Can the constant in the cost function be used as an estimate of fixed maintenance cost per month? Explain.

The controller of Iso-Metsä Oy wants you to estimate a cost function from the following two observations in a general-ledger account called Maintenance:

Month Machine-hours Maintenance costs incurred
January 4000 €3000
February 7000 3900

Required

Can the constant in the cost function be used as an estimate of fixed maintenance cost per month? Explain.

Solution

The cost function in requirement 1 is an estimate of how costs behave within the relevant range, not at cost levels outside the relevant range. If there are no months with zero machine-hours represented in the maintenance account, data in that account cannot be used to estimate the fixed costs at the zero machine-hours level. Rather, the constant component of the cost function provides the best available starting point for a straight line that approximates how a cost behaves within the relevant range.

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