CHAPTER 7

Activity Analysis, Cost Behavior, and Cost

Estimation

ANSWERS TO REVIEW QUESTIONS

7-1 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.
7-2 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.
7-3 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.
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).

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Managerial Accounting, 5/e 7- 1
 7-4 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

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-2 Solutions Manual
7-5 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.
7-6 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.
7-7 As the level of activity (or cost driver) increases, total variable cost increases
proportionately and the variable cost per unit remains constant.
7-8 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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Managerial Accounting, 5/e 7- 3
7-9 (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.
7-10 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.
7-11 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.
7-12 Work measurement is the systematic analysis of a task for the purpose of
determining the inputs needed to perform the task. Work measurement is sometimes
used to help in estimating the costs of various nonmanufacturing activities. The unit
of analysis in work measurement often is called a control factor unit. Appropriate
control factor units 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.

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7-4 Solutions Manual
 c. Picking oranges: Volume or weight of oranges picked.
d. Inspecting computer components in an electronics firm: Number of components
inspected.
7-13 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.
7-14 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.
7-15 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 drawbacks of the
visual-fit method are its lack of objectivity. Two cost analysts may draw two different
visually-fitted cost lines.
7-16 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.

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Managerial Accounting, 5/e 7- 5
7-17 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 distances between
the data and the regression line.
7-18 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.
7-19 In simple regression there is a single independent variable. In multiple regression
there are two or more independent variables.
7-20 Advanced manufacturing technology, such as FMS and CIM systems, have resulted
in a shift in the cost structure toward fixed costs. Moreover, many of these fixed
costs are committed costs.
7-21 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.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-6 Solutions Manual
SOLUTIONS TO EXERCISES
EXERCISE 7-22 (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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Managerial Accounting, 5/e 7- 7
EXERCISE 7-22 (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

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-8 Solutions Manual
EXERCISE 7-22 (CONTINUED)
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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Managerial Accounting, 5/e 7- 9
EXERCISE 7-22 (CONTINUED)
4. Cost of utilities:

Cost per month

$15,000 Total cost

$10,000

$5,000

Patient days
1,000 2,000 3,000

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-10 Solutions Manual
EXERCISE 7-22 (CONTINUED)
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

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 11
EXERCISE 7-23 (15 MINUTES)
1.
Actual Estimated
a. 20,000 miles................................................................... $3,900 $4,400
b. 40,000 miles................................................................... 5,200 5,200
c. 60,000 miles................................................................... 6,000 6,000
d. 90,000 miles................................................................... 8,500 7,200

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.

EXERCISE 7-24 (15 MINUTES)

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.
EXERCISE 7-25 (15 MINUTES)
Variable cost per pint of applesauce produced =
1.

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7-12 Solutions Manual
 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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Managerial Accounting, 5/e 7- 13
EXERCISE 7-26 (30 MINUTES)
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

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-14 Solutions Manual
EXERCISE 7-26 (CONTINUED)
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.

EXERCISE 7-27 (30 MINUTES)

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

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Managerial Accounting, 5/e 7- 15
EXERCISE 7-28 (30 MINUTES)
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

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-16 Solutions Manual
EXERCISE 7-28 (CONTINUED)
2. 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

Variable cost per diagnostic test =

= $10.56†

†
Rounded.

EXERCISE 7-29 (15 MINUTES)

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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Managerial Accounting, 5/e 7- 17
EXERCISE 7-30 (15 MINUTES)

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

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-18 Solutions Manual
EXERCISE 7-31 (15 MINUTES)

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

Control factor
units: tax
20 40 60 80 100 returns audited

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Managerial Accounting, 5/e 7- 19
EXERCISE 7-32 (10 MINUTES)
1. (a) Average time for 4 satellites............................................................... 130 hours
(b) Average time for 8 satellites............................................................... 100 hours

2. (a) Total time for 4 satellites (130 hr. X 4).............................................. 520 hours
(b) Total time for 8 satellites (100 hr. X 8).............................................. 800 hours

3. Learning curves indicate how labor costs will change as the company gains
experience with the production process. Since labor time and costs must be predicted
both for budgeting and for setting cost standards, the learning curve is a valuable
tool.

EXERCISE 7-33 (45 MINUTES)

1. Least-square regression:

(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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7-20 Solutions Manual
EXERCISE 7-33 (CONTINUED)
(b) Calculation of parameters:

a =

b =

(c) Cost formula:

Monthly cost of flight service = $9,667 + $545X, where X denotes thousands of

passengers.

2. Calculation and interpretation of R2:

(a) Formula for calculation:

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.

denotes the mean (average) observation of the dependent variable

(cost).

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Managerial Accounting, 5/e 7- 21
EXERCISE 7-33 (CONTINUED)
(b) Tabulation of data:*

Predicted Cost (in

thousands)
Based on
Regression
Month Y X Line Y' [( Y – Y')2]† [(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/6 = 18.667 (rounded)
†
Rounded.

(c) Calculation of R2:

R2 = 1 – = .49 (rounded)

(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.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-22 Solutions Manual
EXERCISE 7-34 (45 MINUTES)

1. Variable utility cost per hour = = $2.00

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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Managerial Accounting, 5/e 7- 23
EXERCISE 7-34 (CONTINUED)
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

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-24 Solutions Manual
EXERCISE 7-34 (CONTINUED)
3. Least-square regression:

(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:

a =

b =

(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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Managerial Accounting, 5/e 7- 25
EXERCISE 7-34 (CONTINUED)
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

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7-26 Solutions Manual
SOLUTIONS TO PROBLEMS
PROBLEM 7-35 (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.

PROBLEM 7-36 (25 MINUTES)

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
hours) hours)

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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Managerial Accounting, 5/e 7- 27
PROBLEM 7-36 (CONTINUED)

Fixed maintenance cost:

March January
(34,000 (23,000
hours) hours)

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.

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.

PROBLEM 7-37 (25 MINUTES)

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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7-28 Solutions Manual
PROBLEM 7-37 (CONTINUED)

Royalties have both a variable and a fixed component, making it a semivariable

(mixed) cost.

Variable royalty cost = difference in cost  difference in tons

= ($201,000 – $135,000)  (2,600 – 1,500)
= $66,000  1,100 tons
= $60 per ton

Fixed royalty cost:

June December
(2,600 tons) (1,500 tons)

Total royalty cost………………………. $201,000 $135,000

Less: Variable cost at $60 per ton….. 156,000 90,000
Fixed royalty cost……………………… $ 45,000 $ 45,000

2. Total cost for 1,650 tons:

Depreciation…………………………………………... $ 25,000
Charitable contributions……………………………. ----
Mining labor/fringe benefits at $230 per ton……. 379,500
Royalties:
Variable at $60 per ton………………………….. 99,000
Fixed……………………………………………….. 45,000
Trucking and hauling……………………………….. 275,000
Total……………………………………………….. $823,500

3. Hauling 1,500 tons is not very cost effective. Antioch will incur cost of $275,000 if it
needs 1,500 tons hauled or, for that matter, 1,899 tons. The company would be
better off if it had 1,499 tons hauled, saving outlays of $25,000. In general, with this
type of cost function, effectiveness is maximized if a firm operates on the right-most
portion of a step, just prior to a jump in cost.

2. A committed fixed cost results from an entity’s ownership or use of facilities and its
basic organizational structure. Examples of such costs include property taxes,
depreciation, rent, and management salaries. Discretionary fixed costs, on the other
hand, arise from a decision to spend a particular amount of money for a specific
purpose. Outlays for research and development, advertising, and charitable
contributions fall in this category.

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Managerial Accounting, 5/e 7- 29
PROBLEM 7-37 (CONTINUED)

In times of severe economic difficulties, management should try to cut

discretionary fixed costs. Such costs are more easily altered in the short run and do
not have significant long-term ramifications for a firm. The decision to close a
manufacturing facility, for example, could reduce property taxes, rent, and/or
depreciation. However, that decision may result in a significant long-run change in
operations that may be difficult to overturn when economic conditions rebound.

5. Antioch uses a calendar year for tax-reporting purposes. At year-end, it may have
ample funds available and decide to make donations to charitable causes. Such
contributions are deductible in computing the company’s tax obligation to the
government. Tax deductions reduce taxable income and, therefore, produce a tax
savings for the firm.

PROBLEM 7-38 (25 MINUTES)

1. Variable maintenance cost per hour of service =

= $7.50

Total maintenance cost at 300 hours of service......................................... $2,820

Variable maintenance cost at 300 hours of service (300 hr.  $7.50)...... 2,250
Fixed maintenance cost per month............................................................. $ 570

Cost formula:

Monthly maintenance cost = $570 + $7.50X, where X denotes hours of

maintenance service.

2. The variable component of the maintenance cost is $7.50 per hour of

service.

3. Cost prediction at 590 hours of activity:

Maintenance cost = $570 + ($7.50)(590) = $4,995

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-30 Solutions Manual
PROBLEM 7-38 (CONTINUED)
4. Variable cost per hour [from requirement (2)]............................................ $7.50
Fixed cost per hour at 600 hours of activity ($570/600)............................. $ .95

The fixed cost per hour is a misleading amount, because it will change
as the number of hours changes. For example, at 500 hours of
maintenance service, the fixed cost per hour is $1.14 ($570/500 hours).

PROBLEM 7-39 (15 MINUTES)

An appropriate activity measure for the school would be hours of instruction. The costs are
classified as follows:

1. Fixed 6. Variable

2. Fixed 7. Fixed

3. Variable 8. Fixed

4. Semivariable (or mixed)* 9. Semivariable (or mixed)

5. Fixed

*The fixed-cost component is the salary of the school's repair technician. As activity
increases, one would expect more repairs beyond the technician's capability. This increase
in repairs would result in a variable-cost component equal to the dealer's repair charges.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 31
PROBLEM 7-40 (40 MINUTES)

Total course maintenance cost

1.
Step-variable
$12,500 component
of maintenance
cost
2.
$12,400 Semivariable
cost approximation

$12,300

$12,200

$12,100

$12,000

1.
Fixed
component
of
maintenance
cost

0 50 100 150 200 250 300

The lower part of the Number of golfers
vertical axis has been
shortened.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-32 Solutions Manual
PROBLEM 7-40 (CONTINUED)
3. Fixed-cost component = $12,010

Variable-cost component:

Variable cost
per golfer =
= $2
Cost equation:

Maintenance cost per month = $12,010 + $2X, where X denotes the number of golfers
during the month.

4. Predicted Course Maintenance Costs

Using Fixed
Cost Coupled
with Step-
Variable Cost Using
Behavior Semivariable Cost
Pattern Approximation
150 people tee off................................ $12,300 $12,310
158 people tee off................................ 12,320 12,326

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 33
PROBLEM 7-41 (40 MINUTES)

Material-handling costs

$12,500



$12,000 


$11,500
  
 
 
$11,000
2.
Visually-fitted
$10,500 cost line


$10,000

$9,500

Control factor
units
500 1,000 1,500 2,000 2,500
The lower part of the
vertical axis has
been shortened.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-34 Solutions Manual
PROBLEM 7-41 (CONTINUED)
2. See graph for requirement (1).

3. The estimate of the fixed cost is the intercept on the vertical axis.

Fixed-cost component = $9,700

To estimate the variable-cost component, choose any two points on the visually-fitted
cost line. For example, choose the following points:

Activity Cost
0................................................................................................ $ 9,700
2,000......................................................................................... 11,700

Then proceed as follows to estimate the variable-cost component:

Variable cost per control factor unit =

= $1.00

4. Cost equation:

Total material-handling cost = $9,700 + $1.00X, where X denotes the number of control
factor units of activity during the month.

5. High-low method:

Variable cost per control factor unit =

= $1.20

Total cost at 2,600 control factor units......................................................... $12,120

Deduct: Variable cost at 2,600 control factor units (2,600  $1.20).......... 3,120
Fixed cost......................................................................................................... $ 9,000

Cost equation based on high-low method:

Material-handling cost per month = $9,000 + $1.20X, where X denotes the number of
control factor units of activity during the month.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 35
PROBLEM 7-41 (CONTINUED)
6. Memorandum

Date: Today

To: President, Martha’s Vineyard Marine Supply

From: I.M. Student

Subject: Material-handling cost estimates

On the basis of a scatter diagram and visually-fitted cost line, the Material-Handling
Department's monthly cost behavior was estimated as follows:

Material-handling cost per month = $9,700 + $1.00 per control factor unit

A control factor unit is defined in this department as 100 pounds of equipment loaded
or unloaded at the loading dock.

Using the high-low method, the following cost estimate was obtained:

Material-handling cost per month = $9,000 + $1.20 per control factor unit

The two methods yield different estimates because the high-low method uses only
two data points, ignoring the rest of the information. The method of visually fitting a
cost line, while subjective, uses all of the data available.

In this case, the two data points used by the high-low method do not appear to be
representative of the entire set of data.

7. Predicted Material-Handling Costs

Using Visually-Fitted Using

Cost Line* High-Low Method
$12,000 = $9,700 + ($1.00)(2,300) $11,760 = $9,000 + ($1.20)(2,300)

*This method is preferable, because it uses all of the data.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-36 Solutions Manual
PROBLEM 7-42 (45 MINUTES)
1. Least-squares regression:

(a) Tabulation of data:

Independent
Dependent Variable
Variable (units of
(cost in activity in
thousands) thousands)
Month Y X X2 XY
January....................... 11.35 1.4 1.96 15.890
February...................... 11.35 1.2 1.44 13.620
March........................... 11.05 1.1 1.21 12.155
April............................. 12.12 2.6 6.76 31.512
May.............................. 11.40 1.8 3.24 20.520
June............................. 12.00 2.0 4.00 24.000
July.............................. 12.55 2.4 5.76 30.120
August......................... 11.10 2.2 4.84 24.420
September................... 10.20 1.0 1.00 10.200
October....................... 11.25 1.3 1.69 14.625
November.................... 11.30 1.6 2.56 18.080
December.................... 11.70 1.8 3.24 21.060
Total............................. 137.37 20.4 37.70 236.202

(b) Calculation of parameters:

a =

b =

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 37
PROBLEM 7-42 (CONTINUED)
(c) Fixed- and variable-cost components:

Monthly fixed cost = $9,943*

Variable cost = $.89 per control factor unit (rounded)†

*The intercept parameter (a) computed above is the cost per month in thousands.
†
The slope parameter (b) calculated above is the cost in thousands of dollars per
thousand units of activity. Equivalently, it is the cost per unit of activity.

2. Total monthly cost = $9,943 + $.89 per control factor unit

3. Cost prediction for 2,300 control factor units of activity:

Total monthly cost = $9,943 + ($.89)(2,300) = $11,990

4. The cost predictions differ because the cost formulas differ under the three cost-
estimation methods. The high-low method, while objective, uses only two data points.
Ten observations are excluded.
The visual-fit method, while it uses all of the data, is somewhat subjective.
Different analysts may draw different cost lines.
Least-squares regression is objective, uses all of the data, and is a statistically
sound method of estimation.
Therefore, least-squares regression is the preferred method of cost estimation.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-38 Solutions Manual
PROBLEM 7-43 (25 MINUTES)

1. Scatter diagrams:

 Present, in graphic form, the relationship between costs and cost drivers via a plot of
data points
 Require that a straight line be fit through the data points, with approximately the same
number of data points above and below the line
 Easy to use
 Provide a means to easily recognize outliers

Least-squares regression:

 Uses statistical formulas to fit a cost line through the data points
 Is a very objective method of cost estimation that uses all the data points
 Requires more computation than other cost-estimation methods; however, software
programs are readily available

High-low method:

 Relies on only two data points (for the highest and lowest activity levels) in drawing
conclusions about cost behavior
 Is considered more objective than the scatter diagram; however, is weaker than the
scatter diagram because it relies on only two data points

The least-squares regression method will typically produce the most accurate
results.

2. Yes. The three methods produce equations by different means. Scatter diagrams
and least-squares regression rely on an examination of all data points. The scatter
diagram, however, requires an analyst to fit a line through the points by visual
approximation, or “eyeballing.” In contrast, least-squares regression involves the
use of statistical formulas to derive the best possible fit of the line through the
points. Finally, the high-low method is based on an analysis of only two data points:
the highest and the lowest activity levels.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 39
PROBLEM 7-43 (CONTINUED)

3. These amounts represent the fixed and variable cost associated with the ticketing
operation. Fixed cost totals $312,000 within the relevant range, and Global American
incurs $2.30 of variable cost for each ticket issued.

4. C = $320,000 + $2.15PT
C = $320,000 + ($2.15 x 580,000)
C = $1,567,000

5. Yes, she did err by including November data. November is not representative
because of the effects of the Delta Western strike. The month is an outlier and
should be eliminated from the data set.

6. Currently, most of the airline’s tickets are written through reservations personnel,
whose wages are likely variable in nature. Heavier reliance on the Internet means a
greater investment in software, Web-site maintenance and development, and other
similar expenditures. Outlays that fall in these latter categories are typically fixed
costs, assuming that the cost driver is the number of tickets. The outcome would
parallel the experiences of a manufacturing firm that automates its processes and
reduces its reliance on direct-labor personnel.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-40 Solutions Manual
PROBLEM 7-44 (35 MINUTES)
1. The regression equation's intercept on the vertical axis is $200. It represents the
portion of indirect material cost that does not vary with machine hours when
operating within the relevant range. The slope of the regression line is $4 per machine
hour. For every machine hour, $4 of indirect material costs are expected to be
incurred.

2. Estimated cost of indirect material at 900 machine hours of activity:

S = $200 + ($4  900)
= $3,800

3. Several questions should be asked:

(a) Do the observations contain any outliers, or are they all representative of normal
operations?

(b) Are there any mismatched time periods in the data? Are all of the indirect
material cost observations matched properly with the machine hour
observations?

(c) Are there any allocated costs included in the indirect material cost data?

(d) Are the cost data affected by inflation?

4.
April August
Beginning inventory.............................................................. $1,200 $ 950
+ Purchases........................................................................... 6,000 6,100
– Ending inventory................................................................ (1,550) (2,900)
Indirect material used........................................................... $5,650 $4,150

5. High-low method:

Variable cost per machine hour

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 41
PROBLEM 7-44 (CONTINUED)
Fixed cost per month:

Total cost at 1,100 hours................................................................................ $5,650

Variable cost at 1,100 hours
($5  1,100).............................................................................................. 5,500
Fixed cost......................................................................................................... $ 150

Equation form:

Indirect material cost = $150 + ($5  machine hours)

6. The regression estimate should be recommended because it uses all of the data, not
just two pairs of observations.

PROBLEM 7-45 (40 MINUTES)

1. The original method was simply the average overhead per hour for the last 12
months and did not distinguish between fixed and variable costs. Rand divided total
overhead by total labor hours, which effectively treated all overhead as variable.
Regression analysis measures the behavior of the overhead costs in relation to labor
hours and is a model that distinguishes between fixed and variable costs within the
relevant range of 2,500 to 7,500 labor hours.

2. a. Based on the regression analysis, the variable cost per person for a cocktail
party is $22, calculated as follows:

Food and beverages................................................................................ $15

Labor (.5 hr. @ $10/hr.)............................................................................ 5
Variable overhead (.5 hr. @ $4/hr.)......................................................... 2
Total..................................................................................................... $22

b. Based on the regression analysis, the full absorption cost per person for a
cocktail party is $27, calculated as follows:

Food and beverages................................................................................ $15

Labor (.5 hr. @ $10/hr.)............................................................................ 5
Variable overhead (.5 hr. @ $4/hr.)......................................................... 2
Fixed overhead (.5 hr. @ $10/hr.)*.......................................................... 5
Total..................................................................................................... $27

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-42 Solutions Manual
PROBLEM 7-45 (CONTINUED)

*$48,000 x 12 months = $576,000

$576,000/57,600 hr. = $10/hr.

3. The minimum bid for a 200-person cocktail party would be $4,400. The amount is
calculated by multiplying the variable cost per person of $22 by 200 people. At any
price above the variable cost, Dana Rand will be earning a contribution toward her
fixed costs.

4. Other factors that Dana Rand should consider in developing a bid include the
following:

 The assessment of the current capacity of her business. If the business is at capacity,
other work would have to be sacrificed at some opportunity cost.
 Analyses of the competition. If competition is rigorous, she may not have much
bargaining power.
 A determination of whether or not her bid will set a precedent for lower prices.
 The realization that regression analysis is based on historical data, and that any
anticipated changes in the cost structure should be considered.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 43
PROBLEM 7-46 (45 MINUTES)

Cost of
Operating the
Applications Admissions
Received Office
(in thousands) (in thousands)
Month X Y X2 XY
August......................... 20 8.9 400 178.0
September................... 30 10.0 900 300.0
October....................... 25 9.6 625 240.0
November.................... 22 9.1 484 200.2
December.................... 15 8.7 225 130.5
January....................... 10 8.0 100 80.0
Total............................. 122 54.3 2,734 1,128.7

a. Least-squares regression:

7.076* =

.097* =

Total monthly admissions department costs = $7,076 + $.097X, where X denotes

the number of applications in thousands.

*Rounded.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-44 Solutions Manual
PROBLEM 7-46 (CONTINUED)
b. High-low method:

Variable cost per thousand applications =

= $.10

Total cost at 30 thousand applications............................................. $10,000

Variable cost at 30 thousand applications (30,000  $.10)............. 3,000
Fixed cost per month........................................................................... $ 7,000

Total monthly admissions department costs = $7,000 + $.10X

c. Visual-fit method:

Total monthly admissions department costs = $7,100 + $.095X

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 45
PROBLEM 7-47 (45 MINUTES)
1. Scatter diagram:

Airport costs

$30,000

$25,000


 
$20,000  
 
 
 
$15,000

$10,000

$5,000

250 500 750 1,000 1,250 1,500 1,750

Flights

Note: Only 11 data points appear, because two monthly observations were identical (May
and September).

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-46 Solutions Manual
PROBLEM 7-47 (CONTINUED)
2. Least-squares regression:

(a) Tabulation of data:

Dependent Independent
Variable Variable
(cost in (flights in
thousands) hundreds)
Month Y X X2 XY
January....................... 20 11 121 220
February...................... 17 8 64 136
March........................... 19 14 196 266
April............................. 18 9 81 162
May.............................. 19 10 100 190
June............................. 20 12 144 240
July.............................. 18 11 121 198
August......................... 24 14 196 336
September................... 19 10 100 190
October....................... 21 12 144 252
November.................... 17 9 81 153
December.................... 21 15 225 315
Total............................. 233 135 1,573 2,658

(b) Calculation of parameters:

a =

b =

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 47
PROBLEM 7-47 (CONTINUED)
(c) Fixed- and variable-cost components:

Monthly fixed cost = $11,796

Variable cost = $677 per hundred flights

3. Cost equation:

Total monthly airport cost = $11,796 + $677X, where X denotes the number of flights in
hundreds.

4. Cost prediction for 1,600 flights:

Airport cost for the month = $11,796 + ($677)(16) = $22,628

5. Calculation and interpretation of R 2:

(a) Formula for calculation:

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.

denotes the mean (average) observation of the dependent variable

(cost).

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-48 Solutions Manual
PROBLEM 7-47 (CONTINUED)
(b) Tabulation of data:*

Predicted Cost (in

thousands)
Based on
Regression
Month Y X Line Y' [( Y– Y')2]† [(Y – )2]†
January.......... 20 11 19.243 .573 .340
February......... 17 8 17.212 .045 5.842
March.............. 19 14 21.274 5.171 .174
April................ 18 9 17.889 .012 2.008
May................. 19 10 18.566 .188 .174
June................ 20 12 19.920 .006 .340
July................. 18 11 19.243 1.545 2.008
August............ 24 14 21.274 7.431 21.004
September...... 19 10 18.566 .188 .174
October.......... 21 12 19.920 1.166 2.506
November....... 17 9 17.889 .790 5.842
December....... 21 15 21.951 .904 2.506
Total................ 18.019 42.918

*Y' = ($11,796 + $677X)/$1,000

= Y/12 = 233/12 = 19.417 (rounded)
†
Rounded.

(c) Calculation of R2:

R2 = 1 – = .58 (rounded)

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 49
PROBLEM 7-47 (CONTINUED)
(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 .58 means that 58% 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 the county’s
cost estimation, a high R2 would mean that the county budget officer can be
relatively confident in the cost predictions based on the estimated-cost behavior
pattern. An R2 of .58 is not particularly high.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-50 Solutions Manual
SOLUTIONS TO CASES
CASE 7-48 (45 MINUTES)
1. Cairns' preliminary estimate for overhead of $18.00 per direct-labor hour does not
distinguish between fixed and variable overhead. This preliminary rate is applicable
only to the activity level at which it was computed (36,000 direct-labor hours per year)
and may not be used to predict total overhead at other activity levels.

The overhead rate developed from the least-squares regression recognizes the
relationship between cost and volume in the data. The regression suggests that there
is a component of the cost ($26,200 per month) that is unrelated to total direct-labor
hours. This cost component is the intercept on the vertical axis and is often
considered to be the fixed cost as long as the activity level is within the relevant
range. Thus, the least-squares regression results in a cost function with two
components: fixed cost per month and variable cost per direct-labor hour. This cost
formula can be used to predict total overhead at any activity level.

2. Direct material................................................................................................ $400.00

Direct labor (5 DLH*  $10.00 per DLH)....................................................... 50.00
Variable overhead (5 DLH  $9.25 per DLH)............................................... 46.25
Total variable cost per 1,000 square feet..................................................... $496.25

*DLH denotes direct-labor hour.

3. The minimum bid should include the following incremental costs of the project.:

Direct material ($400.00  60)...................................................................... $24,000

Direct labor ($50.00  60)............................................................................. 3,000
Variable overhead ($9.25 per DLH  5 DLH  60)..................................... 2,775
Overtime premium ($5.00 per DLH  5 DLH  60  .4)............................ 600
Minimum bid................................................................................................... $30,375

4. Yes, Cairns can rely on the formula as long as she recognizes that there are some
shortcomings. The fact that least-squares regression estimates cost behavior
increases the usefulness of rates computed from cost data. However, the regression
is based on historical costs that may change in the future, and Cairns must assess
whether the cost equation would need to be revised for future cost increases or
decreases.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 51
CASE 7-48 (CONTINUED)
5. a. Variable OH1 (60  5  $4.10)...................................................................... $1,230
Variable OH2 (60  $13.50)............................................................................ 810
Variable OH3 (80  $6.60).............................................................................. 528
Total incremental variable overhead............................................................ $2,568

b. Variable OH1 (60  5  $4.10)...................................................................... $1,230

Variable OH2 (30  $13.50)............................................................................ 405
Variable OH3 (250  $6.60)............................................................................ 1,650
Total incremental variable overhead............................................................ $3,285

c. The two scenarios in (a) and (b) differ in terms of the activities to be undertaken.
Scenario (a) involves a large amount of seeding activity and relatively little
planting activity. Scenario (b) involves considerably less seeding activity, but a
great deal more planting activity. An activity-based costing system accounts for
the different costs in projects involving different mixes of activity.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-52 Solutions Manual
CASE 7-49 (45 MINUTES)
1. Scatter diagram:

Administrative cost

$25,000

$20,000

2.

Visually-fitted
$15,000 curvilinear
 cost line

 
$10,000  4.
 
 Visually-fitted
semivariable
 cost line

$5,000


Patient load
500 1,000 1,500 2,000
3. Relevant range

2. through 4. See scatter diagram for requirement (1).

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 53
CASE 7-49 (CONTINUED)
5. Fixed cost = $6,900

6. Administrative cost = $6,900 + $3.08X, where X denotes the number of patients.

7. Cost predictions:

Patient Cost
Load Prediction
800............................ $9,300
300............................ 4,000

It makes no difference which cost line is used to make the cost prediction for 800
patients. The semivariable approximation is very accurate at this patient load, which is
near the middle of the relevant range. However, for a patient load of 300 patients, the
curvilinear cost line yields a much more accurate prediction.

CASE 7-50 (50 MINUTES)

1. High-low method:

Variable administrative cost per patient =

Total cost at 1,500 patients............................................................................ $16,100

Variable cost at 1,500 patients....................................................................... 15,000
Fixed cost per month...................................................................................... $ 1,100

Cost formula:

Total monthly administrative cost = $1,100 + $10X, where X denotes the number of
patients for the month.

The variable cost per patient is $10.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-54 Solutions Manual
CASE 7-50 (CONTINUED)
2. Least-squares regression:

(a) Tabulation of data:

Dependent Independent
Variable Variable
(cost in (patients in
hundreds) hundreds)
Month Y X X2 XY
January....................... 139 14 196 1,946
February...................... 70 5 25 350
March........................... 60 4 16 240
April............................. 100 10 100 1,000
May.............................. 119 13 169 1,547
June............................. 92 9 81 828
July.............................. 102 11 121 1,122
August......................... 41 3 9 123
September................... 94 7 49 658
October....................... 111 12 144 1,332
November.................... 83 6 36 498
December.................... 161 15 225 2,415
Total............................. 1,172 109 1,171 12,059

(b) Calculation of parameters:

a =

b =

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 55
CASE 7-50 (CONTINUED)
(c) Cost behavior in formula form (with rounded parameters):*

Total monthly administrative cost = $2,671 + $7.81X, where X denotes the

number of patients for the month.

*When interpreting the regression parameters, remember that both the cost and
patient data were transformed to hundreds. Thus, the 26.707 intercept parameter
(a) is in terms of hundreds of dollars of cost, or $2,671 (rounded). The 7.812
slope parameter (b) is in terms of hundreds of dollars of cost per hundred
patients, or $781 (rounded) per hundred patients. This amount is equivalent to
$7.81 per patient.

(d) The variable cost per patient is $7.81, as explained above.

3. Memorandum
Date: Today
To: Jeffrey Mahoney, Administrator
From: I.M. Student
Subject: Comparison of cost estimates for clinic administrative costs
Three alternative cost-estimation methods were used to estimate the pediatric clinic's
administrative cost behavior. The results of these three approaches (in formula form)
are shown below. In each formula, X denotes the number of patients in a month.

(a) Least-squares regression method:

Total monthly administrative cost = $2,671 + $7.81X

(b) High-low method:

Total monthly administrative cost = $1,100 + $10X

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-56 Solutions Manual
CASE 7-50 (CONTINUED)
(c) Visual-fit method:

Total monthly administrative cost = $6,900 + $3.08X

These cost estimates differ very significantly. The activity level in the clinic
during its first year of operation fluctuated greatly. This fluctuation is not expected in
the future; patient loads in the range of 600 to 1,200 patients per month are
anticipated.
The cost estimates differ so greatly because two of the methods (least-
squares and high-low) used data from outside the relevant range of activity. The
clinic's administrative cost behavior appears from the scatter diagram to be
curvilinear over the entire range. The cost behavior pattern exhibits very low costs in
the range of activity below the relevant range and very high costs in the activity range
above the relevant range. Since the regression and high-low estimates are so heavily
influenced by observations outside the relevant range, they do not provide the best
estimate in this case of how administrative costs are likely to behave within the
relevant range. In this instance, the visually-fitted cost line probably provides the best
estimate. The visually-fitted cost line has a much flatter slope than the other two cost
lines, indicating that total variable administrative costs will probably rise at about
$3.25 per patient.
Another possible approach would be to use least-squares regression, but
restrict the data to those observations within the relevant range. However, only a
handful of observations would remain to include in the analysis.
My overall recommendation is to use the visually-fitted cost line as the best
estimate until the clinic has operated for its second year. Then I would recommend a
new cost analysis using least-squares regression on all of the data from the relevant
range of activity.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 57
CASE 7-50 (CONTINUED)
4. It is very inappropriate for the hospital administrator to manipulate the cost
information supplied by the controller in order to push his own agenda before the
board of trustees. It is the board's legitimate role to decide whether or not to establish
and continue operations in the clinic. In making decisions about the clinic, the board
should have the best information possible, including the controller's best estimate as
to how administrative costs will behave.
Megan McDonough, the hospital’s Director of Cost Management, has a
professional obligation to provide her best professional judgment to the board of
trustees. The standards of ethical conduct for management accountants include the
following requirements concerning objectivity:
(a) Communicate information fairly and objectively.

(b) Disclose fully all relevant information that could reasonably be expected to
influence an intended user's understanding of the reports, comments, and
recommendations presented.

McDonough should insist that the best and most appropriate estimate of the
clinic's administrative cost behavior be presented to the board.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-58 Solutions Manual
CURRENT ISSUES IN MANAGERIAL ACCOUNTING
ISSUE 7-51
"DRUG-PRICE PROGRAM NOTES," THE WALL STREET JOURNAL, AUGUST 10, 2000.

1. A fixed cost is a cost that will not change in total as production levels change within
the relevant range. Common examples include straight-line depreciation,
supervisory salaries, and rent. The pharmaceutical industry has high fixed costs
and low variable costs. Its high fixed costs are “baked in the cake” because of the
research and development necessary to yield a profitable drug. Therefore, research
and development is a fixed cost of the drug industry. Variable costs are low because,
after the discovery and approval process has been completed, it's not very
expensive to manufacture the pills.

2. A variable cost is a cost that will change in total as production levels change. Direct
material and electricity are often classified as variable costs. Many costs are
semivariable (or mixed); they contain both variable and fixed cost components.

ISSUE 7-52

"DELTA, NORTHWEST POST STRONG NET DESPITE FUEL COSTS, HIGHER FARES," THE
WALL STREET JOURNAL, JULY 21, 2000, MARTHA BRANNIGAN AND MICHAEL J.
MCCARTHY.
1. Fuel costs are variable. The distance flown, as well as the weight of the cargo
and/or passengers, determines how much fuel is used during a flight.
2. An airline would benefit from estimating costs since management needs cost
information to schedule routes and determine the sales price of tickets.

ISSUE 7-53

"AIRBUS 'CRUISE SHIP IN THE SKY'," THE WALL STREET JOURNAL, AUGUST 30, 2000,
JEFF COLE AND DANIEL MICHAELS.

1. Significantly different costs would be the variable costs per passenger such as fuel,
food, and personnel costs for the flight attendants. Increased costs of hangar space
due to the size of the plane would be considered fixed costs.
2. Maintenance costs for a new aircraft are always difficult to predict.
3. An airline would benefit from estimating costs. Management needs cost estimates to
schedule routes and to determine the sales price of tickets.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

Managerial Accounting, 5/e 7- 59
ISSUE 7-54

"DELTA PILOTS' UNION PROPOSES PAY RAISES MAKING SALARIES HIGHER THAN
UNITED'S," THE WALL STREET JOURNAL, OCTOBER 16, 2000, MARTHA BRANNIGAN.

1. Pilots' salaries are considered a fixed cost of a particular flight, in the sense that
the cost would not vary with respect to the number of passengers. However,
pilots’ salaries do vary with the number of flights and their length.
2. An airline would benefit from estimating costs. Management needs cost estimates
to schedule routes and to determine the sales price of tickets.

ISSUE 7-55

"HOSPITALS IN NH POST MORE LOSSES," THE WALL STREET JOURNAL, APRIL 26, 2000,
JAMES BANDLER.

1. Fixed costs are costs that remain the same in total as the volume of activity
changes.
2. Sharing laboratory expenses with other hospitals would be an example of a way to
reduce fixed costs.

ISSUE 7-56

"HOLLYWOOD RUSHES TO BEAT A STRIKE," BUSINESS WEEK, JANUARY 8, 2001,

RONALD GROVER.

1. Will Smith will receive $20 million and 20% of revenues. This is a semivariable cost.
2. Colin Farrell will receive $2.5 million for Tigerland. This is a fixed cost.

McGraw-Hill/Irwin  2002 The McGraw-Hill Companies, Inc.

7-60 Solutions Manual