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Cost Estimation
Cost Estimation
Cost estimation involves the use of past costs to predict future costs. It involves breaking
down costs into their fixed and variables elements in order to determine future costs. It
also involves ascertaining the activity. A cost driver can be defined as any factor whose
change causes, a change in the total cost of an activity e.g. direct labour hours, machine
hours etc.
High-Low Method
The high-low method uses the highest and lowest activity levels over a period of time to
estimate the portion of a mixed cost that is variable and the portion that is fixed. Like the
account analysis and scatter graph method, the amounts determined for fixed and variable
costs are only estimates. Because it uses only the high and low activity levels to calculate
the variable & fixed costs, it may be misleading if the high and low activity levels are not
representative of the normal activity. For example, if most data points lie in the range of
60 to 90 percent for a particular accounting test, and one student scored a 20, the use of
the low point might distort the actual expectation of costs in the future. The high-low
method is most accurate when the high and low levels of activity are representation of the
majority of the other points. The steps below guide you through the high-low method:
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Step 1: Determine which set of data represents the total cost and which represents the
activity. Find the lowest and highest activity points.
Step 2: Determine variable costs per unit by using the mathematical formula for a slope
where you take divide the change in cost by the change in activity:
Y2 -Y1
= Variable cost per unit
X2 - X1
Where X2 is the high activity level
X1 is the low activity level
Y2 is the total cost at the high activity level selected
Y1 is the total cost at the low activity level selected
Step 3: Plug your answer to steps 2 along with either the high or the low point into the
cost formula by replacing the slope (VC) with variable cost per unit, the high activity
total cost for the y variable, and the high activity for the x variable. Then solve for fixed
costs (FC).
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Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope
(VC) with variable cost per unit and the y-intercept (FC) with total fixed costs in the
following format:
y = VC x + FC
Regression analysis
Simple regression analysis is based on the assumption that total cost is determined by one
variable whereas multiple regression considers more than one variable. As far as possible,
all the factors related to cost behavior should be brought into the analysis so that costs
can be predicted and controlled more effectively. The equation for single regression can
be expanded to include more than one independent variable.
Y = a + bX
Where:
Y is the cost or variable being estimated
A is the total fixed costs
X is the number of units produced or the independent variable influencing costs
B is the variable cost per unit
In this case:
b = n∑XY - ∑X∑Y
n∑X2 - ∑(X)2
and a= ∑Y -b∑X
n n
If there are two independent variables and the relationship is assumed to be linear, the
regression equation will be:-
Y = a + b1 X1 + b2 X2
Where: a represents the non-variable cost item.
B1 represents the average change resulting from a unit change in X1,
Assuming X2 and all the unidentified items remain constant.
B2 – represents the average change in if resulting from a unit change in
X2 asking that X1 remains constant.
The normal equations for a regression equation with two independent variables are:
∑ y = an + b1 ∑X1 + b 2 ∑ X2
∑Xy = a∑X1 + b1 ∑ X1 2 + b2 ∑X1 X2
∑X2y = a∑X2 + b1 ∑X1 X2 + b2 ∑X12
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Example of application of multiple regression
Consider a plant that generates its own steam and uses this steam for both heating and
motive power. The cost of steam generation is likely to be determined by both
temperature and machine hours, a multiple regression equation would be:-
Y = a + b1 X1 + b2 X2
Multi collinearity
When the independent variable are highly correlated with each other, its is very difficult
to separate the effect of each variable on the dependent variables. This occurs when there
is a simultaneous movement of two or more independent variable in the same direction
and at approximately the same rate. This condition is called multi collinearity.