Advanced: Linear regression analysis with price level adjustments Savitt Ltd manufactures a variety of products at its industrial site in Ruratania. One of the products, the LT, is produced in a specially equipped factory in which no other production takes place. For technical reasons the company keeps no stocks of either LTs or the raw material used in their manu¬ facture. The costs of producing LTs in the special factory during the past four years have been as follows:

The costs of raw materials and skilled and unskilled labour have increased steadily during the past four years at an annual compound rate of 20%, and the costs of factory overheads have increased at an annual compound rate of 15% during the same period. Power prices increased by 10% on 1 January 1999 and by 25% on the 1 January of each subsequent year. All costs except power are expected to increase by a further 20% during 2002. Power prices are due to rise by 25% on 1 January 2002.
The directors of Savitt Ltd are now formulating the company’s production plan for 2002 and wish to estimate the costs of manufacturing the product LT. The finance director has expressed the view that ‘the full relevant cost of producing LTs can be determined only if a fair share of general company overheads is allocated to them.’ No such allocation is included in the table of costs above.
You are required to:

(a) use linear regression analysis to estimate the relationship of total production costs to volume for the product LT for 2002 (ignore general company overheads and do not under¬ take a separate regression calculation for each item of cost), (12 marks)

(b) discuss the advantages and limitations of linear regression analysis for the estimation of cost-volume relationships, (8 marks)

(c) comment on the view expressed by the finance director. (5 marks)
Ignore taxation.
ICAEW Elements ofFinancial Decisions

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(2001) 1998 1999 2000 (estimated) () () () () Raw materials 70 000 100000 130 000 132 000 Skilled labour 40 000 71000 96 000 115 000 Unskilled labour 132 000 173 000 235 000 230 000 Power 25 000 33.000 47 000 44 000 Factory overheads 168 000 206 000 246 000 265 000 Total production 435000 583 000 754 000 786 000 costs Output (units) 160 000 190 000 220 000 180 000