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CHAPTER 5

COST DRIVERS AND COST BEHAVIOR Questions, Exercises, Problems, and Cases: Answers and Solutions 5.1 5.2 See text or glossary at the end of the book. The engineering method of cost estimation does not primarily rely on historical data. Its major drawback is difficulties encountered in cost estimation when the input-output relationship is not well defined or stable over time. Engineering, account analysis, and regression analysis. a. Cost behavior generally depends on one activity variable (except multiple regression).

5.3 5.4 5.5

(Appendix 5.2) d. a, (measures how well the line fits the data) and b, (is a perfect fit when its value is 1.0). a, (has one dependent variable) and b, (has more than one independent variable).

5.6 5.7

d.

It is true that the length of a short-run period is somewhat arbitrary. However, a short-run period is seen as the time period in which management can change the level of production or other activity only within the constraints of current productive capacity. In the long run, total productive capacity can be changed. The $100,000 only accounts for the increase in variable costs. A 50 percent increase in production could require some capacity changes that would increase some fixed costs too. Account analysis and regression methods. Users should note that the account analysis method is subjective. The validity of the results of the regression method is based on several strict assumptions. Hence, users should be aware that: (1) Correlation of variables does not imply a causal relationship;

5.8

5.9

5-1

Solutions

5.9 continued. (2) Statistical estimation problems should be taken into account before too many inferences are made, and; (3) The data base should be examined for errors and outliers. 5.10 Answers will vary. Possible answers include discussing the potential consequences of this action with the supervisor, going to the supervisors boss to discuss the situation, or leaving the company, given the unethical climate that exists there. Organizations that take steps to encourage ethical behavior are more likely to have employees willing to reveal errors. Steps might include training seminars in ethical behavior, communications from top management regarding the importance of integrity (setting the tone at the top), and providing incentives for employees to admit when errors are made (for example, rewards for employee ideas on how to improve the process which might prevent errors in the future). It is possible for empirical data to show a negative intercept even though fixed costs cannot be negative. It may be that the slope of the cost curve is particularly steep over the values used in the estimation process. This would be particularly likely if the company were operating close to capacity. Negative intercepts usually mean that there is some error in the specification of the cost estimate. If the company is operating close to capacity, then the assumption of a linear cost function may be in error. The analysts at UAL specified the regression model by regressing the change in total costs each period against the independent variables changes in revenue passenger miles and number of system-wide takeoffs. The model demonstrated that increases in costs are primarily associated with changes in levels of passenger traffic. This implies that capacity costs behave like variable costs with changes in levels of operations. (Appendix 5.2) The accountant can use regression analysis to find the equation which best fits a set of known data points. This method provides a statistical estimate of the significance of each cost driver in the regression equation which is unavailable using the other methods discussed in the text. This allows the accountant to test the model for reasonableness and reconstruct it if necessary. Coefficients for cost drivers with t-statistics greater than two are likely to have a significant effect on the dependent variable.

5.11

5.12

5.13

5.14

Solutions

5-2

5.15

(Appendix 5.1) The "learning" phenomenon applies to time; thus, any costs that are a function of time will be affected (e.g., labor, supervisory costs, labor support costs). It may also apply to materials when scrap decreases as experience increases.

5.16

Generally, businesses rely on simplified cost behavior patterns for cost/benefit reasons. By simplifying, some information is lost. However, there is a reduction in the cost of analysis and information retrieval. While it is true that account analysis is subjective, expert judgment can uncover cost behavior patterns which can be overlooked using the other methods. One may: a. b. c. adjust the data to present all costs in some common dollar measure, use activity measures that are expressed in dollars that move with the price change effects in the cost to be estimated, or use a multiple regression approach with a suitable price index as one of the predictor variables.

5.17

5.18

5-3

Solutions

5.19

(Graphs of cost relations.)

a. Total Costs

b. Total Costs

Activity Level c. Variable Costs d. Electricity Costs

Activity Level

Activity Level e. Indirect Labor Costs

2,000

Consumption in Units

f. Total Costs

20

40

Number of Clerks

Units of Output

Solutions

5-4

5.20

(Cost behavior in event of capacity change.)

a.

Total Costs

$87,500 $80,000
$50,000

$30,000

$30,000

Current Capacity
b. Additional Fixed Operating Costs = 0.25 X $30,000 = $7,500. 5.21 (Cost behavior when costs are semivariable.) a. Slope = packages) Intercept = ($15,000 = $1. $12,000)/(9,000

Guest-days

packages -

$6,000

= a cost data point (slope X distance from data point to zero) = $15,000 [$1 X (9,000 packages 0)] = $15,000 $9,000 = $6,000.

Costs

Shipping Department

$15,000 12,000 6,000

6,000 9,000

Number of Packages Shipped

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Solutions

5.21 continued. b. c. 5.22 The variable cost per package shipped is $1. (See Part a.) Fixed cost is $6,000 (the point where the line crosses the vertical axis). (See Part a.)

(Identifying cost behavior.)

Costs $4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 500 1000 1500 2000 2500

slope = $2

slope = $1

Number of Packages Shipped

Plotting the data, these costs appear to be semivariable. The fixed cost component is estimated to be $1,500, and the variable cost component is $1 per package up to 2,000 packages. Slope = = ($3,500 - $1,500)/(2,000 packages 0) = $1 Slope = = ($4,500 - $3,500)/(2,500 packages 2,000 packages) = $2 After 2,000 packages, the slope increases to $2 per package. With only four data points, you should view these estimates skeptically, however.

Solutions

5-6

5.23

(Cost estimation using regression analysis.) a.

Costs

$200,000 160,000 78,045

. . .. . .
200 300 Tax Returns

b.

TC = $78,045 + ($401 X 330 returns) TC = $210,375.

5.24

(Learning curve.) Cumulative Number of Units Produced 1 2 4 8 16 Average Labor Costs per Unit $5,000 4,250 3,612.50 3,070.63 2,610.04 ($5,000 X 85%) ($4,250 X 85%) ($3,612.50 X 85%) ($3,070.63 X 85%)

5.25

(Average cost calculations.) a. b. c. Average fixed cost = $40,000 1,000 memberships = $40. Average variable cost per membership = $80. Average cost per membership = $120 (= $40 + $80).

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Solutions

5.26

(Repair cost behavior.) Within the relevant range, total repair costs will decrease as production is increased. The most likely explanation for the inverse relation between production and repair costs is that repair work is scheduled during slow rather than busy times.

5.27

(Interpreting regression results.) a. b. Overhead = $38,000 + (2.20 X Direct Labor Costs). At $20,000 in direct labor costs: Overhead = $38,000 + (2.20 X $20,000) = $38,000 + $44,000 = $82,000.

c.

(Appendix 5.2) The R-square indicates that approximately 85% of the variation in overhead is explained by the direct labor costs. Someone should figure out whether there should be a relation between direct labor costs and overhead, however.

5.28

(Interpreting regression data.) This problem frequently arises when applying analytical techniques to certain costs. Quite often the advertising expenditures result in sales being generated in the following month or so. In addition, many companies increase their advertising when sales are declining and cut back on advertising when there is capacity business. A better model might relate this month's sales to last month's advertising. Similar problems exist for repair and maintenance costs because machines are usually given routine repairs and maintenance during slow periods. An inverse relationship often exists between salespersons' travel expenses and sales because the salesperson spends more time traveling when the sales are more difficult to make.

Solutions

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5.29

(Cost estimation using regression analysis.)

a.

Overhead Costs x x x

x xx x

x x 8,781

x x

0 2.5 5 7.5 10 12.5

Output in 1,000 Gallons

b.

TC = = = =

F + VX $8,781 + ($0.63 X 10,200 boxes) $8,781 + $6,426 $15,207

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Solutions

5.30

(Multiple regression.) a. The regression equation is: Costs = $12,414 + $2.34 Meals + $9.36 Deliveries + $32.91 VIP Services + $831.18 New Customers + $932.51 New Products Therefore, the cost driver rates are: Meals................................................... Deliveries............................................ VIP Services......................................... New Customers................................... New Products...................................... b. $2.34 per Meal $9.36 per Delivery $32.91 per VIP Service $831.18 per New Customer $932.51 per New Product

The estimated costs of doing business given the following activity levels (i.e., cost driver volumes) are computed using the cost driver rates computed above. Activity Meals Produced Deliveries VIP Services New Customers New Products Intercept Activity Level 12,000 1,100 300 5 2 Rate $ 2.34 $ 9.36 $ 32.91 $ 831.18 $ 932.51 Cost $28,080 10,296 9,873 4,156 1,865 12,414 $66,684

X X X X X

= = = = =

Total Estimated Costs for the Month c. 5.31 The company would save $10,296 for the month.

(Account analysis.) a. The company would have to obtain cost data for each of the following costs: Total costs of meals, total costs of deliveries, total costs of VIP services, total costs of new customers, total costs of new products and total facility level costs for the 16 months. (See Part b. on the following page.)

Solutions

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5.31 continued. b. Cost Driver Rates Meals Produced: $334,368/169,730 Meals* = $1.970 per Meal Deliveries: $164,400/16,440 Deliveries* = $10 per Delivery VIP Services: $140,352/3,674 VIP Services* = $38.201 per VIP Service New Customers: $154,904/103 New Customers* = $1,503.922 per New Customer New Products: $18,700/17 New Products* = $1,100 per New Product *Cost driver volumes are from Problem 5.30. c. Cost Driver Computations Activity Activity Level Rate Cost Meals Produced 12,000 X $ 1.970 = $23,640 Deliveries 1,100 X $ 10 = 11,000 VIP Services 300 X $ 38.201 = 11,460 New Customers 5 X $1,503.922 = 7,520 New Products 2 X $1,100 = 2,200 Estimated Facilities Costs ($159,377/16) 9,961 Total Estimated Costs for the Month $65,781 d. 5.32 According to the account analysis estimate, the company would save $11,000 by outsourcing deliveries.

(Engineering method.) a. Activity Activity Level Meals Produced 12,000 Deliveries 1,100 VIP Services 300 New Customers 5 New Products 2 Estimated Facilities Costs Total Estimated Rate $ 1.90 $ 11 $ 38 $1,250 $1,000 Cost $22,800 12,100 11,400 6,250 2,000 9,500 $64,050

X X X X X

= = = = =

Costs for the Month

b.

The company could save $12,100 by outsourcing deliveries, according to the engineering estimates.

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Solutions

5.33

(Multiple regression.) a. The regression equation is: Costs = $25,419 + $13.480 Beer Produced + $0.685 Raw Materials + $69.724 Batches + $0.920 Water + $19.984 CIPs + $514.560 New Products Therefore, the cost driver rates are: Beer Produced..................................... Raw Materials...................................... Batches............................................... Water................................................... CIPs..................................................... New Products...................................... b. $13.480 per hL $0.685 per kg $69.724 per Batch $0.920 per hL $19.984 per CIP $514.56 per New Product

The estimated costs of doing business given the following activity levels (i.e., cost driver volumes) are computed using the cost driver rates computed above. Activity Beer Produced Raw Materials Batches Water CIPs New Products Intercept Activity Level 1,650 hL 25,500 kg 100 10,800 hL 120 1 Rate 13.480 0.685 69.724 0.920 19.984 514.560 Cost = $ 22,242 = 17,468 = 6,972 = 9,936 = 2,398 = 515 25,419 the Month $ 84,950

X X X X X X

$ $ $ $ $ $

Total Estimated Costs for c.

Target water consumption was 105,820 hL (= 21,164 hL beer produced X 5 hL water). Actual water consumption was 141,972 hL. The difference is 36,152 hL. Thus, $33,260 (= 36,152 hL water X $0.92) would have been saved if the company achieved its target. (Approximately $1,848 per month.)

Solutions

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5.34

(Account analysis.) a. The company would have to obtain cost data for each of the following costs: Total unit level costs, total raw materials costs, total batch-level costs, total water costs, total costs of CIPs, total costs of developing new products and total facility level costs for the 18 months. (See Part b. below.) b. Cost Driver Rates Beer Produced: $292,429.28/21,164 hL produced* = $13.817 per hL Produced Raw Materials: $236,168.40/324,140 kg* = $0.729 per kg Batches: $69,173.19/1,269 Batches* = $54.51 per Batch Water: $141,935.36/141,972 hL = $1.000 per hL CIPs: $29,392.65/1,545 CIPs* = $19.024 per CIP New Product Development: $6,204.64/13 New Products* = $477.280 per New Product *Cost driver volumes are from Problem 5.33. c. Estimated Costs Activity Level 1,650 hL X 25,500 kg X 100 X 10,800 hL X 120 2,283 New Products 1 X Estimated Facilities Costs Total Estimated Costs Activity Beer Produced Raw Materials Batches Water CIPs Rate Cost 13.817 = $22,798 0.729 = 18,590 54.51 = 5,451 1.000 = 10,800 X $ 19.024 = $ $ $ $ $ 477.280 for the Month = 477 24,791 $85,190

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Solutions

5.35

(Engineering method.) Activity Activity Level Beer Produced 1,650 hL Raw Materials 25,500 kg Batches 100 Water 10,800 hL CIPs 120 New Products 1 Estimated Facilities Costs Total Estimated Cost = $22,275 = 17,850 = 6,000 = 9,720 = 2,220 = 500 26,008 Costs for the Month $84,573
X X X X X X

Rate $ 13.50 $ 0.70 $ 60 $ 0.90 $ 18.50 $ 500

5.36

(Interpreting regression results [G. Benston adapted].) a. b. Ignoring the effect on the average batch size, total weekly costs would be expected to increase $8.21. C = $265.80 + ($8.21 X 500 widgets) ($7.83 X 25 batches) + ($12.32 X 300 digits). C = $7,871.05. c. The negative coefficient for the variable B indicates that as the average batch size increases total costs would decrease, holding all other things constant.

5.37

(Regression analysis, multiple choice.) a. b. c. d. (3) Variable cost coefficient. (3) Dependent variable. (4) Independent variable. (1) $684.65 + ($14.577 X 180 hours) = $3,309.

Solutions

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5.38

(Graphing costs and interpreting regression output [CMA adapted].).) a. Scattergraph


Overhead $49,500 46,050 42,600 39,150 35,700 32,250 10,000 13,000 16,000 19,000 22,000 Tacos 25,000

N=24

b.

The regression results indicate an equation of the form: Overhead costs = $19,930 + ($1.0774 X Tacos) Which for 20,000 tacos would equal: $ 19,930 + ($1.0774 X 20,000) = $ 19,930 + $21,548 = $ 41,478

The scattergraph appears to imply a relationship between tacos and costs that curves upward between 13,000 tacos and 25,000 tacos. That is, costs increase faster than implied by a simple straight line in that region.

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Solutions

5.39

(Interpreting regression results, multiple choice [CMA adapted].) a. (4) $119,000. TC = = = = $ 55,000 + ($3.20 X DLH) $ 55,000 + ($3.20 X 20,000) $ 55,000 + $64,000 $119,000

b. (1) $4.38. $ 600,000 50,000 80,000 32,000 $ 438,000 selling price ($6 X 100,000 units) direct material direct labor variable overhead ($3.20 X 10,000 hours) contribution

$438,000/100,000 units = $4.38 per unit. c. (3) $1.62. $ .50 .80 .32 $1.62 direct materials ($50,000/100,000 units) direct labor ($80,000/100,000 units) overhead [($3.20 X 10,000 hours)/100,000 units]

d. (2) TC = $55,000 + $1.62X (see Part c. above.) e. (Appendix 5.2) (1) 90.8%. (5) is also an acceptable answer if one wants to think of adjusted R2 as the proper statistic.

Solutions

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5.40

(Appendix 5.2) (Interpreting multiple regression results.) Direct Labor Hours has a poor fit in the regression. This is probably due to the fact that an oil refinery is capital intensive and, therefore, direct labor hours is not a good activity measure. Units of Output appears to be a pretty good measure with an almost significant t-value. Maintenance Costs has a negative correlation because it is likely that the refinery shuts down or slows down operations for maintenance work. Utilities Costs has a significant relationship with overhead costs. However, correlation does not imply causation. It is quite likely that Utilities Cost forms a large percentage of Overhead Costs. The most appropriate activity base is units of output.

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Solutions

5.41

(Effect of learning on cost behavior.)

a.

Y
1,400 1,333 1,200 1,000 750 600 400 200 x x x x x x x

X
0
b. 5.42

3 4

6 7

75 percent learning curve ($1,000/$1,333; $750/$1,000; $562/$750).

(Estimating health care cost behavior.) Knowledge of the behavior of costs allows accountants to estimate a cost model of the form TC = F + VX. This classifies costs according to whether they are fixed or variable in nature and provides an estimate of total costs given different activity levels. Understanding which costs change with volume in the short run and which costs are fixed allows managers to determine which costs can be reduced without a loss in the level of service. Consider a case in which the number of surgeries increased in the short run and the total costs increased. Some surgical costs could be expected to increase, but how much? Without knowing the equation TC = F + VX, we do not know how much TC (total surgical costs) should increase when X (the number of surgeries) increases. Knowing TC = F + VX helps us to know how much of a cost increase is due to an activity increase and how much is due to inefficiency.

Solutions

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5.43

(Learning curves, managerial decisions [CMA adapted].) a. The analysis prepared by the engineering, manufacturing, and accounting departments of Nippon Company was not correct but its recommendation was correct providing the potential labor cost improvements are ignored. A cost analysis similar to the one shown below should have been prepared to determine whether the pump should be purchased or manufactured. In the analysis below, fixed factory overhead costs and marketing and administrative costs have not been included because they are not relevant; these costs would not increase because no additional equipment, space, or supervision would be required if the pumps were manufactured. Therefore, if potential labor cost improvements are ignored, Nippon Company should purchase the pumps because the purchase price of $68.00 is less than the $72.00 differential cost to manufacture. Cost Analysis Cost of 10,000 Unit Assembly Per Run Unit $ 120,000 $ 12.00 300,000 30.00 300,000 30.00 $ 720,000 $ 72.00

Purchased Components..................................... Assembly Labor................................................. Variable Factory Overhead................................ Total Incremental Cost.................................. b.

If Nippon Company can experience an 80% learning factor, it should manufacture the pumps rather than purchase them. The total incremental cost to manufacture the pumps is $3,417,600 or $42.72 per pump as compared to the purchase price of $68.00 per unit or a total cost of $5,440,000 (= $68 X 80,000). This results in a total savings of $2,022,400 or $25.28 per pump in the first year. With an 80% learning curve by lot, Nippon's assembly labor and variable overhead costs should decrease by 20% every time there is a doubling of cumulative production. The reduction is possible as the laborers become more efficient in performing the tasks. (A steadystate phase will probably occur after a time as the operations become more routine or if the production life is sufficiently long.)

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Solutions

5.43 b. continued. The following labor cost and variable overhead cost behavior by lots would occur: Quantity Per Lot Cumulative 10,000 10,000 10,000 20,000 20,000 40,000 40,000 80,000 Cumulative Total Average Labor Cumulative Cost per Unit Labor Cost $ 30.00 $ 300,000 24.00 (30 X .8) 480,000 19.20 (24 X .8) 768,000 15.36 (19.2 X .8) 1,228,800

This means the average cumulative cost of the assembly labor for the first 80,000 pumps is $15.36 per pump. A revised analysis which considers an 80% learning factor is shown below: Cost per Unit Costs to Manufacture 80,000 Pumps: Purchased Components............................ Assembly Labor........................................ Variable Factory Overhead....................... This page is intentionally left blank $ 42.72..................................................$ Cost to Purchase.......................................... Savings if Pumps Are Manufactured............. 3,417,600 68.00 $ 25.28 $ 12.00 15.36 15.36

Total $ 960,000 1,228,800 1,228,800 Total Incremental Cost 5,440,000 $2,022,400

Solutions

5-20

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