# 11

Cost Estimation

11-2

Introduction
Cost behavior
Existing relationship between cost and activity.

Cost estimation
Process of estimating relationship between costs and cost driver activities that cause those costs.

Cost prediction
Using results of cost estimation to forecast a level of cost at a particular activity. Focus is on the future.

McGraw-Hill/Irwin

11-3

Learning Objective 1

McGraw-Hill/Irwin

All rights reserved. Inc. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.11-4 Reasons for Estimating Costs What will my costs be if I introduce the new model in a foreign market? How much will costs increase if sales increase 10 percent? Management needs to know the costs that are likely to be incurred for each alternative. .

All rights reserved. Inc. .11-5 Reasons for Estimating Costs More accurate cost estimates Increased company value Better informed decisions about: • efficient business processes • alternative courses of action • performance standards • financial forecasts McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.

McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. All rights reserved.11-6 Exh. 11-1 Reasons for Estimating Costs 1. . Then manage these Activities  manage costs make decisions  plan and set standards. First identify this 3. To reduce these Relationship between activities and costs Costs We estimate costs to: 2. Inc.

. Inc. All rights reserved. X is the number of cost driver units. Per unit Variable cost per unit remains the same over wide ranges of activity. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.11-7 Basic Cost Behavior Patterns Summary of variable and fixed cost behavior Cost Variable In total Total variable cost changes as activity level changes. Fixed cost per unit goes down as activity level goes up. Fixed Total Costs = Fixed costs + Variable costs TC = F + VX V is the variable cost per cost driver unit (cost driver rate). Total fixed cost remains the same even when the activity level changes.

11-2 One Cost Driver and Fixed/Variable Cost Behavior TC = \$190 + (. Inc. .11-9 Exh.16 Cost Slope = Cost Driver Rate \$300 \$200 \$100 \$0 0 Intercept = Fixed Cost 1000 2000 3000 Miles driven per month McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.16 x Miles Driven) \$600 \$500 \$400 510 350 190 \$. All rights reserved.

11-10 Multiple Cost Drivers and Complex Cost Behavior In cases of complex cost behavior and multiple cost drivers. All rights reserved. . McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Inc. the cost-benefit test should be considered when developing a cost estimation model.

•Also called a “semifixed cost” Activity Total cost remains unchanged over a narrow range of activity. McGraw-Hill/Irwin Cost . All rights reserved. total cost steps up to the next level. Inc. As activity increases to the next range. Copyright © 2008 The McGraw-Hill Companies.11-11 Step Costs Step Cost •A cost that increases in steps as the amount of the cost driver volume increases.

As the business grows more space is rented. . increasing the total cost.000 square feet. Inc. Continue McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. All rights reserved.11-12 Step Costs Example: Office space is available at a rental rate of \$30.000 per year in increments of 1.

McGraw-Hill/Irwin .000 \$30.000 2. Inc.000 Rented Area (Square Feet) Copyright © 2008 The McGraw-Hill Companies. All rights reserved.000 0 1. then jumps to a higher cost for the next range of activity. \$60.11-13 Step Costs \$90.000 3.000 Total cost remains unchanged for a range of activity.

. The activity limits within which a cost projection may be valid is the relevant range of activity. All rights reserved.11-14 Relevant Range of Activity Unit variable costs remain unchanged. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Inc. Total fixed costs remain unchanged.

For example.11-15 Mixed Costs Exhibit 11-4: Mixed Cost Example 80 A mixed cost is one that has both a fixed and a variable component. Inc. .10 per minute thereafter. 60 Cost 40 20 0 0 200 400 600 800 1000 Minutes per month McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. a cellular phone plan that charges \$40 for the first 600 minutes and \$0. All rights reserved.

11-16 Nonlinear Costs Curvilinear Cost Function Total Cost Relevant Range A nonlinear cost pattern (e. All rights reserved. changes in unit variable cost) may often approximate a straight line (when the unit variable cost is constant) within the relevant range. . Inc.g. Activity McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.

. All rights reserved. Inc.11-17 Methods of Estimating Costs Scattergraph and high-low estimates Statistical methods (regression analysis) Account analysis Engineering method McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.

11-18 The Scattergraph Simply plotting past cost behavior on a graph may be a helpful first step in analyzing costs regardless of the estimation method ultimately chosen. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. All rights reserved. . Inc. It can reveal outlier data points and suggest possible relationships between the variables.

11-19 The Scattergraph Plot the data points on a graph (total cost vs. activity).000 * * * * * ** * ** 0 0 1 2 3 4 Activity: Units produced („000) McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.000 \$10. . \$20. Inc. All rights reserved.

. All rights reserved. Inc.000 0 0 1 2 3 4 Activity: Units produced („000) McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.000 * * * * * ** * ** Estimated fixed cost = \$10.11-20 The Scattergraph Draw a line through the plotted data points so that about an equal amount of points falls above and below the line.000 \$10. \$20.

. (Slope is the change in total cost for a one-unit change in activity).000 \$10.000 * * * * * ** * ** Vertical distance is the change in cost. Inc. Total Cost \$20. 0 0 1 2 3 4 Activity: Units produced („000) McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.11-21 The Scattergraph The slope of this line is the unit variable cost. Horizontal distance is the change in activity. All rights reserved.

. All rights reserved.11-22 The High-Low Method The high-low method uses two data points to estimate the general cost equation TC = F  VX TC = the estimated total cost F = a fixed quantity that represents the value of Y when X = zero V = the slope of the line (equivalent to the unit variable cost) X = units of the cost driver activity McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Inc.

11-23

The High-Low Method
The high-low method uses two data points to estimate the general cost equation TC = F + VX
\$20,000

\$10,000

* * * *

* ** * **

The two points should be representative of the cost and activity relationship over the range of activity for which the estimation is made.

0 0 1 2 3 4 Activity: Units produced („000)

11-24

The High-Low Method
WiseCo recorded the following production activity and maintenance costs for two months:
High activity level Low activity level Change Units 9,000 5,000 4,000 Cost \$ 9,700 6,100 \$ 3,600

Using these two levels of activity, compute:  the variable cost per unit;  the fixed cost; and then  express the costs in equation form TC = F + VX.

11-25

The High-Low Method
Units 9,000 5,000 4,000 Cost \$ 9,700 6,100 \$ 3,600

High activity level Low activity level Change

Unit variable cost = \$3,600 ÷ 4,000 units = \$.90 per unit  Fixed cost = Total cost – Total variable cost
Fixed cost = \$9,700 – (\$.90 per unit × 9,000 units)

Fixed cost = \$9,700 – \$8,100 = \$1,600 Total cost = Fixed cost + Variable cost (TC = F + VX) TC = \$1,600 + \$0.90X

. Copyright © 2008 The McGraw-Hill Companies. Data from the past are used to estimate relationships between costs and activities. McGraw-Hill/Irwin Before doing the analysis. take time to determine if a logical relationship between the variables exists. Independent variables are the cost drivers that drive the variation in dependent variables.11-27 Regression Analysis A statistical method used to create an equation relating dependent (or Y) variables to independent (or X) variables. All rights reserved. Inc.

. the cost driver McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. All rights reserved.11-28 Regression Analysis The objective of the regression method is still a linear equation to estimate costs TC = F + VX TC = value of the dependent variable (estimated total cost) F = a fixed quantity. that represents the value of TC when X = 0 V = the unit variable cost. the coefficient of the independent variable measuring the increase in TC for each unit increase in X X = value of the independent variable. Inc. the intercept.

11-29 Regression Analysis A statistical procedure that finds the unique line 400 through data points that minimizes the sum of squared distances from the data points to the line. 350 300 250 200 50 McGraw-Hill/Irwin 100 150 Independent Variable 200 Copyright © 2008 The McGraw-Hill Companies. Inc. All rights reserved. .

All rights reserved. the intercept 50 100 150 Independent Variable 200 McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Inc.11-30 Regression Analysis 400 350 300 250 V = the slope of the regression line or the coefficient of the independent variable. . 200 F = a fixed quantity. Here it represents the increase in TC for each unit increase in X.

All rights reserved.11-31 Regression Analysis 400 350 300 250 proper line. excluding the outlier improper line. 100 150 Independent Variable 200 Copyright © 2008 The McGraw-Hill Companies. . influenced by outlier Outlier 200 50 McGraw-Hill/Irwin Outliers may be discarded to obtain a regression that is more representative of the data. Inc.

000 \$10. 1 2 3 4 Activity: Units produced („000) Copyright © 2008 The McGraw-Hill Companies.000 * * * * 0 * ** * ** 0 The correlation coefficient is highly positive (close to 1.0) if the data points are close to the regression line.11-32 Regression Analysis The correlation coefficient (r) is a measure of the linear relationship between variables such as cost and activity. Inc. Total Cost \$20. McGraw-Hill/Irwin . All rights reserved.

11-33 Regression Analysis The correlation coefficient (r) is a measure of the linear relationship between variables such as cost and activity. Inc.000 * * * * * * \$10.000 * * * * The correlation coefficient is near zero if little or no relationship exists between the variables. 0 0 McGraw-Hill/Irwin 1 2 3 4 Activity: Units produced („000) Copyright © 2008 The McGraw-Hill Companies. Total Cost \$20. . All rights reserved.

Inc. \$20.0 0 0 McGraw-Hill/Irwin 1 2 3 4 Activity: Units produced („000) Copyright © 2008 The McGraw-Hill Companies. All rights reserved.11-34 Regression Analysis The correlation coefficient (r) is a measure of the linear relationship between variables such as cost and activity. approaching a maximum value of –1. .000 * * * * * * * * * This relationship has a negative correlation coefficient.000 * \$10.

the coefficient of determination. Inc. 200 50 McGraw-Hill/Irwin Regression with high R2 (close to 1. All rights reserved. is a measure of the goodness of fit. R2 tells us the amount of the variation of the dependent variable that is explained by the independent variable. .0) 100 150 Independent Variable 200 Copyright © 2008 The McGraw-Hill Companies.11-35 Regression Analysis 400 350 300 250 R2.

R2. is the correlation coefficient squared.11-36 Regression Analysis 400 350 300 250 The coefficient of determination. Inc. . All rights reserved. 200 50 McGraw-Hill/Irwin Regression with low R2 (close to 0) 100 150 Independent Variable 200 Copyright © 2008 The McGraw-Hill Companies.

Generates statistical information that describes the relationship between variables.11-37 Regression Analysis Includes all data points. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Inc. resulting in more thorough study of the relationship between the variables. All rights reserved. Permits the use of more than one cost driver activity to explain cost behavior. .

Let‟s look at an example using Excel. Copyright © 2008 The McGraw-Hill Companies.  Accountants and managers must be able to interpret and use regression estimates.  McGraw-Hill/Irwin .11-38 Regression Analysis  Statistics courses deal with detailed regression computations using computer spreadsheet software. Inc. All rights reserved.

11-39 Simple Regression Example Month January February March April May June July August September October November December January February March April Total Costs \$ 6.400 Units 1.060 7. .820 1.710 2.650 1.280 1. All rights reserved.830 3.790 7.370 6.580 9. Using the data to the right.260 1. let‟s see how to do a regression using Excel.260 7.810 1.620 2. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.580 8.840 1.720 7.610 2.850 1.550 13.320 7.060 12.640 3.990 11.050 11.660 8.480 6.270 11. Inc.940 Eagle Enterprises wants to analyze the relationship between units produced and total costs.620 2.630 2.460 2.

710 2.790 7. All rights reserved.630 2.400 Units 1.370 6.840 1. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Goodness of fit.820 1. Inc. Estimated Fixed Costs (line intercept) 3.060 12.620 2. or R2 To get these three pieces of Month January February March April May June July August September October November December January February March April Total Costs \$ 6.620 2.830 3. INTERCEPT and RSQ.810 1.640 3. Estimated Variable Cost per Unit (line slope) 2.940 information we will need to find the following Excel functions: LINEST.610 2.460 2.320 7.050 11.280 1.650 1.260 7.580 8.990 11.660 8.480 6.260 1.11-40 Simple Regression Using Excel We will obtain three pieces of information from our regression analysis: 1.720 7.580 9.850 1.550 13.060 7. .270 11.

11-42 Simple Regression Using Excel When the function box opens. then on “LINEST” McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. . click on “Statistical”. All rights reserved. Inc.

2. Inc. 1. All rights reserved. .11-43 Simple Regression Using Excel By clicking on the buttons to the left. Enter the cell range for the cost amounts in the “Known_y‟s” box. Enter the cell range for the quantity amounts in the “Known_x‟s” box. you can highlight the desired cells directly from the spreadsheet. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.

As previously.11-46 Simple Regression Using Excel The estimated fixed cost per unit is identified here. All rights reserved. Inc. enter the appropriate cell ranges in their appropriate places. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. .

McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Inc. All rights reserved. . determine the “goodness of fit”. or R2.11-47 Simple Regression Using Excel Finally. by using the RSQ function.

All rights reserved.11-48 Simple Regression Using Excel The estimated R2 for your estimated cost function is identified here. enter the appropriate cell ranges in their appropriate places. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Inc. . As previously.

. Inc.11-49 Simple Regression Example Summary The objective of the regression method is a linear equation to estimate costs TC = F + VX We found the following linear equation for Eagle: TC = \$2.72 + \$2. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. All rights reserved.26 percent of the variation in total cost is explained by the variation in the number of units produced.618.768 per unit The high value for R2 tells us that approximately 93.

Inc. demand for a product may be affected by factors such as inflation. McGraw-Hill/Irwin For example.11-50 Multiple Regression Analysis Multiple Regression is a regression that has more than one independent (X) variable. Copyright © 2008 The McGraw-Hill Companies. . Can be very useful in situations where the dependent variable is impacted by several different independent variables. interest rates and competitors‟ prices. All rights reserved.

Inc. .11-51 Multiple Regression Analysis Terms in the equation have the same meaning as in a simple regression. All rights reserved. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Here there are two or more independent variables instead of only one. TC = F + V1X1 + V2X2 Each additional independent variable increases the proportion of explained variation (R2) which is then adjusted for the number of independent variables.

McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. All rights reserved. Inc.  A logical relationship must be established between the variables.11-52 Regression Analysis Let me give you some pointers on regression analysis. .  Entering data into the analysis that have no logical relationship will result in meaningless estimates.

Inc. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.  The least squares procedure minimizes the sum of squares of the distances from the data points to the line.  Data points that vary significantly from the regression line (outliers) draw the regression line away from the majority of data points.11-53 Regression Analysis Let me give you some pointers on regression analysis. All rights reserved. .

11-54 Regression Analysis Let me give you some pointers on regression analysis. The intercept term should be used with caution to estimate fixed cost.  The intercept is likely to be outside the relevant range of observations as it occurs at an activity level of zero. All rights reserved. Inc. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. .

. . .11-55 Regression Analysis Let me give you some pointers on regression analysis. A regression equation may be a poor predictor of future costs if .  McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. Costs themselves have changed independently of changes in activity.  Cost-activity relationships have changed. Inc. . All rights reserved.

All rights reserved. Inc.11-56 Regression Analysis – Utilization Problems Regression results are questionable when:  Attempting to fit a linear equation to nonlinear data Failing to exclude outliers Including variables that have apparent but spurious relationships McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. .

Inc.11-59 Account Analysis Cost estimates are based on a review of each activity account making up the total cost being analyzed. All rights reserved. . Objective: Relate costs and activity in the form of the general cost equation: TC = F + VX McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.

All rights reserved.  Divide the fixed costs by the number of time periods in the data.  Sum the variable costs for each cost driver activity. . Inc.  Objective: TC = F + VX McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.  Divide the total variable costs for each cost driver activity by the total number of cost driver units to obtain variable cost per unit.11-60 Account Analysis  Identify cost drivers and the costs associated with each driver.  Sum the fixed costs (facility costs).

000 200 300 350 50 500 100 \$ 2. .650 Costs for 1.000 \$ 1.000 ÷ 1. Inc.Example Overhead Total Cost \$ 450 700 1.000 200 300 400 600 \$ 3. All rights reserved.000 units = \$2 per unit TC = \$1.650 + \$2 per unit McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.650 Account Indirect Labor Indirect Material Depreciation Property Taxes Insurance Utilities Maintenance Totals V = \$2.000 Units Variable Fixed Cost Cost \$ 450 700 1.11-61 Account Analysis .

11-62 Account Analysis .450 \$3. b.400 units using the cost relationship from the the preceding example. d. Inc.300 \$4.Example Estimate the total overhead cost for 1. . All rights reserved. c. a.650 \$5.650 McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. \$3.

650 + (\$2 × 1.650 TC = F + VX TC = \$1.Example Estimate the total overhead cost for 1. a. d.450 McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. . b.300 \$4. \$3.400 units) TC = \$1. c. All rights reserved. Inc.650 + \$2.450 \$3.650 \$5.11-63 Account Analysis .800 = \$4.400 units using the cost relationship from the the preceding example.

. based on: • Measurement of work involved in the activities that go into a product. Inc.11-65 Engineering Method Engineering estimates of cost are made. • Assigning a cost to each of the activities. Past costs are not taken into account. All rights reserved. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies.

11-66 Engineering Method Direct Labor Direct Material •Analyze the kind of work performed. •Use local wage rates to obtain labor cost per unit. •Estimate the time required for each labor skill for each unit. All rights reserved. Inc. McGraw-Hill/Irwin •Material required for each unit is obtained from engineering drawings and specification sheets. •Material prices are determined from vendor bids. . Copyright © 2008 The McGraw-Hill Companies.

Copyright © 2008 The McGraw-Hill Companies. McGraw-Hill/Irwin . All rights reserved.  The method is used to estimate costs of new activities.11-67 Engineering Method  Overhead costs are obtained in a similar manner – a detailed step-by-step analysis of the work involved. Advantages of the engineering approach: Detailed analysis results in better knowledge of the entire process. Data from prior activities are not required. Inc.  A disadvantage of the engineering approach is the high cost of detailed analysis.

Copyright © 2008 The McGraw-Hill Companies.11-68 Choice of an Estimation Method Each method will likely yield a different estimate. All rights reserved. Regression and account analysis rely on past data. McGraw-Hill/Irwin . Cost/Benefit must be considered in choosing a method. Inc. The engineering method relies on present data.

Regression provides a cost equation for the data points with statistical measures of fit. Better results are often obtained by use of several of the methods.11-69 Choice of an Estimation Method   No single method is best for all situations. All rights reserved. For example:    Engineering estimates and account analysis may lead to the establishment of logical. Inc. . McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. A scattergraph plot will lead to a better understanding of the relationship and may reveal outlier data points. causal relationships between variables.

feasibility of outsourcing Overall profitability under many cost and price scenarios Just keep in mind the limitations of these estimation techniques! McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies. . Inc.11-70 Use of the Results Cost estimation provides important information for forecasting:     Levels of demand under different prices Success of new products/services Adequacy of present production and office facilities. All rights reserved.