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CHAPTER 3

COST BEHAVIOUR, COST DRIVERS AND


COST ESTIMATION
ANSWERS TO REVIEW QUESTIONS
3.1 (a) Cost estimation: the process of determining how a particular cost behaves.

(b) Cost behaviour: the relationship between cost and the level of activity (that is, cost
driver).

(c) Cost prediction: using knowledge of cost behaviour to forecast the level of a cost at a
particular level of activity.

Cost estimation is the process used to determine what the cost behaviour is for a particular
cost item. The cost behaviour pattern is used to make a cost prediction about the cost at a
particular level of activity.

3.2 A cost driver is an activity or factor that causes costs to be incurred. In identifying cost
behaviour, the management accountant identifies the relationship between a particular cost
and the level of its cost driver (also called level of activity when the cost driver relates to
an activity).

3.3 Volume-based cost drivers are used in conventional management accounting systems. This
assumes that variable costs vary in proportion to production volume and that fixed costs do
not change with production volume. ABC allows a range of cost driverssuch as unit level,
batch level, product level, and facility levelso that for these various types of cost there is a
more realistic link between the cost and its cost driver. The conventional approach only
examines variability with production volumethat is, at the unit level.

3.4 The hierarchy of costs is a way of grouping costs on the basis of them having similar
behaviour patterns. They have similar behaviour patterns because they have the same, or
related, cost drivers. Unit level costs have cost drivers that change with the number of units
of output (for example, units of production, number of direct labour hours, amount of direct
material used, the number of cheques a bank employee processes, the number of operations
in an operating theatre and so on). Batch level costs have cost drivers that are associated
with the number of batches and will vary roughly with the number of batches. Product -
sustaining costs do not change with the number of products but exist because an individual
product is produced. There is no reason why the product-sustaining costs for one product
should be the same as those for a different product. Hence they are probably better referred
to as product-sustaining rather than product level costs. Clearly facility-sustaining costs are
incurred to provide the capability to produce but are not caused by any individual product.
At Holden Engine Company (HEC) an analysis of costs identified these four cost drivers,
plus a fifth cost driver, which was described as administration. Thus, HECs activity-based
costing system identified five different cost behaviour patterns due to five clearly different
causes of costs. The separate recognition of administration costs will also draw attention to
what drives these costs, the value of them to the organisation, and the best ways of
managing them.

3.5 BP targeted certain costs that needed better management. We can see in the Real Life that,
in order to reduce discretionary costs, BP identified activities that did not adequately add
value to the business. Examples are the regular preparation of reports that were rarely (if
ever) used, unnecessary travel (both domestic and international), outsourcing tasks to
consultants, and maintaining excessive layers of management. These four root-cause cost
drivers were better managed to reduce costs.

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3.6 As the level of activity (or cost driver) decreases, total variable cost decreases
proportionately and the variable cost per unit remains constant.

3.7 As the level of activity (cost driver) decreases, total fixed cost remains constant. However,
the fixed cost per unit of activity increases as activity decreases. Examples include factory
rent, managers salaries, straight-line depreciation and property taxes.

3.8 As the level of activity (cost driver) increases, total fixed cost remains constant. However,
the fixed cost per unit of activity declines as activity increases, and the fixed cost per unit
of activity increases as activity decreases. This change in the average fixed cost per unit
may not be understood by a decision making manager who has been presented with product
costs that include unitised fixed costs.

When product costs include unitised fixed costs, managers can mistakenly treat them as
totally variable for decision making. These managers may believe that:

any short term sales that do not cover the unitised fixed costs may result in losing
money, not realising that those sales would help cover fixed costs;

a 20% reduction in production will reduce costs by 20% of the total product costs, not
realising that the fixed costs will not reduce at all (within the relevant range);

making 1000 more products will increase costs by one thousand times the product
cost, not realising that the extra cost will be less than that since total fixed costs will
not change if production is still within the relevant range.

3.9 (a) Variable cost, assuming that rubber is the only direct material used in the
manufacturing process.

(b) Unit-level cost.

(c) The number of tyres produced determines the quantity of rubber used in production
and therefore the total direct material cost. If only the quantity of rubber used is the
cost driver, it ignores any abnormal wastage incurred in the process, or the effects of
changing supply and/or demand on rubber prices. To identify the cost driver from a
cost management perspective, it is necessary to identify the underlying causes of the
direct material cost.

3.10 There are a number of ways in which the behaviour of costs may change over an extended
range of activity. Let us first consider some fixed costs. We would expect rent to change if
activity increases to the extent that extra premises are required, and depreciation would rise
in a large step if we acquired extra equipment to meet growing demand for a product. Hence
we say that fixed costs are only fixed over a particular range. With fixed costs, outside that
range we would expect there to be a large step in the cost, which would then be fixed over
another range.

If we consider variable costs, we must recognise that they are often not perfectly linear. A
simple example would be direct material. There are often discounts when large volumes of
material are purchased, and there can be transportation savings for larger orders. The
assumption of a defined linear relationship between cost and production levels will therefore
only be valid over a particular range.

Outside that range discounts may be obtained or lost and transport charges may change per
unit. In the chapter the example of curvilinear electricity costs in Tasty Bread demonstrates
that efficiencies of scale may only apply up to a particular level and then unit costs can
begin to increase again.

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3.11 The cost analyst should respond by pointing out that in most cases a cost behaviour pattern
should be limited to the relevant range of activity. When the firms electricity 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 firms electricity cost can be approximated reasonably closely
by a semivariable cost behaviour pattern. However, outside that range (including an activity
level of zero) the semivariable cost behaviour pattern should not be used as an
approximation of the cost.

3.12 1 Annual cost of maintaining a national 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.)

2 Ingredients in a breakfast cereal: engineered cost.

3 Advertising for a credit card company: discretionary cost.

4 Depreciation on an insurance companys computer: committed cost.

5 Charitable donations: discretionary cost.

6 Research and development: discretionary cost.

3.13 There are a number of issues to draw out in a discussion about the variability of direct
labour.

Historically direct labour was a variable cost. Now there are different employment
agreements and many workers are on a set income.

Some firms have a basic workforce that can be supplemented by hourly or daily
paid workers on an on call basis. This effectively makes direct labour a variable
cost.

Even when all workers are on contracted incomes, there is an argument that
moving workers from working on one product to another effectively makes the
direct labour cost to that product a variable cost.

3.14 The account classification method of cost estimation involves identifying costs as being of a
particular type and analysing their past behaviour to understand the expected cost in the
future. For example, a manager may identify the costs that will not change with changing
production levels (the fixed costs), and separately address the costs that change with the
levels of production (both variable costs and semi-variable costs). This way the estimation
of costs is based on expected cost behaviour, especially in relation to levels of activity such
as production volumes.

3.15 Some of the possible reasons that approximations are used in estimating cost functions
include the following:

lack of accounting time or lack of knowledge about cost estimation techniques

lack of data

low priority may be given to determining accurate cost functions

the resultant cost functions may be regarded as accurate enough for the firms needs.
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3.16 The chief drawback of the high-low method of cost estimation is that it uses only two data
points, and ignores all other observations. The rest of the data are ignored. 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 also not be
representative of the cost behaviour pattern.

3.17 Regression analysis is a statistical method that measures the average amount of change in the
dependent variable that is associated with a unit change in one or more independent variables.
Simple regression analysis estimates the relationship between the dependent variable and a
single independent variable, while multiple regression estimates the relationship between the
dependent variable and multiple independent variables. Multiple regression can help
management determine more accurate cost estimates because it is able to recognise the effects
of two or more factors that influence total costs, and therefore is more economically plausible.

Assume that a rug manufacturer is trying to estimate the indirect labour cost associated with
the manufacture of rugs, when production on one batch of rugs is stopped and another batch
started. Management believes that, in addition to machine hours, indirect labour costs are
also affected by the number of different batches worked on during the period (a batch-level
cost driver).

3.18 A particular least squares regression line may be evaluated on the basis of criteria such as
economic plausibility and the goodness of fit. The coefficient of determination, represented
by the R2 statistic, is used to evaluate the goodness of fit of the regression line. It indicates
the extent to which the pattern of variability of the dependent variable imitates the pattern of
variability of the independent variable. The more closely they vary (or move together), the
greater the fit between the two variables. This indicates the degree to which the change in
the dependent variable can be explained by the change in the independent variable.

The proportion of change in the dependent variable that can be explained by the change in
the independent variable is what we measure with the coefficient of determination (R2). The
higher the R2, the better the fit.

3.19 Some of the problems often encountered when collecting data for cost estimation include:

missing data due to misplaced documents or failure to record a transaction

outliers which need to be detected and eliminated from the data set

mismatched time periods between dependent and independent variables

trade-offs in choosing the length of the time period

recording of allocated and discretionary costs as per unit data

inflation may affect the currency of historic data.

3.20 A learning curve reflects how production efficiency increases with increased production. An
experience curve shows how product costs from across the value chain decrease with
increased production.

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SOLUTIONS TO EXERCISES
EXERCISE 3.21 (15 minutes) Cost drivers: service firm
A number of different answers are possible here.

Cost Cost driver Cost behaviour

Branch managers salary Number of customer enquiries In practice, fixed for a wide range
of activity, usually one per branch
Number of staff
Number of staff hours worked
(full-time and casual)
Full-time customer service staff Number of customer enquiries In practice, step-fixed as it is
salaries /quotes contractually fixed for a wide range
of activity, until an additional full-
Number of bookings
time staff member is required
Number of staff
Number of full-time staff hours
worked
Casual customer service staff Number of customers Variable, casual labour
wages
Number of journeys quoted
Number of flight, accommodation
and car bookings made
Number of hours worked
Computer expenses Number of bookings processed Step-fixed, each computer can only
process a given number of enquiries
Number of desks
and bookings before an additional
Number of hours worked computer is required
Number of customers' quotes
provided
Telephone expenses Number of bookings processed A wide range of contracts are
available. In practice, this may be
Number of desks/telephones
fixed for a wide range of activity
Number of hours worked before additional charges are made
Number of customers' quotes
provided

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EXERCISE 3.22 (15 minutes) Variable and fixed costs; graphical and tabular
analyses: manufacturer
1 Graph of raw materials cost:

Total raw
material cost

$1 800 000

$1 200 000

$600 000

10 000 20 000 30 000

Balls Produced

Production level (balls) Unit cost Total cost

10 000 $60 per ball $ 600 000

20 000 $60 per ball $1 200 000

30 000 $60 per ball $1 800 000

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3 Graph of fixed production cost:

Total
Fixed cost

$80 000

$60 000

$40 000

$20 000

10 000 20 000 30 000

Balls Produced

Production level (balls) Unit cost Total cost

10 000 $7.50 $75 000

20 000 $3.75 $75 000

30 000 $2.50 $75 000*

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EXERCISE 3.23 (40 minutes) Graphing cost behaviour patterns: hospital
1 Cost of food:

2 Cost of food, salaries and on costs for administrative staff:

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3 Laboratory costs:

4 Cost of electricity:

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5 Nursing costs

EXERCISE 3.24 (15 minutes) Approximating a curvilinear cost: service firm

Actual Estimated

(a) 20 000 km $3900 $4400

(b) 40 000 km 5200 5200

(c) 60 000 km 6000 6000

(d) 90 000 km 7600 7200

2 (a) The approximation is very accurate in the range of 40 000 to 60 000 km per month.

(b) The approximation is less accurate in the extremes of the longer range of 20 000 to

90 000 km per month.

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EXERCISE 3.25 (15 minutes) Account classification method; manufacturer.
1 (a) Fixed; does not change for different levels of production.

(b) Variable: varies proportionately with the number of kilograms sausages


produced.

(c) Variable: varies proportionately with the number of kilograms of sausages


produced

(d) Fixed: does not change for different levels of production.

(e) Semivariable (or mixed): includes a fixed element ($4000 per month) and a
variable element ($0.20 per kilogram of sausages produced).

2 Production cost per month = $33 000* + $2.00X

*33 000 = $19 000 + $10 000 + $4 000



$2.00 = $1.10 + $0.70 + $0.20

EXERCISE 3.26 (15 minutes) Estimating cost behaviour; highlow method:


manufacturer

1 Variable cost per number of machine hours = $36150 - $33150 = $0.10


61500 - 31500

Total cost at 61 500 machine hours $36 150

Variable cost at 61 500 machine hours (61 500 $0.10 per machine hour) 6 150

Fixed cost $30 000

Cost equation:

Total utilities cost = $30 000 + $0.10X, where X denotes machine hours.

2 Cost prediction when 39 000 machine hours are consumed:

Utilities cost = $30 000 + ($0.10)(39 000) = $33 900

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EXERCISE 3.27 (45 minutes) Estimating cost behaviour; regression
analysis: manufacturer
1 The calculations to estimate the companys utilities cost behaviour are shown below,
using Excel. Some of the figures have been rounded.

Regression Statistics

R 0.78833

R Square 0.62147

Adjusted R Square 0.58362

S 1 592.9189

Total number of observations 12

ANOVA

d.f. SS MS F p-level

Regression 1. 41 658 750. 41 658 750. 16.41795 0.00232

Residual 10. 25 373 906.25 2 537 390.625

Total 11. 67 032 656.25

Coefficients

Intercept 26 306.25

Machine hours 0.19167

From this, the equation to explain cost behaviour is as follows.

Y = a + bX, where:

X = the independent variable (activity for one month)

Y = the dependent variable (cost for one month)

Y = $26 306.25 + $0.192X

This can be expressed as total cost = fixed costs of $26 306.25 plus $0.192 per machine
hour. For comparison, this gives a cost at 39 000 machine hours:

$26 306.25 + $0.192 x 39 000 = $33 794

2 Given that this question does not assume knowledge of the appendix, the evaluation will
focus on R2. In this case, the figure for R20.6215suggests that 62 per cent of the
variability of utility costs can be explained by changes in the machine hours. The higher the
R2 figure, the more confident the accountant can be that changes in the dependent variable
can be explained in terms of changes in the independent variable. In this case 38 per cent of
the variability of utility costs remained unexplained.

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EXERCISE 3.28 (15 minutes) Regression analysis: health services firm
1 The calculations to estimate the companys cost behaviour are shown below, using Excel.
Some of the figures have been rounded.

Regression Statistics

R 0.98105

R Square 0.96245

Adjusted R Square 0.9587

S 2 191.16457

Total number of
observations 12

Cost = 29 568.0435 + 10.0957 * No. blood tests

ANOVA

d.f. SS MS F p-level

Regression 1. 1 230 710 478.26087 1 230 710 478.26087 256.33382 0.

Residual 10. 48 012 021.73913 4 801 202.17391

Total 11. 1 278 722 500.

Coefficients Standard Error

Intercept 29 568.04348 3401.33914

No. blood tests 10.09565 0.63057

2 The formula to explain the behaviour of Plasma Pathology's diagnosticblood laboratory


costs is as follows:

Y = a + bX, where:

X = the independent variable (blood tests per month)

Y = the dependent variable (laboratory cost for one month)

Y = $29 568 + $10.0957X

This can be expressed as total cost = fixed costs of $29 568 plus $10.0957 per blood test
completed.

3 When 5500 tests are performed in a month the total monthly costs are predicted to be:

$29 568 + $(10.0957 5500) = $85 094

Note that this is very similar to the recorded cost for 5300 blood tests in the data provided
($87 000). With an R2 of 0.96245 (and an adjusted R2 of 0.9587), it appears that the number
of blood tests completed is the major factor in explaining the costs in the diagnostic blood
laboratory of Plasma Pathology.
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EXERCISE 3.29 (45 minutes) Estimating cost behaviour using multiple
methods: retailer
1 Variable electricity cost per hour = $3800 $2600 = $4 per hour
700 400

Total electricity cost at 700 hours $3800

Variable electricity cost at 700 hours ($4.00 700 hours) 2800

Fixed cost per month $1000

Cost formula: Monthly electricity cost = $1000 + $4 X, where X denotes hours of operation.

2 Regression analysis:

Using Excel

Regression statistics

Multiple R 0.975590116

R square 0.951776075

Adjusted R square 0.939720093

Standard error 109.8180313

Observations 6

Coefficients Standard error

Intercept 1002 246.6107401

Hrs of operation 4.04 0.454689847

Cost formula:

Monthly electricity cost = $1002 + $4.04X, where X denotes hours of operation

Variable electricity cost = $4.04 per hour of operation

3 Cost predictions at 470 hours of operation:

(a) Highlow method:

Electricity cost = $1000 + ($4)(470) = $2880

(b) Regression:

Electricity cost = $1002 + ($4.04)(470) = $2901*


* rounded

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EXERCISE 3.30 (10 minutes) (appendix) Learning curve; high technology:
manufacturer
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 hours 4) 520 hours

(b) Total time for 8 satellites (100 hours 8) 800 hours

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

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SOLUTIONS TO PROBLEMS
PROBLEM 3.31 (20 minutes) Cost drivers: service firm
Answers to this question will vary. Rather than looking for a right answer, instructors should seek
an understanding of the concepts.

(a) This is a fixed cost and, therefore, has no obvious cost driver in the short run. It is a facility
level cost. In the long run one cost driver may be the number of patients, because the larger
and busier the hospice, the more skilled (and, therefore, highly salaried) the administrator
will need to be, although the salary is unlikely to vary in proportion to the number of
patients.

(b) Number of patients: the more patients, the more staff.

Location of patients may be a cost driver as the dispersion may create extra travelling time
(but there is unlikely to be a proportional relationship here) (unit level).

(c) Depends whether the physiotherapist is paid by the hour or by the clinic. If paid hourly, the
length of time of a clinic and the number of patients are possible cost drivers (unit level). If
paid per clinic, the number of clinics held is the cost driver (batch level).

(d) Refer to (c) above. Perhaps the number of patients (unit level), severity of patient
conditions and the number of visits (batch level).

(e) Likely to be a fixed cost (product level, as it relates only to outpatients). It is a committed
cost with no obvious cost driver, although the cost of the lease may be affected by the size
of the cars and the length of time they can be kept.

(f) Number of outpatients: more driving (unit level).

Distance travelled to see patients (unit level).

(g) The depreciation cost is a fixed cost per pump but the total depreciation cost will vary with
the number of pumps, which is likely to vary with the number of patients (unit level).

(h) Fixed cost: no driver (facility level).

(i) Number of shifts worked, which will vary to some degree, with the number of patients. At
a maximum capacity, where three shifts are worked every day, this becomes a fixed cost.

(j) While the amount of cleaning may vary with the number of patients, the contract is for a set
payment. Therefore, this is a fixed cost (facility level).

PROBLEM 3.32 (30 minutes) Cost behaviour patterns in a variety of settings


1 h 5 b 9 d

2 i 6 g 10 j

3 f 7 c 11 l

4 e 8 a

Note that k was not used.

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PROBLEM 3.33 (25 minutes) Cost behaviour; engineered cost; committed
and discretionary costs: manufacturer

Cost Fixed/ Engineered / Explanation


Variable Committed /
Discretionary
a Cost of daily radio Fixed Discretionary Cost arising from management
advertising on the local decision relating to advertising
community radio station expenditure, easy to change in short
term
b Cost of the fabric used to Variable Engineered Cost of fabric has a direct physical
make T-shirts relationship to the number of
T-shirts manufactured
c Cost of the ink used in the Variable Engineered Cost of ink has a direct physical
designs relationship to the number of
T-shirts manufactured
d Salary of the managing Fixed Committed Management salary cost is part of
director organisations basic structure,
difficult to change in short term
e Wages of the production Variable Engineered Cost with clear direct physical
employees who sew and relationship to the level of output
print the T-shirts
f Cost of movie tickets Fixed Discretionary Cost arising from managements
provided for Employee of decision, easy to change/vary in
the Month award each short term
month
g Depreciation on the Variable Engineered Cost with clear direct physical
sewing machine, relationship to the level of output
calculated on a units of
production basis
h Cost of electricity used in Variable Engineered Cost of electricity consumed in
the factory building production is directly related to the
level of manufacturing activity
i Rent of the factory Fixed Committed Cost resulting from organisations
building use of premises, difficult to change
in short term
j Wages of the staff who Variable Engineered Cost of packaging directly related
package the finished T- to the level of output produced
shirts
k Cost of sewing machine Fixed Discretionary Cost arising from managements
maintenance decision regarding maintenance,
easy to change/vary in short term
l Cost of a new company Fixed Discretionary Cost arising from management
advertising sign placed in decision relating to advertising
front of the factory expenditure, easy to change in short
term
m Cost of company car used Fixed Discretionary Cost arising from managements
by the managing director decision, easy to change/vary in
short term

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PROBLEM 3.34 (15 minutes) Account classification; cost drivers: school
Answers to this question will vary. Rather than looking for a right answer, instructors should seek
an understanding of the concepts.

a The cost of paper used in The Sunshine Times is a variable cost. If the number of pages
varied for each edition, the number of pages would be an appropriate cost driver. However
since the number of pages for each edition is constant, the cost varies per newspaper
printedthe cost driver is units of production.

b The number of business cards printed is the cost driver for this variable cost.

c No cost driver; a fixed cost.

d The number of units of production is the cost driver of this variable cost.

e No cost driver; a fixed cost .

f If each set up consumes the same amount of resources the cost driver would be the number
of set ups. As the set ups are for different kinds of jobs it is likely that set up time would be
a suitable cost driver for this variable cost.

g A semi-variable cost, partly fixed (lease charge) and partly driven by the distance travelled
or number of deliveries.

h Fixed; no cost driver.

i A variable cost; the cost driver is the number of business card designs undertaken.

j Variable, advertising revenue is the cost driver.

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PROBLEM 3.35 Cost estimation: high low; regression: wholesaler
1 Scatter diagram:

Shipping Department
costs

$25 000

$24 000

$23 000

$22 000

$21 000

$20 000

$19 000

1000 2000 3000 4000 5000 Hundreds of


kilograms of
The lower part of the vertical axis has been supplies
shortened

2 Highlow method:

Variable cost per unit of cost driver $24 240 - $20 400
=
5200 - 2000

= $1.20 per kg of supplies


loaded/unloaded

Total cost at 5200 units of cost driver $24 240

Total variable cost at 5200 units of cost


driver (5200 $1.20) 6 240

Fixed cost $18 000

Cost equation based on highlow method:

Shipping Department cost per $18 000 + $1.20X


=
month

where X denotes the number of kilograms of supplies loaded/unloaded during the month

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3 Cost when 4500 kgs are moved:

Total cost = 18 000 + (1.20 x 4 500) = $23 40

4 Estimating the fixed and variable cost components using regression analysis can be
determined by using Excel and StatPlus, the output from which is reproduced below.

Regression statistics
R 0.77355

R Square 0.59838

Adjusted R Square 0.55821

S 796.98293

Total number of observations 12

Standard
Coefficients Error

Intercept 19,885.66225 812.87843

Kg of supplies 0.8851 0.22931

5 The formula to explain the behaviour of the Shipping Departments costs is as follows.

Y = a + bX,

where:

X = the independent variable (the kilograms of supplies handled for one month)

Y = the dependent variable (cost for one month)

Y = $19 885.66 + $0.885X

This can be expressed as total cost = fixed costs of $19 885.66 plus $0.885 per kilogram of
supplies handled.

6 Predicted Shipping Department costs

Total cost = $19 885.66 + ($0.885 4 500) = $23 868.16

7 On the basis of using the highlow method and regression analysis, the Shipping
Departments monthly cost behaviour was estimated as follows:

Using the highlow method, the following cost estimate was obtained:

Material-handling cost per month = $18 000 + $1.20 per unit of cost driver

Using regression analysis = $19 885.66 + $0.885 per unit of cost driver

The two methods yield different estimates because the highlow method uses only two data
points, ignoring the rest of the information. Regression analysis, on the other hand, is a
statistical technique that can be used to estimate the relationship between the dependent

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variable (cost) and the independent variable (quantity of supplies handled). Regression
analysis uses all of the data points to determine the line of best fit.

In this case, the two data points used by the highlow method do not appear to be
representative of the entire set of data. Hence, I suggest that the cost line determined using
regression analysis be utilised.

PROBLEM 3.36 (40 minutes) Cost behaviour; committed and discretionary


costs; highlow method: Mining company
1 Straight-line depreciation committed fixed

Charitable contributions discretionary fixed

Mining labour (including on costs) variable

Trucking and hauling step-fixed

The mining labour costs with on costs are considered as variable, because the labour cost is
$225 per tonne of ore extracted. This labour rate is the same when

315 000
1400 tonnes are extracted (labour rate = = $225) or when
1400

607 500
2700 tonnes are extracted (labour rate = = $225).
2700

2 Given the assumption that royalties is semi-variable we could use the high-low method to
identify its fixed and variable components.

Variable cost per unit of cost driver $224 500 $140 000
=
2700 1400

= $65 per tonne

Total cost at 2700 units of cost driver $224 500

Total variable cost at 2700 units of cost


driver (2700 $65) 175 500

Fixed cost $49 000

Cost equation based on highlow method:

Royalty cost per month = $49 000 + $65X

where X denotes the number of tonnes of ore extracted

The total cost for February production of 1650 tonnes of ore

= ($30 000 + $0 + $49 000 + $280 000) + (($225 + 65) x 1 650) = $837 500

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3 OMLs trucking and hauling costs increase from $240 000 to $280 000 when the hauling
capacity reaches 1500 tonnes. This seems to indicate that OML is not cost effective in
handling 1500 tonnes of ore. It costs $40 000 less to truck 1499 tonnes than it does 1500
tonnes. This may reflect OMLs commercial arrangement with trucking and hauling
equipment, as the production capacity reaches 1500 tonnes, the costs related to trucking and
hauling equipment escalate to a new level.

The cost effectiveness in utilising the trucking and hauling equipment can be improved by
planning the monthly production level so that the output is always slightly below the
maximum output (1500, 1900 and 2300 tonnes) of each step-fixed cost range.

4 The committed fixed costs refer to the facilities owned or used by the business as the bare
necessity of a basic organisation structure. As the name indicates, they cannot be avoided.
On the other hand, the discretionary fixed costs arise as a result of the management decision
to spend a particular amount of money for some purpose. For example, OMLs charitable
contribution is only managements decision.

In times of economic downturn, the management would be likely to cut the discretionary
fixed costs. This is because a discretionary cost can be avoidable. However, the cutting of
discretionary costs can cause long-term problems. For example, reducing discretionary costs
such as machine maintenance, employee training and advertising can lead to equipment
breakdowns, poorly used equipment, lack of knowledge about new software and reduced
sales. The decision to reduce these discretionary costs should not be undertaken lightly,
rather it should be a last resort and managers underspending in these areas should be
monitored.

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PROBLEM 3.37 (45 minutes) Multiple regression analysis: service firm
1 Because there are two independent variables, it is necessary to use multiple regression
analysis. The following data is provided.

Regression Statistics

R 0.993371

R Square 0.986785

Adjusted R Square 0.983849

S 242.405

Total number of observations 12

Standard
Coefficients Error

Intercept 1 298.843101 567.099285

Number of photocopies 0.003203 0.002126

Hours of maintenance
service 7.345228 0.285104

The coefficients for the regression are in the lower panel of output. The constant, or intercept, is
$1298.843, and the coefficients of the two variables are the number of photocopies and the number
of hours of maintenance. The regression equation can be expressed as follows:

Y = $1298.843+ $0.003X1 + $7.35X2

Where Y = the estimated maintenance cost for the month

X1 = the number of photocopies produced for the month

X2 = the number of hours of maintenance for the month

2 The R2 for the equation is 0.987 (rounded), which means that 98.7 per cent of the variation
in the monthly maintenance cost can be explained by the variation in the numbers of hours
of maintenance and the number of photocopies produced. Given that the number of
observations (12) and the number of independent variables (2) are on the borderline for an
acceptable sample size, the adjusted R2 should be used (this measures the coefficient of
determination after adjusting for a relatively small number of observations). In this example,
an adjusted R2 of 0.984 (rounded) occurs, thus, there is little change in the outcome.

3 Using the data from the regression equation:

Variable cost per hour $7.35

Fixed cost per hour ($1299/1500 hours) 0.87

(255 000 copies $0.003)/1500 hours 0.51

Total cost per hour $8.73

The fixed cost per hour is a misleading amount because it will change as the number of
hours change. For example, at 600 hours of maintenance, the fixed cost per hour is $0.72
($432.95/600 hours).
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PROBLEM 3.38 (40 minutes) Interpreting regression analysis in cost
estimation: catering company
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. Dana divided total overhead by total
labour hours, which effectively treated all overhead as variable. Regression analysis
measures the behaviour of the overhead costs in relation to labour hours and is a model that
distinguishes between fixed and variable costs within the relevant range of 2500 to 7500
labour hours.

2 The regression results are shown below:

Regression Statistics

Multiple R 0.980976

R Square 0.962313

Adjusted R
Square 0.958544

Standard Error 1 448.743

Observations 12

Standard Upper Lower Upper


Coefficients Error t Stat P-value Lower 95% 95% 95.0% 95.0%

Intercept 48 126.41 1 257.89 38.25965 3.55E-12 45 323.65 50 929.16 45 323.65 50 929.16

Labour
hours 3.94936 0.247152 15.97946 1.9E-08 3.39867 4.500049 3.39867 4.500049

Using the regression results the variable cost per person is:

Food and beverages $14.00

Labour (0.6 hours @ $20/hour) 12.00

Variable overhead (0.6 hours @ $3.949/hour) 2.37*

Total $28.37
* Rounded.

3 The minimum bid for a 250-person cocktail party would be $7093. The amount is calculated
by multiplying the variable cost per person of $28.37 by 250 people. At any price above the
variable cost, Dana will be earning a contribution toward his fixed costs.

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

the assessment of the current capacity of Danas business. If the business is at


capacity, other work would have to be sacrificed at some opportunity cost

analysis of the competition. If competition is rigorous, Dana may not have much
bargaining power

a determination of whether or not Danas bid will set a precedent for lower prices

the realisation that regression analysis is based on historical data, and that any
anticipated changes in the cost structure should be considered.

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PROBLEM 3.39 (45 minutes) Evaluation of cost estimation models: retailer
1 Method A:

Predicted rental expense = 0.93 +0 .0936T

= 0.93 + (0.0936)(11)

= $1.9596 million

= $1 959 600

Method B:

Predicted rental expense = 0.5597 + 0.02219X

= 0.5597 + (0.02219)(60)

= $1.8911 million

= $1 891 100

Method C:

Predicted rental expense = (1.445/39.900) 60

= $2.172932 million

= $2 172 932

where 1.445 = average annual rent expense for the 10-year period from
Year 1 to Year 10

39.9 = average annual revenue for the 10-year period from Year 1 to
Year 10

2 An advantage of Method A is that using time as an independent variable is a convenient


way to take into consideration all possible factors that may be influencing the dependent
variable during each period of time. A disadvantage of Method A is that there is no causal
relationship between years and rental expense beyond mere inflationary pressure.

An advantage of Method B is that this method is logical because as revenues increase, the
stores increase, and thus rental expense increases. A disadvantage of Method B is that a
prediction of revenues is required.

An advantage of Method C is that the calculations are relatively easy and the method is
easy to understand. A disadvantage of Method C is that the arithmetic average is an
oversimplification that does not recognise any relationship between the variables.

3 Motomation should select Method B, because the relationship between revenue and rental
expense is causally based and it has economic plausibility.

4 The use of multiple regression analysis on the data provided would allow the inclusion of
all causal factors and should give a greater degree of accuracy to the projections.

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PROBLEM 3.40 (30 minutes) (appendix) Learning curve: manufacturer
1 The initial batch took 10 hours for 10 ($200/$20 per hour) or 1 hour each. When the
cumulative output is increased from 10 to 20 the average labour time per unit for the 20
tables should reduce to 0.8 hours per table. The 20 tables should take 16 hours, so the
second batch will take 6 hours (16 hours for the total output of 20 tables minus the 10 hours
for the first 10).

2 Direct labour = 6 hours $20 = $120 or $12 per table.

3 No. Labour is becoming increasingly skilled at making the tables. The hours taken is an
average of the batches and the first one produced of the first batch would take more than 10
hours, and the last of the second batch would take less than 6 hours.

4 Cumulative production is now 20, so the time taken to produce the next batch of 60 can be
estimated as follows:

Cumulative time taken for 80 tables = 80 (0.8 hours 80% 80%) = 40.96 hrs

Cumulative time taken for the first 20 = 16 hrs

Therefore, time taken for the 60 tables = 24.96 hrs

5 The direct labour cost, per table, for the batch of 60 is:

24.96 hours $20 per hour/60 tables = $8.32 per table

Over time, tables will appear to get cheaper. Perhaps Austral needs to take a more long-run
view of their pricing, to stimulate early demand so that they can move quickly along the
learning curve.

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SOLUTIONS TO CASES
CASE 3.41 (45 minutes) Cost estimations: hospital
1 Scatter diagram

2 Relevant range of activity is marked on the diagram


Administrative Cost

(2)
relevant
range

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3 This analysis is based on the costs and activity within the relevant range, that is between 600
and 1200 patients.

Variable cost per unit cost of driver = ($11100 $8300) $4.667 per patient*
(1200 600)

*(rounded)

Total cost at 1200 patients of cost driver = $ 11 100

Total variable cost at 1200 patients of cost driver = 1200 x $4.667

= $5600 (rounded)

Fixed cost = $5500

Cost equation based on highlow method:

Administrative cost = $5500 + $4.667X

where X denotes the number of patients during the period

4 Cost when 800 patients visit the hospital:

Total cost = 5500 + (4.667 x 800) = $9234 (rounded)

Cost when 300 patients visit the hospital:

Total cost = 5500 + (4.667 x 300) = $6900 (rounded)

However, it is not appropriate to use this cost function to estimate the administrative costs at
300 patients, as this is well below the relevant range.

Month Number of emergency Patient load Administrative


procedures cost

April 10 1 000 $ 10 000

June 14 900 $ 9 200

July 8 1 100 $ 10 200

September 12 700 $ 9 400

October 12 1 200 $ 11 100

November 8 600 $ 8 300

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6 (a) If only patient load is considered as a determinant of administration costs and only the
historical patient load data that falls within the relevant range (patient load between 600 and
1200) are considered, then simple regression can be used, utilising Excel. The output is
reproduced below:

Regression Statistics

Multiple R 0.927088078

R Square 0.859492304

Adjusted R Square 0.824365379

Standard Error 401.9749382

Observations 6

ANOVA

df SS MS F Significance F

Regression 1 3 953 664.596 395 3665 24.468191 0.00778042

Residual 4 646 335.4037 161 583.9

Total 5 4 600 000

Coefficients Standard error t Stat P-value Lower 95% Upper 95%

8
Intercept 6 181.36646 730.0175478 8.467422 0.0010661 4 154.51281 208.220107

Patients 3.838509317 0.775999898 4.946533 0.0077804 1.6839882 5.993030436

From this, the equation to explain administrative cost behaviour is as follows.

Y = a + bX, where:

X = the independent variable (patient load for one month)

Y = the dependent variable (administrative cost for one month)

Y = $6181 + $3.84X

This can be expressed as total cost = fixed costs of $6181 plus $3.84 per patient

(b) The clinics administrative cost during the month when 800 patients visit the hospital would
be $6181 + $3.84 x 800 = $9253

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(c) When both patient load and the number of emergency procedures are considered as
determinants of administrative cost, multiple regression must be used. Utilising Excel, the
regression statistics are reproduced below.

Regression Statistics

Multiple R 0.92919029

R Square 0.86339459

Adjusted R Square 0.77232432

Standard Error 457.669779

Observations 6

ANOVA

df SS MS F Significance F

Regression 2 3 971 615.12 1 985 808 9.480532 0.05048959

Residual 3 628 384.8797 209 461.6

Total 5 4 600 000

Standard Lower Upper Lower


Upper
Coefficients Error t Stat P-value 95% 95% 95.0% 95.0%

Intercept 5943.98625 1161.190869 5.118871 0.01443 2 248.558665 9 639.414 2 248.559 9 639.414

Emergency 24.9140893 85.10570782 0.292743 0.788799 245.930256 295.7584 245.93 2 95.7584

Patients 3.80756014 0.889819838 4.279024 0.023443 0.975756281 6.639364 0.975756 6.639364

From this, the equation to explain administrative cost behaviour is as follows:

Y = a + b1X1 + b2X2, where:

X1= the independent variable (the number of emergency procedures for one month)

X2= the independent variable (patient load for one month)

Y = the dependent variable (administrative cost for one month)

that is, Administrative cost = $5944 + $24.91 per emergency procedure + $3.81 per patient

(d) Clinics administrative cost during the month when 800 patients visit the hospital and 12
emergency procedures taken place would be $9291

(calculated as $5944 + $24.91 x 12 + $3.81 x 800 = $9291 rounded)

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7 When patient load is used as the sole independent variable, the figure for R2 is 0.859 as per
the above calculations. This suggests that 86 per cent of the variability of administrative costs
can be explained by changes in patient load. An R2 figure of 86 per cent indicates that 14 per
cent of the variability in administrative costs is not explained by patient load. With only 6
observations and one independent variable, it is more appropriate to use the adjusted R 2,
which is slightly lower at 0.824.

When patient load and emergency procedures are used as independent variables R2 increases
only marginally to 0.863 and the adjusted R2 is 0.772 per the above calculations. Thus the
adjusted R2 indicates that the addition of emergency procedures reduces rather than
increases the explanatory power.

The real problem is that, once we limit the analysis to observations within the relevant
range, there are only 6 observations, which undermines the effectiveness of the regression
analysis.

8 The equation from highlow method is based on only two observations and therefore should
be viewed with caution. However, as discussed above, even though both the regression cost
models have a high R2 and therefore high explanatory power, there are too few observations
to rely on the results of these regression models.

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CASE 3.42 (45 minutes) Interpreting regression analysis; activity-based
costing: service firm
1 Drakes preliminary estimate for overhead of $18.00 per direct labour 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 labour 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 recognises the relationship
between cost and volume in the data. The regression suggests that there is a component of
the cost ($26 201 per month) that is unrelated to total direct labour 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 labour hour. This cost formula can be used to predict total overhead at any activity
level within the relevant range.

Direct material $400.00

Direct labour (5 DLH* $19.00 per DLH) 95.00

Variable overhead (5 DLH $9.27 per DLH) 46.35

Total variable cost per 1000 square metres $541.35


* DLH denotes direct labour hours.

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

Direct material ($400.00 50) $20 000.00

Direct labour ($95.00 50) 4 750.00

Variable overhead ($46.35 50) 2 317.50

Overtime premium ($9.50 per DLH 5 DLH 50 .3) 712.50

Total variable costs for 50 000 square metres $27 780.00

Variable costs per 1000 square metres in this bid $ 555.60

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

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5 (a)

Variable OH1 (50 5 $4.10) $1 025

Variable OH2 (50 $13.50) 675

Variable OH3 (70 $6.60) 462

Total incremental variable overhead $2 162

(b)

Variable OH1 (50 5 $4.10) $1 025.00

Variable OH2 (25 $13.50) 337.50

Variable OH3 (230 $6.60) 1 518.00

Total incremental variable overhead $2 880.50

(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.

CASE 3.43 (45 minutes) Multiple regression: service firm (continuation of


Case 3.42)
The combined data from this case plus Case 3.42 is reproduced below so that the information is
clear.

Month Total Total direct Square metres No. of individual


overhead cost labour hours of turf plantings
$
(DLH) (STS) (PL)

January 54 000 3 100 96 000 100

February 47 000 2 400 88 000 60

March 48 000 2 250 88 000 80

April 56 000 2 800 102 000 130

May 57 000 3 500 106 000 70

June 65 000 4 000 110 000 100

July 64 000 4 000 120 000 120

August 56 000 3 400 100 000 32

September 53 000 2 800 104 000 80

October 47 000 2 800 90 000 74

November 47 000 2 150 92 000 80

December 54 000 2 800 102 000 120

Total $648 000 36 000 599 000


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1 The output data from the multiple regression equation using Excel and StatPlus is shown
below.

Regression Statistics

R 0.9706

R Square 0.9421

Adjusted R Square 0.9204

S 1 747.948

Total number of observations 12

ANOVA

p-
d.f. SS MS F level

Regression 3. 397 557 422 132 519 140.7 43.373 0.00003

Residual 8. 24 442 577.97 3 055 322.25

Total 11 422 000 000

p- H0 (2%)
Coefficients Std Error LCL UCL t Stat level rejected?

Intercept 11 188.151 7 391.604 -10 221.329 32 597.63 1.514 0.169 No

(DLH) 6.155 1.809 0.915 11.395 3.402 0.009 Yes

(STS) 0.216 0.128 -0.155 0.587 1.684 0.131 No

(PL) 32.169 23.526 -35.973 100.312 1.367 0.209 No

The regression equation:

Total overhead = $11 188 + $6.16 per direct labour hour + $0.216 per square metre of turf +
$32.17 per planting.

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2 As shown in (1), the adjusted R2 for this equation is 0.9204. When DLH is used as the sole
independent variable (as in Case 3.42) the R2 is lower (0.8597), although the standard error
of the coefficient is better, as shown below. At this point it would be appropriate in some
classes to discuss the sample size and predictive ability of the regression model. For
example, twelve observations would normally be considered adequate for one variable, as
with just DLH, but not for three variables (and only borderline for two variables in (3)).

Regression Statistics

Multiple R 0.927176006

R Square 0.859655346

Adjusted R
Square 0.845620881

Standard Error 2433.627823

Observations 12

ANOVA

df SS MS F Significance F

Regression 1 362774556.2 362774556.2 61.25315962 1.42616E-05

Residual 10 59225443.79 5922544.379

Total 11 422000000

Std t P- Lower Upper Lower Upper


Coefficients Error Stat value 95% 95% 95.0% 95.0%

Intercept 26201 3620.7 7.2365 3E-05 18134 34269 18134 34269

(DLH) 9.2663 1.184 7.8264 1E-05 6.6282 11.904 6.6282 11.904

3 Regression functions for the various combinations of cost drivers are shown below. These
results suggest that, when considered individually, DL hours is the best of the three cost
drivers. (STS lacks economic plausibility with a negative intercept and PL has low R2.)

When combined, the three independent variable model performs the best, although DLH
combined with either STS or PL seems to be almost as effective. However, before
reaching a final conclusion on the relative performance of these models, a more detailed
analysis should be completed, considering factors such as the standard error of the
coefficients and the F statistics.

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COMPARISONS OF RESULTS: SUMMARY OUTPUT
For all Variables For DLH only

Regression Statistics Regression Statistics

Multiple R 0.970607644 Multiple R 0.927176006

R Square 0.942079199 R Square 0.859655346

Adjusted R Square 0.920358899 Adjusted R Square 0.845620881

Standard Error 1747.94801 Standard Error 2433.627823

Observations 12 Observations 12

Coefficients Coefficients

Intercept 11 188.15061 Intercep 26 201.18343

(DLH) 6.154785902 (DLH) 9.266272189

(STS) 0.2157935 For PL only

(PL) 32.16946703 Regression Statistics

For STS only Multiple R 0.404441735

Regression Statistics R Square 0.163573117

Multiple R 0.926291064 Adjusted R Square 0.079930428

R Square 0.858015136 Standard Error 5941.145889

Adjusted R Square 0.843816649 Observations 12

Standard Error 2447.807442 Coefficients

Observations 12 Intercept 46 246.22674

Coefficients (PL) 88.953422

Intercept 5258.838793 For DLH and PL

(STS) 0.5935779 Regression Statistics

For DLH and STS Multiple R 0.959970232

Regression Statistics R Square 0.921542845

Multiple R 0.963608878 Adjusted R Square 0.904107922

R Square 0.928542069 Standard Error 1918.011679

Adjusted R square 0.912662529 Observations 12

Standard Error 1830.459773 Coefficients

Observations 12 Intercept 22 661.2363

Coefficients (DLH) 8.832453796

Intercept 7030.350985 (PL) 55.54190036

(DLH) 5.036231834

(STS) 0.31914144

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For STS and PL

Regression Statistics

Multiple R 0.926434568

R Square 0.858281008

Adjusted R Square 0.826787899

Standard Error 2577.798684

Observations 12

Coefficients

Intercept 5437.381336

(STS) 0.59887704

(PL) 4.02114619

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