CHAPTER 10

DETERMINING HOW COSTS BEHAVE

10-1
1.
2.

10-2
1.
2.
3.

The two assumptions are

Variations in the level of a single activity (the cost driver) explain the variations in the
related total costs.
Cost behavior is approximated by a linear cost function within the relevant range. A
linear cost function is a cost function where, within the relevant range, the graph of total
costs versus the level of a single activity forms a straight line.
Three alternative linear cost functions are
Variable cost functiona cost function in which total costs change in proportion to the
changes in the level of activity in the relevant range.
Fixed cost functiona cost function in which total costs do not change with changes in
the level of activity in the relevant range.
Mixed cost functiona cost function that has both variable and fixed elements. Total
costs change but not in proportion to the changes in the level of activity in the relevant
range.

10-3 A linear cost function is a cost function where, within the relevant range, the graph of
total costs versus the level of a single activity related to that cost is a straight line. An example of
a linear cost function is a cost function for use of a telephone line where the terms are a fixed
charge of $10,000 per year plus a $2 per minute charge for phone use. A nonlinear cost function
is a cost function where, within the relevant range, the graph of total costs versus the level of a
single activity related to that cost is not a straight line. Examples include economies of scale in
advertising where an agency can double the number of advertisements for less than twice the
costs, step-cost functions, and learning-curve-based costs.
10-4 No. High correlation merely indicates that the two variables move together in the data
examined. It is essential also to consider economic plausibility before making inferences about
cause and effect. Without any economic plausibility for a relationship, it is less likely that a high
level of correlation observed in one set of data will be similarly found in other sets of data.
10-5
1.
2.
3.
4.

Four approaches to estimating a cost function are

Industrial engineering method.
Conference method.
Account analysis method.
Quantitative analysis of current or past cost relationships.

10-6 The conference method estimates cost functions on the basis of analysis and opinions
about costs and their drivers gathered from various departments of a company (purchasing,
process engineering, manufacturing, employee relations, etc.). Advantages of the conference
method include
1.
The speed with which cost estimates can be developed.
2.
The pooling of knowledge from experts across functional areas.
3.
The improved credibility of the cost function to all personnel.

10-7 The account analysis method estimates cost functions by classifying cost accounts in the
subsidiary ledger as variable, fixed, or mixed with respect to the identified level of activity.
Typically, managers use qualitative, rather than quantitative, analysis when making these costclassification decisions.
10-8 The six steps are
1.
Choose the dependent variable (the variable to be predicted, which is some type of cost).
2.
Identify the independent variable or cost driver.
3.
Collect data on the dependent variable and the cost driver.
4.
Plot the data.
5.
Estimate the cost function.
6.
Evaluate the cost driver of the estimated cost function.
Step 3 typically is the most difficult for a cost analyst.
10-9 Causality in a cost function runs from the cost driver to the dependent variable. Thus,
choosing the highest observation and the lowest observation of the cost driver is appropriate in
the high-low method.
10-10
1.
2.
3.

Three criteria important when choosing among alternative cost functions are
Economic plausibility.
Goodness of fit.
Slope of the regression line.

10-11 A learning curve is a function that measures how labor-hours per unit decline as units of
production increase because workers are learning and becoming better at their jobs. Two models
used to capture different forms of learning are
1.
Cumulative average-time learning model. The cumulative average time per unit declines
by a constant percentage each time the cumulative quantity of units produced doubles.
2.
Incremental unit-time learning model. The incremental time needed to produce the last
unit declines by a constant percentage each time the cumulative quantity of units
produced doubles.
10-12 Frequently encountered problems when collecting cost data on variables included in a
cost function are
1.
The time period used to measure the dependent variable is not properly matched with the
time period used to measure the cost driver(s).
2.
Fixed costs are allocated as if they are variable.
3.
Data are either not available for all observations or are not uniformly reliable.
4.
Extreme values of observations occur.
5.
A homogeneous relationship between the individual cost items in the dependent variable
cost pool and the cost driver(s) does not exist.
6.
The relationship between the cost and the cost driver is not stationary.
7.
Inflation has occurred in a dependent variable, a cost driver, or both.

10-13 Four key assumptions examined in specification analysis are

1.
Linearity of relationship between the dependent variable and the independent variable
within the relevant range.
2.
Constant variance of residuals for all values of the independent variable.
3.
Independence of residuals.
4.
Normal distribution of residuals.
10-14 No. A cost driver is any factor whose change causes a change in the total cost of a related
cost object. A cause-and-effect relationship underlies selection of a cost driver. Some users of
regression analysis include numerous independent variables in a regression model in an attempt
to maximize goodness of fit, irrespective of the economic plausibility of the independent
variables included. Some of the independent variables included may not be cost drivers.
10-15 No. Multicollinearity exists when two or more independent variables are highly
correlated with each other.

EXERCISES

10-28
Solution
Various cost-behavior patterns.
1. K
2. B
3. G
4.
J Note that A is incorrect because, although the cost per kg eventually equals a constant at Rs 9.20, the total rupees of cost increases
linearly from that point onward.
5.
I The total costs will be the same regardless of the volume level.
6.
L
7. F This is a classic step-cost function.
8. K
9. C

10-29
Solution
Account analysis method.
1. Variable costs:
Car wash labor
Soap cloth and supplies
Water
Electric power to move conveyor belt
Total variable costs
Fixed costs:
Depreciation
Salaries
Total fixed costs

Rs 24,00,000
3,20,000
2,80,000
7,20,000
Rs 37,20,000
Rs 6,40,000
4,60,000
Rs 11,00,000

Costs are classified as variable because the total costs in these categories change in proportion to the number of cars washed in
Johnsons operation. Costs are classified as fixed because the total costs in these categories do not vary with the number of cars washed.
If the conveyor belt moves regardless of the number of cars on it, the electricity costs to power the conveyor belt would be a fixed cost.
2. Variable costs per car =

Rs 37,20,000
= Rs 46.5 per car
80,000

Total costs estimated for 90,000 cars = Rs 11,00,000 + (Rs 46.5 90,000) = Rs 52,85,000

10-30
Solution
Linear cost approximation.
1. Slope coefficient (b) = Difference in costDifference in labor-hours
=

Rs 52,90,000 Rs 40,00,000
= Rs 430
7,000 4,000

Constant (a) = Rs 52,90,000 (Rs 430 7,000)

= Rs 22,80,000
Cost function = Rs 22,80,000 + Rs 430 (professional labor-hours)
The linear cost function is plotted in Solution Exhibit 10-30.
No, the constant component of the cost function does not represent the fixed overhead cost of the Ernst & Young. 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.
2. A comparison at various levels of professional labor-hours follows. The linear cost function is based on the formula of Rs 22,80,000 per
month plus Rs 430 per professional labor-hour.

Page 2

Total overhead cost behavior:

Actual total overhead costs
Linear approximation
Actual minus linear approximation

Month 1
Rs 34,00,000
35,70,000
Rs (1,70,000)

Month 2
Rs 40,00,000
40,00,000
Rs
0

Month 3
Rs 43,50,000
44,30,000
Rs (80,000)

Month 4
Rs 47,70,000
48,60,000
Rs (90,000)

Month 5
Rs 52,90,000
52,90,000
Rs
0

Month 6
Rs 58,70,000
57,20,000
Rs 1,50,000

3,000

4,000

5,000

6,000

7,000

8,000

Professional labor-hours

The data are shown in Solution Exhibit 10-30. The linear cost function overstates costs by Rs 80,000 at the 5,000-hour level and understates costs by Rs 1,50,000 at the 8,000-hour level.
3.
Based on Actual
Based on Linear Cost Function
Contribution before deducting incremental overhead
Rs 3,80,000
Rs 3,80,000
Incremental overhead
3,50,000
4,30,000
Contribution after incremental overhead
Rs 30,000
Rs (50,000)
The total contribution margin actually forgone is Rs 30,000.
Solution Exhibit 10-30
Linear Cost Function Plot of Professional Labor-Hours
on Total Overhead Costs for Ernst & Young Consulting Group
Rs 7,00,000

Total Overhead Costs

6,00,000
5,00,000
4,00,000
3,00,000
2,00,000
1,00,000
1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

Professional Labor-Hours Billed

10-31
Solution
Regression analysis, activity-based costing, choosing cost drivers.
1a. Solution Exhibit 10-31A presents the plots and regression line of number of packaged units moved on distribution costs.
SOLUTION EXHIBIT 10-31A
Plots and Regression Line of Number of Packaged Units Moved on Distribution Costs

Rs 4,50,000

Distribution Costs

4,00,000
3,50,000
3,00,000
2,50,000
2,00,000
1,50,000
1,00,000
50,000
0

20,000
40,000
60,000
80,000
Number of Packaged Units Moved

Page 3

1b. Solution Exhibit 10-31B presents the plots and regression line of number of shipments made on distribution costs.
SOLUTION EXHIBIT 10-31B
Plots and Regression Line of Number of Shipments Made on Distribution Costs
Rs 4,50,000
4,00,000

Distribution Costs

3,50,000
3,00,000
2,50,000
2,00,000
1,50,000
1,00,000
50,000
0

100

200

300

400

500

Number of Shipments Made

Number of packaged units moved appears to be a better cost driver of distribution costs for the following reasons:
(i) Economic plausibility. Both number of packaged units moved and number of shipments are economically plausible cost drivers. Because the product is heavy, however, costs of freight are likely to be a sizable component of distribution costs. Thus, number of packaged units moved will affect distribution costs significantly because freight costs are largely a function of the number of units
transported.
(ii) Goodness of fit. Compare Solution Exhibits 10-31A and 10-31B. Number of packaged units moved has a better goodness of fit with
distribution costs than do number of shipments made. That is, the vertical differences between actual and predicted distribution costs
are smaller for the number of packaged units moved regression than for the number of shipments made regression.
(iii) Slope of regression line. Again, compare Solution Exhibits 10-31A and 10-31B. The number of packaged units moved regression line
has a relatively steep slope and a small scatter of observations around the regression lines indicating a strong relationship between
number of packaged units moved and distribution costs. On average, distribution costs increase with the number of packaged units
moved. The number of shipments made regression line is flatter and has more scatter of observations about the line indicating a weak
relationship between the number of shipments made and distribution costs. On average, the number of shipments made has a smaller
effect on distribution costs.
2. Using the preferred cost function,
Distribution costs = Rs 13,490 + (Rs 4.96 Number of packaged units moved),
Akshita would budget distribution costs of
Rs 13,490 + (Rs 4.96 40,000) = Rs 13,490 + Rs 1,98,400 = Rs 2,11,890

10-32
Solution
High-low method.
1.
Highest observation of cost driver
Lowest observation of cost driver
Difference
Maintenance costs = a + b (Machine-hours)

Rs 8,00,000
= Rs 20
40,000
Constant (a)
= Rs 25,00,000 (Rs 20 125,000)
= Rs 25,00,000 Rs 25,00,000 = Rs 0
or Constant (a)
= Rs 17,00,000 (Rs 20 85,000)
= Rs 17,00,000 Rs 17,00,000 = Rs 0
Maintenance costs = Rs 20 Machine-hours
Slope coefficient (b) =

Machine-Hours
125,000
85,000
40,000

Maintenance Costs
Rs 25,00,000
17,00,000
Rs 8,00,000

Page 4

2.
SOLUTION EXHIBIT 10-32
Plot and High-Low Line of Machine-Hours on Maintenance Costs
Rs 26,00,000

Maintenance Costs

24,00,000
22,00,000
20,00,000
18,00,000
16,00,000
14,00,000
12,00,000
10,00,000
80,000

90,000

100,000

110,000

120,000

130,000

Machine-Hours

Solution Exhibit 10-32 presents the high-low line.

Economic plausibility. The cost function shows a positive economically plausible relationship between machine-hours and maintenance
costs. There is a clear-cut engineering relationship of higher machine-hours and maintenance costs.
Goodness of fit. The high-low line appears to fit the data well. The vertical differences between the actual and predicted costs appear to
be quite small.
Slope of high-low line. The slope of the line appears to be reasonably steep indicating that, on average, maintenance costs in a quarter
varies with machine-hours used.
3. Using the cost function estimated in 1, predicted maintenance costs would be Rs 20 90,000 = Rs 18,00,000.
Faraz should budget Rs 18,00,000 in quarter 13 because the relationship between machine-hours and maintenance costs in Solution
Exhibit 10-32 is economically plausible, has an excellent goodness of fit, and indicates that an increase in machine-hours in a quarter
causes maintenance costs to increase in the quarter.

10-33
Solution
High-low method versus regression analysis.
1. Solution Exhibit 10-30 presents the plots of advertising costs on revenues.
SOLUTION EXHIBIT 10-33
Plot and Regression Line of Advertising Costs on Revenues
Rs 9,00,000
8,00,000
7,00,000
Revenues

6,00,000
5,00,000
4,00,000
3,00,000
2,00,000
1,00,000
0
Rs 0

Rs 10,000

Rs 20,000 Rs 30,000 Rs 40,000 Rs 50,000

Advertising Costs

Page 5

2. Solution Exhibit 10-33 also shows the regression line of advertising costs on revenues. We evaluate the estimated regression equation
using the criteria of economic plausibility, goodness of fit, and slope of the regression line.
Economic plausibility. Advertising costs appears to be a plausible cost driver of revenues. Restaurants frequently use newspaper advertising to promote their restaurants and increase their patronage.
Goodness of fit. The vertical differences between actual and predicted revenues appears to be reasonably small. This indicates that advertising costs are related to restaurant revenues.
Slope of regression line. The slope of the regression line appears to be relatively steep. Given the small scatter of the observations around
the line, the steep slope indicates that, on average, restaurant revenues increase with newspaper advertising.
3. The high-low method would estimate the cost function as follows:
Highest observation of cost driver
Lowest observation of cost driver
Difference
Revenues = a + (b advertising costs)
Slope coefficient (b) =

or

Advertising Costs
Rs 40,000
10,000
Rs 30,000

Revenues
Rs 8,00,000
5,50,000
Rs 2,50,000

Rs 2,50,000
= 8.333
Rs 30,000

Constant (a) = Rs 8,00,000 (Rs 40,000 8.333)

= Rs 8,00,000 3,33,320 = Rs 4,66,680
Constant (a) = Rs 5,50,000 (Rs 10,000 8.333)
= Rs 5,50,000 83,330 = Rs 4,66,670
Revenues = Rs 4,66,670 + (8.333 Advertising costs)

4. The increase in revenues for each Rs 1,000 spent on advertising within the relevant range is
a. Using the regression equation, 8.723 Rs 1,000 = Rs 8,723
b. Using the high-low equation, 8.333 Rs 1,000 = Rs 8,333
The high-low equation does fairly well in estimating the relationship between advertising costs and revenues. However, Ruha should use
the regression equation. The reason is that the regression equation uses information from all observations whereas the high-low method
relies only on the observations that have the highest and lowest values of the cost driver. These observations are generally not representative of all the data.

10-34
Solution
Cost estimation, cumulative average-time learning curve.
1. Cost to Produce the Second through the Eighth Troop Deployment Boats:
Direct materials, 7 Rs 3,00,000
Direct manufacturing labor, 39,130* Rs 90
Variable manufacturing overhead, 39,130 Rs 60
Other manufacturing overhead, 25% of Rs 35,21,700
Total costs

Rs 21,00,000
35,21,700
23,47,800
8,80,425
Rs 88,49,925

*The direct manufacturing labor-hours to produce the second to eighth boats can be calculated in several ways, given the assumption of a cumulative
average-time learning curve of 85%:

a. Use of Table Format:

Cumulative Number of Units
1
2
4
8

Cumulative Average-Time per Unit

10,000.00
8,500.00 (10,000 0.85)
7,225.00 (8,500 0.85)
6,141.25 (7,225 0.85)

Cumulative Total Time

10,000
17,000
28,900
49,130

The direct labor-hours required to produce the second through the eighth boats is 49,130 10,000 = 39,130 hours.
b. Use of Formula:
y = aXb
where a = 10,000, X = 8, and b = 0.2345
y = 10,000 8 0.2345 = 6,141 hours (rounded)

Page 6

The total direct labor-hours for 8 units is 6,141 8 = 49,128 hours

The direct labor-hours required to produce the second through the eighth boats is 49,128 10,000 = 39,128 hours. (By taking the b factor
to 6 decimal digits, an estimate of 49,130 hours would result.)
Note: The question specifies that the tooling cost was assigned to the first boat. Although Bharat Company may well seek to ensure its
total revenue covers the Rs 21,75,000 cost of the first boat, the concern in this question is only with the cost of producing seven more
PT109s.
2. Cost to Produce the Second through the Eighth Boats Assuming Linear Function for Direct Labor-Hours and Units Produced:
Direct materials, 7 Rs 3,00,000
Rs 21,00,000
Direct manufacturing labor, 7 10,000 hours Rs 90
63,00,000
Variable manufacturing overhead, 7 10,000 hours Rs 60
42,00,000
Other manufacturing overhead, 25% of Rs 63,00,000
15,75,000
Total costs
Rs 1,41,75,000
The difference in predicted costs is:
Predicted cost in requirement 2 (based on linear cost function)
Predicted cost in requirement 1 (based on an 85% learning curve)
Difference

Rs 1,41,75,000
88,49,925
Rs 53,25,075