COST ACCOUNTING AND CONTROL – Solutions Manual

CHAPTER 3
COST BEHAVIOR: ANALYSIS AND USE

I. Answers to Questions

1. a. Variable cost: A variable cost is one that remains constant on a per unit
basis, but which changes in total in direct relationship to changes in
volume.
b. Fixed cost: A fixed cost is one that remains constant in total amount, but
which changes, if expressed on a per unit basis, inversely with changes in
volume.
c. Mixed cost: A mixed cost is a cost that contains both variable and fixed
cost elements.
2. a. Unit fixed costs will decrease as volume increases.
b. Unit variable costs will remain constant as volume increases.
c. Total fixed costs will remain constant as volume increases.
d. Total variable costs will increase as volume increases.
3. a. Cost behavior: Cost behavior can be defined as the way in which costs
change or respond to changes in some underlying activity, such as sales
volume, production volume, or orders processed.
b. Relevant range: The relevant range can be defined as that range of
activity within which assumptions relative to variable and fixed cost
behavior are valid.
4. Although the accountant recognizes that many costs are not linear in
relationship to volume at some points, he concentrates on their behavior within
narrow bands of activity known as the relevant range. The relevant range can
be defined as that range of activity within which assumptions as relative to
variable and fixed cost behavior are valid. Generally, within this range an
assumption of strict linearity can be used with insignificant loss of accuracy.
5. The high-low method, the scattergraph method, and the least-squares
regression method are used to analyze mixed costs. The least-squares
regression method is generally considered to be most accurate, since it derives
the fixed and variable elements of a mixed cost by means of statistical
analysis. The scattergraph method derives these elements by visual inspection
only, and the high-low method utilizes only two points in doing a cost analysis,
making it the least accurate of the three methods.
6. The fixed cost element is represented by the point where the regression line
intersects the vertical axis on the graph. The variable cost per unit is
represented by the slope of the line.

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7. The two assumptions are:
1. A linear cost function usually approximates cost behavior within the
relevant range of the cost driver.
2. Changes in the total costs of a cost object are traceable to variations or
changes in a single cost driver.
8. No. High correlation merely implies that the two variables move together in
the data examined. Without economic plausibility for a relationship, it is less
likely that a high level of correlation observed in one set of data will be found
similarly in another set of data.
9. Refer to page 64 of the textbook.
10. The relevant range is the range of the cost driver in which a specific
relationship between cost and cost driver is valid. This concept enables the use
of linear cost functions when examining CVP relationships as long as the
volume levels are within that relevant range.
11. A unit cost is computed by dividing some amount of total costs (the numerator)
by the related number of units (the denominator). In many cases, the
numerator will include a fixed cost that will not change despite changes in the
denominator. It is erroneous in those cases to multiply the unit cost by activity
or volume change to predict changes in total costs at different activity or
volume levels.
12. Cost estimation is the process of developing a well-defined relationship
between a cost object and its cost driver for the purpose of predicting the cost.
The cost predictions are used in each of the management functions:
Strategic Management: Cost estimation is used to predict costs of alternative
activities, predict financial impacts of alternative strategic choices, and to
predict the costs of alternative implementation strategies.
Planning and Decision Making: Cost estimation is used to predict costs so that
management can determine the desirability of alternative options and to budget
expenditures, profits, and cash flows.
Management and Operational Control: Cost estimation is used to develop cost
standards, as a basis for evaluating performance.
Product and Service Costing: Cost estimation is used to allocate costs to
products and services or to charge users for jointly incurred costs.
13. The five methods of cost estimation are:
a. Account Classification. Advantages: simplicity and ease of use.
Disadvantages: subjectivity of method and some costs are a mix of both
variable and fixed.
b. Visual fit. The visual fit method is easy to use, and requires only that the
data is graphed. Disadvantages are that the scale of the graph may limit
ability to estimate costs accurately and in both graphical and tabular form,
significant perceptual errors are common.

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 c. High-Low. Because of the precision in the development of the equation, it
provides a more consistent estimate than the visual fit and is not difficult
to use. Disadvantages: uses only two selected data points and is,
therefore, subjective.
d. Work Measurement. The advantage is accurate estimates through detailed
study of the different operations in the product process, but like regression,
it is more complex.
e. Regression. Quantitative, objective measures of the precision and
accuracy and reliability of the model are the advantages of this model;
disadvantages are its complexity: the effort, expense, and expertise
necessary to utilize this method.
14. Implementation problems with cost estimation include:
a. cost estimates outside of the relevant range may not be reliable.
b. sufficient and reliable data may not be available.
c. cost drivers may not be matched to dependent variables properly in each
observation.
d. the length of the time period for each observation may be too long, so that
the underlying relationship between the cost driver and the variable to be
estimated is difficult to isolate from the numerous variables and events
occurring in that period of time; alternatively the period may be too short,
so that the data is likely to be affected by accounting errors in which
transactions are not properly posted in the period in which they occurred.
e. dependent variables and cost drivers may be affected by trend or
seasonality.
f. when extreme observations (outliers) are used the reliability of the results
will be diminished.
g. when there is a shift in the data, as, for example, a new product is
introduced or when there is a work stoppage, the data will be unreliable
for future estimates.
15. The dependent variable is the cost object of interest in the cost estimation. An
important issue in selecting a dependent variable is the level of aggregation in
the variable. For example, the company, plant, or department may all be
possible levels of data for the cost object. The choice of aggregation level
depends on the objectives for the cost estimation, data availability, reliability,
and cost/benefit considerations. If a key objective is accuracy, then a detailed
level of analysis is often preferred. The detail cost estimates can then be
aggregated if desired.
16. Nonlinear cost relationships are cost relationships that are not adequately
explained by a single linear relationship for the cost driver(s). In accounting
data, a common type of nonlinear relationship is trend and seasonality. For a
trend example, if sales increase by 8% each year, the plot of the data for sales
with not be linear with the driver, the number of years. Similarly, sales which
fluctuate according to a seasonal pattern will have a nonlinear behavior. A
different type of nonlinearity is where the cost driver and the dependent

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 variable have an inherently nonlinear relationship. For example, payroll costs
as a dependent variable estimated by hours worked and wage rates is nonlinear,
since the relationship is multiplicative and therefore not the additive linear
model assumed in regression analysis.
17. The advantages of using regression analysis include that it:
a. provides an estimation model with best fit (least squared error) to the data
b. provides measures of goodness of fit and of the reliability of the model
which can be used to assess the usefulness of the specific model, in
contrast to the other estimation methods which provide no means of self-
evaluation
c. can incorporate multiple independent variables
d. can be adapted to handle non-linear relationships in the data, including
trends, shifts and other discontinuities, seasonality, etc.
e. results in a model that is unique for a given set of data
18. High correlation exists when the changes in two variables occur together. It is
a measure of the degree of association between the two variables. Because
correlation is determined from a sample of values, there is no assurance that it
measures or describes a cause and effect relationship between the variables.
19. An activity base is a measure of whatever causes the incurrence of a variable
cost. Examples of activity bases include units produced, units sold, letters
typed, beds in a hospital, meals served in a cafe, service calls made, etc.
20. (a) Variable cost: A variable cost remains constant on a per unit basis, but
increases or decreases in total in direct relation to changes in activity.
(b) Mixed cost: A mixed cost is a cost that contains both variable and fixed
cost elements.
(c) Step-variable cost: A step-variable cost is a cost that is incurred in large
chunks, and which increases or decreases only in response to fairly wide
changes in activity.

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 21. The linear assumption is reasonably valid provided that the cost formula is
used only within the relevant range.
22. A discretionary fixed cost has a fairly short planning horizon—usually a year.
Such costs arise from annual decisions by management to spend on certain
fixed cost items, such as advertising, research, and management development.
A committed fixed cost has a long planning horizon—generally many years.
Such costs relate to a company’s investment in facilities, equipment, and basic
organization. Once such costs have been incurred, they are “locked in” for
many years.
23. a. Committed d. Committed
b. Discretionary e. Committed
c. Discretionary f. Discretionary
24. The high-low method uses only two points to determine a cost formula. These
two points are likely to be less than typical since they represent extremes of
activity.
25. The term “least-squares regression” means that the sum of the squares of the
deviations from the plotted points on a graph to the regression line is smaller
than could be obtained from any other line that could be fitted to the data.
26. Ordinary single least-squares regression analysis is used when a variable cost is
a function of only a single factor. If a cost is a function of more than one
factor, multiple regression analysis should be used to analyze the behavior of
the cost.

II. Answers to Exercises

Exercise 1 (Cost Classification)

1. b
2. f
3. e
4. i
5. e
6. h
7. l
8. a
9. j
10. k
11. c or d
12. g

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Exercise 2 (Cost Estimation; Account Classification)

Requirement 1

Fixed Costs:
Rent P10,250
Depreciation 400
Insurance 750
Advertising 650
Utilities 1,250
Mr. Black’s salary 18,500
Total P31,800
Variable Costs:
Wages P17,800
CD Expense 66,750
Shopping Bags 180
Total P84,730

Variable Costs Per Unit = P84,730 / 8,900

= P95.20

Cost Function Equation: y = P31,800 + P95.20 x (CD’s sold)

Requirement 2

New Sales = 8,900 x 1.25

= 11,125 units
= round to 11,130

Total Costs = P31,800 + P95.20 x (11,130)

= P137,760

Per Unit Total Costs = P137,760 / 11,130

= P123.80

Add P1 profit per disc: P123.80 + P10 = P133.80

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Requirement 3

Adjusted New Sales = 8,900 x 11.50

= 10,240 units

Revenue = P133.80 x (10,240)

= P137,010

Total Cost = P31,800 + P95.20 x (10,240)

= P129,280

Cost Per Disc = P129,280 / 10,240 = P126.30

Profit Per Disk = P133.80 – P126.30

= P7.50

Exercise 3 (Cost Estimation Using Graphs; Service)

Requirement 1

Sales and Advertising Expense

P160,000
P140,000
P120,000
P100,000
Sales

P80,000
P60,000
P40,000
P20,000
P0
P2,500

P3,000

P3,500

P5,000

P5,500
P4,000

P4,500

Advertising Expense

Requirement 2

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There seems to be a positive linear relationship for the data between P2,500 and
P4,000 of advertising expense. Llanes’ analysis is correct within this relevant
range but not outside of it. Notice that the relationship between advertising
expense and sales changes at P4,000 of expense.

Exercise 4 (Fixed and Variable Cost Behavior)

Requirement (1)
Cups of Coffee Served
in a Week
1,800 1,900 2,000
Fixed cost P11,000 P11,000 P11,000
Variable cost    4,680    4,940    5,200
Total cost P15,680 P15,940 P16,200
Cost per cup of coffee served * P8.71 P8.39 P8.10
* Total cost ÷ cups of coffee served in a week

Requirement (2)

The average cost of a cup of coffee declines as the number of cups of coffee served
increases because the fixed cost is spread over more cups of coffee.

Exercise 5 (High-Low Method)

Requirement (1)

Month Occupancy-Days Electrical Costs

High activity level (August)......................... 3,608 P8,111
Low activity level (October).........................   186  1,712
Change........................................................... 3,422 P6,399

Variable cost = Change in cost ÷ Change in activity

= P6,399 ÷ 3,422 occupancy-days
= P1.87 per occupancy-day

Total cost (August)........................................................................................................

P8,111
Variable cost element
(P1.87 per occupancy-day × 3,608 occupancy-days)...............................................   6,747
Fixed cost element.........................................................................................................
P1,364

Requirement (2)

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Electrical costs may reflect seasonal factors other than just the variation in
occupancy days. For example, common areas such as the reception area must be
lighted for longer periods during the winter. This will result in seasonal effects on
the fixed electrical costs.

Additionally, fixed costs will be affected by how many days are in a month. In
other words, costs like the costs of lighting common areas are variable with respect
to the number of days in the month, but are fixed with respect to how many rooms
are occupied during the month.

Other, less systematic, factors may also affect electrical costs such as the frugality
of individual guests. Some guests will turn off lights when they leave a room.
Others will not.

Exercise 6 (Least-Squares Regression)

The least-squares regression estimates of fixed and variable costs can be computed
using any of a variety of statistical and mathematical software packages or even by
hand.

Month Rental Returns Car Wash Costs

January............................................ 2,310 P10,113
February.......................................... 2,453 P12,691
March.............................................. 2,641 P10,905
April................................................ 2,874 P12,949
May................................................. 3,540 P15,334
June................................................. 4,861 P21,455
July.................................................. 5,432 P21,270
August............................................. 5,268 P19,930
September....................................... 4,628 P21,860
October........................................... 3,720 P18,383
November....................................... 2,106 P 9,830
December........................................ 2,495 P11,081

Intercept P2,296
Slope P3.74
RSQ 0.92

The intercept provides the estimate of the fixed cost element, P2,296 per month,
and the slope provides the estimate of the variable cost element, P3.74 per rental

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 return. Expressed as an equation, the relation between car wash costs and rental
returns is
Y = P2,296 + P3.74X

where X is the number of rental returns.

Note that the R2 is 0.92, which is quite high, and indicates a strong linear
relationship between car wash costs and rental returns.

While not a requirement of the exercise, it is always a good to plot the data on a
scattergraph. The scattergraph can help spot nonlinearities or other problems with
the data. In this case, the regression line (shown below) is a reasonably good
approximation to the relationship between car wash costs and rental returns.

III. Answers to Multiple Choice Questions

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 1. A 11. C* 21. C 31. D 41. B
2. D 11. C* 22. D 32. B 42. D
3. B 12. C 23. C 33. A 43. C
4. A 13. A 24. A 34. B
5. B 14. D 25. D 35. A
6. B 15. C 26. B 36. D
7. C 16. D 27. D 37. B
8. D 17. B 28. B 38. C
9. C 18. C 29. A 39. B
10. A 19. C 30. D 40. D

* Supporting Computations:
11. (10,000 x 2) – (P3,000 x 2) – P5,000 = P9,000
12. [(P20 + P3 + P6) x 2,000 units] + (P10 x 1,000 units) = P68,000

IV. Answers to Problems

Problem 1

Requirement (a) Miles Total Annual

Driven Cost*
High level of activity............................... 120,000 P13,920
Low level of activity................................ 80,000 10,880
Difference........................................... 40,000 P 3,040

* 120,000 miles x P0.116 = P13,920.

80,000 miles x P0.136 = P10,880.
Variable cost per mile:
Change in cost, P3,040
Change in activity, 40,000 = P0.076 per mile.
Fixed cost per year:
Total cost at 120,000 miles........................................... P13,920
Less variable cost element: 120,000 x P0.076............. 9,120
Fixed cost per year..................................................... P 4,800
Requirement (b)
Y = P4,800 + P0.076X

Requirement (c)

Fixed cost.............................................................................. P 4,800

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 Variable cost: 100,000 miles x P0.076................................ 7,600
Total annual cost............................................................ P12,400

Problem 2

Requirement 1

Cost of goods sold............................................................... Variable

Shipping expense................................................................ Mixed
Advertising expense............................................................ Fixed
Salaries and commissions................................................... Mixed
Insurance expense............................................................... Fixed
Depreciation expense.......................................................... Fixed

Requirement 2

Analysis of the mixed expenses:

Salaries and
Shipping Comm.
Units Expense Expense
High level of activity.................... 4,500 P56,000 P143,000
Low level of activity.................... 3,000 44,000 107,000
Difference.............................. 1,500 P12,000 P 36,000

Variable cost element:

Change in cost
Change in activity = Variable rate

Shipping expense: P12,000

1,500 units = P8 per unit.

P36,000
Salaries and comm. expense: 1,500 units = P24 per unit.
Fixed cost element:
Shipping Salaries and
Expense Comm. Expense
Cost at high level of activity..................... P56,000 P143,000
Less variable cost element:
4,500 units x P8.................................. 36,000
4,500 units x P24................................ 108,000

Fixed cost element..................................... P20,000 P 35,000

The cost elements are:
Shipping expense: P20,000 per month plus P8 per unit or Y = P20,000 +
P8X.

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 Salaries and comm. expense: P35,000 per month plus P24 per unit or Y =
P35,000 + P24X.

Requirement 3
LILY COMPANY
Income Statement
For the Month Ended June 30
Sales in units........................................................... 4,500
Sales revenues......................................................... P630,000
Less variable expenses:
Cost of goods sold (@P56)............................... P252,000
Shipping expense (@P8)................................... 36,000
Salaries and commission expense
(@P24)........................................................... 108,000 396,000
Contribution margin............................................... 234,000
Less fixed expense:
Shipping expense.............................................. 20,000
Advertising........................................................ 70,000
Salaries and commissions................................. 35,000
Insurance........................................................... 9,000
Depreciation...................................................... 42,000 176,000
Net income.............................................................. P 58,000

Problem 3 (Linear Cost Approximation)

Requirement 1

Difference in cost
Slope coefficient (b) =
Difference in labor-hours
P529,000 – P400,000
= = P43.00
7,000 – 4,000
Constant (a) = P529,000 – P43.00 (7,000)
= P228,000

Cost function = P228,000 + P43.00 (professional labor-hours)

The linear cost function is plotted in Figure 3-A (Page 3-15)

No, the constant component of the cost function does not represent the fixed
overhead cost of the ABS Group. The relevant range of professional labor-hours is
from 3,000 to 8,000. The constant component provides the best available starting
point for a straight line that approximates how a cost behaves within the 3,000 to
8,000 relevant range.

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Requirement 2

A comparison at various levels of professional labor-hours follows. The linear cost

function is based on formula of P228,000 per month plus P43.00 per professional
labor-hours.

Total overhead cost behavior:

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6

Actual total
overhead P340,000 P400,000 P435,000 P477,000 P529,000 P587,000
costs
Linear 357,000 400,000 443,000 486,000 529,000 572,000
approximati
on
Actual minus
linear P(17,000) P 0 P (8,000) P (9,000) P 0 P15,000
approximati
on
Professional 3,000 4,000 5,000 6,000 7,000 8,000
labor-hours

The data are shown in Figure 3-A. The linear cost function overstates costs by
P8,000 at the 5,000-hour level and understates costs by P15,000 at the 8,000-hour
level.

Requirement 3
Based on
Based on Linear Cost
Actual Function
Contribution before deducting incremental
overhead P38,000 P38,000
Incremental overhead 35,000 43,000
Contribution after incremental overhead P 3,000 P (5,000)

The total contribution margin actually forgone is P3,000.

Figure 3-A

Linear Cost Function Plot of Professional Labor-Hours

on Total Overhead Costs for ABS Consulting Group

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 P700,000

P600,000
Total Overhead Costs

P500,000

P400,000

P300,000

P200,000

P100,000

P0
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000
Professional Labor-Hours Billed

Answer to Test Material 3-1

Requirement (1)

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The first step in the high-low method is to identify the periods of the lowest and
highest activity. Those periods are November (1,100 patients admitted) and June
(1,900 patients admitted).

The second step is to compute the variable cost per unit using those two data
points:

Number of Admitting
Month Patients Admitted Department Costs
High activity level (June) 1,900 P15,200
Low activity level (November) 1,100 12,800
Change 800 P 2,400

Change in cost
Variable cost =
Change in activity
P240,000
=
800 patients admitted

= P3 per patient admitted

The third step is to compute the fixed cost element by deducting the variable cost
element from the total cost at either the high or low activity. In the computation
below, the high point of activity is used:

Fixed cost element = Total cost – Variable cost element

= P15,200 – (P3 per patient admitted
x 1,900 patients admitted)
= P9,500

Requirement (2)

The cost formula is Y = P9,500 + P3X.

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