Cost Estimation Question

Cost Estimation

Lecture 11

Chapter 5

Learning Objectives:

1. Understand the reasons for estimating fixed and variable costs.

3. Estimate costs using account analysis.

2. Estimate costs using engineering estimates.

4. Estimate costs using statistical analysis.

5. Interpret the results of regression output.

6. Identify potential problems with regression data.

7. Evaluate the advantages and disadvantages of alternative

cost estimates.

Why Estimate Costs?

Managers make decisions and need to

compare costs and benefits among

alternative actions.

What adds value to

the firm?

Good decisions

Basic Cost Behavior Patterns

Costs behave as either fixed or variable.

COSTS

Fixed Costs Variable Costs

Total fixed costs remain

constant as activity

changes.

Total variable costs change

proportionately as activity

changes.

Per unit fixed costs

change inversely as

activity changes.

Per unit variable cost

remain constant as

activity changes.

Basic Cost Behavior Patterns

Cost behavior, how costs vary with activity, is

the key distinction for decision making.

FTC =

Total costs = fixed costs + variable cost

per unit

number

of units

V+ X

With a change in Activity In Total Per Unit

Fixed Cost Fixed Vary

Variable Vary Fixed

Methods to Estimate Cost Behavior

Account analysis

Engineering estimates

Statistical methods

Engineering Estimates

Cost estimates are based on measuring and

then pricing the work involved in a task.

Identify the activities involved

Estimate the time and cost for each activity.

Labor

Rent

Insurance

Engineering Estimates, Continued. . .

Advantages

Details each step required to

perform an operation.

Permits comparison of other

centers with similar operations.

Identifies strengths and weaknesses.

Can be quite expensive to use.

Disadvantages

Account Analysis

Review each

account comprising

the total cost being

analyzed.

Identify each cost as

either fixed or

variable.

Activity level

Costs ($)

Fixed

Variable

Cost ($)

Activity level

Example: Account Analysis

3C Cost Estimation Using Account Analysis

Costs for 360 Repair Hours

Account Total

Office Rent $3,375

Utilities 310

Administration 3,386

Supplies 2,276

Training 666

Other 613

Total $10,626

Per Repair Hour

Variable Cost Fixed Cost

$1,375 $2,000

100 210

186 3,200

2,176 100

316 350

257 356

$4,410 $6,216

$12.25

Example: Account Analysis, Continued. . .

3C Cost Estimation Using Account Analysis

Costs at 360 Repair-Hours

fixed costs +

$6,216

variable cost

per unit

number

of units

$12.25 360

Costs at 520 Repair-Hours

$12,586 $6,216

$6,216 $12.25 520+

$6,370+=

+

$4,410

a unit is a repair- hour

Total Cost =

$10,626 =

Total Cost =

Account Analysis

Advantage

Managers and accountants are familiar

with company operations and the way

costs react to changes in activity levels.

Managers and accountants may

be biased.

Disadvantages

Statistical Cost Estimation

The limits within which a cost estimate

may be valid.

Relevant range for a projection is usually between

the upper and lower limits (bounds)of past activity

levels for which data is available.

Analyze costs within a relevant range.

Relevant range?

Example: Overhead Costs for 3C

The following information is used throughout this chapter:

Month Overhead Costs Repair-Hours

1 $9,891 248

2 $9,244 248

3 $13,200 480

4 $10,555 284

5 $9,054 200

6 $10,662 380

7 $12,883 568

8 $10,345 344

9 $11,217 448

10 $13,269 544

11 $10,830 340

12 $12,607 412

13 $10,871 384

14 $12,816 404

15 $8,464 212

Scattergraph

Plot of cost and activity levels

A visual

representation

of costs

Does it look like a relationship exists between

repair-hours and overhead costs?

M anufacturing Ov e rhe ad

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

0 100 200 300 400 500 600

Repair-Hours

M O

H C

o s ts

Scattergraph, Continued. . .

M anufacturing Ov e rhe ad

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

0 100 200 300 400 500 600

Repair-Hours

M O

H C

o s t s

We use “eyeball judgment” to determine

the intercept and slope of the line.

High-Low Cost Estimation

3C Overhead

Repair-Hours

A method to estimate costs based on two

cost observations, usually at the highest and

lowest activity level.

Choose two data

points.

Use the two points to

determine the line

representing the cost-

activity relation.

Draw a total cost line.

The highest and lowest activity.

Highest

Activity

Level

Lowest

Activity

Level

Ɵ

Slop = tan Ɵ

M

N

Slop = M

N

Δ Total Cost

Δ Activity Slop =

Cost

Activity

Level

High-Low Cost Estimation

TC = VC(X) + FC

Example: High-Low Cost Estimation, Contd .

A method to

estimate cost based

on two cost

observations, the

highest and lowest

activity level.

Month Overhead Costs Repair-Hours

1 $9,891 248

2 $9,244 248

3 $13,200 480

4 $10,555 284

5 $9,054 200

6 $10,662 380

7 $12,883 568

8 $10,345 344

9 $11,217 448

10 $13,269 544

11 $10,830 340

12 $12,607 412

13 $10,871 384

14 $12,816 404

15 $8,464 212

Example: High-Low Cost Estimation, Contd .

A method to estimate cost based on two cost

observations, the highest and lowest activity level.

Month OH Cost

Repair-

Hours

High $12,883 568

Low 9,054 200

Change 3,829 368

By definition, the change in cost due to a

change in activity is variable cost. So, to

calculate unit variable cost:

Δ Total Cost

Δ Activity =

$3,829

368 =

$10.40

VC per unit

TC = VC(X) + FC

$9,054 = VC(200) + FC

$9,054 = $10.40(200) + FC

$9,054 = $2,080 + FC

FC = $6,974

TC = $10.40(X) + $6,974

Example: High-Low Cost Estimation, Contd. . .

Equations

V Cost at highest activity Cost at lowest activity

Highest activity Lowest activity

F Highest activityTotal cost at highest activity level

V

or

Lowest activityTotal cost at lowest

activity level V

Example: High-Low Cost Estimation, Contd. . .

V $12,883 $9,054

568 200

$10.40/RH

V Cost at highest activity Cost at lowest activity

Highest activity Lowest activity

Example: High-Low Cost Estimation, Contd. . .

F

or

$12,883 $10.40 568 $6,976

200$9,054 $10.40 $6,974

Rounding Difference

F Highest activityTotal cost at highest activity level

V

or

Lowest activityTotal cost at lowest

activity level V

Example: High-Low

520

Estimated manufacturing overhead

with 520 repair-hours.

TC = F + V

TC = $6,976 + $10.40 $12,384

Estimated overhead with 720 repair-hours?

Relevant range for a projection is usually

between the upper and lower limits of past

activity levels for which data is available. Not sure.

X