CHAPTER 1: Decision-making based on price setting and capacity utilisation

CHAPTER 1

LEARNING UNIT 4: Cost estimation

ASSESSMENT CRITERIA
After working through this learning unit, you should be able to
• explain the meaning of the term correlation coefficient
• describe the high–low, scatter graph and least-squares methods for calculating a regression
equation in estimating costs
• calculate regression equations using the high–low, scatter graph and least-squares methods

You should spend approximately 7 hours on mastering the learning outcomes of this Learning Unit.

4.1 INTRODUCTION

In Learning Unit 2, you were introduced to various cost concepts and the classification of costs,
including the classification of a cost according to its behaviour as fixed, variable, mixed or stepped at
different levels of output. You will remember that there is a long list of,for example, factory overheads
that must all be considered during the budgeting process. In Learning Unit 3 you were also introduced
to the concept of a flexible budget in which costs were identified according to two behaviours only:
fixed or variable. The variable cost per unit is assumed to remain constant if output is within the relevant
range (total variable costs increase in direct proportion to an increase in output).
One of the more difficult costs to calculate for planning and budgeting purposes is mixed costs (semi-
variable costs), because these costs are a combination of fixed costs and variable costs. For purposes
of preparing a flexible budget, accountants separate mixed costs into their fixed and variable
components for planning purposes.
In this study unit, we shall look at the correlation between two variables and apply methods based on
the linear cost function to separate the fixed and variable components of a mixed cost to enable cost
projection at different levels of output. The three most common methods are:
• the high-low method
• the scatter graph method
• the least squares method
Before we take a closer look at these methods, we shall briefly review correlation between two
variables and linear regression.

4.2 CORRELATION BETWEEN TWO VARIABLES

The correlation between two variables is expressed as a correlation coefficient. The correlation coefficient
lies between -1 and 1 (negative 1 and positive 1 on the number line). A correlation coefficient of 1 indicates
a perfect positive correlation. A perfect positive correlation between two variables exists where, if the
independent variable moves a given amount, the dependent variable moves proportionally in the same
direction. A correlation coefficient of -1 indicates a perfect negative correlation which exists between the two
variables where, if the independent variable moves a given amount, the dependent variable moves
proportionally in the opposite direction. The strength of the correlation grows as the correlation coefficient
approaches 1 or -1.

Within the relevant range, there would, e.g., be a perfect positive correlation between the dependent
variable direct material costs and the independent variable number of units produced. Say the direct
material cost per unit is R10; then consider the behaviour of total direct material costs at different levels of
output, e.g., units produced, within the relevant range:

Units manufactured (independent variable) 100 150 200 250 300

Total cost (dependent variable) (R10 × units made) R1000 R1500 R2000 R2500 R3000
Change in: units manufactured 50% 33,33% 25% 20%
total material costs 50% 33,33% 25% 20%

MAC2601 P a g e | 44 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

As the units of production increase, total cost also increases; i.e., they change in the same direction. They
also change proportionally (see % change). Therefore, there exists a perfect positive correlation (with a
correlation coefficient of 1) between the independent variable units manufactured and the dependent
variable total direct materials cost. See Figure 4.1: plotted on a graph the data points rise from bottom left
to top right in a straight line.
There would be a strong, albeit not perfect, negative correlation between the independent variable, number
of units produced and the dependent variable, fixed cost per unit. If total fixed overhead cost is R1 500 for
the production levels above, fixed cost per unit is:
Units manufactured 100 150 200 250 300
Fixed cost per unit (R1500 ÷ units made) R15 R10 R7,50 R6 R5
units manufactured 50% 33,33% 25% 20%
Change in
fixed costs per unit 33,33% 25% 20% 16,67%

As the units of production increase, the fixed cost per unit decreases, i.e., it moves in the opposite
direction but not proportionally. Therefore, there is a negative correlation (with a correlation coefficient
approaching -1) between the independent variable units manufactured and the dependent variable
fixed cost per unit. See Figure 4.2: plotted on a graph, the data points fall from top left to bottom right,
albeit not in a straight line.
Figure 4.1 Figure 4.2
y y
Total direct material cost

Fixed costs per unit R 10 ●

3000 ● 9
2500 ● 8
●
2000 ● 7
1500 ● 6 ●
R

1000 ● 5 ●
100

150

200

250

300

100

150

200

250

300
x x

Units produced Units produced

A correlation coefficient of 0 indicates there is no correlation between the two variables and data points
plotted on a graph would be ‘all over the show’.

ACTIVITY 4.1

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 If there is a positive correlation between the height and shoe size of a person, then a person of
above average height would be expected to have an above average shoe size.
1.2 If height is independent of wealth, the predicted correlation between the two variables would be -1.
1.3 The range of possible values for a correlation coefficient 0 to 1.
1.4 You measure height in metres and weight in kilogrammes and find a correlation of 0,6. Your
friend in the US measures height in inches and weight in pounds. He will also find a correlation
of 0,6.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.

MAC2601 P a g e | 45 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

2.1 Within the relevant range, variable costs are expected to …

(a) vary in total in direct proportion to changes in the output level.
(b) remain constant in total as the output level changes.
(c) increase per unit as the output level increases.
(d) increase per unit as the output level decreases.
2.2 As the level of output increases, a mixed cost will …
(a) increase in total and decrease per unit.
(b) increase in total and increase per unit.
(c) decrease in total and increase per unit.
(d) increase in total but have no effect per unit.
2.3 Total costs remained stable for several months while the cost per unit was increasing. This may
have been as a result of the behaviour of … costs and a(n) … output level.
(a) fixed, decreasing
(b) fixed, increasing
(c) variable, decreasing
(d) variable, increasing

4.3 SIMPLE LINEAR REGRESSION

In simple linear regression, we predict scores for one variable from the scores of other variables. Figure 4.1
is an example of simple linear regression, where total cost was predicted by units produced. We used the
scores from the variable ‘units produced’ to predict the scores for the variable ‘total direct material costs’;
units produced is therefore the predictor independent variable (the one calling the shots, if you will) that is
shown on the x-axis, while total direct material cost is the dependent variable that is shown on the y-axis.
In simple linear regression, the predictions for y, when plotted as a function of x, form a straight line. The
equation for a straight line (i.e., the linear cost function) is y = a + bx, where:
y = dependent variable
a = is where the straight-line intercepts with y, i.e., where the value of x = 0
b = the slope of the straight line
x = predictor, independent variable
FIGURE 4.3: Elements of the linear cost function y = a + bx
y
30'

25'

20' b

15' a

10' x
0 0 1' 2' 3' 4'

Where the total value of x = 4 000, the total value of y = 30 000. The value of a = 15 000, the point
where the straight-line intercepts y. The slope of the line (b) is a value that describes the rate of change
between the variables x and y; in other words, it tells us by how much y changes for every one unit
increase in x. The slope is calculated by selecting two points on the line and then determining their
coordinates. The coordinates of the selected points are:
y x
Point 1 25 000 2 000
Point 2 20 000 1 000
Difference 5 000 1 000
The slope of the line is 5 000/1 000 = 5. We can therefore predict that for every increase of 1 (unit) in
variable x, variable y will increase by 5 (rand).
Accountants often use linear regression to analyse and predict future costs. There are several methods that
may be used. We shall now take a closer look at the high-low method, the scatter graph method and least

MAC2601 P a g e | 46 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

squares method for separating mixed costs into their fixed and variable components. In all these methods
the linear cost function will be applied. But before we look at these methods, let us do a quick recap of
equations.
Equations
The linear cost function is an equation. An equation is two expressions that are equal in value; e.g.,
the expressions (5 + 9) and (8 + 6) can be written as the equation: 5 + 9 = 8 + 6. The sum of the terms
of the expression on the left-hand side (LHS) of the equal sign (=) is the same as the sum of the terms
of the expression on the right-hand side (RHS) of the equal sign, because both sums are equal to 14.
Because the LHS is equal to the RHS, we can also write 8 + 6 = 5 + 9. All the terms of the equation in
this example are constants, i.e., their values are known. An algebraic equation is an equation where
one or more of the terms are represented by letters, e.g., 5 + x = 8 + 6. The letter, in this instance x, is
called a variable. When a variable is multiplied by a constant, the constant is called a coefficient; for
example, in the expression 6 + 4b, 6 is a constant, 4 is a coefficient and b is a variable. Algebra allows
us to rearrange an equation so that the unknown variable is isolated on one side of the equal sign. In
rearranging the equation only one rule applies: maintain the relationship between the LHS and the
RHS of the equation. This is achieved by ‘doing unto the LHS as you are doing unto the RHS’:
• Whatever you add to one side of an equation, you must also add to the other side of the equation.
• Whatever you subtract from one side of an equation, you must also subtract on the other side of
the equation.
• Whatever you multiply by on one side of the equation, you must multiply the other side of the
equation by the same amount.
• Whatever you divide by on one side of the equation, you must divide the other side of the equation
by the same amount.

For example, we can find the value of x in the equation 5 + x = 8 + 6 by isolating x on one side of the
equal sign (i.e., making x the subject of the equation): subtract 5 on both sides of the equal sign:
5 + x – 5 = 8 + 6 – 5, thus x = 8 + 6 – 5, i.e., x = 9.
Let us take a closer look at Figure 4.3 and the linear cost function, y = a + bx. For example, at Point 1
y = 25 000, x = 2 000 and we have calculated that b = 5. By substituting these values in the linear cost
function, we can predict the value of a (by looking at the graph we already know that a = R15 000):
25 000 = a + 5(2 000), thus a = 25 000 – 5(2 000) = 25 000 – 10 000 = 15 000 (rand).
The linear cost function can be rewritten to make any of its terms the subject. Most people find it easier
to work with the unknown variable on the LHS of the equal sign. Because the LHS and the RHS are
equal, we can write y = a + bx as a + bx = y. Then:
a + bx – a = y – a (subtract a on both sides of the equation), and then
bx/x = (y – a)/x (divide both sides by x), thus
b = (y – a)/x
Any one of the variables in the linear cost function can be made the subject. See Table 4.1.
Table 4.1
Find y Find a Find b Find x
y = a + bx a = y - bx b = (y – a)/x x = (y – a)/b
y = 15 000 + (5×3000) a = 30 000 – (5×3000) b = (30000 – 15000)/3000 x = (30 000 – 15 000)/5
y = 30 000 a = 15 000 b=5 x = 3 000
In the above table we have used the values from Figure 4.3 to illustrate.
In this module you will often have to apply this basic algebraic technique (of rearranging an equation)
to find the value of an unknown variable.

ACTIVITY 4.2

QUESTION 1

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.

MAC2601 P a g e | 47 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

1.1 In describing the linear cost function, y = a + bx, it is correct to say …

(a) y is the independent variable.
(b) a is the variable cost per unit.
(c) a and b are both constant at all levels of output.
(d) b equals the change in cost divided by the change in output.
1.2 Given the cost formula (function) y = R13 000 + R7x, total production costs at an output level of
3 000 units would be …
(a) R13 000
(b) R34 000.
(c) R21 000.
(d) There is not sufficient information to calculate the total production cost.

4.4 HIGH-LOW METHOD

This method involves comparing and applying the data for two output levels (within the relevant range)
to the linear cost function y = a + bx. This simple method identifies and selects the periods of highest
and lowest output levels with their respective costs from a set of data to determine the variable cost
per unit, whereafter the linear cost function is applied to calculate the total fixed costs.

Example 4.1
In this example, output refers to the quantity of units manufactured. Consider the following data relating
to a mixed production overhead cost (MPOH):

Month Units MPOH (R) Month Units MPOH (R)

1 18 512 443 008 7 36 537 718 557
2 15 224 462 799 8 33 492 691 763
3 21 313 508 470 9 31 053 652 751
4 19 486 515 899 10 29 494 634 043
5 28 620 670 815 11 16 996 484 067
6 25 576 585 806 12 23 103 557 351
We identify and select the highest and lowest levels of output (the independent variable). We are
therefore looking for the highest and lowest levels of production. Month 2 had the lowest level (only
15 224 units produced) and month 7 the highest, with 36 537 units produced. We now find the
difference between the production levels and the difference between the corresponding costs:

Units produced (x) Total MPOH (y)

High (Month 7) 36 537 R718 557
Low (Month 2) 15 224 R462 799
Difference 21 313 R255 758
The variable cost per unit is R255 758 / 21 313 = R12,00009.
If we apply the linear cost function y = a + bx for separating mixed costs, then:
y = total costs
a = total fixed costs
b = variable cost per unit
x = output

You can use either the cost and unit information at the highest output level, or the cost and unit
information at the lowest output level, to substitute into the equation.

MAC2601 P a g e | 48 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

Total fixed cost, based on month 7 Total fixed cost, based on month 2
y = a + bx y = a + bx
718 557 = a + (12,00009 × 36 537) 462 799 = a + (12,00009 × 15 224)
718 557 = a + 438 447 462 799 = a + 182 689
718 557 – 438 447 = a + 438 447 – 438 447 462 799 – 182 689 = a + 182 689 – 182 689
∴ 280 110 = a ∴ 280 110 = a
or a = R280 110 or a = R280 110
________________________________________________________________________________

Think about it: if, within the relevant range, fixed cost is assumed to be the same at all output levels,
then the fixed cost in month 7 would be the same as the fixed cost in month 2. It is therefore reasonable
to assume that the difference in the total cost between the two months is due to the increase in variable
cost. Between month 2 and month 7, production increased by 21 313 units. The total increase in
variable cost must therefore have been caused by the extra 21 313 units made. The variable cost per
unit is therefore R12,00009 (R255 758 / 21 313). For every one of the 21 313 additional units made, total
mixed production overheads increased by R12,00009.
In our discussion of variable costs in Learning Unit 2 (see Figure 2.3), we determined that the slope of
the line is equal to the variable cost per unit, because every one additional unit produced (x-axis) adds
the amount of variable cost per unit to total cost (y-axis).
Take another look at Figure 2.4 in Learning Unit 2 and you will notice that the line for total cost begins
on the base of total fixed cost (point a) where x = 0, and then rises in parallel with the line for total
variable cost, i.e., the lines have the same slope. The variable costs line rises for every one unit made;
thus, the slope of the line must represent the variable cost per unit. In the discussion of linear
regression, we already learned that the slope of the line (b in the linear cost function) tells us how much
y changes for every one unit increase in x. To reiterate, the slope of the line, b, represents the variable
cost per unit.
The high-low method is therefore based on the assumption that, within the relevant range, total fixed
costs will be the same at both the highest output level and the lowest output level, and that the change
in total costs at the two output levels necessarily represents the change in total variable costs.

ACTIVITY 4.3

QUESTION 1

Doublet Limited incurred the costs as indicated below for the six months ended 30 June. During this
period, the costs increased, but not in direct proportion to the output volume.
Units made Total cost (R)
January 98 1 980
February 100 2 000
March 105 2 070
April 95 1 950
May 104 2 040
June 106 2 060

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Applying the high-low method, the variable cost per unit is R10.
1.2 Total fixed costs amount to R100.
1.3 The linear cost function that explains and predicts the cost behaviour for planning purposes is
y = R1 000 + R10x.
1.4 The total costs of an estimated 110 units of production are R1 010.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.

MAC2601 P a g e | 49 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

2.1 When the high-low method is used the variable cost per unit is determined by …
(a) performing regression analysis on the associated cost and cost driver database.
(b) subtracting the fixed cost per unit from the total cost per unit based on either the highest or
lowest observation of the output.
(c) using the difference between the highest and lowest observations of the cost driver as numerator
and the difference between costs associated with the highest and lowest observations of the
output as denominator.
(d) using the difference between the highest and lowest observations of the cost driver as
denominator and the difference between costs associated with the highest and lowest
observations of the output as numerator.
2.2 The production overhead costs per unit is R64,60 when 1 000 units are manufactured and
R33,80 when 3 000 units are manufactured. What is the best estimate of variable production
overhead costs per unit?
(a) R12,27
(b) R36,80
(c) R30,80
(d) R18,40
2.3 A careful analysis by the cost accountant of Xhosa (Pty) Ltd has determined that; if a plane
operates for 1 450 kilometres (km) during a month, the average semi-variable operating costs is
R1,50 per km. If the plane operates only 980 km during a month, the average semi-variable
operating costs is R1,95 per km. Using the high-low method, the variable costs per km is
calculated as:
(a) R0,56
(b) R562
(c) R264
(d) R211,50

QUESTION 3

The following information was obtained from the records of Plastic Manufacturers Ltd for the year:
Number of bags Mixed manufacturing
manufactured overheads (R)
March 120 2 000
April 130 2 100
May 125 2 020
June 115 1 900
July 132 2 100
August 124 2 040
September 130 2 060
October 140 2 150
November 135 2 120
December 134 2 110
January 130 2 100
February 126 2 080
REQUIRED
Use the high-low method to calculate the total budgeted mixed (semi-variable) manufacturing
overheads if 120 bags are manufactured.

MAC2601 P a g e | 50 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

QUESTION 4

Below are the quarterly production and cost data recorded in five expense accounts of Valkop Ltd.

Quarters → 1 2 3 4
U n i t s p r o d u c e d
8 000 10 000 11 000 9 000
Total cost per cost item
R’000 R’000 R’000 R’000
Maintenance 46 54 58 50
Indirect labour 24 30 33 27
Direct labour 80 100 110 90
Production plant insurance 36 36 36 36
Utilities 18 22 24 20

REQUIRED
4.1 Briefly discuss whether each cost item is fixed (F), variable (V), or mixed (M).
4.2 Write down the cost equation (cost function) for (i) Maintenance and (ii) Indirect labour; use the
high-low method where applicable.

It is important that the identification of the high and low points is based on output level, i.e., the
independent variable, and not on cost; the cost is the dependent variable, i.e., its value depends on
the value of the output. Although in most instances the highest and lowest output levels will also be the
highest and lowest cost levels, it is not always the case; there could be outliers. For example, if March
above had exceptionally high maintenance cost resulting in total cost of R2 100, then selection by cost
would have picked March (high) and April (low) instead of, based on output, June and April You are
also reminded that all the output levels in the set of data must fall within the relevant range.

Advantages of the high-low method

• It is easy to calculate as it does not require complex calculations.
• It is fairly accurate where the correlation between the variables is very close to 1.

Disadvantages of the high-low method

• It only works where there is near perfect correlation between the two variables.
• It only takes into account the highest and lowest output level, ignoring the rest of the data. Either
the highest or lowest output level (or both) may have been an outlier, affecting the linear
relationship between the two variables.
• It ignores stepped costs.

4.5 THE SCATTER GRAPH

The scatter graph method (also called a scatter diagram and scatter gram) considers all the data points
in a set of data and not only the highest and lowest levels of output. As before, it involves plotting the
data points of total cost (dependent variable) on the y-axis for each output level (independent variable)
shown on the x-axis. The assumption is again that output levels fall within the relevant range. The
following are the four steps followed to prepare a scatter graph:
Step 1: Plotting the scatter graph
Plot data (make dots) from the set of data on a graph: output on the x-axis and total mixed cost for
each output level on the y-axis. If the dots rise from left to right, there is a positive correlation between
the two variables.
Step 2: Draw a regression line
Draw the regression line between the data points so as to minimise the total vertical distance between
the line and all the points. (Each vertical distance between the line and a data point represents an
estimation error and we shall take a look at it again in discussing the least squares method.) Now
extend the line to the y-axis.

MAC2601 P a g e | 51 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

Step 3: Determine the total fixed cost

The total fixed cost is given where the regression line intercepts with the y-axis.
Step 4: Determine the variable cost per unit
The variable cost per unit is equal to the slope of the line. As we have seen earlier, the slope is
established by taking the coordinates of two data points on the line, expressed as (x1,y1) and (x2,y2),
and applying the following formula: (y2-y1) ÷ (x2-x1).

Example 4.2
Let us assume that the table below contains data for the maintenance cost (a mixed cost) and machine
hours (output level) of a manufacturing company for the last six months:
Total
Machine Maintenance
hours cost R
(x) (y)
Jun 300 5 900
Jul 272 5 500
Aug 250 5 250
Sep 215 5 050
Oct 195 4 750
Nov 125 3 800
The scatter graph based on the above information appears below. The extended regression line
intercepts the y-axis at R3 250; thus, the fixed cost is considered to be R3 250.
The selected two coordinates for determining variable cost per machine hour are (x150,y4000) and
(x225,y5000); (5000 – 4000) / (225 – 150) = 1000/75 = R13,333̇ per machine hour. The variable cost per
machine hour is therefore considered to be R13,333.
y
6 000 •
5 750

5 500 •
5 250 •
5 000 •
(x = 225; y = 5000)
Total mixed costs (R)

4 750 •
4 500

4 250

4 000 (x = 150; y = 4000)

3 750 •

3 500

3 250

3 000

0 125 150 175 200 225 250 275 300 x

Total machine hours
________________________________________________________________________________

The linear cost function that explains and predicts cost behaviour is y = R3 250 + R13,333x. We can
use this equation to forecast total costs at different output levels, say 100, 325 and 500 hours:
100 hours: y = R3 250 + R13,333̇ (100) = 3 250 + 1 333,33 = R4 583,30
325 hours: y = R3 250 + R13,333̇ (325) = 3 250 + 4 333,33 = R7 583,33
500 hours: y = R3 250 + R13,333̇ (500) = 3 250 + 6 666,67 = R9 916,67

MAC2601 P a g e | 52 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

Advantages of the scatter graph method

• It is very simple method that requires very little calculations.
• It is not influenced by the size of outlying items'
• It can be used for testing the relationship between two variables as it provides an indication if
correlation exists and if it is high or low.

Disadvantages of the scatter graph method

• It cannot establish the exact degree of correlation between the variables.

ACTIVITY 4.4

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 A scatter graph shows the relationship between two sets of data.
1.2 A scatter graph can only estimate the fixed cost component of a mixed cost.

4.6 LEAST SQUARES METHOD (SIMPLE REGRESSION ANALYSIS)

As seen earlier, simple regression analysis is a statistical process to determine the correlation between an
independent variable and a dependent variable. In order to use the results of the simple regression
analysis, the correlation between the dependant and independent variables must be strong. In practice,
it is a good idea to roughly plot the data points on a scatter graph (see paragraph 4.5) to determine if
a correlation exists. For purposes of this module, you can assume that the correlation is good enough
to predict cost behaviour.
The least squares method is used in regression analysis to approximate the relationship of the
dependent variable to the independent variable. We mentioned earlier that the vertical distance
between each data point and the regression line on the scatter graph represents an estimation error.
These errors exist because we draw a straight line (which represents perfect correlation) through data
points of variables that are not perfectly correlated. Least squares regression minimises the sum of the
squares of these estimation errors.
Like the high-low method and scatter graph method of segregating fixed costs and variable costs, the least
squares method also applies the linear cost function, y = a + bx. With differential calculus (which falls
beyond the scope of this module) the following normal equations can be formed and solved as
simultaneous equations (through a process of elimination) to find the values of a and b. These values
for a and b are then substituted in the, by now familiar, y = a + bx:
Σy = an + bΣx
Σxy = aΣx + bΣx2
Formulae for total fixed costs (a) and variable cost per unit (b) can be derived from the above equations.
In the equation y = a + bx, y is the subject of the equation. The equation y = a + bx can also be written
as b = (y-a)/x or a = y – bx. (See Table 4.1.) These equations are the basis for the formulae used in
simple regression analyses. The equation used to determine the slope of the line (i.e., variable cost
per unit of output) is
b = n(Σxy) – (Σx)( Σy) / n(Σx2) – (Σx)2
and the equation to determine the y-axis intercept (fixed costs) is
a = Σy – b(Σx) / n.
In these equations:
x = the level of output (the independent variable)
y = the total mixed cost (the dependent variable)
a = the total fixed cost (the y-axis intercept)
b = the variable cost per unit of output (the slope of the line)
n = the number of observations

MAC2601 P a g e | 53 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

Note
Σ (pronounced sigma) means ‘the sum of’, thus Σy means the sum of all the observations for y.
x2 (pronounced x squared) means x multiplied by x.
b(Σx) means b × Σx (b × the sum of all the observations for x).
n(Σxy) means n multiplied by Σxy, (the individual x-values × the individual y-values, added together
and multiplied by n).

Example 4.3
Assume that the table below contains the data of a mixed cost and units manufactured (output level)
of a manufacturing company for the first six months of the year:

Units made Total mixed

x cost (R) y
January 400 1 000
February 350 800
March 250 700
April 200 600
May 500 1 200
June 300 900
We shall now use the least squares method to determine the variable cost and fixed cost components
of the mixed cost. Thereafter we shall define a linear cost function for the cost behaviour.
Least squares method using normal equations
You will first have to add columns to the table to calculate the additional two values required by the
equations: x2 and xy. Each observation for volume x (the independent variable) is squared (x2) and
shown in a separate column. Each observation for x is multiplied by each observation for y and the
product shown in a separate column (xy). The months that we have data on represent the number of
observations and n represents the number of observations. All the columns are totalled and we are
ready to substitute the values in the equations.
n=6 x y x2 xy
January 400 1000 160000 400 000
February 350 800 122500 280 000
March 250 700 62500 175 000
April 200 600 40000 120 000
May 500 1200 250000 600 000
June 300 900 90000 270 000
Σ→ 2 000 5 200 725 000 1 845 000
From the expanded data, insert values of known variables into the equations:
Σy = an + bΣx : 5200 = 6a* + 2000b 
Σxy = aΣx + bΣx2 : 1845000 = 2000a* + 725000b 
* Whether we write a6 or 6a, and b2000 or 2000b does not matter; it means 6 × a or a × 6 and
2 000 × b or b × 2 000. The commutative rule of arithmetic states that in multiplication we can swap
the factors being multiplied around and still get the same answer (3 × 4 gives the same answer as
4 × 3).
We now have two equations,  and , both with the same two unknown variables (a and b) that must
be solved simultaneously. You may recall from your school maths that there are three methods for
solving two different equations with the same two unknown variables in each: elimination, substitution
and graphing. We shall use the elimination method, which involves the following steps:
1) Make the coefficients of one of the unknown variables (the coefficients are the constants by which
a and b are multiplied) the same or exact opposites by multiplying one or both equations by the
same number.
2) Add or subtract the two equations to eliminate that unknown variable, e.g., a.

MAC2601 P a g e | 54 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

3) Solve for the remaining unknown variable (e.g., b) by inserting the new value found in the previous
step.
4) Solve for the other unknown variable.
You may find it easier to swop the equations around to make the unknown variables the subject on the
left-hand side of the equation:
6a + 2 000b = 5 200 
2 000a + 725 000b = 1 845 000 
The first step is multiplying one or both equations by the same number. We can multiply one equation
only when the coefficient of one variable in one equation is a multiple of the coefficient of the same
variable in the other equation. In this instance, for a, 2 000 is not a multiple of 6 (2 000 ÷ 6 leaves a
remainder) and for b, 725 000 is not a multiple of 2 000. We must therefore multiply both equations.
Let us eliminate a, i.e., make the coefficient of a the same in both equations and subtract the one from
the other. We can do this by multiplying  by the coefficient of a in , and by multiplying  by the
coefficient of a in :
 2000 × (6a + 2000b = 5200) ∴ 12 000a + 4 000 000b = 10 400 000 
 6 × (2000a + 725000b = 1845000) ∴ 12 000a + 4 350 000b = 11 070 000 
Subtract  from  350 000b = 670 000

Now solve for b: b = 670000/350000 = R1,91428. The variable cost per unit (b in the linear cost
function) is therefore R1,91428. We can now find the value of a (total fixed costs) in either (or both to
check your workings) of the original equations:
6a + 2000b = 5200
6a + 2000(1,91428) = 5200
6a = 5200 – 3829
a = 1371/6 = 228,5
We have used the unrounded 1,91428 to limit rounding differences. Rounded, the variable cost per
unit manufactured is R1,91 and the total fixed cost is R229.

Least squared method using derived formulae

Insert the values of the variables from the expanded data into the formulae:
b = n(Σxy) - (Σx)( Σy) / n(Σx2) - (Σx)2
= 6(1 845 000) - (2 000)(5 200) / 6(725 000) – (2 000)2
= 11 070 000 – 10 400 000 / 4 350 000 – 4 000 000
= 670 000 / 350 000
= 1,91428, rounded R1,91
Find the value of a by substituting b by 1,91 in the next formula:
a = Σy - b(Σx) / n
= 5200 – 1,91428(2000) / 6
= (5200 - 3829) / 6
= 1371 / 6
= 228,5, rounded R229
The variable cost is R1,91 per unit produced and the total fixed cost is R229.
The linear cost function for the cost behaviour is y = 229 + 1,91x
________________________________________________________________________________

Advantages of the least squares method

• It is easy to understand and perform.
• It is widely applicable.
• It has a strong statistical foundation.
Disadvantages of the least squares method
• It is susceptible to outliers.
• It assumes that the two analysed variables have a correlation.

MAC2601 P a g e | 55 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

ACTIVITY 4.5

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 The high-low method should yield better results than the least squares method because it uses
more data points.
1.2 In the linear function y = a + bx, y is the intercept and x is the slope of the straight line.
1.3 The slope of a linear function is equal to the change in the dependent variable divided by the
corresponding change in the independent variable.
1.4 A regression line that is calculated by ordinary least squares will have an intercept and slope
that minimise the sum of the squared differences observed in a scatter graph.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 Output levels and total mixed costs for the last four months were as follows:
25 units at R363; 22 units at R345; 23 units at R348 and 20 units at R322. Using the least
squares method, the cost formula would be …
(a) y = R168,08 + R5,27x.
(b) y = R160,36 + R8,18x.
(c) y = R164,50 + R8x.
(d) y = R158 + R8,10x.

2.2 The management of C Manufacturing Limited believes that machine-hours is an appropriate

measure of output for separating mixed overhead costs for the last year, when machine hours
were always within the relevant range. C's independent variable would be …
(a) 12 months.
(b) machine hours.
(c) total mixed overhead costs.
(d) the relevant range.

QUESTION 3

The following information was obtained from the records of Plastic Manufacturers Ltd for the year:
Number of Mixed Number of Mixed
bags manufacturing bags manufacturing
manufactured overheads (R) manufactured overheads (R)
March 120 2 000 September 130 2 060
April 130 2 100 October 140 2 150
May 125 2 020 November 135 2 120
June 115 1 900 December 134 2 110
July 132 2 100 January 130 2 100
August 124 2 040 February 126 2 080
REQUIRED
Use the least squares method to calculate the budgeted mixed manufacturing overheads if 120 bags
are manufactured. Use the following equations: Σxy = aΣx + bΣx2 and Σy = an + bΣx

MAC2601 P a g e | 56 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

QUESTION 4

Below is a maintenance cost and machine hours report extracted from the records of Magic Limited:

Machine Maintenance Machine Maintenance

Month hours Cost (R) Month hours Cost (R)
1 400 1 000 6 250 700
2 250 900 7 200 600
3 100 500 8 500 1 200
4 400 1 200 9 300 900
5 350 800 10 150 400
REQUIRED
4.1 Explain which of the two variables is the dependent variable and which is the independent
variable.
4.2 Use the high-low method to calculate the fixed and variable components of maintenance
costs.
4.3 Use the scatter diagram to calculate the budgeted maintenance cost if 385 machine hours
are worked.
4.4 Use the least squares method to calculate the fixed costs and variable cost per hour, using
the normal equations Σy = an + bΣx and Σxy = aΣx + bΣx2
4.5 Define the linear cost functions for cost behaviour, based on your answers in 4.2, 4.3 and 4.4.

QUESTION 5

The information below pertains to Anon Ltd.

x y
OBSERVATION VOLUME TOTAL OVERHEAD
COSTS (R)
1 4 000 23 000
2 3 000 18 000
3 2 400 16 000
4 4 400 24 000
5 2 000 11 000
6 3 600 23 000
7 2 200 15 000
REQUIRED
5.1 Calculate the variable cost per unit as well as the total fixed overhead costs, using the least
squares method (use the equations Σxy = aΣx + bΣx2 and Σy = an + bΣx).
5.2 Write a linear cost function for the cost behaviour.

4.7 SUMMARY

In this learning unit, we provided an overview of the correlation between two variables (paragraph 4.2)
and simple linear regression (paragraph 4.3). We saw that the correlation coefficient measures the
association between two variables, namely the dependent variable (cost) and independent variable
(output). A high degree association between the two variables (high proportional movement between
the variables) will, if plotted on a graph, approach a straight line and the correlation coefficient will be
very close to either 1 or -1 (or, if perfectly correlated, exactly 1 or -1). A positive correlation between two
variables exists where a movement in the independent variable is associated with a movement in the
independent variable, in the same direction. A negative correlation between two variables exists where a
movement in the independent variable is associated with a movement in the independent variable, in the
opposite direction. Where there is very little or no association between the two variables, the correlation
coefficient is zero.

MAC2601 P a g e | 57 Learning unit 4

 CHAPTER 1: Decision-making based on price setting and capacity utilisation

We then described three methods for cost estimation, by calculating regression equations. The high-
low method (paragraph 4.4) selects the periods of highest and lowest output levels and then divide the
difference in total cost by the difference in output level to find the variable cost per unit; using either
the highest or he lowest readings, the total cost, the output level and the calculated variable cost per
unit is inserted in the linear cost function to find the total fixed cost. See Example 4.1. The scatter graph
method (paragraph 4.5) plots data for total costs and corresponding output levels on a graph and then
draws a straight line through the middle of the plotted points; the distances of the points below the line
and the points above the line should be (theoretically) equal; each vertical distance between a data
point and the line represents an estimation error. Total fixed cost is where the straight line intercepts
the y-axis and the variable cost per unit is equal to the slope of the line. The slope of the line is
determined by observing the differences between any two points on the straight line: the number of
units on the y-axis that the total cost moves between the two points for every one unit on the x-axis
that the output level moves between the two points. See Example 4.2. The least squares method
(paragraph 4.6) uses mathematics and is based on the principle that the sum of the squares of the
vertical estimation errors from this straight line is less than the sum of the squares of the vertical errors
of any other straight line that may be drawn on the same scatter graph. This method uses all
observations for total cost and output level to determine a line of best fit and is considered to yield
more accurate results than the other methods. See Example 4.3.

Have you given any thought to ethics and to how you could integrate the knowledge from your other
modules in what you have learnt in this learning unit? Accountants must be qualified and capable to
perform the duties assigned to them. Accepting the task of separating costs without understanding or
being capable of choosing the most appropriate method and properly applying it, would constitute
unethical behaviour. If employees do not understand how to perform a task, they should ask for
assistance and training.

MAC2601 P a g e | 58 Learning unit 4