Red's Furniture Manufacturing produces a line of tables and chairs from specialty hardwoods. It makes three different styles of chairs, and each chair takes about the same amount of direct labour time to manufacture. Shawn Hargrove is the company's new cost accountant and is preparing a direct labour cost budget for 2013 or (next year). The previous cost accountant always estimated direct labour costs based on a regression of the cost against the number of chairs produced, using monthly data from the prior four years. This approach seemed to be economically plausible, so Shawn begins his cost estimate by following the method used in prior years. However, Shawn is not pleased with his regression results, and he thinks about ways to improve the cost function estimate. He realizes that the past cost information did not take into account pay raises. Every January, the company gives its employees a cost-of-living pay increase. Each of the past four years, the employees have received a 2% raise. Shawn learns from management that a 2% raise is planned for 2013, too.
Shawn thinks that prior years' labour costs should be increased to 2013 pay levels to provide a more accurate prediction of 2013 costs. He plans to adjust prior-year pay using the following formula:
Labour cost at 2013 (next year's) level = Labour cost at prior pay level × (1.02)t
where
t = 1 for 2012
t = 2 for 2011
t = 3 for 2010
t = 4 for 2009
Shawn is also considering the degree to which direct labour costs vary with production. The company's policy is to increase the number of workers when production volumes increase and to decrease the number of workers when production volumes decrease. However, it often takes time for the company to hire qualifi ed new workers, and the managers often delay laying off employees when volumes decline. Thus, at least some lag is evident between the time that production volumes change and labour costs change. Shawn thinks that an additional cost driver for direct labour costs might be the prior month's volume of chairs produced.
The data provide monthly direct labour costs and number of chairs produced for the past four years. These data are available at www.wiley.com/canada/eldenburg.
REQUIRED
A. Estimate the cost function, using the same method as in prior years. Explain why Shawn is displeased with the results.
B. Explain why the annual pay increases cause a problem with the cost function estimated in Part A. In what way is the cost function mismeasured?
C. Use the formula Shawn developed to adjust the labour cost data for pay increases. Re-estimate the cost function. Explain whether you consider it to be a reasonable cost function for estimating 2013 direct labour costs.
D. To the analysis you performed in Part C, add a second independent variable for the number of chairs produced in the preceding month. Re-estimate the cost function. Do the statistics suggest that it is a reasonable cost function?
E. Explain what the two slope coeffi cients from Part D mean in terms of the cost function.
F. Do you agree that both independent variables should be used to estimate 2013 direc labour costs? Why or why not?