Determination (R2)—measures how
much of the fluctuation of a cost is explained by changes in the cost
driver (see EXHIBIT 3-5).

V. Appendix 3: Use and Interpretation of Least-Squares Regression

This appendix provides an example of the use of computer spreadsheet regression

commands to perform simple linear regression. Plotting the data and the possible
elimination of outliers are discussed. A data set with two possible cost drivers is
presented (see EXHIBIT 3-6) and the output from the regression commands is
presented. The R2 values of two regression equations are compared to see which
regression equation best fits the data. Caution is provided because the assumptions of
regression analysis should be examined to ensure that the data comply so that useful
results can be obtained. Regression Assumptions—(1) Linearity within the relevant
range; (2) Constant variance of residuals; (3) Independence of residuals; and (4)
Normality of residuals.

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CHAPTER 3: Quiz/Demonstration Exercises

Learning Objective 1

1. Managers influence cost behavior through their _____.

a. technology decisions
b. product and service decisions
c. capacity decisions
d. only A and B
e. A, B and C

2. One of the following costs is an example of a discretionary fixed cost.

a. research and development costs

b. investment in the factory
c. electricity costs
d. investment in production equipment
e. raw material purchases

Learning Objective 2

3. In the cost function equation Y = F + VX, V represents the _____.

a. total cost at the X level of activity

b. fixed cost at the Y level of activity
c. variable cost at the F level of activity
d. variable cost per unit of activity X

4. In the cost function equation Y = F + VX, F represents the _____.

a. slope
b. dependent variable
c. intercept
d. independent variable

Learning Objective 3

5. Which of the following may use activity analysis?

a. Apple Inc.
b. Google

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 c. PriceWaterhouseCoopers LLP (international auditing, tax, and
consulting firm)
d. A, B, and C
e. only C
f. A and B
d
6. Activity analysis provides cost drivers for cost functions. The cost functions should
_____.

a. predict costs
b. be plausible
c. be reliable
d. have benefits that outweigh the costs
e. A, B, and C
e f. only A and D
g. A, B, C, and D

Learning Objective 4

7. The cafeteria department at Tonka Center incurred the following costs for September
20x7:

Monthly Cost September

20x7 Amount

Manager’s salary $ 9,000

Hourly workers’ wages and benefits 28,000
Food 12,000
Equipment depreciation and rental 11,000
Supplies 4,000
Total cafeteria costs $64,000

The cafeteria served 12,500 meals during the month. Using an account analysis to
classify costs, the cost function for Olmstead’s cafeteria department is _____ per
meal.

a. $20,000 + $1.62
b. $20,000 + $3.52
c. $44,000 + $1.60
d. $44,000 + $3.52

Use the following information for questions 8 through 10.

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 The cafeteria department at State University has experienced the following costs and
number of meals served from January through September of 20x7:

Month Cafeteria Costs Meals Served

January $31,800 8,800

February 34,400 9,000
March 36,900 9,800
April 38,300 10,200
May 38,600 10,500
June 34,700 9,200
July 36,300 9,700
August 43,000 12,000
September 41,200 11,500

8. Using the high-low method of cost estimation, the variable cost per meal served is
_____.

a. $ 2.666
b. $ 2.76
c. $ 3.54
d. $ 3.50

9. The estimate of the fixed costs of running the cafeteria department using the high-
low method is _____.

a. $ 1,000
b. $ 630
c. $ 10,733
d. $ 10,928

10. The cost function derived using the high-low method, which can be used to estimate
the costs of running the cafeteria is _____.

a. $1,000 + $3.50X
b. $10,733 + $2.666X
c. $630 + X
d. $10,928 + $2.76X
e. $10,733 + $2.76

11. Bolt Corp. used regression analysis to predict the annual cost of indirect materials.
The results were as follows:

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 Regression Output:

Constant $21,890
Std Err of Y Est $ 4,560
R Squared 0.7832
Number of Observations 22

X Coefficient(s) 11.75
Std Err of Coef. 2.1876

What is the linear cost function?

a. Y = $20,100 + $4.60X
b. Y = $21,890 + $11.75X
c. Y = $21,300 + $2.1876X
d. Y = $ 4,560 + $5.15X

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CHAPTER 3: Solutions to Quiz/Demonstration Exercises

1. [e]
2. [a]
3. [d]
4. [c]
5. [d]
6. [g]

7. [b] In order to answer this problem, the costs must first be classified as
fixed or variable in relation to the cost driver. In this case, the supervisor’s
salary ($9,000 per month) and the equipment depreciation and rental ($11,000
per month) are fixed, whereas the remaining costs ($44,000) vary with the
number of meals served. Dividing the variable costs by the number of meals
served gives $3.52 per meal, and the department’s cost function is $20,000 +
$3.52 per meal.

8. [d] The data for January and August are used because 8,800 is the low
level of activity for the data set and 12,000 is the high level of meals served.
Subtracting the cost for the low activity level from the cost at the high activity
level gives $11,200 ($43,000 – $31,800). Dividing this by the difference in
the activity levels of 3,200 meals (12,000 – 8,800) gives a rate of $3.50 per
meal.

9. [a] Using the variable cost per meal found above of $3.50 and the low
level of activity of 8,800 meals, the variable cost at that activity level is
$30,800. Because the total cost of operating the cafeteria when 8,800 meals
were served is $31,800, $1,000 is the estimate of fixed costs ($31,800 –
$30,800). The variable cost per meal could also be multiplied by the high-
activity level 12,000 to get $42,000, which can be deducted from the total
cost at that level of $43,000 to also arrive at the estimate of fixed costs of
$1,000.

10. [a] This answer is constructed using the elements found in answering
questions 8 and 9.

11. [b]

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