CHAPTER 3:
1. Why is the knowledge of cost behavior important for
managerial decision making? Give an example to
illustrate your answer.
- Knowledge of cost behavior allows a manager to
assess changes in costs that result from changes in
activity. For example, the manager’s knowledge
about cost behavior is helpful in preparing the
budgets of the company. If he/she knows that the
demand of the company’s products is increasing,
then he/she can increase the budget for the costs of
production.
2. What is a driver? Give an example of a cost and its
corresponding output measure or driver.
- A cost driver is a causal factor that measures the
output of the activity that leads costs to change. An
example is electricity cost and its cost driver the
hours of using the electricity.
3. Suppose a company finds that shipping cost is $3,560
each month plus $6.70 per package shipped. What is
the cost formula for monthly shipping cost? Identify the
independent variable, the dependent variable, the fixed
cost per month and the variable rate.
- The cost formula for monthly shipping cost is:
Monthly shipping cost = $3,560 + $6.70 (Packages
shipped)
The independent variable is packages shipped. The
dependent variable is monthly shipping cost. The
fixed cost per month is $3,560. The variable rate is
$6.70.
4. Some firms assign mixed cost to either the fixed or
variable cost categories without using any formal
methodology to separate them. Explain how this
practice can be defended.
- Assigning all of the cost to either a fixed or variable
category is unlikely to result in large errors. For
example, cost of telephone expense for the sales
office, if it consisted primarily of long-distance calls,
could be seen as largely variable (variable with
respect to the number of customers).
5. Explain the difference between committed and
discretionary fixed costs. Give examples of each.
- Committed fixed costs are the costs that a business
has already made or obliged to make in the future
and are difficult to alter. Discretionary fixed costs are
the costs that can be eliminated or reduced at a
management’s discretion without having a direct
impact on profitability.
- Examples of discretionary: R&D, training programs,
advertising campaigns
- Examples of committed: property taxes, rent,
insurance, depreciation
6. Explain why the concept of relevant range is important
when dealing with step costs.
- It is important in dealing with step costs because if
the relevant range is contained completely within
one step, the cost behaves as a fixed cost. However,
if the relevant range spans two or more steps, the
accountant must be aware of the cost increase as
output increase within the relevant range.
7. Why do mixed costs pose a problem when it comes to
classifying costs into fixed and variable categories?
- Mixed costs are usually reported in total. The
amount of fixed cost and also the amount of variable
cost is unknown and must be estimated.
8. Describe the cost formula for a strictly fixed cost such as
depreciation of $15,000 per year.
- The cost formula for a strictly fixed cost has only a
fixed cost amount. There is no variable rate and no
independent variable.
Depreciation per year = $15,000
9. Describe the cost formula for a strictly variable cost
such as electrical power cost of $1.15 per machine hour
(i.e., every hour the machinery is run, electrical power
cost goes up by $1.15).
- The cost formula for a strictly variable cost has only
the independent variable and the variable rate.
Electrical power = $1.15 (Machine Hours)
10. What is the scattergraph method, and why is it used?
Why is a scattergraph a good first step in separating
mixed costs into their fixed and variable components?
- Scattergraph method is a method to fit a line to a set
of data using two points that are selected by
judgment. It is used because it allows a visual
representation of data. It is a good first step in
separating mixed costs into their fixed variable
components to see whether or not a straight line
reasonably describes the relationship between cost
and activity.
11. Describe how the scattergraph method breaks out the
fixed and variable costs from a mixed cost. Now
describe how the high-low method works. How do the
two methods differ?
- Scattergraph method uses a graphical/visual
technique to separate fixed and variable costs from a
mixed cost. By plotting all relevant data points in a
graph, the fixed and variable costs are determined
whereas in high-low method, it only considers the
highest and lowest level of activity only.
12. What are the advantages of the scattergraph method
over the high-low method? The high-low method over
the scattergraph method?
- The scattergraph method is a visual representation
of data and inspecting the graph may easily reveal
the points that do not seem to fit the general
pattern of behaviors (outliers), unlike in high-low
method. On the other hand, high-low method is
more objective, quick and inexpensive that
 scattergraph method which is subjective and
depends on judgment.
13. Describe the method of least squares. Why is this
method better than either the high-low method or the
scattergraph method?
- It is a statistical way to find the best-fitting line
through the set of data points. When the need for
accuracy is high, this method is best because it uses
all of the given data points, thereby producing the
best and most accurate estimates.
14. What is meant by best-fitting line?
- The best-fitting line is the one that is “closest” to the
data points. This is usually measured by the line that
has the smallest sum of squared deviations.
15. What is the difference between the unit cost of a
product under absorption costing and variable costing?
- The unit cost of a product under absorption costing
consists of DM, DL, and both variable and fixed
MOH. Thus, absorption costing allocates a portion of
fixed MOH cost to each unit of product, along with
the variable manufacturing costs. Under variable
costing, only those manufacturing costs that vary in
output are treated as product costs. This usually
includes DM, DL, and the variable portion of MOH.
Fixed MOH is not treated as product cost but as a
period cost in this method, so the unit cost of a
product in this costing method does not contain any
fixed MOH.
16. If a company produces 10,000 units and sells 8,000 units
during a period, which method of computing operating
income (absorption costing or variable costing) will
result in the higher operating income? Why?
- The absorption costing will result into higher income
because there are fewer units sold than were
produced. There are 10,000 units produced and only
8,000 units were sold.
17. (Appendix 3A) Explain the meaning of the coefficient of
determination.
- The coefficient of determination is the
percentage of total variability in a dependent
variable that is explained by an independent
variable.