Chapter 2 The Cost Function

LEARNING OBJECTIVES
Chapter 2 addresses the following questions: What are different ways to describe cost behavior? What is a learning curve? What process is used to estimate future costs? 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. Q1 Q2 Q3 Q4

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

000 $11. and Piecewise Linear Cost Functions A.000 + $8. In a service business such as this. The time records that the tax partner maintains support this cost as a direct cost.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 $9.000 Total Cost $12. CPAs do keep detailed time records.000 $10. For the firm to make this cost direct for the personal returns cost object. 2.00*Q Graph of Cost Function $14. Of course. Stepwise Linear.000 $8. the CPA's time is the product being sold. the tax partner probably spends some time in non-billable activities. so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects. the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. TC = $10.000 $13.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.13 Linear.

000 Total cost at 12.000 F = $450.000 units = 10.000 $30.$390.000 * $44 = $528.000 4.000 + $8.000 * $45 = $450.000 $20.000 $40.000)/(12.000 . it is first necessary to estimate the cost function. for Q ≤ 2.000 3. TC = $25.00*Q.000 – 10.000 Calculate the variable cost per unit using the Two-Point method: Change in cost = ($528.000 = $39 per unit Use one data point in the total cost function and solve for F: Using the data for 10.000 Total Cost $50.000 $60.$450.000 units: $450. To estimate the costs at another production level.00*Q.000 $70. Convert the average costs to total costs for each production level: Total cost at 10.000 2.000 $10.000 + $8. for Q > 2.000 .000 $0 0 1.000) Change in volume = $78.000 = $60.000 Combining the fixed and variable costs to create the cost function: TC = $60.000 Number of Units C.000 = F + $39*10.000/2.000 TC = $35.000 units = 12.2-6 Cost Management B.000 + $39*Q .000 Graph of Cost Function $80.

00*Q 2-7 Graph of Cost Function $75.000 $55.00*Q .000 1.000 Number of Units Slope is $10 per unit Slope is $9 per unit Total Cost .000 + $585.14 Piecewise Linear Cost Function A.000 $70.000 + $9. Inserting $10.00*Q.000 in revenues into the cost function.000 + $10.Chapter 2: The Cost Function Estimated total cost at 15.000 Estimated cost per unit = $645.000 = $60.000 units: TC = $60.000 TC = $51. TC = $50.00*(Q-1.000 $65.000 = $645.$9.000 + 45%*$10.500 2. for Q < 1.000) TC = $50.000 = $43 D.000 * $10.000 For Q > 1.000 0 500 1.000 $60.000 + (1.000 + $9.000/15. total cost is estimated as: TC = $5.000 $50.000 + $39*15.500 2.000: TC = $50.000 + $10.000 = $9.00) + $9.000 $45.

000 + $9.000 units but would overestimate total cost for Q > 1. Hours for two returns would be determined as follows. then the cost function would appear to be: TC = $50.000 units but would underestimate total cost for Q ≤ 1.00*Q.000 + $10. 3.3219 Y = 4. This cost function would provide reasonable estimates for Q ≤ 1. then the cost function would appear to be: TC = $51.2-8 Cost Management B.4.000 units.00*Q.000 units. There are three general situations: 1. the cost function mismeasurement depends on the values of Q. This cost function will either overestimate or underestimate costs for almost any level of Q (see Exhibit 2A. 2.3 and 2A. If all of the data estimation points occurred when Q was ≤ 1.8 hours (average time for each of the next two returns) B. Graph of Learning Curve Cumulative Average Hours Per Return 7 6 5 4 3 2 1 2 3 4 Cumulative Number of Returns Prepared .000 units.000 units. If all of the data estimation points occurred when Q was > 1. If the data estimation points occurred across the two relevant ranges. using the learning curve equation Y = αXr Learning rate = 80% α = 6 hours X (units produced) = 2 Learning rate = (ln 0. If the accountant did not detect that there were two different relevant ranges. then the cost function would be some mixture of the functions for the two relevant ranges.80/ln2) = −0. 2.3219 Y = 6 hours*2-0. This cost function would provide reasonable estimates for Q > 1.15 Tax Plus A.

Chapter 2: The Cost Function 2-9 As the accounting graduates become more familiar with the tasks involved in preparing simple tax returns.000. V C. In addition. Total clay cost will vary with the number of bowls made.000/$32. If total variable costs were $8. if time is not traced to individual bowls (for example. 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.17 Glazed Over [Note about problem complexity: Items F and H are coded as “Extend” because judgment is needed for categorization.] A. Note: Depreciation using a method such as declining balance is not constant over time. wages are a direct cost. However. D. F Assuming that employee time can be traced to each bowl. and variable costs remain constant within the relevant range. it improves less quickly for the next return. F . but would still be considered fixed because it does not vary with production volume.25. that is. then variable cost per dollar of revenue is calculated as follows: $8. then wages would be an indirect cost. 2. Wages are fixed because they remain constant (the employee always works 40 hours). it is a direct cost. D or I. However. Assumptions: Fixed costs remain fixed within the relevant range. 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.000 = 0.16 Bison Sandwiches A. I. and their productivity rate will remain stable. The cost probably does not depend on production volume (assuming depreciation is not based on units produced). B. the cost function is: TC = $20. this particular cost function assumes that variable costs are driven by sales. Eventually their learning will plateau. or 25% of sales Combining fixed and variable costs. Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls. it is a common cost of production for all of the bowls that are heat-treated in the kiln. their productivity increases. as their performance improves. making it a fixed cost. Assuming that the cost of clay can be traced to each bowl. 2.000 + 25%*Total sales B.000 on total sales of $32.

it is probably a mixed cost. it is most likely traced to individual bowls. making it a direct and variable cost. 2. making them a common cost for multiple units and an indirect cost. part of the cost might vary proportionately with volume. Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9. E. F or M Pottery studio maintenance is an indirect and fixed cost if it is the same payment every week. depending on whether they are “used up” after a certain quantity of production. so it is treated as fixed. I. I. F or M Electricity is an indirect cost because it cannot be traced to individual bowls. if the cost is too small to justify tracing them). I. V If the glaze is expensive and therefore a relatively large cost.] A. D or I. V Assuming that the cost of packing materials is traced to each bowl. It might be fixed or mixed. This cost is also discretionary. G. because the production area may need more cleaning as volumes increase.2-10 Cost Management D.000 in sales $1.300 $3. then this cost could be indirect. making it an indirect cost. making it a fixed cost. making it an indirect cost.500 . J. D or I.18 Yummy Yogurt [Note about problem complexity: Item A is coded as “Extend” because judgment is needed for categorization. it might not be traced to individual bowls. if the cost is small it might be grouped with overhead costs (variable). making it an indirect cost. depending on what causes the cost to vary. If the kiln is electric.500 ______ $4. this is a direct cost. If it is an hourly charge.000 2. I. They might be fixed or variable. I. Also. Packing costs are most likely variable because they will increase as production increases. Advertising is not directly related to production. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume. F The business license is not related to production. V or F Brushes for the glaze are most likely used for multiple bowls. If the packing materials are not traced (for example. H.300 Variable $4. F. If the cost of glaze is very small. F I.

these costs would be mixed with a large proportion of the cost fixed. total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4. While hourly wages may be related to number of fish caught. and unemployment insurance. Some may be sent home if business is very slow. or M There would most likely be hourly wages in both types of businesses (assuming employees are hired). this cost would most likely be fixed because the cost would not vary within a relevant range of activity. In this type of situation. or 50% of revenue Combining fixed and variable costs. D. workers’ compensation.000 = 0. V Ingredients are used in making pizzas. . FB. so they would tend to be fixed or mixed (see Item A above). F. V. Hourly wages on the fishing boat most likely vary with the number of days or hours the boat is out fishing. costs vary with dollars of revenue.500/$9. because of uncertainty in the success of each fishing expedition. In many organizations. In the pizza shop.300 + 50%*Total revenue C.] A. PS. they are more likely related to time on the boat than pounds of fish. and G are coded as “Extend” because they require substantial business knowledge and/or ability to visualize cost behavior. B. the cost function is: TC = $3. In the fishing boat business. C. as well as voluntary items such as health insurance and retirement benefits. E. Benefits might include mandated items such as social security. D. F or M Employee benefits occur in any business in which employees are hired. B. F. The cost of rent is irrelevant because it will not change with either alternative. and the cost would vary with number of pizzas produced. 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.Chapter 2: The Cost Function 2-11 B. B.19 Pizza Shop and Fishing Boat [Note about problem complexity: Items C.50. There most likely would not be any ingredients in a fishing boat business. 2. Therefore. Benefit costs often vary with level of wages or salaries. employees are likely scheduled in advance on a fixed schedule.

0863 5. 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.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 1.2414 2. Cost of plain burger = $0.0863 0.0033 10.0179 0.3489 $0.$0. For the fishing boat business. B. they are treated as fixed costs. and yellow pages advertisements.95/2.2414 $0.3489 (calculated above) B. depending on how the insurance cost is calculated.0198 0. In general.1619) = $0. Mustard ($.69/7) $0. If the fishing boat is for tourists.99/50) 0. newspaper advertisements. Lettuce ($. Because advertising costs tend to be discretionary.59/16) 0.0053 8.0179 4.6815 .1075 0.1619 0. F. B.5195 = $1. although the cost would probably be much higher for the pizza business because of the utilities needed to run the pizza shop.15/45) 0.2-12 Cost Management E. Cheese ($2.5196 Suggested selling price: 300% * $0.49/(16 x 4)] 0.1075 3. Dill pickles [($8.56 .0233 0.000) * 4] 0. Mayonnaise [$1. Hamburger patty ($1. Cost of burger with everything except cheese = ($0.69/8) 0.6815 A. there might be some utility costs for the fishing operation and for a business office.1619 0.59/40) 0. advertising costs would be incurred. Tomato ($. but it might be mixed if a portion of the cost relates to levels of business activity. F Some type of utility costs (such as water and electricity) would be incurred in both types of business.0053 0. the utility costs for these two businesses would tend to be fixed (would not vary with production). 2.79/150) 0. It will be a fixed cost if it is a flat amount. G. F Most pizza shops incur advertising costs such as flyers.1075 0. PS. Catsup ($. Hamburger bun ($1.0148 6.0233 7.0148 0.0033 $0. F or M Any type of business will have insurance costs.0198 9.2414 $0. The cost might be fixed or mixed.29/12) 0. Onions ($.

In the current business environment. FICA taxes (Social Security taxes) – Mixed – mostly fixed because most employee wages would be fixed J. she needs to know what competitors charge for a similar quality sandwich and price hers competitively.04 . in which case the total cost would be primarily fixed. Professional subscriptions.6815 = $2. 2.79 Some students will view this higher price as "unfair. B. Staff wages – Could be variable or mixed (salary + overtime) for regular staff. 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.Fixed D. Alternatively. If Ms. Therefore. Alternatively.Mostly fixed and discretionary H. Office supplies . If there is part time help." However. Long is able to differentiate her hamburgers from others in the market. the price of the plain hamburger should be: $2.] A.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 and discretionary I. and F) are the ones requiring significant assumptions to generate an answer. there is no moral obligation to maintain a 300% markup on each item. they set prices considering their competitors’ prices. and then mixed C. The Step 2 questions (A. Selling price of cheeseburger with everything: 300% * $0. Long’s prices are too high. D.Mixed. that cost would be variable. she foregoes profits and people may believe there could be quality problems with her food.Fixed E. B. Insurance. if Ms.Fixed . if her prices are too low.25 = $1. Professional dues. that is.Chapter 2: The Cost Function 2-13 C.04 Therefore. most organizations are price takers. This means that her costs need to be below the competitive price. Clerical wages – Fixed unless overtime is regularly scheduled.$0. It is just a general guideline. volumes will drop because customers will go to other fast food restaurants that sell hamburgers. Rent . mostly variable G. Property taxes. Market forces will dictate achievable prices. However staff are often salaried.Fixed F. Licenses.

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

Potential Cost Driver: Output Maintenance Costs Against Output $2.4342166 0.026826 0.78591283 0.58E-05 0.000514 .582691 P-value 6.61765897 0.761602 4.500 Maintenance Costs $2.113687834 Intercept Output Coefficients 884.Chapter 2: The Cost Function 2-15 A.119724 15 Standard Error 153.000 $500 $0 0 500 1000 Output 1500 2000 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.52099624 t Stat 5.000 $1.58824812 182.500 $1.

005847 0.291084 2.60187065 0.36224828 0.000 $1.7549386 1.457384 3.31319046 235.500 $1.210849 15 Standard Error 261.02569657 t Stat 3.000 $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 0.2-16 Cost Management Potential Cost Driver: Direct Labor Hours Maintenance Costs Against Direct Labor Hours $2.717372 P-value 0.017601 .500 Maintenance Costs $2.113464425 Intercept Direct Labor Hours Coefficients 861.

the trend line for machine setups looks as if the intercept could be zero or very close to zero. the cost driver does not explain the variation in cost and either it is the wrong driver.500 Maintenance Costs $2.97410583 0.94495003 66. .5343 P-value 0. a good cost driver would present a linear or football-shaped positive slope or trend.94888217 0.6778973 t Stat 1.500 $1.910475729 Intercept Machine Setups Coefficients 126. For example. In a scatter plot.000 $1.000 $500 $0 0 20 40 Machine Set-Ups 60 80 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0. or the cost is mostly fixed. In Part A. machine setups appears to be the most likely cost driver and direct labor appears to be the least likely cost driver. This indicates that the cost could be totally variable. If the observations are widely scattered.96E-10 B.815737 29. Sometimes a cost that is mostly variable can be identified from a scatter plot. However. all three potential cost drivers appear to be positively related to maintenance costs.357393 15.Chapter 2: The Cost Function 2-17 Potential Cost Driver: Machine Setups Maintenance Costs Against Machine Set-Ups $2.197755 8.5913391 15 Standard Error 93.42597461 1.

so it is excluded from the cost function. the cost is likely to be totally variable. The use of past cost data to predict the future assumes that future resource costs and volumes of activities will remain the same as in the past.945 Cost Function TC = $884 + $0. In the machine setups regression.945. the economic environment. 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. Therefore.025*Direct Labor Hours TC = $29.521*Output TC = $861 +$3. and technology can cause future costs to be different than estimated. . This means that variation in setups explains about 95% of the variation in cost.588 0. business processes.68* Machine Setups The machine setups intercept coefficient is not significant. The regression using machine setups has the highest adjusted R-Square of 0. The regression results and cost function for the three potential cost drivers are: Potential Cost Driver Output Direct labor hours Machine setups Adj.2-18 Cost Management C. R-Square 0. Changes in many factors such as resource prices. the t-statistic is significant for the independent variable but not for the intercept. D.313 0.

which could be outliers.333)/($1.Chapter 2: The Cost Function 2-19 PROBLEMS 2. . the cost function is calculated using the highest and lowest values of the cost driver. the variable cost is calculated: ($68.605 = $11.333 .333 = F + 5%*$1. Under the high-low method. this cost function might provide poor estimates of future costs. that is.$56. Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver.728 Thus. not represent the cost most of the time. That means that the cost function might not represent the actual cost. The high low method uses the most extreme cost driver values.000 = 0.000/$500.728 + 5%*Sales B.132. Therefore.24 Big Jack Burgers A.05. or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68. on average. the total cost function is: TC = $11.100) = $25.100 – $632.132.333 – $43. First.100 F = $68.

Analysis at the account level can be used to increase the understanding of this cost. but the p-value is greater than 10% at 0. Chart of data with trend line added by Excel.5% x sales .000 $20.000 $40.172. Alternatively. Then. Additional judgment is required to decide whether it is appropriate to include a fixed cost in the cost function.000 Administrative Costs $60. etc). the regression intercept can be used as an estimate of the fixed costs. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero.000 $600. Then.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. In that case. trend line extended to Y-axis (dashed line) using Word: Scatter Plot With Trend Line $80.000 $900. the cost function would be: TC = 4. Notice that the t-statistic for the intercept coefficient is 2. D.800 + 4. fixed costs are likely to be zero and would be excluded from the cost function. Based on the p-value. the cost function would be TC = $16.162. analysis at the account level might indicate that there are few fixed costs. there is a 16% probability that the intercept (fixed cost) is not different from zero. If this cost pool includes items such as salaries and other fixed costs (insurance.200. Following is the regression output.000 $1.2-20 Cost Management C. the p-value result for the tstatistic is atypical. The upward slope of the line indicates that there are variable costs. Because this regression has few observations.5% x sales.000 Sales It appears that the cost is most likely mixed.

The cons of the high-low method as an estimation technique were discussed in Part B above. the cost function is: TC = $50. however. Future costs . Cost Function Using Regression A. causing fluctuations in cost that are unrelated to any cost driver. on average. In addition.2444 7734.365 + 0. both of these methods assume that the data points are representative of future costs. and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. The past costs used for estimation might not be representative.45937486 P-value 0.9680477 R Square 0. Unusual cost items are assumed to continue in the future. This means that variation in sales explains only about 18% of the variation in research and development cost.0319523 Intercept X Variable 1 E.90567454 Standard Error 3293. Sales does not appear to explain much of the variation in research and development costs.Chapter 2: The Cost Function 2-21 Regression Statistics Multiple R 0. Using the regression results.186. regression analysis incorporates all of the observations into the analysis. If there are only two or three data points.04466925 0.25 Scatter Plot. Sales might not be the activity that drives administrative costs. The plot shows costs that are widely scattered. F. If there are more data points.17205158 5. Because of unforeseen changes in cost behavior. If these assumptions do not hold.93711636 Adjusted R Square 0. 2. there does appear to be a general upward trend. then both methods may be unsuitable for estimating future costs. the results rely on more complete information and provide a better estimate. especially because so few observations were used in the estimation. The adjusted R-Square statistic is very low at 0.73545 0. However.4038 Observations 4 Coefficients Standard Error 16800. Both methods assume that the cost function is linear and that all data points come from a single relevant range. a cost function may not provide a good estimate for the next month’s costs. This method can be used in cases where there is not enough data to perform regression.16197623 0. There might be a large discretionary component in administrative costs. Therefore.82%*Sales C. B. and possible changes in costs such as those described in Part E are ignored. There might be a change in business operations or in the economy that would cause future costs to be different than in the past.00818212 t Stat 2. the high-low method may be the best option available.

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

90/ln2) = −0.067 $0.00 Average Cost $0. using the learning curve equation Y = αXr α = 10 hours X (units produced) = 4 Learning rate = (ln 0. It is .152 Y = 8. students may think of others. Cons • If Susan has a number of projects in her local area or will be traveling a lot.27 Fancy Furniture A.152 Y = 10 hours*4-0.Chapter 2: The Cost Function 2-23 H.00 + (600-500)*$0. Minutes 300 400 500 600 700 Total Cost $20. Here are some of the reasons. 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. she will pay a very high rate of 10 cents per minute 2. so Susan may need to maintain her own records if she wishes to trace telephone usage. There are many different reasons that the time could be different from the amount determined above.10 = $40. 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. If her calls are over 400 minutes or under 600 minutes. her phone bill will be less than it would be at a rate 5 cents per minute.00 $20.00 + (700-500)*$0.00 $20.10 = $30.1 hours (average time for the first four batches) B. It also depends on whether she can trace telephone calls to individual consulting jobs.05 $0.00 $20. which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). In most businesses.04 $0. Many cellular telephone bills do not list the calls made. 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. Hours per batch would be determined as follows.05 $0.00 $20. telephone costs are viewed as an indirect cost.057 The average cost is lowest at exactly 500 minutes per month. I. she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month.

or overestimated the amount of hand work performed. then the cost would be overestimated.000 + 40%*Total revenue . Wildcat Lair costs: Purchases of prepared food Serving personnel Cashier Administration University surcharge Utilities Totals Fixed $ 30. If a worker is absent one day. If these values are used in a regression to estimate a cost function. C. the cost function is: TC = $47. 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. the rate will change if the replacement employee has never worked on this machine. then this chart suggests that the learning curve will be slower than the 90% estimate.000 Total revenue is the most likely cost driver for both variable costs.000/$70. and B. Food costs are likely to vary proportionately with sales. The observations of labor costs over the first few weeks would not be representative of the labor costs once productivity has stabilized. However. In addition. D.500 10. if managers believe that more than 25% of the work is done by hand. C.000 Variable $21.000 = 0. and the University surcharge is specifically based on sales. they would be higher than the labor costs in later periods. or has a great deal of experience on the machine.500 $47.000 _______ $28. 2.2-24 Cost Management possible that the managers under. it is possible that different types of wood affect the rate at which chairs can be produced.000 5.000 1. In this case the learning rate would be wrong and so the time would also be wrong. or 40% or revenue Combining fixed and variable costs.000 7.40. total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28. Thus. then the chart suggests that the learning rate estimate is reasonable. Because revenue is the cost driver for both variable costs. if managers believe that 25% of the work is done by hand.28 Wildcat Lair A.

less the fixed costs and the variable food costs. but this is not considered a cost driver (a business activity that causes variations in total variable cost).$4. (This is the same as the previous 40% variable cost rate less the university surcharge of 10% of revenues.000.000— the operating loss of $(5. total variable costs are expected to increase by $4. 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).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. Variable food costs are estimated to be 30% ($21.] A.000 = $79.000 .000+$6.000 = $1. If the university were to close the Lair. Thus. F. so the estimated profit in August is $1.000/$70. and the increase is estimated to be 40% of the increase in revenues. the additional profit from a $10.000 ($10.000 increase in revenues is expected to be $6. To estimate the opportunity cost for August.$79.000 Profit = Revenues – Total costs = $80.000 increase in revenues.000 using the cost function is: TC = $47.000 + 30%*Total revenue During August. Item D will be VERY difficult for most students.000. The estimate of total costs given revenues of $80.000) (24. In July there was a loss of $5.000).000*40%). A shop located near a ski area is likely to incur high heating costs during the winter.000 E. Only total variable costs are expected to increase.000 .000).000 (47.000 + 40%*80. the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%*$80. So.Chapter 2: The Cost Function 2-25 D. it would lose the revenues. In a retail business.000) of revenues.000) Net 2. So.000)+the university surcharge of $7.000 ($10. for July the opportunity cost would have been $2. the variable cost part of the cost function can be adjusted. electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning).) The adjusted cost function is: TC = $47. Electricity costs also vary with changes in electricity rates.000 (-$5.000 . Lair’s fixed costs are assumed to be unchanged with the $10.000) $ 9. Because the university surcharge is an allocation within the university. $80.

costs would be higher when there were fewer sales. correlation does not necessarily mean causation. Although these expenditures are made because more money is available. in turn. it might even close when the ski area shuts down.028. However. Assuming the highest electricity cost is during the winter when fewest bathing suits are sold. 2. higher profits generally occur during periods when activity is high. the shop might experience very little business activity.22 . generally mean there is more money available to spend on administrative travel.69 (average cost for each of the 5 units) Total cost = $205. special promotions. For example.2345 Y = $300*5-0. Higher profits. if the bathing suit shop is located in a geographic region where the highest electricity costs occur during the summer because of air conditioning.50 = $1. a 50% markup on total cost will cause sales to be: $1.85/ln2) = 0. C.542.69 x 5 = $1. then the highest sales might coincide with the highest electricity costs. During the spring and summer months.45 Although each customer paid a different price.67 Firm A's income for last year was: Sales Costs Income $1.45 $ 514. employee training. using the learning curve equation Y = αXr α = $300 instead of hours X (units produced) = 5 Learning rate = (ln 0.542.45 x 1. they are discretionary expenditures and not caused by the level of activity. and new office furniture or equipment.028.67 1.028. D. Many costs can be related to volume of activity.30 Firm A and Firm B Costs for Firm A in the first year would be determined as follows. A correlation may appear in a scatter plot or regression analysis. so the trend would be the opposite of this plot. generating most its sales around the ski season (fall and winter).2345 Y = $205. However.2-26 Cost Management B. The shop is most likely a seasonal business.

2345 (notice that the cumulative units produced is 15) Y = $158.50 $ 9.84) Costs (150 x $ 92.00 13.89 x 1.65) Income Firm A's revenues for this year are: (10 x $152. Total cumulative production cost (300 x $78.84 Firm B's costs.10 $ 172. assuming an 85% learning effect would be: Y = $300*150-0.00 13.897.50 .5 = $152. given a 100 unit production level: Y = αXr Y = $300*100-0.384.50 $ 9.625.97) 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 $1.356.528.50 Firm B's calculation for its selling price is as follows: Y = $300*300-0.2345 Y = $101.75 (average cost for each of the 300 units) Note that the cumulative production for Firm B through this year is 300 units.2345 Y = $92.97 (average cost for each of the 15 units produced) Total cost to produce the first 15 units (15 x $158.Chapter 2: The Cost Function 2-27 Firm B set its selling price based on the average cost.55 1.028.356.926.65 (average cost for each of the 150 units produced) Firm B's income statement for last year was: Sales (150 x $152.028.40 Firm A's costs may be computed as follows: Y = $300*15-0.45 $1. firm B's selling price is: $101.75) Total costs to produce the first 150 (from last year’s income statement) Total costs of this year’s production (150 units) $23.84) = $1.2345 Y= $78.897.727.30 $2.528.40 1.10 $22.89 (average cost for each of the 100 units produced) Given a 50% markup on cost.

50 = $97.000 Marketing Dept.000 $8.28) Costs (150 x $64.2-28 Cost Management Average cost per unit = $9.wiley.000 $145. such extreme differences in cost can occur.85 Thus Firm B's selling price this year was $64.727.000 Sales .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.wiley.00 9.85) Income $14.000 $6. available on both the Instructor and Student web sites for the textbook (available at www.com/college/eldenburg). A.000 $5.61. Scatter Plot of Marketing Costs Against Sales $175. Costs $165.28 is lower than Firm A's average cost per unit: $1.592.28 Firm B's income statement for this year is Sales (150 x $97.356.000 $135.864.500. 2.000 $155.500.50 Note that Firm B's selling price for this year of $97.500.31 Belford’s The data for this problem can be found on the datasets file for chapter 2.85 x 1.50/150 units = $64.50 $ 4.000 $7.10/10 = $135.727. Such results often lead to charges of "unfair dumping" but with large differences in cumulative production volumes.500.

34%*Sales D. Here is the regression output.5289E-14 Adjusted R Square 0. Instead. F. they may be positively correlated with sales.63816 0. Regression Statistics Multiple R R Square Standard Error Observations Coefficients Intercept X Variable 1 65584. usually annually. .58184484 13. and most of the observations appear to have a fairly linear trend. the decision maker(s) should be asked what next year’s cost will be. the cost function is: TC = $65. discretionary costs such as marketing are often increased when profits increase.584 + 1. the cost estimate should not be based on past costs. E. When more money is spent on marketing.87116829 4015. Assuming that profits are more likely to increase when sales increase.93336396 0.Chapter 2: The Cost Function 2-29 B. Discretionary costs are set by decision.2608 0. Even if marketing department costs are discretionary. There is a positive slope. it is economically plausible for sales to be a cost driver. Sales seems to be a potential cost driver because there appears to be a positive correlation between the marketing department costs and sales. sales may go up. C.08144 30 Standard Error 6844. In addition.00097028 t Stat 9.01335108 0.86656716 Based on the regression results.4501E-10 5. If the variable portion of the marketing cost is sales commissions.7600071 P-value 2. there would be a positive correlation between marketing department costs and sales. Therefore. using regression or any other technique.

000 $120.com/college/eldenburg).wiley.2-30 Cost Management 2.000 $80.000 $160.000 $40.000 $80.000 $40.32 Peer Jets International The data for this problem can be found on the datasets file for chapter 2.com/college/eldenburg).000 $0 0 300 600 900 1200 1500 Machine Hours .000 $120.wiley. Manufacturing Overhead Against Labor Hours Manufacturing Overhead Cost $200. available on both the Instructor and Student web sites for the textbook (available at www. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.000 $160. A.000 $0 0 500 1000 1500 2000 2500 Labor Hours Manufacturing Overhead Against Machine Hours Manufacturing Overhead Cost $200.

56597156 t Stat 10.552864 .01272369 -0. either the driver is wrong or the cost is mostly fixed.1543 0.11279932 0.600936029 Coefficients Intercept Labor Hours 150410.600712 P-value 6. Costs and potential cost driver data are plotted to determine whether further analysis is necessary. D.Chapter 2: The Cost Function 2-31 Manufacturing Overhead Against Raw Materials Manufacturing Overhead Cost $200. If the observations are widely scattered. Based only on the cost plots.000 $120. None of the plots show a definite trend.86E-11 0. the cost driver does not explain the variation in cost.000 $40.682 4.000 $0 0 100 200 300 400 500 600 700 Raw Materials B. The plots help determine whether regression analysis should be performed using any of the potential drivers. labor hours could be deleted as a potential cost driver. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend.000 $80. but the plot for labor hours appears to have the least trend.000 $160.50852 7.02253618 11114.8173 30 Standard Error 14812. C. Sometimes a cost that is mostly variable. Labor Hours Regression: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.

411 Machine Hours Regression: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.2-32 Cost Management Only the intercept term is significantly different from zero.217192 t Stat 11.56778 19.2533351 0.612063 0.53627459 Coefficients Intercept Raw Materials 126216.082222 P-value 3. The coefficients for each of the other .67 38. so the cost function is estimated as: TC = $126. Labor hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D).5033241 0.331580777 Coefficients Intercept Machine Hours 117598.68E-12 0.62907 3.22* Raw materials E. so the cost function is estimated as: TC = $150.2266685 9665.91 60.215128 t Stat 11.217 + $60.599 + $38.1555 30 Standard Error 10291.000325 Both the intercept and slope coefficients are significant.22*Machine hours Raw Materials Regression: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.004579 Both the intercept and slope coefficients are significant.095468 P-value 4. so the cost function is estimated as: TC = $117.11E-12 0.9786 30 Standard Error 10853.47803 9.3746211 0.3522862 8846.4268 4.

210187 P-value 3. the direct labor hours was not significantly related to manufacturing overhead costs using simple regression. machine hours appears to do the best job of explaining manufacturing overhead costs.wiley.12E-09 1.489 -0.com/college/eldenburg).wiley.10654585 Coefficients Intercept Labor Hours Machine Hours Raw Materials 60988.953575 1. 2. available on both the Instructor and Student web sites for the textbook (available at www.8067018 4832.8266982 0.Chapter 2: The Cost Function 2-33 potential cost drivers are significantly different from zero. however.2349 3.5558 30 Standard Error 10361.05878 9.976635 t Stat 5. Yes. F.226 Based on the simple regression results.com/college/eldenburg).3E-06 0.1959303 48.886218 -0.333162437 5. and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials 0.218173 8.352 0. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.778501 82.291558412 10. Multiple regression with all three potential cost drivers: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.08E-08 . this driver explains only 35% of the variation in cost. A.9092294 0.33 Peer Jets International (continued) The data for this problem can be found on the datasets file for chapter 2.

22 (<0.226) for these two cost drivers.7422519 82.001) B. Manufacturing can be a complex activity requiring a number of different tasks.82667515 0.001) $60.599 (<0.86E-07 4.001) $-0.001) $117.57 (0. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression.2-34 Cost Management Comparison of simple and multiple regression results: Intercept t-stat (p-value) Independent Variables t-stat (p-value) Labor Machine Raw Hours Hours Materials Adj.5348 30 Standard Error 8743.98 (<0.391636 P-value 1.806) than in either of the simple regressions (0. its coefficient is negative rather than positive in the multiple regression.022 0. its coefficient is not significantly different from zero in either regression.005) $82.001) $4.81383627 4742. Also.217 (<0. Each task includes different activities.78 (<0.93*Raw materials D.954) $48.411 (<0.806 $150.226 0.664851 5.29E-09 The cost function is: TC = $60.74*Machine hours + $82. R2 Simple Regressions: Labor Hours Machine Hours Raw Materials Multiple Regression 0.001) $126.939606 9.925842 t Stat 6.352 and 0. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.881964042 Coefficients Intercept Machine Hours Raw Materials 60677. C. labor hours can be eliminated as a potential cost driver. machine hours and raw materials explain different activity .157604083 9. The adjusted RSquare is far higher in the multiple regression (0. Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.450561 8. Costs for these activities are likely related to specific cost drivers.71E-10 5.678 + $48. Thus.352 0.22 (0. Labor hours does not appear to be a cost driver when using either simple regression or multiple regression.20 (0.988 (<0.5902 48.001) $60.90921678 0.55) $38. In this example.

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

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. 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). B.000 $20.000 $10. Scatter Plot of Maintenance Costs Against Number of Maintenance Hours Worked Maint. Costs $25. available on both the Instructor and Student web sites for the textbook (available at www. or number of classes and activities per period.wiley.000 $0 528 530 532 534 536 538 540 542 Number of Students C.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.000 $15.wiley. square feet cleaned. number of hours students attend school.000 $5. 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. Dept.000 $15.000 $10. Students may have thought of other drivers that could be logically related to cleaning maintenance costs. A.000 $20. number of hours the building is open.000 $5. Costs $25. Dept.

18E-05 Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.68624 0. it is rational to conclude that hours worked will provide a reasonable estimate of future costs. The p-values on the Tstatistics are very small.832184392 Standard Error 1217. An unidentified cost driver could have a higher R-Square.796328319 Intercept X Variable 1 Coefficients 9134.0261 t Stat -0.807201 P-value 0. E.453062 P-value 2. maintenance hours is a reasonable cost driver.Chapter 2: The Cost Function 2-37 D. Therefore.461245 7.06772 Observations 12 Standard Error 965. The most current value is used to . providing high confidence that both the intercept and slope are different from zero. it is logical to expect a strong relation between hours worked and cost.173 Observations 12 Standard Error 130954. and rent for this type of facility is usually fixed. 2. changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none.920565237 R Square 0.061172 Adjusted R Square -0.74733262 t Stat 9.247329 R Square 0. Utilities cost varies with season not visits.9 244. From the analyses performed.63E-06 2.0857 Intercept X Variable 1 Coefficients -89867 197. The total cost function is: TC = $9.5045837 4.508157 0.875134 35. it is considered fixed. However.36 The Elder Clinic A and B Salaries are always fixed.438328 According to the R Square statistics. Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.847440356 Adjusted R Square 0.03271 Standard Error 3019. 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.74*maintenance hours worked.135 + $35.

412 1. Use the same method for other expenses. At 940 patient-visits. These would be variable. and costs go up as patient-visits increase. 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. July expenses are estimated to be: TC = $19.441. . medical supplies is a mixed cost. Some supplies. Prices of all inputs could change (usually increase). so this cost is classified as a mixed cost. Given the preceding computations and cost summary. and so on.182 . but not proportionately. There are many possible reasons that could be listed. gloves. Treatments and related costs may change as new drugs are available.182 = F + $3. the cost function is: TC = $19. Here are some of the reasons: • The managers will not know how many visits they will receive. Also.$2. There is no one answer to this part. to find fixed: $3.wiley. such as snake anti-venom.49 Cost Driver Patient-visits Mixed X 2. each patient requires a certain number of supplies. other facilities may open or close.com/college/eldenburg). Use March.2-38 Cost Management predict next period’s utilities. or there are changes in treatment procedures for certain illnesses. current illnesses that are circulating in the area.80 D. weather. variable cost is $3. Other expenses appear to increase and decrease with number of patientvisits. • • E.100 226 664 $19. This analysis suggests that there are some of the other expenses are variable costs and some fixed. affecting the number of visits at this clinic.49 ($3.934)/(849 – 778).07*patient-visits C. **Using high-low.736 + $6. Medical supplies vary with number of patient-visits. high point of medical supplies cost and patient data. and so on.736 Variable $3. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses Fixed $14. new equipment is acquired.49*849. must be kept on hand whether or not they are used. Visits are affected by season. such as tongue depressors. These would be fixed.736 + $6. Therefore.07*940 = $25.07 Patient-visits X * The value in June is used for fixed costs because the increase in salaries will hold into the future.58 $6.115 219 3.

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

com/college/eldenburg).39 Smeyer Industries The data for this problem can be found on the datasets file for chapter 2.286 68.800 .036 68.850 2 . IP-14 3 Payroll paid every two weeks.000 + 500 + 500 + 500 + 500 + 500 Depreciation(b) +$36 1 + 36 -4.486 68. No adjustments are needed for items (c) and (d).350 68. The miscellaneous supplies account also looks suspicious.376 65.310 70.500 38.750 . 1/2 of August 5 payroll goes to July: 5.800.2.8 x 6. 80% of September 2 payroll to August: . but there is insufficient information to make an adjustment.750.300/10 x 12 = 35. A.500 x 1/2 = 2.200 Apr 71. as shown in the scatter plot below.300 + 36 + 36 + 36 + 36 + 36 + 36 + 36 Other Payroll3 Adjusted Cost $68.wiley.736 To predict future overhead. available on both the Instructor and Student web sites for the textbook (available at www. Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead Mar $68. Operations in the month of July are not typical of the rest of the time period.686 71.000 = 4.2-40 Cost Management 2.83/mo.236 69. B.596 73. Because of the large difference between these values and the values in other months.250 May June July Aug Sept Oct Nov 1 Property Tax(a) +$500 + 500 + 500 + 500 -3. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.800 41. (rounded to $36) 2 Note IB-4's power added to Dept.736 67.10.4.com/college/eldenburg). these are correctly handled. the trend line is likely to distort costs.200 +$2.150 73.750 + 4. the first month is adjusted even though it is not an actual cost: 4. Similarly.wiley.750 68. If these observations are included in the regression analysis.790 80. . July’s result is an outlier and should be removed from the data.

412139 0.47 8 Standard Error 29406. According to the details provided for August and September.086126 Based on the t-statistic and p-value for the intercept.050976 P-value 0.775388 0. Therefore.314163 1980.000 $40.000 $45.26 3.500 8.000 2. the fixed cost does not appear to be different from zero. they are most likely recorded at the time of purchase rather than at the time of use.000 Overhead Costs $70.000 $60.000 $55. D. supplies were a large proportion of overhead cost.Chapter 2: The Cost Function 2-41 Scatter Plot of Adjusted Overhead Costs Against Direct Labor Hours $75.500 Outlier Direct Labor Hours C. Based on the variation in dates at which supplies are recorded. Here are the regression results: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.000 6. considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labor hours.000 $50.818 6.298502 2.310484 Intercept X Variable 1 Coefficients 8777.000 9.79 * 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). Thus.000 3. the cost function is estimated as: Overhead cost = $6.641981 0.789722 t Stat 0.500 5.000 $65. Monthly overhead costs for supplies may be significantly overstated or understated .

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

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

then it may be more important to provide the cost function information rapidly than to prepare a high quality report. the manager should be informed about key uncertainties or risks associated with using the cost function. students might think of others. It is typically appropriate to use more technical language in reports written for other accountants than in reports written for non-accounting audiences. If the report will be presented to a superior within the accounting department. and/or unreliable. The desired quality of the report should be weighed against the timeliness of information for the user.2-44 Cost Management 5. • • • . However. The use of technical language should depend on the audience. If the user needs to make a decision quickly. D. Here are some desirable characteristics of a report about an estimated cost function. then the details of the estimation process may be irrelevant. the user should be informed about the priorities used in creating the report. • 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. Note: Some of these ideas were adapted from the Path to Higher-Quality Management Decisions presented in Chapter 1 (Exhibit 1.9). People who lack objectivity are likely to present biased information that impairs high quality decision making. and easy to understand. If the report will be used by a manager who needs to estimate future costs. Changing circumstances can change the patterns of cost behavior and cause an estimated cost function to be inappropriate. The format should be concise. It is important to present the cost function information objectively to improve its relevance and reliability for the user. irrelevant. However. taking into account the knowledge and interests of the user. clear.

.437E-24 1.com/college/eldenburg). available on both the Instructor and Student web sites for the textbook (available at www.7748991 R Square 0. using monthly data for the prior 4 years. the regression explains only about 59% of the variation in labor costs. A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.] The data for this problem can be found on the datasets file for chapter 2.5917832 Standard Error 6216. A. the cost function was estimated by regressing actual labor costs on number of chairs produced.3147402 P-value 3.02E-10 Based on the regression results. The cost function is estimated as: Labor cost = $133.678620854 Intercept X Variable 1 Coefficients 133194. Also. the prior labor costs are biased downward—future labor costs are expected to be higher than past labor costs.194 + $13.7995 Observations 48 Standard Error 6710. However. Because of the annual pay increases.wiley. In prior years.848277 8. Considerable variation in labor costs is not explained by changes in the volume of production. B.com/college/eldenburg).957296 t Stat 19. students are likely to struggle interpreting and choosing a method (Parts E and F). the fixed cost and the variable cost per unit are each positive and statistically different from zero.41 Integrating Across the Curriculum: Statistics [Note about problem complexity: This homework problem was written with adequate instructions so that students should be able to perform the various regression analyses that are called for.609693 1.Chapter 2: The Cost Function 2-45 2. the degree of downward bias is higher for older data than for more recent data. Here are the simple regression results: Regression Statistics Multiple R 0.wiley.04 13.96 x number of chairs produced However.6004687 Adjusted R Square 0.

73E-20 5.23439 t Stat 24.23 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 0.02 Adjusted Labor Cost $220.863839 Standard Error 3742.742261 Standard Error 5148.2-46 Cost Management C. approximately 26% of the variation in labor costs is still unexplained.02)4 $196.010513 1.533 x (1.74).09577 6. the fixed cost and the variable cost per unit are each positive and statistically different from zero. Here are a couple of months’ data for double-checking the calculation of adjusted labor costs: Original Labor Cost Month Jan 20X1 $203. Here are the multiple regression results: Regression Statistics Multiple R 0.486389 P-value 4.06236 11.411 Observations 48 Standard Error 5689.274 Using the adjusted labor cost data.932541 R Square 0.00872 Intercept X Variable 1 X Variable 2 Coefficients 107748.864722 R Square 0. Nevertheless. The cost function is estimated as: Labor cost = $133.869633 Adjusted R Square 0. Also.26499 6.533 Dec 20X4 196.93821 16. which is reasonable given the increase in wage rates over time.8 16.347 x 1.736 + $16.57E-23 2.891 1. The fixed cost is nearly the same.96 to $16. D.54295 t Stat 18.91E-08 .05E-27 2.67711 P-value 1.905 Observations 48 Standard Error 5557.390275 Intercept X Variable 1 Coefficients 133736 16. here are the regression results: Regression Statistics Multiple R 0.35E-15 Based on the regression results.747745 Adjusted R Square 0. but the variable cost increased from $13.23 per chair. this cost function would result in a higher estimate for future costs.347 Calculation $203.492 1.311 200.

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