Chapter 3

I. Questions
1. (A) Variable cost – are costs whose total changes are in direct proportion with the change in
volume.
(B) Fixed cost – are costs that remain unchanged in total regardless of changes in volume.
(C) Mixed cost – contains both fixed and variable component.

2. a. Unit fixed costs will decrease as volume increases.

b. Unit variable costs will remain constant as volume increases.
c. Total fixed costs will remain constant as volume increases.
d. Total variable costs will increase as volume increases
3. (A) Cost behavior – Cost behavior can be defined as the way in which costs
change or respond to changes in some underlying activity, such as sales
volume, production volume, or orders processed.
(B) Relevant range – Relevant range is the activity within which assumptions relative to
variable cost and fixed cost behavior are valid.
[Link] accountant at times may recognize that costs are not always linear in relationship to the
volume. He or she then concentrates on their behavior within the relevant range. The relevant
range can be defined as the range of activity within which assumptions as relative to variable and
fixed cost behavior are valid. Within this range an assumption of strictly linearity can be used
without losing accuracy.
5. The high-low method, the scattergraph method, and the least-squares regression method are
used to analyze mixed costs. The least-squares regression method is the most accurate, since it
derives the fixed and variable elements of a mixed cost by means of statistical analysis. The
scattergraph method derives these elements by visual inspection only, and the high-low method
utilizes only two points in doing a cost analysis, making it the least accurate of the three methods.
6. The fixed cost element is represented by the point where the regression line intersects the
vertical axis on the graph. The variable cost per unit is represented by the slope of the line.
7. The two assumptions are:
- Linear costs function usually approximates cost behavior within the relevant range of the cost
driver.
- Changes in the total costs of a cost object are traceable to variations or changes in a single
cost driver.
8. No. Because high correlation implies that the two variables move together in the data
examined. Without economic plausibility for a relationship, it is less likely that a high level of
correlation observed in one set of data will be found similarly in another set of data.
9. (A.) Account analysis method
(B) Industrial engineering method or Work measurement method
 (C) Conference method
(D) Quantitative analysis of current and past costs relationships
- High-low method
- Regression analysis method
1) Scattergraph or Visual fit method
2) The Least-squares Regression method

10. The relevant range is the range of the cost driver in which a specific
relationship between cost and cost driver is valid. This concept enables the use
of linear cost functions when examining CVP relationships as long as the
volume levels are within that relevant range.
11. A unit cost is computed by dividing some amount of total costs (the numerator)
by the related number of units (the denominator). In many cases, the
numerator will include a fixed cost that will not change despite changes in the
denominator. It is erroneous in those cases to multiply the unit cost by activity
or volume change to predict changes in total costs at different activity or
volume levels.
12. Cost estimation is the process of developing a well-defined relationship
between a cost object and its cost driver for the purpose of predicting the cost.
The cost predictions are used in each of the management functions:
Strategic Management: Cost estimation is used to predict costs of alternative
activities, predict financial impacts of alternative strategic choices, and to
predict the costs of alternative implementation strategies.
Planning and Decision Making: Cost estimation is used to predict costs so that
management can determine the desirability of alternative options and to budget
expenditures, profits, and cash flows. Management and Operational Control: Cost estimation is
used to develop cost standards, as a basis for evaluating performance. Product and Service
Costing: Cost estimation is used to allocate costs to products and services or to charge users for
jointly incurred costs.

13 The five methods of cost estimation are:

a. Account Classification. Advantages: simplicity and ease of use.
Disadvantages: subjectivity of method and some costs are a mix of both variable and fixed.
b. Visual fit. The visual fit method is easy to use, and requires only that the
data is graphed. Disadvantages are that the scale of the graph may limit
ability to estimate costs accurately and in both graphical and tabular form,
significant perceptual errors are common.
c. High-Low. Because of the precision in the development of the equation, it
provides a more consistent estimate than the visual fit and is not difficult
to use. Disadvantages: uses only two selected data points and is, therefore, subjective.

d. Work Measurement. The advantage is accurate estimates through detailed

study of the different operations in the product process, but like regression,
it is more complex.
e. Regression. Quantitative, objective measures of the precision and
accuracy and reliability of the model are the advantages of this model.
disadvantages are its complexity: the effort, expense, and expertise
necessary to utilize this method.

14. Implementation problems with cost estimation include:

a. cost estimates outside of the relevant range may not be reliable.
b. sufficient and reliable data may not be available.
c. cost drivers may not be matched to dependent variables properly in each
observation.
d. the length of the time period for each observation may be too long, so that
the underlying relationship between the cost driver and the variable to be
estimated is difficult to isolate from the numerous variables and events
occurring in that period of time; alternatively, the period may be too short,
so that the data is likely to be affected by accounting errors in which
transactions are not properly posted in the period in which they occurred.
e. dependent variables and cost drivers may be affected by trend or
seasonality.
f. when extreme observations (outliers) are used the reliability of the results
will be diminished.
g. when there is a shift in the data, as, for example, a new product is
introduced or when there is a work stoppage, the data will be unreliable
for future estimates.

15. The dependent variable is the cost object of interest in the cost estimation. An
important issue in selecting a dependent variable is the level of aggregation in
the variable. For example, the company, plant, or department may all be
possible levels of data for the cost object. The choice of aggregation level
depends on the objectives for the cost estimation, data availability, reliability,
and cost/benefit considerations. If a key objective is accuracy, then a detailed
level of analysis is often preferred. The detail cost estimates can then be
aggregated if desired.

16. Nonlinear cost relationships are cost relationships that are not adequately
explained by a single linear relationship for the cost driver(s). In accounting
data, a common type of nonlinear relationship is trend and seasonality. For a
trend example, if sales increase by 8% each year, the plot of the data for sales
with not be linear with the driver, the number of years. Similarly, sales which
fluctuate according to a seasonal pattern will have a nonlinear behavior. A
different type of nonlinearity is where the cost driver and the dependent
variables have an inherently nonlinear relationship. For example, payroll costs
as a dependent variable estimated by hours worked and wage rates is nonlinear,
since the relationship is multiplicative and therefore not the additive linear
model assumed in regression analysis.

17. The advantages of using regression analysis include that it:

a. provides an estimation model with best fit (least squared error) to the data
b. provides measures of goodness of fit and of the reliability of the model
which can be used to assess the usefulness of the specific model, in
contrast to the other estimation methods which provide no means of self-evaluation
c. can incorporate multiple independent variables
 d. can be adapted to handle non-linear relationships in the data, including
trends, shifts and other discontinuities, seasonality, etc.
e. results in a model that is unique for a given set of data
18. High correlation exists when the changes in two variables occur together. It is
a measure of the degree of association between the two variables. Because
correlation is determined from a sample of values, there is no assurance that it
measures or describes a cause and effect relationship between the variables.

19. An activity base is a measure of whatever causes the incurrence of a variable

cost. Examples of activity bases include units produced, units sold, letters
typed, beds in a hospital, meals served in a cafe, service calls made, etc.

20. (a) Variable cost: A variable cost remains constant on a per unit basis, but
increases or decreases in total in direct relation to changes in activity.
(b) Mixed cost: A mixed cost is a cost that contains both variable and fixed
cost elements.
(c) Step-variable cost: A step-variable cost is a cost that is incurred in large
chunks, and which increases or decreases only in response to wide
changes in activity.

21. The linear assumption is reasonably valid provided that the cost formula is
used only within the relevant range.

22. A discretionary fixed cost has a fairly short planning horizon—usually a year.
Such costs arise from annual decisions by management to spend on certain
fixed cost items, such as advertising, research, and management development.
A committed fixed cost has a long planning horizon—generally many years.
Such costs relate to a company’s investment in facilities, equipment, and basic
organization. Once such costs have been incurred, they are “locked in” for
many years.
23. a. Committed d. Committed
b. Discretionary e. Committed
c. Discretionary f. Discretionary
24. The high-low method uses only two points to determine a cost formula. These
two points are likely to be less than typical since they represent extremes of
activity.

25. The term “least-squares regression” means that the sum of the squares of the
deviations from the plotted points on a graph to the regression line is smaller
than could be obtained from any other line that could be fitted to the data.

26. Ordinary single least-squares regression analysis is used when a variable cost is
a function of only a single factor. If a cost is a function of more than one
factor, multiple regression analysis should be used to analyze the behavior of
the cost.

II. Answer to Exercises

1. B
2. F
3. E
4. I
5. E
6. H
7. L
8. A
9. J
10. K
11. C
12. G

Exercise 2 (Cost Estimation; Account Classifications)

Requirement 1
Fixed Costs:

Rent P10,250
Depreciation 400
Insurance 750
Advertising 650
Utilities 1,250
Mr. Black’s salary 18,500
Total P31,800
Variable cost:
Wages P17,800
CD Expense 66,750
Shopping Bags 180
Total P84,730
Variable Cost Per Unit = P84,730 / 8,900
= P95.20

Cost Function Equation: y = P31,800 + P95.20 x (CD’s sold)

Requirement 2

New Sales = 8,900 x 1.25

= 11,125 units
= round to 11,130
Total Costs = P31,800 + P95.20 x (11,130)
= P137,760
Per Unit Total Costs = P137,760 / 11,130
= P123.80
Add P1 profit per disc: P123.80 + P10 = P133.80

Requirement 3

Adjusted New Sales = 8,900 x 11.50

= 10,240 units
Revenue = P133.80 x (10,240)
= P137,010
Total Cost = P31,800 + P95.20 x (10,240)
= P129,280
Cost Per Disc = P129,280 / 10,240 = P126.30
Profit Per Disk = P133.80 – P126.30
= P7.50

Exercise 3 (Cost Estimation Using Graphs; Service)

Requirement 1
 Requirement 2
There seems to be a positive linear relationship for the data between P2,500 and
P4,000 of advertising expense. Llanes’ analysis is correct within this relevant range
but not outside of it. Notice that the relationship between advertising expense and
sales changes at P4,000 of expense.

Exercise 4 (Fixed and Variable Cost Behavior)

Requirement (1)

Cups of Coffee Served in a week

1,800 1,900 2,000

Fixed Cost P11,000 P11,000 P11,000
Variable cost 4,680 4,940 5,200
Total cost P15,680 P15,940 P16,200
Cost per cup of coffee served* P8.71 P8.39 P8.10
* Total cost ÷ cups of coffee served in a week
Requirement (2)
The average cost of a cup of coffee declines as the number of cups of coffee served
increases because the fixed cost is spread over more cups of coffee.

Exercise 5 (High-Low Method)

Requirement (
Month Occupancy-Days Electrical Costs
High activity level (August)......................... 3,608 P8,111
Low activity level (October)......................... 186 1,712
Change........................................................... 3,422 P6,399
Variable cost = Change in cost ÷ Change in activity
= P6,399 ÷ 3,422 occupancy-days
= P1.87 per occupancy-day
Total cost (August)............................................................................................... P8,111
Variable cost element
(P1.87 per occupancy-day × 3,608 occupancy-days)..................................... . . 6,747
Fixed cost element............................................................................................... P.1,364

Requirement (2)
Electrical costs may reflect seasonal factors other than just the variation in
occupancy days. For example, common areas such as the reception area must be
lighted for longer periods during the winter. This will result in seasonal effects on
the fixed electrical costs.
Additionally, fixed costs will be affected by how many days are in a month. In
other words, costs like the costs of lighting common areas are variable with respect
to the number of days in the month, but are fixed with respect to how many rooms
are occupied during the month.

Other, less systematic, factors may also affect electrical costs such as the frugality
of individual guests. Some guests will turn off lights when they leave a room.
Others will not.

Exercise 6 (Least-Squares Regression)

The least-squares regression estimates of fixed and variable costs can be computed
using any of a variety of statistical and mathematical software packages or even by
hand.
The intercept provides the estimate of the fixed cost element, P2,296 per month,
and the slope provides the estimate of the variable cost element, P3.74 per rental
return. Expressed as an equation, the relation between car wash costs and rental
returns is
Y = P2,296 + P3.74X

where X is the number of rental returns.

Note that the R2 is 0.92, which is quite high, and indicates a strong linear
relationship between car wash costs and rental returns.

While not a requirement of the exercise, it is always a good to plot the data on a
scattergraph. The scattergraph can help spot nonlinearities or other problems with
the data. In this case, the regression line (shown below) is a reasonably good
approximation to the relationship between car wash costs and rental returns.
III. Answers to Multiple Choice Questions
1. A 11.C * 21. C 31. D 41. B
2. D 11. C * 22. D 32. B 42. D
3. B 12. C 23. C 33. A 43. C
4. A 13. A 24. A 34. B
5. B 14. D 25. D 35. A
6. B 15. C 26. B 36. D
7. C 16. D 27. D 37. B
8. D 17. B 28. B 38. C
9. C 18. C 29. A 39. B
10. A 19. C 30. D 40. D

Supporting Computations:
11. (10,000 x 2) – (P3,000 x 2) – P5,000 = P9,000
12. [(P20 + P3 + P6) x 2,000 units] + (P10 x 1,000 units) = P68,000
IV. Answers to Problems
Problem 1
Requirement (a)

Miles Driven Total Annual Cost*

High level of activity............................... 120,000 P13,920
Low level of activity................................ 80,000 10,880
Difference........................................... 40,000 P 3,040

* 120,000 miles x P0.116 = P13,920.

80,000 miles x P0.136 = P10,880.
Variable cost per mile: Change in cost, P3,040
Change in activity, 40,000 = P0.076 per mile.

Fixed cost per year:

Total cost at 120,000 miles............................................ P13,920
Less variable cost element: 120,000 x P0.076............. 9,120
Fixed cost per year..................................................... P 4,800

Requirement (b)
Y = P4,800 + P0.076X

Requirement (c)
Fixed cost.............................................................................. P 4,800
Variable cost: 100,000 miles x P0.076............................... . 7,600
Total annual cost............................................................ P12,400

Problem 2
Requirement 1
Cost of goods sold............................................................... Variable
Shipping expense................................................................ Mixed
Advertising expense............................................................ Fixed
Salaries and commissions................................................... Mixed
Insurance expense............................................................... Fixed
Depreciation expense.......................................................... Fixed

Requirement 2

Analysis of the mixed expenses:

Units
Shipping
Expense
Salaries and
Comm.
Expense Units Shipping Expense Comm Expense
High level of activity.................... 4,500 P56,000 P143,000
Low level of activity.................... 3,000 44,000 107,000
Difference.............................. 1,500 P12,000 P 36,000

Variable cost element:

Change in cost = Variable rate
Change in activity
Shipping expense: P12,000
1,500 units = P8 per unit.

Salaries and comm. expense: P36,000

1,500 units = P24 per unit

Fixed cost element:

Shipping Expense Salaries and Comm. Expense
Cost at high level of activity..................... P56,000 P143,000
Less variable cost element:
4,500 units x P8.................................. 36,000
4,500 units x P24................................
108,000
Fixed cost element..................................... P20,000 P 35,000

The cost elements are:

Shipping expense: P20,000 per month plus P8 per unit or Y = P20,000 +
P8X.

Salaries and comm. expense: P35,000 per month plus P24 per unit or
Y = P35,000 + P24X.

Requirement 3
LILY COMPANY
Income Statement
For the Month Ended June 30
Sales in units........................................................... 4,500
Sales revenues......................................................... P630,000
Less variable expenses:
Cost of goods sold (@P56)............................... P252,000
Shipping expense (@P8)................................... 36,000
Salaries and commission expense
(@P24)........................................................... 108,000 396,000
Contribution margin............................................... 234,000
Less fixed expense:
Shipping expense.............................................. 20,000
Advertising........................................................ 70,000
Salaries and commissions................................. 35,000
Insurance........................................................... 9,000
Depreciation...................................................... 42,000 176,000
Net income.............................................................. P 58,000

Problem 3 (Linear Cost Approximation)

Requirement 1
Slope coefficient (b) = Difference in cost
Difference in labor-hours

= P529,000 – P400,000
7,000 – 4,000

= P43.00

Constant (a) = P529,000 – P43.00 (7,000)

= P228,000
Cost function = P228,000 + P43.00 (professional labor-hours)

The linear cost function is plotted in Figure 3-A (Page 3-15)

No, the constant component of the cost function does not represent the fixed
overhead cost of the ABS Group. 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.
Requirement 2
A comparison at various levels of professional labor-hours follows. The linear cost
function is based on formula of P228,000 per month plus P43.00 per professional
labor-hours.

Total overhead cost behavior:

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6
Actual total
Overhead costs P340,000 P400,000 P435,000 P477,000 P529,000 P587,000

Linear
Approximation 357,000 400,000 443,000 486,000 529,000 572,000
Actual minus
Linear approximation P(17,000) P 0 P (8,000) P (9,000) P0 P15,000

On Professional labor-hours 3,000 4,000 5,000 6,000 7,000 8,000

The data are shown in Figure 3-A. The linear cost function overstates costs by
P8,000 at the 5,000-hour level and understates costs by P15,000 at the 8,000-hour
level.

Requirement 3
Based on Actual Based on Linear Cost
Function

Contribution before deducting incremental

overhead P38,000 P38,000
Incremental overhead 35,000 43,000
Contribution after incremental overhead P 3,000 P (5,000)

The total contribution margin actually forgone is P3,000.

Figure 3-A
Linear Cost Function Plot of Professional Labor-Hours
on Total Overhead Costs for ABS Consulting Group
Requirement (1)

The first step in the high-low method is to identify the periods of the lowest and
highest activity. Those periods are November (1,100 patients admitted) and June
(1,900 patients admitted)

The second step is to compute the variable cost per unit using those two data
points:

Month Number of Patients Admitted Admitting Department Costs

High activity level (June) 1,900 P15,200
Low activity level (November) 1,100 12,800
Change 800 P2,400

Variable cost = Change in cost

Change in activity
= P240,000
800 patients admitted
P3 = per patient admitted

The third step is to compute the fixed cost element by deducting the variable cost
element from the total cost at either the high or low activity. In the computation
below, the high point of activity is used:
Fixed cost element = Total cost – Variable cost element
= P15,200 – (P3 per patient admitted
x 1,900 patients admitted)
= P9,500

Requirement (2)

The cost formula is Y = P9,500 + P3X.