Terry Lawler, managing director of the Little Rock Reviewers Company, is examining how

overhead costs behave with changes in monthly professional labor-hours billed to clients.
Assume the following historical data:
Total Overhead Professional Labor-Hours Billed to Clients
Costs
$330,000 3,000
395,000 4,000
425,000 5,000
467,000 6,000
521,000 7,500
577,000 8,500

Required:
1. Compute the linear cost function, relating total overhead costs to professional labor-hours, using
the representative observations of 4,000 and 7,500 hours. Plot the linear cost function. Does the
constant component of the cost function represent the fixed overhead costs of the Little Rock
Reviewers Company? Why? 
2. What would be the predicted total overhead costs for (a) 5,000 hours and (b) 8,500 hours using
the cost function estimated in requirement 1? Plot the predicted costs and actual costs for 5,000
and 8,500 hours. 
3. Lawler had a chance to accept a special job that would have boosted professional labor-hours
from 4,000 to 5,000 hours. Suppose Lawler, guided by the linear cost function, rejected this job
because it would have brought a total increase in contribution margin of $31,000, before
deducting the predicted increase in total overhead cost, $36,000. What is the total contribution
margin actually forgone?

SOLUTION

(30–40 min.) Linear cost approximation.

1. Slope coefficient (b) =   

=    ($521,000– $395,000)/(7,500 – 4,000)
= $36.00

Constant (a) =   $521,000 – ($36.00 × 7,500) =   $251,000

Cost function =   $251,000 + ($36.00 professional labor-hours)

The linear cost function is plotted in Solution Exhibit 10-29.

No, the constant component of the cost function does not represent the fixed overhead cost of the
Little Rock Reviewers Company. The relevant range of professional labor-hours is from 3,000 to
8,500. The constant component provides the best available starting point for a straight line that
approximates how a cost behaves within the 3,000 to 8,500 relevant range.

2. A comparison at various levels of professional labor-hours follows. The linear cost

function is based on the formula of $251,000 per month plus $36.00 per professional labor-hour.
 Total overhead cost behavior:
Month 1 Month 2 Month 3 Month 4 Month 5 Month 6
Professional labor-hours 3,000 4,000 5,000 6,000 7,500 8,500
Actual total overhead $330,000 $395,000 $425,000 $467,000 $521,00 $577,000
costs   359,000 395,000   431,000   467,000 0   557,000
Linear approximation 521,000
Actual minus linear $(29,000 $           0 $  $         0 $  20,000
Approximation ) (6,000) $     
0

The data are shown in Solution Exhibit 10-29. The linear cost function overstates costs by
$6,000 at the 5,000-hour level and understates costs by $20,000 at the 8,500-hour level.

3. Based on Based on Linear

  Actual    Cost Function
Contribution before deducting incremental overhead$31,000 $31,000
Incremental overhead   30,000 36,000
Contribution after incremental overhead $  1,000 $ (5,000)

The total contribution margin actually forgone is $1,000.

SOLUTION EXHIBIT 10-29

Linear Cost Function Plot of Professional Labor-Hours

on Total Overhead Costs for Little Rock Reviewers Company