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Cost Estimation

# Cost Estimation

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02/23/2014

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COST ESTIMATION
Introduction:
Cost estimation may be defined as ‘a study which attempts to predict the between costs and the activity levelor cost driver that causes those costs. In practice, managers frequently encounter such cost drivers (what is acost driver?) as machine hours, number of transaction, work cells, labour hours, and units of output e.t.c. The cost estimating function is
y = a + bx
,Where Y represents Total costa represents cost fixed component of the total costbx represents the variable costs component of the total costb represents the unit variable cost (this is the gradient of the equation)x represents output level This is the usual straight line equation you have been encountering in elementary mathematics.
2.4.1 Purpose of Estimation
It assists in estimating the future expenditure (cost prediction) as the expenditure will depend on the cost of the respective activitiesa)

It assists in determining the net benefits anticipated in a specific activity based on the relationshipbetween projected costs and projected revenue.Cost estimation is useful in business planning, cost control, performance evaluation and decision making.
2.4.2 Methods of cost estimation
We will consider following cost estimation methods commonly utilized, namely:a)

High Low Activity methodb)

Account Analysisc)

Engineering Analysisd)

Visual Fit (Scatter graph) methode)

Simple linear regression analysisf)

Learning curve Theorya)

High Low method
Here, cost estimation is based on the relationship between past cost and past level of activity. Variablecost is based on the relationship between costs at the highest level of activity and the lowest level of activity. The difference in cost between high and low activity level is taken to be the total variable costfrom which the unit variable cost can be computed by dividing it by the change in output level. This isindicated below: Total Variable Cost = Cost at high activity level Cost at low activity level Therefore,Unit Variable cost = Variable cost = Cost at high level activity – cost at low level activityOutput Units Units at high activity level units at low activity level

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The variable cost per unit so calculated forms the bof the straight line equation mentioned earlier. Bysubstituting ‘ b’ into the equation, we can obtain ‘a’, the fixed cost.
Illustration
Based on performance, you have been provided with the following information regarding ABC Ltd forthe year ended 31 December 2004 :
Labour hours Service cost (Shs)
Highest activity level 800 200,000Lowest activity level 300 150,000
Required
Develop a total cost function based on the above data using the high-low method.
Solution
Unit Variable cost = Variable cost = Cost at high level activity – cost at low level activityOutput Units Units at high activity level – units at low activity levelVariable Cost Per Unit = Shs.200,000 – shs.150,000800 hrs – 300 hrs= Shs.50,000 = shs.100/hr500 hrs Therefore b = 100 To get the fixed cost a, substitute binto the straight line equation as follows:When labour hours (x) = 800, service cost (total cost, y) = shs.200,000 Therefore from the Straight Line equation, y = a + b x200,000 = a + (100) 800200,000 = a + 80,000a = 200,000 – 80,000a = 120,000 Therefore fixed costs = shs.120,000NB: Even if we used the 2
nd
set of labour hours and service costs, were would still get he same answer i.e.When labour hours (x) = 300, service cost (total cost, y) = Shs.150,000. Therefore 150,000 = a + 100(300)

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a =150,000 – 30,000 = Shs.120,000 Therefore the cost equation is:y = 120,000 + 100x This equation can be used to estimate or predict the total costs : for example, when the activity level is say at1000 labour hours, then the total cost would be Y= 120,000 + 1000(100)=120,000 + 100,000= Shs.220,000.

Account Analysis (Inspection of Accounts)
Using account analysis, the accountant examines and classifies each ledger account as variable, fixed ormixed. Mixed accounts are broken down into their variable and fixed components. They base theseclassifications on experience, inspection of cost behaviour for several past periods or intuitive feelings of the manager.
Example
Management has estimated Shs.1,090 variable costs, Shs.1,430 fixed costs to make 100 units using 500machine hours. Since machine hours drives variable costs in our example, the variable cost stated as Then we get the total cost equation as Y = ,1430 +2.18 xWhere y = total costx = number of machine hoursFor 550 machine hours Total cost = Shs.1,430 + Shs. 2.18 (550) = 1,430 + 1,999 = Shs.2,629 This analysis should determine whether any factors apart from output machine hours are influencing totalcost.A danger in using this method lies in the fact that many managers may assume a cost’s behaviour withoutfurther analysis. This is because the method is highly subjective.
c)

Engineering method
This method is based on a detailed study of each operation where careful specification is made formaterials, labour and equipment necessary to produce a product. It involves identifying the level of inputrequired of an activity in form of raw material and labour while total cost is based on the cost of eachinput. This approach is applicable where no past data exists. The main setback of the approach is that itrequires a complex analysis of all the constituents of an activity and the requirements of an activity interms of costs detailed into materials, labour, overheads and time.d)

Visual fit (scatter graph method)
Cost estimation is based on past data regarding the dependent variable and the cost driver. The past dataon cost levels and the output levels) is plotted on a graph( called a scatter graph )and a line of best fit isdrawn as shown in the diagram . A line of best fit is a line drawn so as to cover the most points possibleon a scatter graph. Its intersection with the vertical axis indicates the fixed cost while the gradientindicates the variable cost per unit.