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Purchasing Department cost drivers, activity-based costing, simple regression analysis.

1 Fashion Flair
operates a chain of 10 retail department stores. Each department store makes its own purchasing decisions. Barry
Lee, assistant to the president of Fashion Flair, is interested in better understanding the drivers of Purchasing
Department costs. For many years, Fashion Flair has allocated Purchasing Department costs to products on the
basis of the dollar value of merchandise purchased. A $100 item is allocated 10 times as many overhead costs
associated with the Purchasing Department as a $10 item.

Lee recently attended a seminar titled Cost Drivers in the Retail Industry. In a presentation at the
seminar, Couture Fabrics, a leading competitor that has implemented activity-based costing, reported
number of purchase orders and number of suppliers to be the two most important cost drivers of Purchasing
Department costs. The dollar value of merchandise purchased in each purchase order was not found to be a
significant cost driver. Lee interviewed several members of the Purchasing Department at the Fashion Flair store
in Miami. They believed that Couture Fabrics conclusions also applied to their Purchasing Department.
Lee collects the following data for the most recent year for Fashion Flairs 10 retail department stores:

Dollar
Purchasing Value of Number of
Department Merchandise Purchase Number of
Department Costs Purchased Orders Suppliers
Store (PDC) (MPS) (No. of P0s) (No. of 5s)
Baltimore $1,523,000 $68,315,000 4357 132
Chicago 1,100,000 33,456,000 2550 222
Los Angeles 547000 121,160,000 1,433 11
Miami 2,049,000 119,566,000 5944 190
New York 1056000 33,505,000 2,793 23
Phoenix 529000 29,854,000 1,327 33
Seattle 1,538,000 102,875,000 7586 104
St. Louis 1,754,000 38,674,000 3617 119
Toronto 1,612,000 139,312,000 1707 208
Vancouver 1,257,000 130944000 4,731 201

Lee decides to use simple regression analysis to examine whether one or more of three variables (the last three
columns in the table) are cost drivers of Purchasing Department costs. Summary results for these regressions
are as follows:

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This case has been adapted from a text book by Horngren, Datar and Foster,2003.

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Regression 1 :PDC = a+ (b x MP$)

Variable Coefficient Standard Error t-Value


Constant $1,039,061 $343,439 3.03
Independent variable 1: MP$ 0.0031 0.0037 0.84
r2= 0.08; Durbin-Watson statistic = 2.41

Regression 2: PDC=a+ (b x No.of PO's)

Variable Coefficient Standard Error t-Value


Constant $730,716 $265,419 2.75
Independent variable 1: No. of P0s $156.97 $64.69 2.43
r2=0.42; Durbin-Watson statistic = 1.98

Regression 3:PDC=a+(b x No. of S's)

Variable Coefficient Standard Error t-Value


Constant $814,862 $247,821 3.29
Independent variable 1: No. of S's $3,875 $1,697 2.28
r2=0.39; Durbin-Watson statistic = 1.97

Required
1. Compare and evaluate the three simple regression models estimated by Lee. Use (a) Economic
plausibility, (b) Goodness of fit measure (r-squared), (c) Significance of independent variables based on
t-values, and (d) Specification analysis of estimation assumptions as criteria to evaluate the three
different regression estimates.

2. Do the regression results support the Couture Fabrics presentation about Purchasing Department
cost drivers? Which of these cost drivers would you recommend in designing an ABC system?
3. How might Lee gain additional evidence on drivers of Purchasing Department costs at each of
Fashion Flairs stores?

Purchasing Department cost drivers, multiple regression analysis

To understand whether any of the three simple regression models capture the underlying economic relations
adequately, the business analyst suggests running the following two multivariate regressions:

Regression 4 : PDC = a+ (b1 x No. of PO's)+ ( b2 x No. of S's)

Regression 5: PDC = a +(b1 X No. of P0s) +(b2 x No. of Ss) + (b3 x MP$)

1. Evaluate regression 4 using the criteria of economic plausibility, goodness of fit, significance of independent
variables and specification analysis of estimation assumptions. Compare regression 4 with regressions 2
and 3 in first part. Which model would you recommend that Lee use? Why?

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2. Compare regression 5 with regression 4. Which model would you recommend that Lee use? Why?

3. Lee estimates the following data for the Baltimore store for next year: dollar value of merchandise
purchased, $75,000,000; number of purchase orders, 3,900; number of suppliers, 110. How much should Lee
budget for Purchasing Department costs for the Baltimore store for next year?

4. What difficulties do not arise in simple regression analysis that may arise in multiple regression analysis? Is
there evidence of such difficulties in either of the multiple regressions presented in this case? Explain.

5. Give two examples of decisions in which the regression results reported here could be informative.