OPERATION MANAGEMENT & TQM

OM-02

COST BEHAVIOR WITH REGRESSION ANALYSIS

COST BEHAVIOR
Cost behavior patterns indicate how costs change in response to changes in production or sales. A
thorough understanding of cost behavior is necessary in order to perform cost-volume-profit analysis and to
prepare for production and sales budgets.
As activity increases, some costs remain the same (constant) while some costs will vary or change.
Consider the following cost behavior patterns, assuming activity is based on production:
TOTAL costs PER UNIT costs
Decreases as production increases
FIXED Constant
(i.e., inverse relationship)
Increases as production increases
VARIABLE Constant
(i.e., direct relationship)
MIXED Increases less proportionately (vs. total Decreases less proportionately (vs. unit
(semi-variable) variable costs) as production increases fixed costs) as production increases

COST BEHAVIOR ASSUMPTIONS and LIMITATIONS

RELEVANT RANGE Assumption
Relevant range refers to the range of activity within which the cost behavior patterns are valid. It is
also the level of activity where cost relationships exhibit linear relationship.
TIME PERIOD Assumption
The cost behavior patterns identified are true only over a specified period of time. Beyond this, the
cost may show a different cost behavior pattern.

COST ESTIMATION: SEGREGATING VARIABLE & FIXED COSTS

The Cost Function: Y = a + bX

[Y] - total costs (dependent variable) [X] - activity or cost driver (independent variable)
[a] - total fixed costs (Y-axis intercept) [b] - variable cost per unit (slope of the line)
[bX] – the total variable costs
1) HIGH-LOW POINTS Method
The fixed and variable components of the mixed costs are computed from the highest and lowest
points based on activity or cost driver.
Change in Costs (YH – YL)
Variable cost per unit (b) =
Change in Activity (XH – XL)
2) SCATTERGRAPH (Scatter Diagram) Method
All observed costs at different activity levels are plotted on a graph. Based on sound judgment, a
regression line is then fitted to the plotted points to represent the line function.
3) LEAST-SQUARES REGRESSION Method
A statistical technique that determines the "line of best fit" for all the data points by minimizing the
sum of the squared deviations between line and the data points.
 If there is only one independent variable, the analysis is known as SIMPLE regression.
 If the analysis involves multiple independent variables, it is known as MULTIPLE regression.
4) Other Cost Estimation Methods:
A) Industrial Engineering method – study between physical inputs and outputs especially meant for
totally new activities; engineering estimates indicate what how much costs should be.
B) Account Analysis method – each account is classified as either fixed or variable based on
experience and judgment of accounting and other qualified personnel in the organization.
C) Conference method – costs are classified based on opinions from various company departments
such as purchasing, process engineering, manufacturing, employee relations and so on.
CORRELATION ANALYSIS
CORRELATION ANALYSIS is used to measure the strength of linear relationship between two or more
variables. The correlation between two variables can be seen by drawing a scatter diagram.
COEFFICIENT OF CORRELATION (r) measures the relative strength of linear relationship between two (2)
variables. Its value ranges from – 1.0 to + 1.0:
"r" Linear Relationship Scatter Diagram/Graphical Representation
-1.0 Inverse Downward Sloping Line
0 None No Apparent Pattern (Random Points)
+1.0 Direct Upward Sloping Line
COEFFICIENT OF DETERMINATION (r2) indicates the degree to which the behavior of independent variable
predicts the dependent variable. The closer r2 is to 1.0, the better (i.e., more confidence) the independent
variable predicts the behavior of the dependent variable.

NOTE: Correlation analysis does not establish cause-&-effect pattern; it merely indicates a relationship.

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EXERCISES: COST BEHAVIOR with REGRESSION ANALYSIS

1. Variable Costs vs. Fixed Costs

Akio Company manufactures and sells a single product. A partially completed schedule of costs over a
relevant range of 25 to 75 units produced each year is given below:
Units Produced
(I) 25 units (II) 50 units (III) 75 units
TOTAL COSTS:
(A) Variable costs P 50 ? ?
(B) Fixed costs ? P 600 ?
(C) Total costs ? ? ?
PER UNIT COSTS:
(D) Variable costs ? ? P2
(E) Fixed costs ? ? ?
REQUIRED:
1. Determine the correct amounts of those with (?) mark.
2. Which two (2) specific costs remain constant over the relevant range?
3. Which two (2) specific costs are directly related with production?
4. Which specific cost is inversely related with production?
5. Express the cost formula based on the line equation form ‘Y = a + bX.’
6. If Akio plans to produce 60 units, then how much is the expected total costs?
(Managerial Accounting by Garrison & Noreen)
2. High-Low Method
The controller of Stairway-to-Heaven Hospital would like to come up with a cost formula that links
Admitting Department cost to the number of patients admitted during a month. The Admission
Department’s costs and the number of patients admitted during the past nine months follow:
Month Number of Patients Admission Department’s Cost
April 18 P 15,600
May 19 P 15,200
June 17 P 13,700
July 15 P 14,600
August 15 P 14,300
September 11 P 13,200
October 11 P 12,800
November 48 P 72,500
December 16 P 14,000

REQUIRED: Using the high-low method, determine the admission department’s:

1. Variable cost per unit
2. Total annual fixed costs
3. Monthly cost function
4. Estimated cost assuming 12 patients will be admitted next month.
(Managerial Accounting by Garrison)
3. Correlation Analysis
3A) The closeness of the linear relationship between the cost and the activity is known as
a. Correlation c. Deviation
b. Variation d. Standard error
3B) Looking at the following scatter diagrams, we can conclude that:
Cost A Cost B
Costs Costs

Units Units
a. Cost A will be easier to predict than cost B.
b. Cost B will be easier to predict than cost A.
c. Cost B has no variable component.
d. Cost A is out-of-control.

3C) Which correlation coefficient represents strongest relationship between two variables?
a. + 0.50 c. - 0.05
b. - 0.75 d. + 1.05
(Adapted: Managerial Accounting by Louderback)

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4. Least-Squares Regression Method

Sydney Company’s total overhead costs at various levels of activity are presented below:
Month Machine Hours Total Overhead Costs
March 500 P 970
April 400 P 851
May 600 P 1,089
June 700 P 1,208
The breakdown of the overhead costs in April at 400 machine-hour level of activity is as follows:
Supplies (Variable) P 260
Salaries (Fixed) 300
Utilities (Mixed) 291
Total P 851
REQUIRED:
1. How much of June’s overhead cost of P 1,208 consisted of utilities cost?
2. Using high-low method, determine the cost function for utilities cost.
3. Using high-low method, determine the cost function for total overhead cost.
4. Using least-squares method, determine the cost function for total overhead costs.
5. What would be the total overhead costs if operating level is at 550 machine hours?
(Adapted: Managerial Accounting by Garrison)
SOLUTION GUIDE (Requirement 1)
April (400 hours) June (700 hours)
Supplies (Variable) P 260
Salaries (Fixed) 300
Utilities (Mixed) 291
Total Overhead Costs P 851 P 1,208
SOLUTION GUIDE (Requirement 4 – Least squares method)
Month X (Hours) Y (Total Costs) XY X2
Mar 500 970
Apr 400 851
May 600 1,089
Jun 700 1,208
SUM
WRAP-UP EXERCISES
1. If a cost has a per unit value of P 5 at 10 units, P 5 at 20 units and P 5 at 30 units, then it is likely a:
a. Fixed cost c. Variable cost
b. Mixed cost d. Semi-variable cost
2. If a cost has a per unit value of P 12 at 10 units, P 6 at 20 units and P 4 at 30 units, then it is likely a:
a. Fixed cost c. Variable cost
b. Mixed cost d. Semi-variable cost
3. A cost that is fixed over a short range of activity, then rises abruptly and remains fixed over another short
range is called a:
a. Step cost c. Mixed cost
b. Fixed cost d. Variable
4. In cost analysis using the line equation Y = a + bX, "a" or total fixed cost is regarded as the
a. Dependent variable c. Slope of the line
b. Independent variable d. Y-axis intercept
5. A company has developed a production cost equation for its lone product: Y = 100 + 5X, where X is based
on the number of labor hours. Assuming a relevant range of 10 to 20 labor hours, what is the estimated
production cost at zero (0) labor hour?
a. P 100
b. P 150
c. P 200
d. The exact amount cannot be determined without additional information
6. The high-low method may give unsatisfactory results if:
a. Volume is light c. All data points fall on a single line
b. Volume is heavy d. The points are unrepresentative
7. When compared to the high-low method, the graphic approach to cost estimation is usually
a. Less accurate c. More representative
b. Equally representative d. Less representative
8. A data point that falls far away from other data points in a scatter diagram is called a (an)
a. Outlier c. Standard deviation
b. Margin of error d. Coefficient of determination
9. If the coefficient of correlation (r) between two variables is - 1, then a scatter diagram will appear to be
a regression line that
a. Slopes upward to the left c. Slopes downward to the left
b. Slopes upward to the right d. Appears to be horizontal or vertical

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10. Ana Company is interested in the relationship between sales (dependent variable) and occurrence of rain
(independent variable). Using the proper formula, the coefficient of correlation (r) is computed as – 0.99.
What conclusion about the sales and rain occurrence could one make?
a. An increase in sales causes an increase in rain occurrence.
b. An increase in sales causes a decrease in rain occurrence.
c. An increase in rain occurrence causes a decrease in sales.
d. An increase in rain occurrence causes an increase in sales.
11. What is the appropriate range for the coefficient of determination (r2)?
a. 0 to +1 c. - 1 to 0
b. 0 to -1 d. -1 to +1
12. Simple regression analysis involves the use of
a. One dependent variable and one independent variable
b. One dependent variable and many independent variables
c. Many dependent variables and one independent variable
d. Many dependent variables and many independent variables
13. What cost segregation technique gives the most mathematically precise cost estimate?
a. Scatter diagram method c. High-low method
b. Least-squares method d. Calendar method
14. Using statistical normal relationships, the least-squares method uses which of the following equations?
a. y = na + bx c. y = a + bx2
xy = ax + bx2 y = na + bx
b. y = na + bx d. y = na + bx
xy = ax + bx xy = ax + bx2
15. Under Cost-Volume-Profit (CVP) analysis, a mixed cost should be:
a. Disregarded c. Treated as a variable cost
b. Treated as a fixed cost d. Separated into fixed & variable components

SELF-TEST QUESTIONS (with suggested answers)

1. Sinovac Company has estimated the following cost formulas for overhead:
Cost Formula
Lubricants P 1,500 plus P 0.50 per machine-hour
Utilities P 2,000 plus P 0.60 per machine-hour
Depreciation P 1,000
Maintenance P 200 plus P 0.10 per machine-hour
Machine setup P 0.30 per machine-hour
Based on the cost formulas, what is the total expected overhead cost at 300 machine hours?
D a. P 4,700 c. P 5,000
b. P 4,950 d. P 5,150
2. Which of the following statements is true?
D a. The higher is the production within the relevant range, the higher is the variable cost per unit
b. The higher is the production within the relevant range, the higher is the fixed cost per unit
c. The lower is the production within the relevant range, the lower is the total fixed cost
d. The lower is the production within the relevant range, the lower is the total variable cost
3. Within the relevant range, the amount of variable cost per unit
D a. Differs at each production level c. Decreases as production increases
b. Increases as production increases d. Remains constant at each production level
4. Which of the following best describes a fixed cost?
C a. It is constant per unit of changes in production.
b. It may change in total when such change is related to changes in production.
c. It may change in total when such change is unrelated to changes in production.
d. It may change in total when such change depends upon production or within the relevant range.
5. What are fixed costs that cannot be reduced or avoided within a short period of time?
A a. Committed c. Avoidable
b. Variable d. Unnecessary
6. What would be an example of a discretionary fixed cost?
D a. Depreciation on equipment c. Salaries of top management
b. Rent on a factory building d. Research and development
7. Which of the following best describes a step cost?
D a. It is partly variable and partly fixed c. It increases proportionately with volume
b. It remains constant in all cases d. It increases abruptly outside the relevant range
8. In describing the cost formula equation Y = a + bX, which of the following statements is correct?
D a. ‘Y’ is the independent variable
b. ‘a’ is the variable rate
c. ‘a’ and ‘b’ are valid for all levels of activity
d. In the high-low method, ‘b’ equals the change in cost (Y) divided by the change in activity (X)
9. The fixed cost of a semi-variable cost is comparable to the mathematical concept of
A a. Y-intercept c. Dependent variable
b. Slope of the line d. Independent variable

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