STUDENT ACCOUNTANT PAPER F5

THE USE OF QUANTITATIVE TECHNIQUES IN BUDGETING

RELEVANT TO ACCA QUALIFICATION PAPER F5

A budget can be defined as a ‘quantified plan relating to a given period’.

It’s not surprising, therefore, that there are a number of quantitative
techniques available to help us prepare a budget. Most of these
techniques help address forecasting and planning issues such as:
• If I make this quantity, what will costs be?
• How much do we expect to sell in the first quarter of 2011?
• How long will it take people to make these units?

This article looks at four quantitative techniques:

• the high-low (or range) method
• least squares linear regression
• time series analysis
• learning curves.

THE HIGH-LOW (OR RANGE) METHOD

The high-low method is a quick but crude technique. It is usually seen in
the context of separating fixed and variable costs.

EXAMPLE 1
Units produced Total factory
costs ($)
Quarter 1 1,000 35,000
Quarter 2 1,500 45,000
Quarter 3 2,000 50,000
Quarter 4 1,800 48,000

Just by looking at the figures in Example 1 you can see that the costs are
not purely variable otherwise they would double from Quarter 1 to Quarter
2 as output doubles. The assumption is that there are also fixed costs in

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 STUDENT ACCOUNTANT PAPER F5
each of the four quarters which can be removed by subtracting two pairs
of total costs.

The range method looks at the costs incurred at the lowest and highest
outputs and says that any increment in costs must be purely with the
result of additional variable costs. So:

Units Costs ($)

Highest output 2,000 50,000

Lowest output 1,000 35,000
Difference 1,000 15,000

If the extra 1,000 units are causing the extra $15,000 in costs then the
variable cost per unit is $15,000/1,000 = $15.

The other cost in the total costs must be fixed cost, and this can be
estimated using either of the highest or lowest data sets:

Lowest output:
Total costs = $35,000 of which 1,000 x $15 = $15,000 are variable. The
remaining $20,000 of the total costs must therefore be fixed.

Or

Highest output:
Total costs = $50,000 of which 2,000 x $15 = $30,000 are variable. The
remaining $20,000 of the total costs must therefore be fixed.

Armed with this information, we can estimate costs at any level of output.
For example:

Output = 1,200 units, costs = $20,000 + 1,200 x $15 = $38,000

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The high-low method is quick and easy but, as said earlier, crude. For
example, all the data falling between the highest and lowest values are
ignored.

You will see here that the predicted costs for output of 1,800 units is
$20,000 + 1,800 x $15 = $47,000, whereas the actual reading was
$48,000. No matter how sophisticated the forecasting tool, there will
always be anomalies between actual and forecast data: factors such as
efficiency, commodity prices, the weather, can all change unexpectedly
and cause forecasting anomalies.

LEAST SQUARES LINEAR REGRESSION

Linear regression is an objective way of fitting the best possible straight
line through any set of points.

Within that sentence lie two important warnings concerning the use of
linear regression:
• It results in a straight line, even if a curved or kinked line might be
better.
• It will work for any set of points, so, you could collate people’s ages
and apartment or house numbers and a linear regression would
give the best fit possible between where you live and your age (but
whether you are then expected to move every birthday is not
clear!).

So, just because you can perform a least squares regression, it gives you
no information whatsoever about how much you can rely on the predictive
power of the result. For that, you also have to calculate the coefficient of
correlation, or r.

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The regression analysis and coefficient of correlation formulae, both given

in the Paper F5 exam, are:

y = a+bx

b = nxy - xy
nx2 - (x) 2

a = y - bx
n n

r= nxy-xy

(nx2-(x) 2)(ny2-(y) 2)

where x is the independent variable and y is the dependent variable. This

means that changing x should cause a change in y, not the other way
round. So, when establishing a relationship between volume and costs,
volume should be x, because making more causes more costs. When
establishing a relationship between price and quantity sold, x should be
price, because charging less will cause more units to be sold. n is the
number of pairs of readings.

The formulae require mainly simple, relatively unskilled, arithmetic

manipulation that would be better done on a spreadsheet than by hand.
The real skill comes in interpreting the results.

EXAMPLE 2
Figure 1



$

















© ACCA 2010

  
 
 
 

Output
 STUDENT ACCOUNTANT PAPER F5

Costs
Month Volume ($)

1 1,000 8,500
2 1,200 9,600
3 1,800 14,000
4 900 7,000
5 2,000 16,000
6 400 5,000

You can see from Figure 1 that when plotted, the data does follow a
straight line relationship fairly well, and we could draw a fairly accurate
straight line to represent how cost depended on volume, but linear
regression takes the subjectivity out of that.

Month Volume Costs ($)

x Y xy x2 y2
1 1,000 8,500 8,500,000 1,000,000 72,250,000
2 1,200 9,600 11,520,000 1,440,000 92,160,000
3 1,800 14,000 25,200,000 3,240,000 196,000,000
4 900 7,000 6,300,000 810,000 49,000,000
5 2,000 16,000 32,000,000 4,000,000 256,000,000
6 400 5,000 2,000,000 160,000 25,000,000

x =
y =
xy =
x2 =
y2 =
n=6 7,300 60,100 85,520,000 10,650,000 690,410,000

b = 6 x 85,520,000 – 7,300 x 60,100 = 74,390,000 = 7

6 x 10,650,000 – 7,3002 10,610,000

© ACCA 2010
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Figure 2






















  
 
 
 


a = 60,100 - 7 x 7,300 = 1,500

6 6
This is interpreted as:
Total costs (y) = 1,500 + 7 x Volume (x)

Where $1,500 = fixed cost and $7 = variable cost per unit

The regression line is shown in Figure 2 (in red), superimposed on the

original Figure 2 points.

So, if we were asked to predict costs if for output of 1,500 units, we would
predict:

Total costs = 1,500 + 7 x 1,500 = $12,000

Even though we can see from Figure 2 that the line is a good fit, it is still
important that the coefficient of correlation is calculated.

r= 74,390,000

(6 x 10,650,000 – 7,300 x 7,300)(6 x 6,410,000 - 60,100 x
60,100)
= 0.99

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If r = 1, there is perfect positive correlation (all points fit on the

regression line) and as one variable increases, so does the other.

If r = -1, there is perfect negative correlation (all points fit on the

regression line) and as one variable increases, the other decreases.

If r = 0, there is no correlation.

More usefully, r2 is the coefficient of determination, and this can be

interpreted as the proportion of variation in one variable that is explained
by variation in the other. Here, r2 is 0.98, meaning that there is very good
association between volume and costs. In other words, the formula
derived should be good at predicting costs from volume.

But take heed of these warnings:

1 A linear regression based on very few points, even with a good

coefficient of correlation, is not necessarily reliable. In the extreme
case, if you had only two readings, anyone could draw a straight line
through them but it would prove nothing.

2 Good correlation does not prove cause and effect. In Example 2, few
would argue that producing more units would not cause more costs.
But what if we were to do a linear regression on advertising and sales
volume and found a strong correlation coefficient? That does not prove
that more advertising causes more sales. For example, we might have
seen the economy recovering so decide to advertise more, but the
extra sales could have happened anyway as the economy improved.

3 It is dangerous to extrapolate. What we mean by this is to go outside

the range of data used in the analysis. In Example 2, we forecast
costs of $12,000 for output of 1,500 units, which is an example of
interpolation because we have examined and used data on either side
of 1,500 units. If, however, we were asked to predict costs for an

© ACCA 2010
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output volume of 3,000 units, then we have no experimental data

which we can use. Applying the formula would imply:

Total costs = 1,500 + 7 x 3,000 = 22,500

But how do we know that costs keep behaving in the same way at this
higher level of output? Fixed costs could step up, variable costs per
unit could increase, and employees may have to be paid overtime
rates.

4. You must remove other known effects before attempting to uncover

the association between two variables. If, for example, instead of our
data relating to months 1 – 6 it related to years 1 – 6, then other
effects are likely to interfere. The easiest to correct would be inflation
effects. Say that inflation runs at the rate of 5% for each year, then,
before the data is used, we should inflation-adjust all amounts of
money before attempting the regression. The data would then be:

Inflation Inflation
Costs adjustment adjusted
Year Volume ($) costs ($)

1 1,000 85,000 x (1.05)5 108,484

2 1,200 96,000 x (1.05)4 116,689
3 1,800 140,000 x (1.05)3 162,068
4 900 70,000 x (1.05)2 77,175
5 2,000 160,000 x 1.05 168,000
Now Current $ 50,000
6 400 50,000

The regression should be carried out on the data in the Volume and
Inflation-adjusted costs columns.

Other effects should also be adjusted for, if possible, such as supply

difficulties affecting one period’s costs. Remember, however, that over

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an extended period, the technologies used and products made can

change and these changes will also have confounding effects on the
cost volume relationship.

5. Always be aware that a linear relationship might not be appropriate.

The relationship might be better described by a curve or a kinked line.

TIME SERIES ANALYSIS

Linear regression assumes that the relationship between two variables is
strictly linear – explained by a straight line. Time series analysis is more
adaptable and recognises that the following effects could be present:

1 A trend: this is an underlying smooth increase or decrease of an

amount as time passes.

2 Seasonal variations: cycles of variation repeating in less than a year,

such as spring, summer, autumn and winter, or sales for each day of
the week.

3 Cyclical variations: cycles of variation repeating in more than a year,

typically, the long-term trade cycle.

4 Random effects: non-repetitive and non-predictable variations.

Time series analysis investigates the first two of these.

EXAMPLE 3

Look at this data: FIGURE 3

Sales

Sales  



Time $000


Year Qtr series 


2006 1 1 989.0 


 

2 2 990.0






© ACCA 2010 


     Time
 STUDENT ACCOUNTANT PAPER F5
3 3 994.0
4 4 1,015.0
2007 1 5 1,030.0
2 6 1,042.5
3 7 1,036.0
4 8 1,056.5
2008 1 9 1,071.0
2 10 1,083.5
3 11 1,079.5
4 12 1,099.5
2009 1 13 1,115.5
2 14 1,127.5
3 15 1,123.5
4 16 1,135.0
2010 1 17 1,140.0

You can see from Figure 3 that there is some sort of trend (the line
increases overall) and there are seasonal variations with a dip occurring at
times 7, 11, and 15, corresponding to the third quarter of each year.
Quarter 2 tends to look high each year. So, if we are going to try to
forecast sales for the third quarter of 2010, we would first try to project
the trend, then superimpose the seasonal effect on to the trend in order
to decrease it appropriately.

Performing a time series analysis is rather tedious and it is likely, in any

exam question, that much of the work will have been done for you leaving
you to interpret and apply the results. However, for the purposes of
explanation, we will carry out the full process on this data.

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4-part Centred Seasonal Seasonal

Time Raw moving moving variation variation
Year Qtr series data average average (additive) (multiplicative)

2006 1 1 989.0 -8.1 = 994 – 1002.1

2 2 990.0 0.9919 = 994/1002.1

997.0
3 3 994.0 1,002.1 -8.1 0.9919
1,007.3
4 4 1,015.0 1,013.8 1.2 1.0012
1,020.4
2007 1 5 1,030.0 1,025.6 4.4 1.0043
1,030.9
2 6 1,042.5 1,036.1 6.4 1.0062
1,041.3
3 7 1,036.0 1,046.4 -10.4 0.9901
1,051.5
4 8 1,056.5 1,056.6 -0.1 0.9999
1,061.8
2008 1 9 1,071.0 1,067.2 3.8 1.0036
1,072.6
2 10 1,083.5 1,078.0 5.5 1.0051
1,083.4
3 11 1,079.5 1,088.9 -9.4 0.9913
1,094.5
4 12 1,099.5 1,100.0 -0.5 0.9995
1,105.5
2009 1 13 1,115.5 1,111.0 4.5 1.0041
1,116.5
2 14 1,127.5 1,120.9 6.6 1.0059
1,125.4
3 15 1,123.5
1,131.5
4 16 1,135.0

2010 1 17 1,140.0

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The first four columns are as before.

Column five is called ‘4-part moving average’ – ‘4-part’ because we

believe the data repeats over four seasons. If we thought it repeated
over, say, five days in the week, we would create the 5-part moving
average.

The moving average is the average of the four components in the cycle.
So, in 2006, it is:

997 = (989 + 990 + 994 + 1015)/4

Then, moving down one season:

1,007.3 = (990 + 994 + 1,015 + 1,030)/4

Progressing down the data, the 4-part moving average contains one
element from each season. This is really where we can isolate the trend
because the high season and low season components tend to cancel out.

The trouble with 4-part moving averages (or any even periodicity) is that
the moving average is not really ‘opposite’ any season. To get a figure
which is centred on a season, adjacent moving averages are themselves
summed. This is not necessary if we start with, say, five seasons in the
repetitive cycle.

Therefore:

1,002.1 = (997.0 + 1,007.3)/2

1,013.8 = (1007.3 + 1,020.4)/2

This data represents the trend line, and if plotted on a graph it would look
like Figure 4:

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 STUDENT ACCOUNTANT PAPER F5
Sales



 

 



 

 


  Time

FIGURE 4

Figure 4 yields a very smooth trend; you would not always expect such a
linear result.

The trend figure has gone from 1,002.1 to 1,120.9 in 11 seasonal

increments, so the increase per season is (1,120.9 – 1,002.1)/11 = 1.7.

The seasonal variations are obtained by comparing the raw data for each
season with the trends. The comparisons can either be done by
subtraction (the additive model) or by proportions (the multiplicative
model).

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The variations are grouped by season and averaged out:

Additive: Multiplicative:

1 2 3 4
1 2 3 4
0.9919 1.0012
1.0043 1.0062 0.9901 0.9999
-8.1 1.2 1.0036 1.0051 0.9913 0.9995
- - 1.0041 1.0059
Average 1.0040 1.0057 0.9911 1.0002
4.4 6.4 10.4 0.1
-
3.8 5.5 -9.4 0.5
4.5 6.6
Average 4.2 6.2 -9.3 0.2

The analysis has now been completed, and the results can be used to
make forecasts. Let’s say we want to forecast season 3 for 2010. The
approach is as follows:

1 Project the trend.

2 Adjust for the seasonal variation appropriate for that season.

The last trend figure we have is for season 2 of 2009 and that was
1,120.9. Season 3 of 2010 is five seasons further on, so the predicted
trend figure would be:

1,120.9 + 7 x 1.7 = 1,132.8

Season 3 has an adjustment amount of -9.3, or 0.9957. Applying these

adjustments to the trend would result in predictions of:

Additive: 1,132.8 – 9.3 = 1,123.5

Multiplicative: 1,132.9 x 0.9911 = 1,122.8

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This method of predicting future amounts is more sophisticated than

linear regression, but neither method, of course, guarantees an accurate
answer. However, they are at least based on historical evidence and this
must surely be better than pure guesswork.

LEARNING CURVES

The learning curve phenomenon was first quantified for business use in
the early 1900s in the aircraft construction industry. It is perhaps no
accident that this was where learning was investigated in a commercial
context because the construction of aircraft was then both highly manual
and highly complex, and it is exactly these complex, manual tasks which
give the greatest opportunity for learning.

The rule for quantifying learning is simple to quote, but very subtle in
operation:

The cumulative average time taken to complete a task decreases

by (or to) a given proportion every time the cumulative output
doubles.

Learning curves are easy to tabulate by doubling cumulative

output and applying the learning curve factor to the cumulative
average time. For example, if the first item (or batch of items)
takes 20 hours to make and the learning effect is 80% or (0.8),
then the table will be:

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Cumulative Cumulative Cumulative

output average time
unit time
(a) (b) (a x b)
1 20.00 0.8 20.00
2 16.00 0.8 32.00
0.8
4 12.80 51.20
8 10.24 81.92
0.8
16 8.19 0.8 131.04
0.8
32 6.55 209.60
64 5.24 335.36

EXAMPLE 4

A typical question would be: 'A company has already made the
first four units, how long will it take to produce the next four?'

Questions such as these can only be solved by working with

cumulative outputs. The table tells us that the first eight items
will take 81.92 hours in total; the first four of those would have
taken 51.20 hours. Therefore, the time needed for the second
four will be:

81.92 – 51.20 = 30.72.

Knowledge of the learning curve effect and its impacts on

times/unit change is important for the following:

1 Costing. Variable labour and overheads are directly affected;

fixed overheads are usually absorbed on a time basis.

2 Pricing. You need to make sure that your price is

competitive and, at the same time, that you make a profit.

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3 Scheduling work. If the learning effect is not taken into
account. machines might become idle because not enough
work is planned.

It is instructive to draw a graph of cumulative output against

cumulative average unit time (Figure 5). This shows that:

• learning is particularly important in the early stages of

production, shown by a rapid fall off in the cumulative
average unit times

• learning is much less marked in later stages, showing very

little improvement.

FIGURE 5
Cumulative average unit time










       
Cumulative production

In fact, it is usually assumed that eventually the learning effect

will cease and that the time per unit will reach a steady state.
Improvement stops because:

• there is a limit to human dexterity

• some processes cannot be speeded up any more (for

example, a chemical reaction)

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• new, inexperienced staff will replace practised ones from
time to time, slowing things down again.

To find the steady state time for production, we usually have to

free ourselves from the tabular approach, which is linked to
cumulative output doubling. Let’s say, in the Example 4, that it
is believed that a steady state is reached from the 80th item
onwards. This doesn’t fall on a cumulative doubling stage so we
can’t solve it by this using the table…but there is a formula
(provided below). Students are expected to have a scientific
calculator in the exam, and be able to calculate b.

y = axb

where

y = average time per batch

a = time for first batch
x = cumulative number of batches produced
b = log learning rate/log2

We can test this formula by using it to calculate the table figure

for a cumulative output of 32.

a = 20 x = 32

log 0.8 = -0.0969 log 2 = 0.3010

So, b = 0.0969/0.3010 = -0.3219

Therefore, y, the cumulative time per unit when production has

reached 32, is:

-0.3219
y= 20 x 32 = 6.55 (as derived previously in the
table).

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But now back to the steady state problem. We need to find the
time for the 80th item. This can only be calculated by finding the
total time for 80 items and then subtracting the total time for the
first 79 of those items:

.
Cumulative production = 80 Cumulative production = 79

y (the cumulative average time for 1st 80) y (the cumulative average time for 1st 79)

= 20 x 80 -0.3219 = 4.8801 = 20 x 79 -0.3219 = 4.899

Total time for first 80: Total time for first 79:

= 80 x 4.8801 = 390.41 = 80 x 4.899 = 387.09

Therefore, the time taken to make the 80th item must be:

390.41 – 387.09 = 3.32

and so, if you were asked to forecast the total time that 100
items would take:

The first 80 would take (from above) 390.41 hours

The next 20 would take 20 x 3.32 = 66.40 hours

Total for 100 items 456.81 hours

Ken Garrett is a freelance write and lecturer

© ACCA 2010