Estimating a cost function, high-low method. Reisen Travel offers helicopter service
from suburban towns to John F. Kennedy International Airport in New York City. Each
of its 10 helicopters makes between 1,000 and 2,000 round-trips per year. The records
indicate that a helicopter that has made 1,000 round-trips in the year incurs an average
operating cost of $300 per round-trip, and one that has made 2,000 round-trips in the year
incurs an average operating cost of $250 per round-trip.
1. Using the high-low method, estimate the linear relationship y = a + bX, where y is the
total annual operating cost of a helicopter and X is the number of round-trips it makes to
JFK airport during the year.
2. Give examples of costs that would be included in a and in b.
3. If Reisen Travel expects each helicopter to make, on average, 1,200 round-trips in the
coming year, what should its estimated operating budget for the helicopter fleet be?
4. How would you determine the most important cost driver when estimating cost
functions in the case of Reisen Travel? Identify the cost driver and how it would impact
Reisen's operating budget
1)
Reisen Travel
Volume
Cost
High Level of Activity
1000 $300,000
Low Level of Activity
2000 $500,000
Difference in Cost
Difference in Activity Level
=
$200,000
1000
$200, 000
1, 000
= 200
Constant = $500,000 -$200(2000)
= $100,000
Therefore, the linear relationship is:
y = $100,000 + $200x
Where y is the annual operating cost of a helicopter and X represents the number of round
trips it makes annually
2)
Examples of the costs that would be included in a (constant) are the fixed costs of
operating a helicopter, irrespective of the number of trips it makes. These costs would
include items such as insurance, pilots’ salaries, and depreciation of the plane.
The slope b represents the variable costs of each trip and those would include items such
as fuel, landing fees, costs of meals and refreshments served on board.
3)
Since:
y = $100,000 + $200x
Therefore for 1,200 round trips per year, the operating costs would be:
y = $100,000 + $200(1,200)
= $100,000 + $240,000
= $340,000
Since the fleet consists of 10 planes, then the estimated operating budget is 10  $340,000 =
$3,400,000.
4)
A Cost Driver is an activity that creates a cost. Therefore, for Reisen Travel, the most
important cost driver would be the number of trips. At higher levels of activity an increase in
the number of trips would cause high increases in operating income because at the Breakeven
Point, all Fixed Costs would have been covered, hence for any level of activity above the
breakeven point, increases in cost drivers would lead to higher increases in operating income.
At lower levels of activity, an increase in the number of trips would still lead to a higher
revenue but at a decreasing rate.