Advanced: Linear regression analysis with price level adjustments Savitt Ltd manufactures a variety of products at its industrial site in Wales. One of the products, the L T, 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 manufacture. The costs of producing L Ts 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% of 1 January 1978 and by 25% on the 1 January of each subsequent year. All costs except power are expected to increase by a further 20% during 1981.
Power prices are due to rise by 25% on 1 January 1981.
The directors of Savitt Ltd are now formulating the company's production plan for 1981 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 L T s 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 L T for 1981 (ignore general company overheads and do not undertake 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.
Ignore taxation.

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1977 1978 1979 (1980) (estimated) () () () () Raw materials 70 000 100000 130000 132000 Skilled labour 40000 71000 96 000 115000 Unskilled labour 132000 173000 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 costs 435 000 583 000 754000 786000 Output (units) 160 000 190 000 220000 180 000