ANALYTICAL TECHNIQUES IN BUDGETING AND FORECASTING
HIGH-LOW METHOD ADVANTAGES & DISADVANTAGES OF USING
● A mathematical technique used to determine HIGH-LOW METHOD
the fixed and variable elements of a partially Advantages:
fixed and partially variable. ● Easy way to segregate Fixed and Variable
● Provides an easy way to split fixed and Costs
variable components of combined costs ● Requires only two values
● Easy to apply but seldomly used because it ● Quick and easy determination of cost behavior
distort costs ● Doesn't use any complex tools/programs
● Formula: (In determining Variable Cost Per Disadvantages:
● Does not consider the small details such as
variation in costs
● Assumes that fixed and unit variable costs are
Unit)
constant
● Formula : (In determining Total Costs)
● Variation in costs are not captured in the
Total Costs = Fixed Cost + Variable Cost ×
estimate
Unit Activity
In a mathematical equation or also known
CORRELATION, REGRESSION & TIME SERIES
as the Cost Function:
CORRELATION
Y=a+bx Wherein, (Y) is the Total Cost, (a) is
- Measures the strength and direction of the
the Fixed Cost, (b) is the Variable Cost, and (x)
relationship between two accounting variables
is the No. of Units
Examples:
Note: Fixed Cost can be determined by using the
● Relationship between sales revenue and
highest activity cost or using the lowest activity cost.
advertising expense
Fixed cost = Highest activity cost – (Variable
● Relationship between production cost and
cost per unit x Highest activity units) or
output level
Fixed cost = Lowest activity cost – (Variable
● Relationship between labor cost and project
cost per unit x Lowest activity units)
duration
Steps in using High-Low Method
Step 1: Identify the highest and lowest activities
Types of Correlation
Step 2: Calculate variable cost per unit
1. Positive correlation - both variables increase
Step 3: Calculate fixed Cost
2. Negative correlation - one increases, the other
Step 4:Calculate total variable costs for new activity
decreases
Step 5: Calculate total cost
3. Zero correlation - no relationship
Application: Factory Overhead costs in the
FORMULA
previous three months was as follows:
where:
Costs Units r → Correlation coefficient
n → Number of observations (ex: number of months,
January $ 30,000 6,000 projects, or transactions)
x (X) → Independent variable (ex: Units produced,
February $ 27,000 5,000 labor hours, Advertising expense)
y (Y) → Dependent variable (ex:Total cost, sales
March $25,000 4,000 revenue, profit)
Σx → Sum of all X values
Company expects to produce 7,000 units in April
Σy → Sum of all Y values
Calculate the expected factory overhead cost in Σxy → Sum of the product of X and Y
April using the High-Low method. Σx² → Sum of squared X values
Σy² → Sum of squared Y values
Step 1: Highest Unit: 6,000 & Lowest Unit: 4,000
APPLICATION EXAMPLE
Note: It is important to remember that it is the
A business wants to know if increasing advertising
highest and lowest activity levels that need to be
expenses affects sales. The data shows advertising
identified first rather than the highest & lowest cost. expenses of 1, 2, and 3 (in thousands), while sales
Step2: VCPU= costs(30,000-25,000) revenue is 10, 20, and 30.
units (6,000-4,000) Answer: r = +1
=$2.5per unit SOLUTION:
Step 3: FC =$30,000 - ($2.5 × 6,000 units) n = 3; Σx = 6; Σy = 60; Σxy = 140; Σx² = 14; Σy² =
=$30,000 - $15,000 1400.
Substitute into the formula → r = 1.
= $15,000
Interpretation: Perfect positive correlation;
Step 4: TVC= $2.5 × 7,000 advertising increases sales.
= $17,500
Step 5: TC= $15,000 + $17,500 REGRESSION
= $32,500 ● Used to predict the dependent variable (Y)
based on the independent variable (X).
ANALYTICAL TECHNIQUES IN BUDGETING AND FORECASTING
Examples: Time series data can be broken down into four
● Predicting total production cost based on units components:
produced
● Estimating future sales revenue TECHNIQUE MEANING EXAMPLE
● Forecasting project expenses APPLICATION
TREND long-term sales steadily
BASIC MODEL (Linear Regression)
ANALYSIS upward or increasing over 10
Y = a + bX downward years
Where: movement
Y - dependent variable (ex. Total costs)
X - independent variables (ex. Units produced) CYCLICAL Long-term economic boom vs.
a - fixed cost ANALYSIS oscillations recession;
(business depression and
b - variable cost per unit
cycles) that recovery
happen over
Regression Application Examples periods
Data: longer than a
Advertising Expenditure (X): 1, 2, 3, 4, 5 year
Sales (Y): 10, 20, 30, 50, 40
SEASONAL regular ice cream sales
ANALYSIS patterns peak in summer
Regression Line of Y on X: within a year
Y = 3 + 9X
→ If advertising expenditure is 7 lakhs, sales are IRREGULAR random, sudden drop in
predicted as: Y = 3 + 9(7) = 66 lakhs VARIATIONS unpredictable sales due to a
changes, pandemic; chance
and chance events like wars,
Regression Line of X on Y:
events earthquakes,
X = 0.3 + 0.09Y floods, or strikes
→ If sales target is 80 lakhs, required advertising that cause sudden
expenditure: X = 0.3 + 0.09(80) = 7.5 lakhs deviations.
Coefficient of Correlation: LEARNING RATE & LEARNING EFFECT
r = +0.9 → High positive correlation ● The learning curve effect reduces time per
unit as workers gain experience. Different from
Analysis Techniques: Regression Equations
economies of scale (which reduce costs
he primary technique involves forming regression
T through bulk buying and fixed cost spreading)
lines, which are expressed as algebraic equations: ● Learning effect is human-driven (skill,
familiarity, repetition)
● R egression Line of Y on X (Y = a + bX): ● Workers are slower at the beginning due to
Used to predict Y when X is known. unfamiliar processes
● Regression Line of X on Y (X = a + bY): ● Repetition improves efficiency and reduces
Used to predict X when Y is known. production time per unit
● First observed in 1925 in the aircraft industry
C
onstants Explained: ● T. P. Wright studied it in the 1920s–1930s.
Found learning is predictable, not random
● a (Intercept): The value of the dependent ● Enabled estimation of future labor time.
variable when the independent variable is zero. Widely used during World War II by US
● b (Slope): The amount of change in the contractors. Applied to predict costs and
dependent variable for every one-unit change production time (ships, aircraft). Later
in the independent variable. adopted by private companies
Key principle:
Time Series Definition
● A time series is a set of observations ● Cumulative average time decreases by a fixed
recorded at equal time intervals. percentage when output doubles
● It arranges statistical data according to the
time of occurrence. Example:
● Its purpose is to study trends, seasonal
patterns, cyclical movements, and irregular ● Aircraft industry learning rate ≈ 80%
variations over time.
Learning rates vary by industry. Sometimes
Time Series Examples measured per batch instead of per unit. Learning
● Yearly national income data (5–7 years) starts from the first unit or batch. Effect reduces
● Yearly steel production data over time as output increases. Eventually, learning
● Yearly population or sales data stops and production stabilizes
● Number of deaths/births per year
ANALYTICAL TECHNIQUES IN BUDGETING AND FORECASTING
Curve shape: ○ Important tip: never round learning
curve calculations to less than three
● Steep at the beginning decimal places—small rounding errors
● Flattens as production increases can erase the learning effect.
● Learning curve formula:
The importance of the learning curve effect ○ Y=axb
Purpose: ■ Y = cumulative average time per
unit for x units
● They help predict how long future tasks will
■ a = time for the first unit
take.
■ x = cumulative units produced
● Management accountants must consider the
■ b = index of learning (log
learning rate when planning, controlling, and
LR/log2)
making decisions. Ignoring it can cause
■ LR = learning rate (decimal
serious problems.
form)
Importance in decision-making: ○ In most past exams, b or LR is given,
but candidates should know how to
● Example: A company launching a new product calculate it using a scientific calculator.
prices it using full absorption cost + 5% ● Examples from past exams:
profit. ○ Dec 2011: Exam included lifecycle
○ The first unit takes 1 hour; labor cost = costing; students calculated
$15/hour; other costs = $45 → price = incremental labor time for the 100th
$63. unit.
○ If the learning effect is ignored and ○ June 2013: Again lifecycle costing;
actual time per unit = 0.5 hours, the learning rate and b were given.
price is too high. ○ June 2009: Target costing; average
● Consequences: cost for first 128 units calculated; then
○ Sales may be lower than expected. cost of last unit determined for ongoing
○ Product launch may fail. production.
○ The company may incorrectly decide ● Key observation:
not to launch because it thinks the price ○ Past exam questions follow a regular
is uncompetitive. pattern.
○ Candidates often memorize
Importance in planning and control: procedures without understanding the
reasoning.
● When using standard costing, accurate ○ In real workplace situations:
standard costs are needed for meaningful ■ The learning rate may not be
variances. known in advance.
● Ignoring the learning effect makes labor usage ■ Actual learning rate may differ
variances appear favorable, giving a false from estimates.
sense of efficiency. ○ Future exams are expected to test
calculation of the learning rate itself,
Beyond manufacturing:
not just application of given values.
● Learning curves are not just for assembly
Calculating the learning rate
industries.
● They are also used in services: professional ● Calculate the time to produce a single unit
practice, financial services, publishing, travel, or multiple units when the learning curve is
etc. active or has ended.
● Research shows nearly half of learning curve ● Usually the index of learning (b) is given.
users are in the service sector. ● Sometimes candidates are required to
calculate the learning rate (LR) themselves.
How learning curves have been examined in the
● The tabular method is the simplest way to
past
solve these types of learning curve questions.
● Understanding how to calculate time per unit
● Learning curves in exams and performance
with or without the learning effect is essential
management:
for accurate planning, costing, and
○ Frequently tested in Performance
decision-making.
Management and life cycle costing.
○ Candidates often calculate revised
lifecycle cost per unit considering the
learning effect.
○ Tests understanding of cumulative vs.
incremental time for producing units.