MGT Act CH6-2-30

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CHAPTER 6
Activity Analysis, Cost Behavior, and Cost
Estimation
FOCUS ON ETHICS (Located before the Chapter Summary in the text.)

Is direct labor a variable cost? Is it ethical to “tap and zap” employees?
Direct labor is a variable cost if management is both able and willing to continually
adjust the workforce to meet short-term needs. Many observers would argue that it is
ethical to “tap and zap” employees provided that those employees are appropriately
notified about and compensated for the added risks and uncertainties surrounding their
employment. For example, hourly rates for temporary employees may be set somewhat
higher than for permanent employees to account for temps not having paid vacation,
health benefits, and other standard compensation features of the modern workforce.
For many cyclical industries (e.g., recreational resorts) such labor flexibility is essential.
For industries with more stable labor levels, there are legal limitations, which seek to
prevent classifying labor incorrectly as “temporary.” The deliberate misclassification of
employees to avoid appropriate compensation is unethical, and in certain
circumstances may be illegal.
ANSWERS TO REVIEW QUESTIONS

6-1 Cost behavior patterns are important in the process of making cost predictions. Cost
predictions are used in planning, control, and decision making. For example, cost
budgets are based on predictions of costs at various levels of activity. Cost control
is accomplished by comparing actual costs against budgeted costs, which are based
on cost predictions. Cost predictions are also important in decision making, since
the desirability of various alternatives often depends on the costs that will be
incurred under those alternatives.
6-2 a. Cost estimation is the process of determining how a particular cost behaves.
b. Cost behavior is the relationship between cost and activity.
c. Cost prediction is the forecast of cost at a particular level of activity.
Cost estimation determines the cost behavior pattern, which is used to make a cost
prediction about the cost at a particular level of activity contemplated in the future.
6-3 a. Hotel: Percentage of rooms occupied or the number of occupancy-days, where
an occupancy-day is defined as one room occupied for one day.
Managerial Accounting, 11/e 6-1

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b. Hospital: Patient-days, where a patient-day is defined as a one-day stay by one

patient.
c. Computer manufacturer: Number of computers manufactured, throughput,
engineering specifications, engineering change orders, or number of parts in the
finished product.
d. Computer sales store: Sales revenue.
e. Computer repair service: Repair calls or hours of repair service.
f. Public accounting firm: Hours of auditing service provided by each classification
of personnel (partner, manager, supervisor, senior accountant, and staff
accountant).
6-2 Solutions Manual


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6-4 Graphs of the cost behavior patterns are as follows:

Cost Cost
Activity Activity
a. Variable b. Step-variable
Cost Cost
Activity Activity
c. Fixed d. Step-fixed
Cost Cost
Activity Activity
e. Semivariable f. Curvilinear

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6-5 As the level of activity (or cost driver) increases, total fixed cost remains constant.
However, the fixed cost per unit of activity declines as activity increases.
6-6 A manufacturer's cost of supervising production might be a step-fixed cost, because
one supervisor is needed for each shift. Each shift can accommodate a certain range
of production activity; when activity exceeds that range, a new shift must be added.
When the new shift is added, a new production supervisor must be employed. This
new position results in a jump in the step-fixed cost to a higher level.
6-7 As the level of activity (or cost driver) increases, total variable cost increases
proportionately and the variable cost per unit remains constant.
6-8 a. A semivariable cost behavior pattern can be used to approximate a step-variable
cost as shown in the following graph:
Cost
Semivariable
approximation
Step-variable
cost
Activity
b. A semivariable cost behavior pattern can be used to approximate a
curvilinear cost as shown in the following graph:
Cost
Curvilinear
cost
Semivariable
approximation
Activity


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6-9 (a) Annual cost of maintaining an interstate highway: committed cost. (Once the
highway has been built, it must be maintained. The transportation authorities are
largely committed to spending the necessary funds to maintain the highway
adequately.)
(b) Ingredients in a breakfast cereal: engineered cost.
(c) Advertising for a credit card company: discretionary cost.
(d) Depreciation on an insurance company's computer: committed cost.
(e) Charitable donations: discretionary cost.
(f) Research and development: discretionary cost.
6-10 The cost analyst should respond by pointing out that in most cases a cost behavior
pattern should be limited to the relevant range of activity. When the firm's utility cost
was shown as a semivariable cost, it is likely that only some portion in the middle of
the graph would fall within the relevant range. Within the relevant range, the firm's
utility cost can be approximated reasonably closely by a semivariable cost behavior
pattern. However, outside that range (including an activity level of zero), the
semivariable cost behavior pattern should not be used as an approximation of the
utility cost.
6-11 A learning curve shows how average labor time per unit of production changes as
cumulative output changes. In many production processes, as production activity
increases and learning takes place, there is a significant reduction in the amount of
labor time required per unit. The learning phenomenon is important in cost
estimation, since estimates must often be made for the level of cost to be incurred
after additional production experience is gained.
6-12 Appropriate independent variables for several tasks are as follows:
a. Handling materials at a loading dock: Weight of materials handled.
b. Registering vehicles at a county motor vehicle office: Number of registrations
processed.
c. Picking oranges: Volume or weight of oranges picked.
d. Inspecting computer components in an electronics firm: Number of components
inspected.


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6-13 An outlier is a data point that falls far away from the other points in the scatter
diagram and is not representative of the data. One possible cause of an outlier is
simply a mistake in recording the data. Another cause of an outlier is a random event
that occurred, which caused the cost during a particular period to be unusually high
or low. For example, a power outage may have resulted in unusually high costs of
idle time for a particular time period. Outliers should be eliminated from a data set
upon which cost estimates are based.
6-14 Fixed costs are often allocated on a per unit-of-activity basis. For example, fixed
manufacturing-overhead costs, such as depreciation, may be allocated to units of
production. As a result, such costs may appear to be variable in the cost records.
Discretionary costs often are budgeted in a manner that makes them appear variable.
A cost such as charitable donations, for example, may be fixed once management
decides on the level of donations to be made. If management's policy is to budget
charitable donations on the basis of sales dollars, however, the cost will appear to
be variable to the cost analyst. An experienced analyst should be wary of allocated
and discretionary costs and take steps to learn how the amounts are determined.
6-15 In the first step of the visual-fit method of cost estimation, data points are plotted on
graph paper to form a scatter diagram. Then a line is drawn through the scatter
diagram in an attempt to minimize the distance between the line and the plotted
points. The scatter diagram and the visually-fitted cost line provide a valuable first
approximation in the analysis of any cost suspected to be semivariable or
curvilinear. The method is easy to use and to explain to others and provides a useful
view of the overall cost behavior pattern. The visual-fit method also enables an
experienced cost analyst to spot outliers in the data. The primary drawback of the
visual-fit method is its lack of objectivity. Two cost analysts may draw two different
visually-fitted cost lines.
6-16 The chief drawback of the high-low method of cost estimation is that it uses only two
data points. The rest of the data are ignored by the method. An outlier can cause a
significant problem when the high-low method is used if one of the two data points
happens to be an outlier. In other words, if the high activity level happens to be
associated with a cost that is not representative of the data, the resulting cost line
may not be representative of the cost behavior pattern.
6-17 The term least squares in the least-squares regression method of cost estimation
refers to the process of minimizing the sum of the squares of the vertical distances
between the data and the regression line.


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6-18 A least-squares regression line may be expressed in equation form as follows:

Y = a + bX
In this equation, X is referred to as the independent variable, since it is the variable
upon which the estimate is based. Y is called the dependent variable, since its
estimate depends on the independent variable. The intercept of the line on the
vertical axis is denoted by a, and the slope of the line is denoted by b. Within the
relevant range, a is interpreted as an estimate of the fixed-cost component, and b is
interpreted as an estimate of the variable cost per unit of activity.
6-19 In simple regression there is a single independent variable. In multiple regression
there are two or more independent variables.
6-20 Potential cost drivers in the cruise industry include the following: number of
passengers, number of passenger miles traveled, number of port calls, cruise ship
tonnage (i.e., ship size), and number of crew members, among others.
6-21 A particular least-squares regression line may be evaluated on the basis of
economic plausibility or goodness of fit.
The cost analyst should always evaluate a regression line from the perspective of
economic plausibility. Does the regression line make economic sense? Is it
intuitively plausible? An experienced cost analyst should have a good feel for
whether the regression line looks reasonable.
Statistical methods can also be used to determine how well a regression line fits the
data upon which it is based. This method is referred to as assessing the goodness of
fit of the regression. A commonly used measure of goodness of fit is the coefficient
of determination, which is described in the appendix at the end of the chapter. The
coefficient of determination is also denoted by R2.


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SOLUTIONS TO EXERCISES
EXERCISE 6-22 (40 MINUTES)
1. Cost of food:
Cost
$25,000
$24,000  Total cost
$20,000
$15,000
$10,000
$5,000
Patient days
1,000 2,000 3,000


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EXERCISE 6-22 (CONTINUED)
2. Cost of salaries and fringe benefits for administrative staff:
Cost per month
$12,000 Total cost

$10,000
$5,000
Patient days
1,000 2,000 3,000


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3. Laboratory costs:
Cost per month

$80,000
Total cost
$70,000 
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
Patient days
1,000 2,000 3,000


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4. Cost of utilities:
Cost per month
$15,000 Total cost
$10,000
$5,000
Patient days
1,000 2,000 3,000


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5. Nursing costs:
Cost per month

$17,500
$15,000
$12,500 Total cost
$10,000
$7,500
$5,000
$2,500
Patient days
200 400 600 800 1,000


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1.
Actual Estimated
a. 20,000 miles ................................................................. $1,950 $2,200
b. 40,000 miles ................................................................. 2,600 2,600
c. 60,000 miles ................................................................. 3,000 3,000
d. 90,000 miles ................................................................. 4,250 3,600
2. (a) The approximation is very accurate in the range 40,000 to 60,000 miles per
month.
(b) The approximation is less accurate in the extremes of the longer range, 20,000 to
90,000 miles.
1.
Cost per Broadcast Hour
Cost Item July September
Production crew:
$4,875/390 hr. ............................................ $12.50 per hr.
$8,000/640 hr. ............................................ $12.50 per hr.
Supervisory employees:
$5,000/390 hr. ............................................ 12.82 per hr.*
$5,000/640 hr. ............................................ 7.81 per hr.*
*Rounded.
2. December cost predictions:
Production crew (420  $12.50 per hr.).............................................. $5,250

Supervisory employees ...................................................................... 5,000
3.
Cost per Broadcast Hour
Cost Item in December
Production crew ........................................................ $12.50 per hr.
Supervisory employees ($5,000/420 hr.) ................. 11.90 per hr.*
*Rounded.


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$24,100  $22,100
1. Variable cost per pint of applesauce produced =  $.10
41,000  21,000
Total cost at 41,000 pints ........................................................................... $24,100

Variable cost at 41,000 pints
(41,000  $.10 per pint)..................................................................... 4,100
Fixed cost ................................................................................................... $20,000
Cost equation:
Total energy cost = $20,000 + $.10X, where X denotes pints of applesauce produced
2. Cost prediction when 26,000 pints of applesauce are produced
Energy cost = $20,000 + ($.10)(26,000) = $22,600


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1. Scatter diagram and visually-fitted line:
Monthly energy cost
$30,000

$25,000 

    
$20,000
$15,000
$10,000
$5,000
Pints of apple
10,000 20,000 30,000 40,000 50,000 sauce produced


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2. Answers will vary on this requirement because of variation in the visually-fitted lines.
Based on the preceding plot, the cost prediction at 26,000 pounds is:
Energy cost = $22,600
3. The July cost observation at the 40,000-pint activity level appears to be an outlier.
The cost analyst should check the observation data for accuracy. If the data are
accurate, the outlier should be ignored in making cost predictions.
Answers will vary widely, depending on the company and costs selected. Some examples
of typical manufacturing costs follow.
Direct material: variable
Electricity: variable
Depreciation on plant and equipment: fixed
Plant manager’s salary: fixed
Property taxes: fixed
Some typical service-industry costs are the following:
Restaurant manager’ salary: fixed
Depreciation on vehicles: fixed
Food ingredients: variable


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1. Scatter diagram and visually-fitted line:
Cost of diagnostic testing
$100,000 



$80,000  

$60,000 
$40,000
$20,000
Tests
1,000 2,000 3,000 4,000 5,000 6,000 7,000


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2. Note that the question asks for an estimate based on the visually-fit cost line.
Therefore, answers will vary on this requirement because of variation in the visually-
fitted lines.
Based on the preceding plot:
Monthly fixed cost............................................................................................. $28,000

Variable cost per diagnostic test ..................................................................... $ 10.56*
*Calculation of variable cost:
Total cost at 7,200 tests ........................................... $ 104,000

Total cost at 0 tests ........................................... 28,000
Difference: 7,200 tests ........................................... $ 76,000
$76,000
Variable cost per diagnostic test =
7,200
= $10.56†
†Rounded.
1. a. Fixed
b. Variable
c. Variable
d. Fixed
e. Semivariable (or mixed)
2. Production cost per month = $33,000* + $2.00X †
*33,000 = $19,000 + $10,000 + $4,000

†$2.00 = $1.10 + $.70 + $.20


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1. Variable maintenance
cost per tour mile = (12,500r-11,000r) / (20,000 miles – 8,000 miles)
= .125r
r denotes the real, Brazil’s national currency.
Total maintenance cost at 8,000 miles ....................................................... 11,000r

Variable maintenance cost at 8,000 miles (.125r  8,000) ......................... 1,000r
Fixed maintenance cost per month ............................................................ 10,000r
2. Cost formula:
Total maintenance cost per month = 10,000r + .125rX , where X denotes tour miles
traveled during the month.
3. Cost prediction at the 22,000-mile activity level:
Maintenance cost = 10,000r + (.125r)(22,000)

= 12,750r
4. In the electronic version of the solutions manual, press the CTRL key and click on the
following link: Build a Spreadsheet 06-30.xls


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Monthly audit cost
$100,000
Total cost when 100 audits are performed

in a month: $78,200 = $10,000 + ($682) (100)
$80,000  
$60,000
$40,000
$20,000
 Fixed cost per month: $10,000

Tax
returns audited
20 40 60 80 100


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1. (a) Average time for 4 satellites .............................................................. 225 hours*

(b) Average time for 8 satellites .............................................................. 160 hours*
*Answers may vary depending on how the graph is read by each student.
2. (a) Total time for 4 satellites (225 hr. X 4).............................................. 900 hours
(b) Total time for 8 satellites (160 hr. X 8).............................................. 1,280 hours
3. Learning curves indicate how labor costs change as the company gains experience
with the production process. Since labor time and costs must be predicted for
budgeting and for setting cost standards, the learning curve is a valuable tool.
The following alternative approach to calculating the regression parameters and R 2 is not a
requirement in the problem.
Least-square regression using manual calculations:
(a) Tabulation of data:
Independent
Dependent Variable
Variable (thousands
(cost in of
thousands) passengers)
Month Y X X2 XY
January....................... 18 16 256 288
February ..................... 18 17 289 306
March .......................... 19 16 256 304
April ............................ 20 18 324 360
May ............................. 18 15 225 270
June ............................ 19 17 289 323
Total ............................ 112 99 1,639 1,851


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(b) Calculation of parameters:

( Y )( X 2 )  (  X )( XY )
a =
n(  X 2 )  (  X )( X )
(112)(1,63 9)  (99)(1,851 )
=  9.667 (rounded)
(6)(1,639)  (99)(99)
n(  XY)  (  X)(  Y)
b =
n(  X 2 )  (  X)(  X)
(6)(1,851)  (99)(112)
=  .545 (rounded)
(6)(1,639)  (99)(99)
(c) Cost formula:
Monthly cost of flight service = $9,667 + $545X, where X denotes thousands of

passengers.
Calculation and interpretation of R2 using manual calculations:
(a) Formula for calculation:
(Y  Y ') 2
R  1
2
(Y Y ) 2
where Y denotes the observed value of the dependent variable (cost) at a

particular activity level.
Y' denotes the predicted value of the dependent variable (cost)

based on the regression line, at a particular activity level.
Y denotes the mean (average) observation of the dependent variable

(cost).


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(b) Tabulation of data:*
Predicted Cost (in

thousands)
Based on
Regression
Month Y X Line Y' [( Y – Y')2]† [(Y – Y )2]†
January .......... 18 16 18.387 .150 .445
February ........ 18 17 18.932 .869 .445
March ............. 19 16 18.387 .376 .111
April ............... 20 18 19.477 .274 1.777
May ................ 18 15 17.842 .025 .445
June ............... 19 17 18.932 .005 .111
Total ............... 1.699 3.334
*Y' = ($9,667 + $545X)/$1,000

Y =  Y/6 = 18.667 (rounded)
†Rounded.
(c) Calculation of R2:
1.699
R2 = 1 – = .49 (rounded)
3.334
(d) Interpretation of R2:
The coefficient of determination, R2, is a measure of the goodness of fit of the

least-squares regression line. An R2 of .49 means that 49% of the variability of
the dependent variable about its mean is explained by the variability of the
independent variable about its mean. The higher the R2, the better the regression
line fits the data. The interpretation of a high R2 is that the independent variable
is a good predictor of the behavior of the dependent variable. In cost estimation,
a high R2 means that the cost analyst can be relatively confident in the cost
predictions based on the estimated-cost behavior pattern.


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$1,900  $1,300
1. Variable utility cost per hour = = $2.00
700  400
Total utility cost at 700 hours ...................................................................... $ 1,900

Variable utility cost at 700 hours ($2.00  700 hours) ............................... 1,400
Fixed cost per month ................................................................................... $ 500
Cost formula:
Monthly utility cost = $500 + $2.00 X , where X denotes hours of operation.
2. Variable-cost estimate based on the scatter diagram on the next page:
Cost at 600 hours ....................................................................... $1,700

Cost at 0 hours ....................................................................... 450
Difference 600 hours ....................................................................... $1,250
Variable cost per hour = $1,250/600 hr. = $2.08 (rounded)


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Scatter diagram and visually-fitted line:
Utility cost
per month
$2,500
$2,000

 

$1,500
 
$1,000
$500
100 200 300 400 500 600 700

Hours of
operation


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3. Estimation of variable- and fixed-cost components of cost behavior using least-

squares regression:
In the electronic version of the solutions manual, press the CTRL key and click on
the following link: Build a Spreadsheet 06-34.xls
4. Cost predictions at 300 hours of operation:
(a) High-low method:
Utility cost = $500 + ($2.00)(300) = $1,100
(b) Visually-fitted line:
Utility cost = $1,095
This cost prediction was simply read directly from the visually-fitted cost line.
This prediction will vary because of variations in the visually-fitted lines.
(c) Regression:
Utility cost = $501 + ($2.02)(300) = $1,107
5. Calculation of R2:
In the electronic version of the solutions manual, press the CTRL key and click on
the following link: Build a Spreadsheet 06-34.xls


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The following alternative approach to calculating the regression parameters is not a

requirement in the problem.
Least-square regression using manual calculations:
(a) Tabulation of data:
Dependent Independent
Variable Variable
(cost) (hours)
Month Y X X2 XY
January....................... 1,620 550 302,500 891,000
February ..................... 1,700 600 360,000 1,020,000
March .......................... 1,900 700 490,000 1,330,000
April ............................ 1,600 500 250,000 800,000
May ............................. 1,350 450 202,500 607,500
June ............................ 1,300 400 160,000 520,000
Total ............................ 9,470 3,200 1,765,000 5,168,500
(b) Calculation of parameters:
( Y )( X 2 )  (  X )( XY )
a =
n(  X 2 )  (  X )( X )
= (9,470)(1,765,000) (3,200)(5,168,500)
 501
(6)(1,765,000)  (3,200)(3,200)
b = n(  XY)  (  X)( Y)

n(  X 2 )  (  X)(  X)
(6)(5,168, 500)  (3,200)(9, 470)
=  2.02
(6)(1,765, 000)  (3,200)(3, 200)
(c) Cost formula:
Monthly utility cost = $501 + $2.02X, where X denotes hours of operation.
Variable utility cost = $2.02 per hour of operation


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SOLUTIONS TO PROBLEMS
PROBLEM 6-35 (20 MINUTES)
1. e 5. b 9. d
2. a 6. h 10. k
3. g 7. i 11. l
4. c 8. f
Note that j was not used.
1. Machine supplies: $102,000  34,000 direct-labor hours = $3 per hour

January: 23,000 direct-labor hours x $3 = $69,000
Depreciation: Fixed at $15,000
2. Plant maintenance cost:

March January
(34,000 (23,000
hrs) hrs)
Total cost*…………………….. $ 586,000 $ 454,000

Less: Machine supplies……. (102,000) (69,000)
Depreciation………….. (15,000) (15,000)
Plant maintenance…………... $ 469,000 $ 370,000
* Excludes supervisory labor cost
Variable maintenance cost = difference in cost  difference in direct-labor hours

= ($469,000 – $370,000)  (34,000 – 23,000)
= $99,000  11,000 hours
= $9 per hour


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PROBLEM 6-36 (CONTINUED)
Fixed maintenance cost:

March January
(34,000 hrs) (23,000 hrs)
Total maintenance cost………………. $469,000 $370,000

Less: Variable cost at $9 per hour…. 306,000 207,000
Fixed maintenance cost……………… $163,000 $163,000
3. Manufacturing overhead at 29,500 labor hours:
Machine supplies at $3 per hour……. $ 88,500

Depreciation……………………………. 15,000
Plant maintenance cost:
Variable at $9 per hour…………… 265,500
Fixed…………………………………. 163,000
Supervisory labor……………………… 90,000
Total…………………………….. $622,000
4. A fixed cost remains constant when a change occurs in the cost driver (or activity
base). A step-fixed cost, on the other hand, remains constant within a range but will
change (rise or fall) when activity falls outside that range. A fixed cost is constant
over a much larger range of activity than is a step-fixed cost.
5. Ideally, the company should operate on the right-most portion of a step, just prior to
the jump in cost. In this manner, a firm receives maximum benefit (i.e., the maximum
amount of activity) for the dollars invested.
1. Straight-line depreciation—committed fixed

Charitable contributions—discretionary fixed
Mining labor/fringe benefits—variable
Royalties—semivariable
Trucking and hauling—step-fixed
The per-ton mining labor/fringe benefit cost is constant at both volume levels
presented, which is characteristic of a variable cost.
$345,000  1,500 tons = $230 per ton

$598,000  2,600 tons = $230 per ton


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FOCUS ON ETHICS (Located before the Chapter Summary in the text.)

ANSWERS TO REVIEW QUESTIONS

Managerial Accounting, 11/e 6-1

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b. Hospital: Patient-days, where a patient-day is defined as a one-day stay by one

6-2 Solutions Manual

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6-4 Graphs of the cost behavior patterns are as follows:

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6-4 Solutions Manual

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Managerial Accounting, 11/e 6-5

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6-6 Solutions Manual

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6-18 A least-squares regression line may be expressed in equation form as follows:

Managerial Accounting, 11/e 6-7

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6-8 Solutions Manual

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EXERCISE 6-22 (CONTINUED)

2. Cost of salaries and fringe benefits for administrative staff:

Cost per month

$12,000 Total cost

Managerial Accounting, 11/e 6-9

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EXERCISE 6-22 (CONTINUED)

Cost per month

6-10 Solutions Manual

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EXERCISE 6-22 (CONTINUED)

Cost per month

$15,000 Total cost

Managerial Accounting, 11/e 6-11

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EXERCISE 6-22 (CONTINUED)

Cost per month

$12,500 Total cost

6-12 Solutions Manual

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EXERCISE 6-23 (15 MINUTES)

EXERCISE 6-24 (15 MINUTES)

2. December cost predictions:

Production crew (420  $12.50 per hr.).............................................. $5,250

Managerial Accounting, 11/e 6-13

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EXERCISE 6-25 (15 MINUTES)

Total cost at 41,000 pints ........................................................................... $24,100

2. Cost prediction when 26,000 pints of applesauce are produced

Energy cost = $20,000 + ($.10)(26,000) = $22,600

6-14 Solutions Manual

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EXERCISE 6-26 (30 MINUTES)

1. Scatter diagram and visually-fitted line:

Monthly energy cost

Managerial Accounting, 11/e 6-15

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EXERCISE 6-26 (CONTINUED)

Energy cost = $22,600

EXERCISE 6-27 (30 MINUTES)

Direct material: variable