Question

The controller of Chittenango Chain Company believes that the identification of the variable and fixed components of the firm’s costs will enable the firm to make better planning and control decisions. Among the costs the controller is concerned about is the behavior of indirect-materials cost. She believes there is a correlation between machine hours and the amount of indirect materials used.

A member of the controller’s staff has suggested that least-squares regression be used to determine the cost behavior of indirect materials. The regression equation shown below was developed from 40 pairs of observations.

S = $205 + $4H

where S = Total monthly cost of indirect materials

          H = Machine hours per month

1. Choose the correct statement(s) that explain the meaning of “205” and “4” in the regression equation S = $205 + $4H. (You may select more than one answer. Single click the box with the question mark to produce a check mark for a correct answer and double click the box with the question mark to empty the box for a wrong answer.)

• The regression equation's intercept on the vertical axis is $205.
• The slope of the regression line is $4 per machine hour.
• The regression equation's intercept on the vertical axis is $4 per machine hour.
• The slope of the regression line is $205.
• None of the above.

2. Calculate the estimated cost of indirect materials if 910 machine hours are to be used during a month. (Assume that 910 falls within the relevant range for this cost equation.)

3. To determine the validity of the cost estimate computed in requirement (2), what question(s) would you ask the controller about the data used for the regression? (You may select more than one answer. Single click the box with the question mark to produce a check mark for a correct answer and double click the box with the question mark to empty the box for a wrong answer.)

• Do the observations contain any outliers, or are they all representative of normal operations?
• Are there any mismatched time periods in the data? Are all of the indirect material cost observations matched properly with the machine hour observations?
• Are there any allocated costs included in the indirect material cost data?
• Are the cost data affected by inflation?
• None of the above.

4. The high and low activity levels during the past four years, as measured by machine hours, occurred during April and August, respectively. Data concerning machine hours and indirect-materials usage follow.

	April			August
Machine hours		1,150			900
Indirect materials:
Beginning inventory	$	1,450		$	2,200
Ending inventory		1,950			4,200
Purchases		7,100			7,400

Determine the cost of indirect materials used during April and August.

Use the high-low method to estimate the behavior of the company’s indirect-material cost. Express the cost behavior pattern in equation form. (Round variable cost per machine hour to 2 decimal places.)

indirect material cost=

______+

______

per machine hour

Answer 1

(1): The correct options are the first 2 options - “The regression equation's intercept on the vertical axis is $205” and “The slope of the regression line is $4 per machine hour”.

Explanation: The intercept is the expected value of S when H = 0. Here when H =0 then Y will be $205. Slope is $4 and this means that when machine hours increases by $1 then indirect costs will increase by $4.

(2): Here S = 205 + (4*910) = 205+3640 = $3,845

The questions that I will ask the controller are – “Do the observations contain any outliers, or are they all representative of normal operations”, “Are all of the indirect material cost observations matched properly with the machine hour observations”.

Explanation: This is because there are some outliers that are called influential points that can influence the slope of the regression line.

(3): Let us first compute the indirect material usage for each month. Indirect material used = opening balance + purchase - closing balance

	April	August
Opening	1450	2200
Add: Purchase	7100	7400
Less: closing	1950	4200
Materials used	6600	5400

Now we can use the high low method.

Variable cost = (Highest activity cost - lowest activity cost)/(highest activity units - lowest activity units)

= (6600-5400)/(1150-900)

= $4.80

Fixed cost = 6600 - (4.8*1150) = 1080

Thus Indirect material cost = $1,080 + $4.80 per machine hour.