Linda Olson owns a professional character business in a large metropolitan area.

She hires local

college students to play these characters at children’s parties and other events. Linda provides
balloons, cupcakes, and punch. For a standard party the cost on a per-person basis is as follows:

Balloons, cupcakes, and punch $ 7

Labor (0.25 hour  × $20 per hour) 5
Overhead (0.25 hour × $40 per hour  10
Total cost per person $22

Linda is quite certain about the estimates of the materials and labor costs, but is not as
comfortable with the overhead estimate. The overhead estimate was based on the actual data for
the past 9 months, which are presented here. These data indicate that overhead costs vary with
the direct labor-hours used. The $40 estimate was determined by dividing total overhead costs
for the 9 months by total labor-hours.

Month Labor-Hours Overhead Costs

April 1,400 $  65,000
May 1,800 71,000
June 2,100 73,000
July 2,200 76,000
August 1,650 67,000
Septembe 1,725 68,000
r
October 1,500 66,500
November 1,200 60,000
December   1,900     72,500
Total 15,475 $619,000

Linda has recently become aware of regression analysis. She estimated the following regression
equation with overhead costs as the dependent variable and labor-hours as the independent
variable:

Required:
1. Plot the relationship between overhead costs and labor-hours. Draw the regression line and
evaluate it using the criteria of economic plausibility, goodness of fit, and slope of the regression
line.
2. Using data from the regression analysis, what is the variable cost per person for a standard party?
3. Linda Olson has been asked to prepare a bid for a 20-child birthday party to be given next
month. Determine the minimum bid price that Linda would be willing to submit to recoup
variable costs.

SOLUTION

Regression analysis, service company.

1. Solution Exhibit 10-31 plots the relationship between labor-hours and overhead costs and
shows the regression line.
y = $43,563 + $14.66 X

Economic plausibility. Labor-hours appears to be an economically plausible driver of

overhead costs for the character company. Overhead costs such as scheduling, hiring and training
of workers, and managing the workforce are largely incurred to support labor.

Goodness of fit. The vertical differences between actual and predicted costs are extremely
small, indicating a very good fit. The good fit indicates a strong relationship between the labor-
hour cost driver and overhead costs. 

Slope of regression line. The regression line has a reasonably steep slope from left to
right. Given the small scatter of the observations around the line, the positive slope indicates that,
on average, overhead costs increase as labor-hours increase.

2. The regression analysis indicates that, within the relevant range of 1,200 to 2,200 labor-
hours, the variable cost per person for a birthday party equals:

Balloons, cupcakes and punch $ 7.00

Labor (0.25 hrs. × $20 per hour) 5.00
Variable overhead (0.25 hrs. × $14.66 per labor-hour)     3.67
Total variable cost per person $15.67

3. To earn a positive contribution margin, the minimum bid for a 20-child birthday party
would be any amount greater than $313.40. This amount is calculated by multiplying the variable
cost per child of $15.67 by the 20 children. At a price above the variable cost of $313.40, Linda
Olson will be earning a contribution margin toward coverage of her fixed costs.

Of course, Linda Olson will consider other factors in developing her bid including (a) an
analysis of the competition––vigorous competition will limit Linda’s ability to obtain a higher
price (b) a determination of whether or not her bid will set a precedent for lower prices––overall,
the prices Linda Olson charges should generate enough contribution to cover fixed costs and earn
a reasonable profit, and (c) a judgment of how representative past historical data (used in the
regression analysis) is about future costs.