Question

Write your answer in the space provided or on a separate sheet of paper. 5) What are the two assumptions behind a simple linear cost function? Briefly explain the three ways that a linear cost function may behave?

Answer 1

The two usual assumptions behind a simple linear cost function are 1) Variations in the level of a single activity (the cost driver) explain the variations in the related total costs; 2) Cost behavior is approximated by a linear cost function within the relevant range. This means that total cost versus the level of a single activity that is related to that cost is a straight line within the relevant range.

Once linearity is established, there are three possible types of linearity: 1) A strictly variable cost of the form Y = bX, where b is the slope of the straight line and is the variable cost per unit of the cost driver; 2) A strictly constant cost of the form Y = a, where a is the total fixed cost or constant; 3) A mixed or semivariable cost of the form Y = a + bX, where a is the total fixed cost or constant, and b is the variable cost per unit of the driver or the slope of the straight line.