COST ACCOUNTING

TOPIC 2: COST ESTIMATION AND FORECASTING

Cost forecasting entails determination of how much cost will be in future for
purposes of planning and decision making.
Cost normally behave differently with change in activity level. Normally there are
many factors that influence cost however activity is the major influence. e.g.
number of units produced, electricity consumed, invoices processed, machine
hours worked etc.
Behavior of cost is of importance since variable cost will be expected to change
with change in level, fixed cost will remain the same. Mixed cost must be
separated into their fixed and variable elements so that that the variable elements
so that the variable elements can be adjusted with change in activity.
Cost forecasting is based on the assumption that the total cost can be objectively
and accurately separated into fixed and variable components. i.e.
TC= Fixed cost + Variable Cost
This is then expressed in the form of a linear equation
Y= a + bx Where;
Y= Total Cost
a= Total fixed Cost
b= unit variable cost
x= Measure of activity level such as units, hours, etc.

Methods used in cost forecasting:

1. Non–Mathematic methods
 Industrial Engineering technique
  Accounts Analysis/Inspection method
 High Low method

2. Mathematic methods
 Scatter Diagram/ visual Fit method
 Linear regression analysis (Simple and Multiple)
 Nonlinear regression methods:
 Learning Curve models
 Time series

1. Industrial Engineering technique

This method uses measures of work done to derive a relationship between inputs
and outputs. Industrial engineers conduct studies which shows the production units
and cost so that direct relationship between inputs and output is established. The
estimate physical inputs which are then converted into money using market prices
and a cost estimation function established.
Advantages
i) It provides an estimate of the ideal relationship between inputs and
outputs.
ii) It is applicable where no historical and past records exist.
iii) It is applicable to new and/or unique products.
iv) It is flexible in nature as standards can frequently be updated.
Disadvantages
i) The method is subjective as two experts may differ in estimates.
ii) Many indirect costs have no relationship between inputs and outputs
rendering this method inappropriate.
iii) Change in technology and production methods may mean change in
inputs. This means there is risk of estimates becoming outdated.
iv) The method is expensive to implement as experts have to be paid.

2. Accounts Analysis Method.

 This method requires the cost analyst to review accounts and ledgers involving
costs and classify them as fixed or variable. The total classified costs are then
used to develop a total cost relationship for estimation purposes.
Illustration:

Advantages
i) Easy to use and explain
ii) Relatively inexpensive
iii) Flexible as it depends on the professional knowledge, skills and
experience of the cost accountant.
Disadvantages
i) Subjective as cost accountants may differ on the cost behavior.
ii) The initial separation of cost into fixed and variable elements is arbitrary.
iii) The reliability and validity of results cannot be determined.
iv) The method assumes that the cost structure remains the same from period
to period.

3. High Low method.

This method involves identifying the highest and the lowest values of X and Y.
This helps in the separation of mixed costs into fixed and variable elements using
the equation in the form Y= a + bx
Advantages
i) Easy to calculate
ii) Simple to understand
iii) Easy to separate mixed costs for prediction purpose.
Disadvantages
i) It only uses two points and ignores the rest of the data set
ii) It uses extreme values which may distort the prediction results
iii) It can only be used in case of two variables only
iv) It is not possible to measure the size of probable error.

4. Visual fit / Scattered diagram method

This is a graphical method where available historical cost is plotted on the Y-axis
and level of activity on the X-axis on graph. Data points/co-ordinates are plotted as
per the historical data set, which will be scattered on graph. From the plotted data
points, a line of best fit is drawn based on the scatteredness of the data points. This
forms the predictor/estimator function with intercept and slope/gradient.

5. Simple Linear Regression analysis (ordinary least squares method)

It is a statistical method used to measure the average amount of change in one
variable that is associated with a unit change in one or more independent variables.
Its objective is to minimize the size of the estimation between the actual value and
the predicted value.
The line of best fit should minimize the sum of the squared error between the
estimated values and the actual values i.e. Ɛ(y-y)2 =Minimum.
We can obtain the values of parameters b and a in the predictor equation y = a + bx
using formula as follows:

n ∑ xy−∑ x ∑ y ∑ Y −b ∑ X
b= n ∑ x 2−¿ ¿ and a= n or a = ӯ −bẋ

Illustration:
The following data relate to machine age in months and the weekly maintenance
cost (thousand shillings) of different machines in a manufacturing company:

Machine 1 2 3 4 5 6 7 8 9 10
Age 5 10 15 20 25 30 30 50 50 60
Cost 90 150 200 250 280 330 300 350 360 380
Required:
a) Draw a scatter diagram for this data.
b) What is the apparent relationship?
c) Obtain the least squares regression line of maintenance cost on age
d) Use the least squares regression line and the high low method to predict the
maintenance cost for a machine of this type which is 40 months old.

Regression method:
X=295 Y=2690 XY=94150 X2=11775 Y2=806900 n=10
x- = 29.5 y- =269 a=126.95 b=4.82 r=0.92
Y = a + bX
Y = 126.95 + 4.82x
Y(40) = 126.95 + 4.82(40) = sh.319.75

High-Low method:
Y = a + bX
b= (380 – 90) / (60 – 5) = 5.27
380 = a + 5.27(60); a= 63.64
Y = 63.64 + 5.27X

6. Multiple Linear Regression Analysis Method.

It is called multiple since it has more than one independent variables. This helps
increase the explanatory power of the model.
A multiple linear regression equation takes the following general form
Y = a + b1x1 + b2x2 + ....................+ bnxn
where a= constant representing the Y intercept.
bj= Rate at which Y changes when Xi changes by 1 unit.
Illustration:
Develop a multiple regression equation for the following data:
X1 X2 Y X1Y X2Y X12 X22 X1X2
3 1 50 150 50 9 1 3
6 2 55 330 110 36 4 12
7 3 60 420 180 49 9 21
8 4 65 520 260 64 16 32
ΣX1 ΣX2 ΣY ΣX1Y ΣX2Y ΣX12 ΣX22 ΣX1X2
=24 =10 =230 =1420 =600 =158 =30 =68

Let the multiple linear regression equation be of the form

Y= a + b1x1 + b2x2

To obtain the values of a, b1 and b2 we solve the following 3 normal multiple

regression equations
ΣY = an + b1ΣX1 + b2ΣX2 ……... equation 1
ΣX1Y = aΣX1 + b1ΣX12 + b2ΣX1X2 ……equation 2
ΣX2Y = aΣX2 + b1ΣX1X2 + b2ΣX22…… equation 3

forming the equations:

230= 4a +24b1 + 10b2
1420=24a +158b1 + 68b2
600= 10a + 68b1 + 30b2

Solving the equations:

Parameter estimates
a=23.86
b1 = 7.69
b2= -5
therefore, the multiple linear regression equation can be expressed as
Y = 23.86 + 7.69X1 – 5X2
Interpretation;
a =23.86: represents the value of Y independent X1 and X2
b1 =7.69: A unit increase in X1 will lead to an increase in Y by 7.69 units and vice
versa.
b2 = -5: A unit increase in X2 will lead to a decrease in Y by 5 units and vice versa

Mr Benjamin Kinuthia (CPA)