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Least-squares linear regression is a statistical technique that may be used to estimate the total cost at the given level
of activity (units, labor/machine hours etc.) based on past cost data. It mathematically fits a straight cost line over a
scatter-chart of a number of activity and total-cost pairs in such a way that the sum of squares of the vertical
distances between the scattered points and the cost line is minimized. The term least-squares regression implies that
the ideal fitting of the regression line is achieved by minimizing the sum of squares of the distances between the
straight line and all the points on the graph.
Assuming that the cost varies along y-axis and activity levels along x-axis, the required cost line may be represented
in the form of following equation:
y = a + bx
In the above equation, a is the y-intercept of the line and it equals the approximate fixed cost at any level of activity.
Whereas b is the slope of the line and it equals the average variable cost per unit of activity.
Formulas
By using mathematical techniques beyond the scope of this article, the following formulas to calculate a and bmay be
derived:
Unit Variable Costbnxyxynx2x2
Total Fixed Costaybxn
Where,
n is number of pairs of unitstotal-cost used in the calculation;
y is the sum of total costs of all data pairs;
x is the sum of units of all data pairs;
xy is the sum of the products of cost and units of all data pairs; and
x2 is the sum of squares of units of all data pairs.
The following example based on the same data as in high-low method tries to illustrate the usage of least squares
linear regression method to split a mixed cost into its fixed and variable components:
Example
Based on the following data of number of units produced and the corresponding total cost, estimate the total cost of
producing 4,000 units. Use the least-squares linear regression method.
Month
Units
Cost
1
2
3
4
5
6
7
8
1,520
1,250
1,750
1,600
2,350
2,100
3,000
2,750
$36,375
38,000
41,750
42,360
55,080
48,100
59,000
56,800
Solution:
x
1,520
1,250
1,750
1,600
2,350
2,100
3,000
2,750
16,320
We have,
n = 8;
x2
y
$36,375
38,000
41,750
42,360
55,080
48,100
59,000
56,800
377,465
2,310,400
1,562,500
3,062,500
2,560,000
5,522,500
4,410,000
9,000,000
7,562,500
35,990,400
xy
3,511,808,000
1,953,125,000
5,359,375,000
4,096,000,000
12,977,875,000
9,261,000,000
27,000,000,000
20,796,875,000
84,956,058,000
x = 16,320;
y = 377,465;
x2 = 35,990,400; and
xy = 84,956,058,000
Calculating the average variable cost per unit:
b884,956,058,00016,320377,465835,990,40016,320213.8
Calculating the approximate total fixed cost:
a377,46513.807816,320819,015
The cost-volume formula now becomes:
y = 19,015 + 13.8x
At 4,000 activity level, the estimated total cost is $74,215 [= 19,015 + 13.8 4,000].
High-Low Method
High-Low method is one of the several techniques used to split a mixed cost into its fixed and variable components
(see cost classifications). Although easy to understand, high low method is relatively unreliable. This is because it only
takes two extreme activity levels (i.e. labor hours, machine hours, etc.) from a set of actual data of various activity
levels and their corresponding total cost figures. These figures are then used to calculate the approximate variable
cost per unit (b) and total fixed cost (a) to obtain a cost volume formula:
y = a + bx
y2 y1
Variable Cost per Unit =
x2 x1
Where,
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity
The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost change in number of
units produced).
Example
Company wants to determine the cost-volume relation between its factory overhead cost and number of units
produced. Use the high-low method to split its factory overhead (FOH) costs into fixed and variable components and
create a cost volume formula. The volume and the corresponding total cost information of the factory for past eight
months are given below:
Month
Units
FOH
1,520
$36,375
1,250
38,000
1,750
41,750
1,600
42,360
2,350
55,080
2,100
48,100
3,000
59,000
2,750
56,800
Solution:
We have,
at highest activity: x2 = 3,000; y2 = $59,000
at lowest activity: x1 = 1,250; y1 = $38,000
Variable Cost per Unit = ($59,000 $38,000) (3,000 1,250) = $12 per unit
Total Fixed Cost = $59,000 ($12 3,000) = $38,000 ($12 1,250) = $23,000
Cost Volume Formula: y = $23,000 + 12x
Due to its unreliability, high low method is rarely used. The other techniques of variable and fixed cost estimation are
scatter-graph method and least-squares regression method.
px = vx + FC + Profit
Where,
p is the price per unit,
x is the number of units,
v is variable cost per unit and
FC is total fixed cost.
Calculation
px = vx + FC
Solving the above equation for x which equals break-even point in sales units, we get:
FC
Break-even Sales Units = x =
pv
Example
Calculate break-even point in sales units and sales dollars from following information:
$15
$7
$9,000
Solution
We have,
p = $15
v = $7, and
FC = $9,000
Substituting the known values into the formula for breakeven point in sales units, we get:
Breakeven Point in Sales Units (x)
= 9,000 (15 7)
= 9,000 8
= 1,125 units
Break-even Point in Sales Dollars = $15 1,125 = $16,875
2.
The sales mix must not change within the relevant time period.
The calculation method for the break-even point of sales mix is based on the contribution approach method. Since we
have multiple products in sales mix therefore it is most likely that we will be dealing with products with different
contribution margin per unit and contribution margin ratios. This problem is overcome by calculating weighted average
contribution margin per unit and contribution margin ratio. These are then used to calculate the break-even point for
sales mix.
The calculation procedure and the formulas are discussed via following example:
Product
$15
$21
$36
$9
$14
$19
20%
20%
60%
$40,000
Calculation
Step 1: Calculate the contribution margin per unit for each product:
Product
$15
$21
$36
$9
$14
$19
$6
$7
$17
Step 2: Calculate the weighted-average contribution margin per unit for the sales mix using the following formula:
Product A CM per Unit Product A Sales Mix Percentage
+ Product B CM per Unit Product B Sales Mix Percentage
+ Product C CM per Unit Product C Sales Mix Percentage
= Weighted Average Unit Contribution Margin
Product
$15
$21
$36
$9
$14
$19
$6
$7
$17
20%
20%
60%
$1.2
$1.4
$10.2
$12.80
Step 3: Calculate total units of sales mix required to break-even using the formula:
Break-even Point in Units of Sales Mix = Total Fixed Cost Weighted Average CM per Unit
$40,000
$12.80
3,125
Product
Sales Mix Ratio
Total Break-even Units
Product Units at Break-even Point
20%
20%
60%
3,125
3,125
3,125
625
625
1,875
Product
625
625
1,875
$15
$21
$36
$9,375
$13,125
$67,500
$90,000
Payback Period
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash
inflows generated by the investment. It is one of the simplest investment appraisal techniques.
Formula
The formula to calculate payback period of a project depends on whether the cash flow per period from the project is
even or uneven. In case they are even, the formula to calculate payback period is:
Payback Period =
Initial Investment
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the
following formula for payback period:
Payback Period = A +
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
B
C
(cash flows in
Cumulative
millions)
Cash Flow
Year
Cash Flow
0
(50)
(50)
1
10
(40)
2
13
(27)
3
16
(11)
4
19
8
5
22
30
Payback Period
= 3 + (|-$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years
2.
It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are
considered more uncertain, payback period provides an indication of how certain the project cash inflows are.
3.
For companies facing liquidity problems, it provides a good ranking of projects that would return money early.
Payback period does not take into account the time value of money which is a serious drawback since it can
lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted
payback period method.
2.
It does not take into account, the cash flows that occur after the payback period.
Where,
i is the discount rate;
n is the period to which the cash inflow relates.
Usually the above formula is split into two components which are actual cash inflow and present value factor ( i.e. 1 /
( 1 + i )^n ). Thus discounted cash flow is the product of actual cash flow and present value factor.
The rest of the procedure is similar to the calculation of simple payback period except that we have to use the
discounted cash flows as calculated above instead of actual cash flows. The cumulative cash flow will be replaced by
cumulative discounted cash flow.
Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A;
C = Discounted cash flow during the period after A.
Note: In the calculation of simple payback period, we could use an alternative formula for situations where all the cash
inflows were even. That formula won't be applicable here since it is extremely unlikely that discounted cash inflows
will be even.
The calculation method is illustrated in the example below.
Decision Rule
If the discounted payback period is less that the target period, accept the project. Otherwise reject.
Example
An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted
payback period of the investment if the discount rate is 11%.
Solution
Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by
present value factor. Create a cumulative discounted cash flow column.
Year
n
Cash Flow
CF
Discounted Cash
Flow
CFPV$1
Cumulative Discounted
Cash Flow
$
2,324,000
1.0000
$ 2,324,000
$ 2,324,000
600,000
0.9009
540,541
1,783,459
600,000
0.8116
486,973
1,296,486
600,000
0.7312
438,715
857,771
600,000
0.6587
395,239
462,533
600,000
0.5935
356,071
106,462
600,000
0.5346
320,785
214,323
Sales Budget
Sales budget is the first and basic component ofmaster budget and it shows the expected number of sales units of a
period and the expected price per unit. It also shows total sales which are simply the product of expected sales units
and expected price per unit.
Sales Budget influences many of the other components of master budget either directly or indirectly. This is due to the
reason that the total sales figure provided by sales budget is used as a base figure in other component budgets. For
example the schedule of receipts from customers, the production budget, pro forma income statement, etc.
Due to the fact that many components of master budget rely on sales budget, the estimated sales volume and price
must be forecasted with sufficient care and only reliable forecast techniques should be employed. Otherwise the
master budget will be rendered ineffective for planning and control.
Company A
Sales Budget
For the Year Ending December 30, 2010
Quarter
1
Sales Units
Price per Unit
Total Sales
Year
1,320
954
1,103
1,766
$91
$92
$97
$112
$120,120
$87,768
$106,991
$197,792
5,143
$512,671
However if a business sells more than one product having different prices or the price per unit is expected to change
during the period, its sales budget will be detailed.
Written by Irfanullah Jan
Production Budget
Production budget is a schedule showing planned production in units which must be made by a manufacturer during a
specific period to meet the expected demand for sales and the planned finished goods inventory. The required
production is determined by subtracting the beginning finished goods inventory from the sum of expected sales and
planned ending inventory of the period. Thus:
Planned Produciton in Units
= Expected Sales in Units
+ Planned Ending Inventory in Units
Begining Inventory in Units
Production budget is prepared after sales budgetsince it needs the expected sales units figure which is provided by the
sales budget. It is important to note that only a manufacturing business needs to prepare the production budget.
Company A
Production Budget
For the Year Ending December 30, 2010
Quarter
1
Budgeted Sales Units
Year
1,320
954
1,103
1,766
5,143
210
168
213
225
225
Beginning Units
196
210
168
213
196
1,334
912
1,148
1,778
5,172