CHAPTER 6 – SUMMARY HANDOUT

ASSUMPTIONS
1. All cost relationships are linear. If they are not, then simply reduce the relevant range.
2. One Cost Driver explains Cost Behavior. Since only 1 X-axis, then only 1 Cost Driver.

COST EQUATION
TC = TFC + (UVC x Quantity). This is a mixed Cost (fixed & variable)
Y = A + B X, Where Y = Total Cost, A= Y-Intercept or Total Fixed Cost, B=Unit Variable Cost

HIGH LOW METHOD

- Select the highest and lowest point of the Cost Driver (X-Axis), NOT the cost (Y-Axis).
- Find slope which is gradient which is rise over run which is B:
B = UVC = Change in Y / Change in X
- Find A which is the TFC by using the Lowest Point or the Highest Point from above.

Limitations of the High Low Method

1. The highest and lowest points could be outliers. Statistical ways to check, not tested.
2. Only two data points are considered. 1,000’s of data points potentially ignored.
3. Assumes only one cost driver. What if this is dependent on many cost drivers?
4. No data quality. Statistical quality measures such as R-Squared, T-Stats, P-Stat ignored.

LEAST SQUARES REGRESSION METHOD

The minimization of the sum of the squares of the errors.

Accounts for all data points, allows multiple cost drivers to be set as variables, and also gives
information on the quality of the estimated cost function:

R-Squared = known as the line of best fit or goodness of fit. Also known as the coefficient of
determination for simple regression. MAX 1, >0.60 Preferred, Industry Dependent.

T-Value = measures whether the cost and cost driver are Related by Coincidence.
If T-Value is less than 2.0, ignore that component of the cost estimation.

P-Value or calculated probability measures the Population Bias. Not tested on this course.

Error is large if R-Square or T-Value are low

For Multiple Regression Outputs

Choose the output that gives the highest R-Squared (must be >0.60).
Then create an equation with the fixed and variable components if T-Values are >2.0.
Ignore Variable if T-Value < 2.0

Pros and Cons

1. Can accommodate more than one Cost Driver.
2. Takes into account ALL data points.
3. Provides Measurement of Cost Prediction Model and Quality.
4. Con – Costly to track and analyze data.