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Questions and Answers
What assumption(s) are frequently made when estimating a cost function?
What assumption(s) are frequently made when estimating a cost function?
Cost behavior is approximated by a linear function within the relevant range. Variations in the level of a single activity explain the variations in the related total costs.
Select the linear cost function equation for direct materials cost being $1.70 per pound.
Select the linear cost function equation for direct materials cost being $1.70 per pound.
- Y = $1.70x (correct)
- Y = $80.00 + $2.00X
- Y = $1000 + 12x
- Y = $8000
What are the four approaches to estimating a cost function?
What are the four approaches to estimating a cost function?
- Industrial engineering method (correct)
- Quantitative analysis of current or past relationships (correct)
- Account analysis method (correct)
- Adding method
Describe the account analysis method for estimating a cost function.
Describe the account analysis method for estimating a cost function.
What is the difference between a linear and a nonlinear cost function? Give an example of each type.
What is the difference between a linear and a nonlinear cost function? Give an example of each type.
Should high and low observations using the high-low method be based on the dependent variable?
Should high and low observations using the high-low method be based on the dependent variable?
What are the three criteria for evaluating cost functions and choosing cost drivers?
What are the three criteria for evaluating cost functions and choosing cost drivers?
What type of cost function changes total costs in proportion to the changes in the level of activity?
What type of cost function changes total costs in proportion to the changes in the level of activity?
Do you agree that high correlation between two variables means that one is the cause and the other is the effect? Explain.
Do you agree that high correlation between two variables means that one is the cause and the other is the effect? Explain.
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Study Notes
Cost Function Estimation Assumptions
- Cost behavior is generally modeled as a linear function within the relevant range.
- Fluctuations in a single activity are believed to directly influence associated total costs.
Linear Cost Function Equations
- Direct materials cost: Y = $1.70x (cost per pound)
- Fixed total cost: Y = $8000 (constant regardless of production)
- Auto rental: Y = $80 + $2.00X (fixed daily fee plus cost per mile)
- Machine operating costs: Y = $1000 + 12x (monthly maintenance plus variable daily costs)
Account Analysis Method
- Cost functions are estimated by categorizing ledger accounts into variable, fixed, or mixed based on activity level.
- Managers often rely on qualitative insights rather than quantitative metrics for cost classification.
High-Low Method
- High and low observations should be based on the cost driver, not the dependent variable.
Approaches to Estimating Cost Functions
- Conference method
- Quantitative analysis of historical or current relationships
- Account analysis method
- Industrial engineering method
Linear vs. Nonlinear Cost Functions
- Linear cost functions exhibit a straight-line relationship between total costs and activity levels within the relevant range (e.g., videoconferencing costs).
- Nonlinear cost functions demonstrate non-linear relationships; examples include economies of scale in advertising, step-cost functions, and learning-curve-based costs.
Evaluating Cost Functions
- Economic plausibility
- Goodness of fit
- Slope of the regression line
Types of Cost Functions
- Variable Cost Function: Costs that vary directly with the level of activity.
- Fixed Cost Function: Costs that remain unchanged regardless of activity level.
- Mixed Cost Function: Contains both fixed and variable components; total costs fluctuate but not in direct proportion to changes in activity.
Correlation vs. Causation
- High correlation between two variables does not inherently imply causation; economic plausibility must also be evaluated to establish a true cause-and-effect relationship.
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