Cost Behavior Analysis; Alternative Models.

Motorco Corporation plans to acquire several retail automotive parts stores as part of its expansion pro¬ gram. Motorco carries out extensive review of possi¬ ble acquisitions prior to making any decision to approach a specific company. Projections of future financial performance are one of the aspects of such a review. One form of projection relies heavily on using past performance (normally 10 prior years) to esti¬ mate future performance.

Currently, Motorco is conducting a preacquisition review of Alpha Auto Parts, a regional chain of retail automotive parts stores. Among the financial data to be projected for Alpha are the future rental costs for its stores. The following schedule presents the rent and revenues (in millions of dollars) for the past 10 years:

Year Revenues Annual Rent Expense 19A.

$22

$1.00 19B.

24 1.15 19C.

36 1.40 19D.

27 1.10 19E.

43 1.55 19F.

33 1.25 19G.

45 1.65 19H.

48 1.60 191.

61 1.80 19J.

60 1.95 The following three alternative methods of estimat¬ ing future rental expense are being considered:

Alternative A: A linear regression was performed using time as the independent variable. The resulting formula is as follows:

Rental expense = .93 + .0936y r = .895 Standard error of the estimate = .150 where y is equal to (actual year - 19A), e.g., 19J = 10.

Alternative B: The annual rental expense was related to annual revenues through linear regression. The formula for predicting rental expense in this case is as follows:

Rental expense = .5597 + .02219y r = .978 Standard error of the estimate = .070 where y is equal to (Revenues + 1,000,000), e.g., yfor 19J is 60.

Alternative O. The third alternative is to calculate rental expense as a percent of revenues using the arith¬ metical average for the 10-year period of 19A-19J inclu¬ sive. The formula for predicting rental expense in this case is as follows:

Rental expense =

(2E 2R)y =

(14.45 + 399)y = ,0362y where IE is equal to the sum of the rental expenses for the 10-year period, SR is equal to the sum of the revenues for the 10-year period, and y is equal to revenue in the prediction year, e.g., yfor 19J is 60.

Required:

(1) Discuss the advantages and disadvantages of each of the three alternative methods for estimating the rental expense for Alpha Auto Parts.

(2) Identify one method from alternatives A, B, or C that Motorco should use to estimate rental expense and explain why that alternative is preferred.

(3) Explain whether a statistical technique is an appro¬

priate method in this situation for estimating rental expense.