Chapter 3

Measurement of Cost Behavior

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

1. Describe step- and mixed-cost behavior.

2. Explain management influences on cost behavior.

3. Measure and mathematically express cost functions and use them

to predict costs.

4. Describe the importance of activity analysis for measuring cost

functions.

5. Measure cost behavior using the engineering analysis, account

analysis, high-low, visual-fit, and least-squares regression methods.

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 CHAPTER 3: ASSIGNMENTS
CRITICAL THINKING EXERCISES

26. Mixed Costs and the Sales Force

27. Committed and Discretionary Fixed Costs in
Manufacturing
28. Cost Functions and Decision Making
29. Statistical Analysis and Cost Functions

EXERCISES

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

PROBLEMS

43. Controlling Risk, Capacity Decisions, Technology

Decisions
44. Step Costs
45. Government Service Cost Analysis
46. Cost Analysis at US Airways
47. Separation of Drug Testing Laboratory Mixed Costs into
Variable and Fixed Components
48. School Cost Behavior
49. Activity Analysis
50. High-Low, Regression Analysis
51. Interpretation of Regression Analysis
52. Regression Analysis
53. Choice of Cost Driver

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 54. Use of Cost Functions for Pricing
55. Review of Chapters 2 and 3

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 CASES

56. Government Health Cost Behavior

57. Activity Analysis
58. Identifying Relevant Data
59. Nike 10-K Problem: Step- and Mixed Cost Drivers

EXCEL APPLICATION EXERCISE

60. Fixed and Variable Cost Data

COLLABORATIVE LEARNING EXERCISE

61. Cost-Behavior Examples

INTERNET EXERCISE

62. Cost Behavior at Southwest Airlines

(http://www.southwest.com)

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CHAPTER 3: OUTLINE
I. Cost Drivers and Cost Behavior

Accountants and managers assume that cost behavior is linear

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

In practice, many organizations use a single cost driver to describe

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

A. Step- and Mixed-Cost Behavior Patterns {L.

O. 1}
CHAPTER 2 describes variable costs as those that vary in
proportion to changes in their cost drivers and fixed costs as
those that are not affected by cost-driver activity. Two types
of costs combine characteristics of both fixed and variable
cost behavior.

1. Step costs - change abruptly at intervals of activity

because the resources and their costs come in
indivisible chunks. A large step (e.g., the cost of leasing
oil and gas drilling equipment) is a step-fixed cost. A
small step (e.g., the wage cost of cashiers in a
supermarket) is a step-variable cost (see EXHIBIT 3-2).

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 2. Mixed costs - contain elements of both fixed and
variable cost behavior. The fixed portion is determined
by the planned range of activity level, while the variable
cost element varies proportionately with activity within
the relevant range (e.g., the cost of facilities
maintenance in a medical center). Salaries of the
maintenance personnel and costs of equipment are
fixed, while cleaning supplies and repair materials vary
with the number of patient-days (see EXHIBIT 3-3).

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II. Management Influence on Cost Behavior {L. O.
2}
Managers can influence cost behavior through their decisions about
such factors as product or service attributes, capacity, technology,
and policies to create incentives to control costs.

A. Product and Service Decisions and the Value Chain -

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

B. Capacity Decisions. Strategic decisions about the scale

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

C. Committed Fixed Costs - usually arise from the possession

of facilities, equipment, and a basic organization. These are
large, indivisible chunks of cost that the organization is
obligated to incur or usually would not consider avoiding (e.g.,
mortgage or lease payments, interest payments on long-term
debt, property taxes, insurance, and salaries of key
personnel).

D. Discretionary Fixed Costs - no obvious relationship to

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

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

manufacturing or traditional banking services versus
automated tellers) position a company to meet current goals

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 and to respond to changes in the environment and affect the
costs of products and services.

F. Cost-Control Incentives - created by management in order

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

Copyright ©2011 Pearson Education, Inc., Publishing as Prentice Hall. 37

III. Cost Functions {L. O. 3}
Cost Measurement (or measuring cost behavior) - the first step in
estimating or predicting costs as a function of appropriate cost
drivers. The second step is to use these cost measures to estimate
future costs at expected levels of the cost-driver activity. Measuring
costs without obvious links to cost drivers presents some difficulty.
Assumed relationships between costs and cost drivers are often
used.

A. Form of Cost Functions. Cost Function - Algebraic

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

Y = F + VX where: Y = Total cost

F = Fixed cost
V = Variable cost
X = Cost-driver activity

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

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

B. Developing Cost Functions

Two principles should be applied to obtain accurate and useful

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

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

4}
Activity Analysis - identifies appropriate cost drivers and
their effects on the costs of making a product or providing a
service. The final product or service may have a number of
cost drivers because a number of separate activities may be
involved.

Cost Prediction - applies cost measures to expected future

activity levels to forecast future costs. Activity analysis is

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 especially important for measuring and predicting costs for
which cost drivers are not obvious.

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

IV. Methods of Measuring Cost Functions {L. O. 5}

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

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

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

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

These methods rely on the use of past cost data to predict

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

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

activity levels for the high and low activity levels in a set
of data (unless one of these levels is viewed as an
outlier). The difference in costs for the two activity
levels is divided by the difference in activity levels to
determine the variable cost per unit of activity. Then,
either the high activity level and the cost at that activity

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 level or the low activity level and the cost at that
activity are used to solve for the fixed cost. Due to its
reliance on just two data points, this method is rarely
used in practice (see EXHIBIT 3-4).

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

method because all the available data are used. In the
visual fit method, the cost analyst visually fits a straight
line through a plot of all of the available data. The line
is extended back until it intersects the vertical axis of
the graph. The analyst measures where the line
intersects the cost axis to estimate the fixed cost. An
activity level is selected and the mixed cost at that
activity level is used to determine the variable cost per
unit of activity by subtracting fixed cost from mixed cost
and dividing by the activity level. The subjectivity in
placing the line and in estimating the fixed and variable
costs are disadvantages of this method and is rarely
used in practice (see EXHIBIT 3-5).

3. Least-Squares Regression Method – (or simply

regression analysis) uses statistics to fit a cost function
to all the data. Using one cost driver requires simple
regression, while using more than one cost driver
requires the use of multiple regression. Regression
analysis usually measures cost behavior more reliably
than other cost measurement methods. In addition,
regression analysis yields important statistical
information about the reliability of cost estimates so
analysts can assess confidence in the cost measures
and select the best cost driver. Coefficient of
Determination (R ) - measures how much of the
2

fluctuation of a cost is explained by changes in the cost

driver (see EXHIBIT 3-6).

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

Regression

This appendix provides an example of the use of computer

spreadsheet regression commands to perform simple linear
regression. Plotting the data and the possible elimination of outliers
are discussed. A data set with two possible cost drivers is

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 presented (see EXHIBIT 3-7) and the output from the regression
commands is presented. The R 2 values of two regression equations
are compared to see which regression equation best fits the data.
Caution is provided because the assumptions of regression analysis
should be examined to ensure that the data comply so that useful
results can be obtained. Regression Assumptions – (1) Linearity
within the relevant range; (2) Constant variance of residuals; (3)
Independence of residuals; and (4) Normality of residuals.

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CHAPTER 3: Quiz/Demonstration
Exercises
Learning Objective 1

1. A cost that changes abruptly at intervals of activity because the

resources and the costs come in indivisible chunks is called a(n)
_____ cost.

a. indivisible
b. mixed
c. activity
d. step

2. The portion of a mixed cost that remains constant per unit

with activity within the relevant range.

a. indivisible
b. fixed
c. variable
d. step

Learning Objective 2

3. Managers influence cost behavior through their _____.

a. technology decisions
b. product and service decisions
c. capacity decisions
d. all of these
e. only A and B

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

cost.

a. investment in production equipment

b. investment in the factory
c. electricity costs
d. research and development costs
e. raw material purchases

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Learning Objective 3

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

a. total cost at the X level of activity

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

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

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

Learning Objective 4

7. Which of the following may use activity analysis?

a. Apple Inc.
b. Google
c. Price Waterhouse, Coopers LLP (international auditing, tax,
and consulting firm)
d. only A and B
e. only C
f. A, B, and C
d
8. Activity analysis provides cost drivers for cost functions. The cost
functions should _____.

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

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Learning Objective 5

9. The cafeteria department at Olmstead Center incurred the following

costs for September 20x7:

Monthly Cost September 20x7

Amount

Manager's salary $ 9,000

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

The cafeteria served 12,500 meals during the month. Using an

account analysis to classify costs, the cost function for Olmstead's
cafeteria department is _____ per meal.

a. $20,000 + $3.52b. $20,000 + $1.62

c. $44,000 + $1.60 d. $44,000 + $3.52

Use the following information for questions 10 through 12.

The cafeteria department at Mercy Hospital has experienced the

following costs and number of meals served from January through
September of 20x7:

Month Cafeteria Costs Meals

Served

January $31,800 8,800

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

10. Using the high-low method of cost estimation, the variable cost per

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 meal served is _____.

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

$3.54

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

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

10,928

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

a. $630 + $3.54X
b. $10,733 + $2.666X
c. $1,000 + $3.50X
d. $10,928 + $2.76X
e. $10,733 + $2.76

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

Regression Output:

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

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

What is the linear cost function?

a. Y = $20,100 + $4.60X
b. Y = $21300 + $2.1876X
c. Y = $21,890 +11.75X
d. Y = $ 4,560 + $5.15X

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CHAPTER 3: Solutions to
Quiz/Demonstration Exercises

1. [d] 2. [c] 3. [d] 4. [d]

5. [c]

6. [b] 7. [f] 8. [e]

9. [a] In order to answer this problem, the costs must first be

classified as fixed or variable in relation to the cost driver. In
this case, the supervisor's salary ($9,000 per month) and the
equipment depreciation and rental ($11,000 per month) are
fixed, while the remaining costs ($44,000) vary with the
number of meals served. Dividing the variable costs by the
number of meals served gives $3.52 per meal, and the
department's cost function is $20,000 + $3.52 per meal.

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

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

12. [c] This answer is constructed using the elements found in

answering questions 10 and 11.

13. [c]

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