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Cost Estimation

5-1. Common methods of cost estimation are engineering analysis, account analysis, and statistical analysis of historical data. 5-2. Engineering estimates are based on design specifications and industry and firm cost standards. 5-3. Engineering estimates are particularly helpful when: Attempting to compare company operations with standards; Trying to estimate costs for projects that have not been undertaken in the past (e.g., new construction, major special orders such as defense items); Considering alternatives to present operations, such as assembly line reorganization and similar changes, where it would be too costly to carry out the change and then see if it was cost-effective.

5-4. The biggest problem likely to be encountered from the indiscriminate use of regression methods is that the model may not have any logical foundation. This may result in a model that appears sound on a statistical basis, but with no logical relationship between Y and X's, the model may not continue to provide good predictions. A number of spurious correlation and regression studies have been presented in the literature. For example, a simple run of correlations between average education levels in the U.S. and U.S. inflation rates might lead one to conclude that education causes inflation.

5-5. The longer the data series used in the analysis, the easier it is to see a trend in the data when using the scattergraph method. When using any method, the longer the data series, the greater the likelihood of having the widest possible range of observations. When using statistical methods, the more observations, the smaller the standard deviations and the tighter the resulting estimates. On the other hand, the longer the data series, the more likely that operating conditions, technology, prices and costs have changed. Thus, the order data may not be very representative of the operations expected over the period for which the estimate is made. 5-6. Simple regression assumes a single independent variable (e.g., cost driver) and multiple regression assumes two or more independent variables. 5-7. Adjusted R2 considers the number of independent variables used in the estimation and adjusts the R2 to reflect the use of additional variables. 5-8. Accurate cost estimates improve decision-making. Better decisions lead to higher company value.

5-9. a. Direct labor would be fixed if a union contract limited the company's ability to lay off unneeded personnel or if management were contemplating a change in facilities but maintaining the same labor force. b. Equipment depreciation would be a variable cost if computed on a unit-of-production basis. c. Utilities are variable above the minimum, but if the company's usage falls to the minimum or below, the costs would be fixed. d. Supervisory salaries normally increase in steps. If the activity range is narrow, the costs are fixed; but if the range is wide enough so that several "steps" would fall within the range, then the costs would appear to be variable. e. A certain level of spoilage may be a fact of life in some operations. 5-10. Account analysis incorporates the judgment of the executive where experience would be quite helpful. As a result it may include factors that are not easily captured in statistical models. The best overall cost estimate may be derived by considering both account analysis results and statistical results. 5-11. Data in the historical accounting records should only be used insofar as they are likely to continue in the future. In periods of price instability or technological innovation, use of the historical data without adjustment is likely to result in incorrect estimates. A better alternative is to use the costs that are expected to be incurred during the period for which the cost estimate is prepared. 5-12. One may: Adjust the data to present all costs in some common dollar measure; Use activity measures that are expressed in dollars that move with the price change effects in the cost to be estimated, Use a multiple regression approach with a suitable price index as one of the predictor variables.

5-13. The scattergraph can be useful in checking for outliers in the datathe regression model will not pick this up. Also, the scattergraph may point out changes in the data series that need to be considered when constructing the regression database. 5-14. It is possible for empirical data to show a negative intercept even though fixed costs cannot be negative. It may be that the slope of the cost curve is particularly steep over the values used in the estimation process. It may be that the operations are relatively far away from the intercept. This would be particularly likely if the company were operating close to capacity. Negative intercepts usually mean that there is some error in the specification of the cost estimate. If the company is operating close to capacity, for example, then the assumption of a linear cost function may be in erroror may only be a reasonable approximation in the range of activity close to capacity. 5-15. How well defined is the model? That is, does the one independent variable explain variation in the dependent variable? Are there any outliers? Is the relation linear? 5-16. This was probably unethical. Of course, it might be that there are legitimate reasons for dropping the observations. They might represent very unusual conditions (a strike, bad weather) that would not be expected to occur. 5-17. You should probably tell the executive about the error. If correcting the errors does not change the result (perhaps there are offsetting results or they are not significant), it might matter less when you tell the executive, but he or she needs the correct information to make good decisions. 5-18. You should report your concerns. At a minimum, the manager responsible for recording costs should be told. 5-19. Answers will vary. (1) Income tax preparers become more proficient as they learn; (2) graders on an exam can process an individual exam paper in less time as they complete more; and, (3) a travel agent will be able to book a flight in less time the more reservation requests they handle.

5-20. It is possible that material costs could be affected by learning curves. If material is difficult to work with making it subject to breakage or spoilage, employees will develop skills in working with it resulting in less scrap. 5-21. By using standardized techniques, McDonalds is able to transmit information to its employees effectively so they learn quickly.

Solutions to Exercises

5-22. (15 min.) Methods of Estimating CostsAccount Analysis: FarOut Cards. a. Cost estimate with new costs and volume. This Years Cost (at last years volume) (1) x (2) = (3) $756,000 546,000 462,000 792,000

Growth in Volume (4) 220,000 210,000 220,000 210,000 220,000 210,000 (fixed)

Direct 525,000 labor .................. Variable 462,000 overhead ........... Fixed 720,000 Overhead .......... Total $2,337,000 costs.................. b. Costs per unit: Last year: This year:

= 792,000 $2,640,000

$11.13 $12.00

5-23. (15 min.) Methods of Estimating CostsAccount Analysis. a. Cost estimate with new costs and volume. Year 2 Cost (at last years volume) (1) x (2) = (3) = = = = $132,000 989,000 180,000 210,000

Year 1 Cost Cost Item (1) Direct materials ... Direct labor .......... Variable overhead ... $120,000 860,000 180,000a

Growth in Volume (4) 130,000 100,000 130,000 100,000 130,000 100,000 (fixed)

a

$1,901,300

b. Costs per unit: Last year: This year: $13.60 $14.63 (= $1,360,000 100,000) (= $1,901,300 130,000)

5-24. (10 min.) Methods of Estimating CostsHigh-Low, Ethical Issues: Oak Island Amusements Center. a. Variable cost = Cost at highest activity cost at lowest activity Highest activity lowest activity $2,500,000 $ 1,950,000 2,375,000 1,825,000 = = = or Fixed costs b. Maintenance costs = $125,000 + ($1 x 2,600,000) = $125,000 + $2,600,000 = $2,725,000 = = $1,950,000 ($1 x 1,825,000) $125,000 Total costs variable costs $2,500,000 ($1 x 2,375,000) $125,000

= $1

Fixed costs

Note that 2,600,000 visitors is outside the range of the cost observations, so this estimate may not be reliable. c. Whether this is ethical depends on the reason for dropping the observation. If you are convinced that the higher number of visitors represents such unusual activity that this should be treated as an outlier, then you should eliminate the observation. If, however, the reason for dropping the observation is that someone does not like the result, then you should not change the analysis.

5-25. (25 min.) Methods of Estimating CostsHigh-Low: Lecouvreur Corporation. a. High-low estimate Machine Hours 1,604 1,298 Overhead Costs $112,842 $100,755

Highest activity (month 12)................. Lowest activity (month 11).................. Variable cost =

Cost at highest activity cost at lowest activity Highest activity lowest activity $112,842 $ 100,755 1,604 1,298 Total costs variable costs $112,842 ($39.50 x 1,604) $49,484

= $39.50

Fixed costs

= = =

The cost equation then is: Overhead costs = $49,484 + ($39.50 per MH x Machine hours) b. For 1,500 MH: Overhead costs = = = $49,484 + ($39.50 x 1,500) $49,484 + $59,250 $108,734

5-28. (10 min.) Methods of Estimating CostsSimple Regression: Lecouvreur Corporation. Simple regression estimate: Overhead = = = = $41,293 + $45.83 x Machine-hours $41,293 + 45.83 x 1,800 Machine-hours $41,293 + $82,494 $123,787

5-29. (10 min.) Estimating CostsSimple Regression: Lecouvreur Corporation. Simple regression estimate: Overhead = = = = $43,521 + $88.61 x Labor-hours $43,521 + $88.61 x 600 Labor-hours $43,521 + $53,166 $96,687

5-30. (20 min.) Estimating CostsMultiple Regression: Lecouvreur Corporation. Multiple regression estimate: Overhead = = = = $24,913 + $31.93 x Labor-hours + $41.10 x Machine-hours $24,913 + $31.93 x 600 Labor-hours + $41.10 x 1,800 Machine-hours $24,913 + $19,158 + $73,980 $118,051

5-31. (20 min.) Interpretation of Regression ResultsMultiple Choice: Cortez Company. a. (3) R2 = .848 (84.8%), the explanation of variation in Y from the X regressor. b. (1) $370,000. The equation resulting from this regression analysis is Total = Estimated fixed cost + estimated variable cost per labor-hour x laboroverhead hours = Intercept estimate + Coefficient estimate on independent variable x 50,000 DLH = $120,000 + $5 x 50,000 DLH = $120,000 + $250,000 = $370,000 c. (2) $82 Total labor-hours = Total direct labor costs Direct labor wage rate = $640,000 $16 per hour = 40,000 direct labor-hours = Total labor hours Total units = 40,000 20,000 = 2 labor-hours per unit = Direct materials + Direct labor + Variable overhead = ($800,000 20,000) + ($640,000 20,000) + $5 x 2 labor-hours = $40 + $32 + $5 x 2 labor-hours = $82 d. (4) $14 Contribution-margin per unit

= Price variable cost per unit = $96 $82 = $14 Fixed manufacturing cost + Variable manufacturing cost $120,000 + $82 x units

= =

*CMA adapted

5-32. (15 min.) Interpretation of Regression Results: Brodie Company. This problem is frequently encountered when applying analytical techniques to certain costs. Quite often the advertising expenditures result in sales being generated in the following month or so. In addition, many companies increase their advertising when sales are declining and cut back on advertising when there is capacity business. A better model might be developed by relating this month's sales to last month's advertising. Similar problems exist for repair and maintenance costs since machines are usually given routine repairs and maintenance during slow periods. An inverse relationship often exists between salespersons' travel expenses and sales because the salesperson spends more time traveling when the sales are more difficult to make. 5-33. (30 min.) Interpretation of Regression ResultsSimple Regression: Freds Fish Fry. a. Estimation equation for nonfood kitchen costs: Nonfood kitchen costs b. Nonfood kitchen costs = = = = $23,400 + 250% Food cost $23,400 + 250% x $25,000 $23,400 + $62,500 $85,900 = Fixed costs + Variable cost as a percentage of food cost = $23,400 + 250% Food cost

c. The R2 for the equation is only 23.3%, which is very low for this type of regression. Fred should consider identifying other cost drivers and using them to estimate other nonfood kitchen costs.

5-34. (20 min.) Learning Curves: General Dynamics. a. The learning rate is 80% for every doubling of output: Unit Time Required to Produced (X) Produce the Xth Unit 1................. 10,000 hours 2................. 8,000 hours 4................. 6,400 hours 8................. 5,120 hours 16............... 4,096 hours

(= 10,000 hours x 0.80) (= 8,000 hours x 0.80) (= 6,400 hours x 0.80) (= 5,120 hours x 0.80)

b. Cost of producing the first unit = $1,000,000 (= 10,000 hours x $100 per hour) Cost of producing the 16th unit = $409,600 (= 4,096 hours x $100 per hour) = 40.96% of the first unit cost (= $409,600 $1,000,000) 5-35. (20 min.) Learning Curves: Whee, Cheatham, and Howe. a. The learning rate is 90% for every doubling of output: Financial Time Required to Statements Proofread the Xth Proofread (X) Financial Statement 1................ 4.0000 hours 2 ................. 3.6000 hours 4 ................. 3.2400 hours 8 ................. 2.9160 hours 16 ............... 2.6244 hours

(= 4.0000 hours x 0.90) (= 3.6000 hours x 0.90) (= 3.2400 hours x 0.90) (= 2.9160 hours x 0.90)

b. Cost of proofreading the first report = $40 (= 4.0 hours x $10 per hour) Cost of proofreading the 16th report = $26.24 (= 2.6244 hours x $10 per hour) = 65.60% of the first unit cost (= $26.24 $40)

5-36. (20 min.) Learning Curves. The formula for the time to produce unit z is Y =100 z Substitute 5, 6, 7 for z, to obtain:

0.3219

Formula for Time to Produce Unit z Unit (z) 0.3219 5................ Y =100 (5) 0.3219 6 ................. Y =100 (6) 0.3219 7 ................. Y =100 (7)

Also, note that the time to produce the third unit is 70.21. Doubling production, the time to produce the sixth unit is 56.17 (= 70.21 x 0.80). The remaining numbers can be verified easily. The cumulative time for the 5th unit is simply the cumulative time for the 4th unit (314.21) plus 59.56 (the time to produce the 5th unit), or 373.77 hours, and so on. The total cost is the cumulative time multiplied by $50 per hour. For example, the total cost for five units is $18,688.50 (=$50 x 373.77 hours) and so on. Finally, the average cost is the total cost divided by the number of units produced. So the average cost of producing five units is $3,737.70 (= $18,688.50 5 units) and so on.

Solutions to Problems

5-37. (20 min.) Account Analysis. a. Activity Process paychecks Maintain customer accounts Perform special analyses Total Cost ($180,100 ($109,600 ($120,000 Volume 15,945 checks) 3,650 accounts) 30 analyses) = Unit Cost $11.30 = = 30.03 = 4,000.00

b. The average fixed costs for a month are $34,391 (= $550,250 16 months). For 1,000 checks, 200 accounts, and 3 analyses, the estimated cost is: $63,697 = $34,391 + (1,000 x $11.30) + (200 x $30.03) + (3 x $4,000). 5-38. Regressions from Published Data Answers will vary.

5-39. (30 min.) High-Low Method, Scattergraph: Cubicle Solutions. a. High-low estimate Support Calls 61 37 Call Center Cost $720 528

Variable cost =

Cost at highest activity cost at lowest activity Highest activity lowest activity $720 $528 61 37

Fixed costs

The cost equation is: Overhead costs = $232 + ($8.00 per call x Support calls)

c. The scattergraph shows a reasonably linear pattern, but the high point would lie below a straight line that best fits the data. In fact, because the data suggest a curvilinear pattern, while the high-low method assumes a linear relation between cost and activity, you would probably not be confident in your estimate in part a.

5-40. (30 min.) High-Low Method, Scattergraph: Academy Products. a. High-low estimate Machine Hours 1,035,000 630,000 Overhead Costs $3,700,000 660,000

Variable cost =

Cost at highest activity cost at lowest activity Highest activity lowest activity

Fixed costs

Note that the estimated fixed cost is negative. Your answer for fixed costs might differ if you use a rounded amount for the machine-hour rate.

c. The scattergraph shows a pattern that is convex (costs are increasing faster than machine hours), suggesting that a nonlinear cost function might provide a better estimate. This helps explain the negative estimate for fixed costs in requirement a.

5-41. (40 min.) Interpretation of Regression ResultsSimple Regression Using a Spreadsheet: Lucas Plant. a. High-low estimate Labor Hours 226,250 106,250 Overhead Costs $2,079,046 $1,322,535

Variable cost =

Cost at highest activity cost at lowest activity Highest activity lowest activity $2,079,046 $1,322,535 226,250 106,250

Fixed costs

= = =

The cost equation is: Overhead costs = $652,707 + ($6.30426 per LH x Labor hours)

Note that two observations do not appear (separately) on this scattergraph. These are observations 1 and 13. The dots actually overlap. These observations have the same number of labor hours as observations 8 and 23, respectively, and the overhead costs are close to the same.

Regression Statistics Multiple R 0.94877977 R Square 0.90018305 Adjusted R Square 0.89564591 Standard Error 100790.077 Observations 24

Coefficients $305,062.88 $8.04

5-42. (30 min.) Interpretation of Regression ResultsSimple Regression, Regression Problems Although the correlation coefficient (or R) is 0.82, the R2, the percentage of the variation in the independent variable explained by the dependent variable, is about 67%. This is not low for real, data, but it is not as convincing as Lance would have us believe. The first thing we would look at in checking Lances result is a scattergraph of the data (on the next page). There we see one observation that does not seem consistent with the others. It appears to be an outlier. (This is observation 5.) If the regression is re-estimated omitting observation 5, the results are: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations Intercept Unit Production

This regression has an R2 of 98%, which is much better. The cost equation with the new results is: Overhead cost = $3,911 + $17.53 x Units. This implies a cost structure where variable costs are much more important. These results also suggest that the controllers estimates are very reasonable.

5-42. (continued)

5-43. (30 Min.) Interpretation of Regression ResultsMultiple Choice: Eastern College Business School a. (4) Variable cost coefficient b. (2) Dependent variable c. (1) Independent variable d. (5) Some other equation Credithours 1,392 115 Administrative Costs $228,580 $82,613

Variable cost =

Cost at highest activity cost at lowest activity Highest activity lowest activity $228,580 $82,613 1,392 115

Fixed costs

= = =

The equation is $69,468 + $114.3046 x Number of credit hours. e. (3) Administrative costs = $96,415 + $103.56 x 1,000 credit hours = $199,975. f. (1) The correlation coefficient is the Multiple R. g. (2) 87.1%, the R2.

5-44. (30 Min.) Interpretation of Regression Results: Simple Regression. a. The first step in understanding the difference is to prepare a scattergraph of the data:

Notice the one observation that appears to be unusual. (This is observation 5.) Without knowing more about the reasons for the high cost, we might want to treat it as an outlier meaning we would estimate the regression without this observation. The results of that regression are: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations Intercept Number of deliveries

The McGraw-Hill Companies, Inc., 2008 156

5-44 (continued) b. Using the results from the improved regression, the cost equation for overhead costs can be written as: Monthly overhead = $9,777 + $11.69 x number of deliveries This implies a contribution margin per delivery of $8.31 (= $20.00 $11.69). To earn operating profits of $10,000, the company needs approximately 2,380 (= [$10,000 + $9,777] $8.31) deliveries. Note, however, that this level of deliveries is outside the range of the observations used to develop the regression estimates. Therefore, this estimate needs to be used with caution. 5-45. (30 Min.) Interpretation of Regression Results: Lerner, Inc. a. The letter b is best described as the estimate of the maintenance cost for an hour of maintenance. b. The letter y is best described as the observed maintenance costs for a given month. c. The letter x is best described as the observed maintenance hours for a given month. d. The estimated maintenance costs for month with 360 maintenance hours is $3,309.05 (= $684.65 + $7.29 x 360 maintenance hours). e. The total variance that can be explained by the regression is 79.7% (= R

2

).

5-46. (30 Min.) Cost EstimationSimple Regression: Arnies Arcade & Video Palace a. Yes. We would expect that, in general, there is a positive relation between maintenance costs and activity. Revenue seems to be a reasonable measure of activity. b. When we estimate the regression, we obtain the following results: Regression Statistics Multiple R R Square Standard Error Observations

Intercept Revenues

These suggest that maintenance costs are negatively related to revenues. The R2 is reasonably high, suggesting a good fit. This problem is frequently encountered when applying analytical techniques to certain costs. These include maintenance and repair costs because machines are usually given routine repairs and maintenance during slow periods. Advertising is another cost that exhibits similar behavior. Many companies increase their advertising when sales are declining and cut back on advertising when there is capacity business. A better model might be developed by including seasonal variables in the regression or separating the maintenance and repair costs into routine and unscheduled costs.

5-47. (40 min.) Methods of Cost AnalysisAccount Analysis, Simple and Multiple Regression Using Spreadsheets: Caiman Distribution Partners. a. Estimating equation based on account analysis: Cost Item Supplies ................................ Supervision ........................... Truck expense ...................... Building leases...................... Utilities .................................. Warehouse labor................... Equipment leases ................. Data processing equipment .. Other..................................... Total...................................... Operating Cost $ 350,000 215,000 1,200,000 855,000 215,000 860,000 760,000 945,000 850,000 $6,250,000 Fixed Cost $ 0 150,000 190,000 550,000 125,000 140,000 600,000 945,000 400,000 $3,100,000 Variable $ 350,000 65,000 1,010,000 305,000 90,000 720,000 160,000 0 450,000 $3,150,000

= = =

Total variable cost/Cases produced $3,150,000 450,000 cases $7.00 per case

Estimated overhead

= = = =

Fixed overhead + Variable overhead per case x Number of cases $3,100,000 + $7.00 x Number of cases $3,100,000 + $7.00 450,000 $6,250,000

5-47. (continued) b. Cost estimate using high-low analysis. Operating Costs $6,362,255 $5,699,139

Variable cost =

Cost at highest activity cost at lowest activity Highest activity lowest activity $6,362,255 $5,699,139 432,000 345,000

Fixed costs

= = =

The cost equation then is: Overhead costs = $3,069,542 + ($7.622 per case x Cases). For 450,000 cases: Operating costs = = $3,069,542 + $7.622 x 450,000 $6,499,442

5-47. (continued) c. Simple regression based on cases: Regression Statistics Multiple R 0.98034501 R Square 0.96107634 Standard Error 39850.1391 Observations 12 Coefficients $3,411,468 $6.70765 = = = $3,411,468 + $6.70765 x cases $3,411,468 + $6.70765 x 450,000 $3,411,468 + $3,018,443 $6,429,911

d. Multiple regression based on cases and price level. Regression Statistics Multiple R 0.9905 R Square 0.9810 Adjusted R Square 0.9768 Standard Error 29315.827 Observations 12 Coefficients $3,176,995 $4.41892 $8,857.73 = = = $3,176,995 + $4.41892 x cases + $8,857.73 x Price level $3,176,995 + $4.41892 x 450,000 + $8,857.73 x 145 $3,176,995 + $1,988,514 + $1,284,371 $6,449,880

5-47. (continued) e. Recommendation. The multiple regression appears to improve the fit (compare the adjusted R2s), but the rationale for the inclusion of the price level as a cost driver is unclear. There is some possibility that the price index variable is a surrogate for some other factor correlated with the growth of the business. It might be better to adjust the cost figures to real (price-level adjusted) and forecast the adjusted operating costs. Once the simple regression is complete, and it is relatively easy to do, there is no reason for the high-low estimate, because it ignores most of the information. Therefore, some combination of the controllers account analysis estimate and the estimate from the simple regression seems most appropriate.

5-48. (40 min.) Learning Curves: Appendix 5B. a. The learning rate coefficient is -0.152004, so the table in Exhibit 5-18 would be as follows a learning rate of 90%: Labor Time Required to Produce the Xth Unit (i.e, the Last Cumulative Single Unit Total Time Produced)

1

Unit Produced

in Labor Hours

2

Total Cost $5,000.00 9,500.00 13,731.02 17,781.02 21,695.95 25,503.87 29,223.60 32,868.59

3

Average Cost Per Unit $5,000.00 4,750.00 4,577.01 4,445.25 4,339.19 4,250.64 4,174.80 4,108.57

4

(X) 1 ................. 2 ................. 3 ................. 4 ................. 5 ................. 6 ................. 7 ................. 8 ................. 1. Y = 100 (X

-0.152004

2. Cumulative time in labor hours for unit X is the sum of the time for each of the units up to and including unit X. 3. Total cost is equal to the cumulative time multiplied by $50. 4. Average cost is equal to the total cost divided by the number of units produced.

5-49. (40 min.) Learning CurvesAppendix 5B: Krylon Company. Krylon should produce the tool itself. With an 80 percent learning rate (learning rate coefficient of -0.3219), the average cost of a tool for 8 tools is $93,461, which is less than the supplier cost. This is shown in the table below, which is similar to Exhibit 518.

Learning Factor

1

Total Labor Cost $ 80,000.00 144,001.25 200,171.28 251,373.27 299,026.41 343,963.31 386,724.81 427,687.20

2

3

Total Materials Average Cost $120,000.00 112,000.62 106,723.76 102,843.32 99,805.28 97,327.22 95,246.40 93,460.90

Per Unit Cost $80,000.00 $40,000.00 72,000.62 40,000.00 66,723.76 40,000.00 62,843.32 40,000.00 59,805.28 40,000.00 57,327.22 40,000.00 55,246.40 40,000.00 53,460.90 40,000.00

1. This is the ratio of the labor time it takes to produce unit X relative to the first unit and -0.3219 is equal to X 2. The total labor cost is $80,000 (the labor cost to produce the first unit) multiplied by the cumulative learning factor. 3. The average cost is the total cost divided by the number of units produced.

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