Section I |

Part I

Cost Estimation
Section I |
Part I
Intended learning outcomes
Explore the meaning of cost estimation.
Identify and describe methods of estimating cost.
Estimate cost using different methods.
 Cost Estimation
Section I |
Part I
Defined as a study which attempts to predict the
relationship between costs and the activity level or
cost drivers based on an analysis of historical costs.
cost estimation occurs when an individual attempts to
measure historical costs in order to predict future costs.
Measurement of past costs for the purpose of
predicting future costs for decision-making purposes.
Cost estimation techniques attempt to establish cost
function to estimate costs within a relevant range.
A problem with a cost overruncan be avoided with a
credible, reliable, and accurate cost estimate
Section I |
Part I
The Goal of Cost Estimation

• The ultimate goal of cost estimation is to determine

the amount of fixed and variable costs to create a cost
formula to be used to predict future costs.
• The cost formula, or cost equation, is the output of the
cost estimation process. Because you have only one
variable (number of units), the formula will be a
straight line, or linear equation.
• (You should remember the concept of functions from
your math classes.
 Section I | Cont…

Part I
1) The formula that represents the equation of a
line will appear in the format of:
The cost estimating function is
y = a + bx,
• Where
TC=FC+VQ
• Y represents Total cost
• a represents fixed cost component of the total cost, the
y-intercept
• bx represents the variable costs component of the total
cost
• b represents the unit variable cost (this is the gradient of
the equation, slope of the line)
• x represents output level
Section I |
Part I

Cont…
• Recall that the Y = TFC+VQ is the equivalent equation
used in accounting for estimating costs.
• The total cost side of the equation (Y) can also be
expressed as f(x) so that the formula appears as:
• TC = VQ + TFC
• As such, the equation is often referred to as a
function. In accounting, it is referred to as a cost
function because the 'Y' equates to total cost.
Section I |
Part I
Purpose of Estimation
• Determining a linear function is useful in predicting cost
amounts at different levels of activity.
• This is useful because managers must be able to predict
costs to plan for future operations.
• Cost estimation is useful in the execution of managerial
functions: planning, cost control, performance
evaluation etc.

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Section I |
Part I
Cost estimation components
Your goal it to determine the cost equation for a
particular cost, so that managers can estimate 'total'
costs at various activity levels.
The cost equation will contain the variable cost per unit
and total fixed costs
 Section I |
Part I
Cost estimation methods:
Engineering method
Accounts analysis
High-low method
Scatter graph method
Ordinary Least Squares Regression Method
 Section I |
Part I
1) Engineering Method
• The Engineering Cost Estimating method builds the overall cost
estimate by summing detailed estimates done at lower levels of the
Work Breakdown Structure (WBS).
• It’s a technique where the system being costed is broken down into
lower-level components (such as parts or assemblies), each of which is
costed separately for direct labor, direct material, and other costs.
• Engineering estimates for direct labor hours may be based on analyses
of engineering drawings and contractor or industry-wide standards.
• Engineering estimates for direct material may be based on discrete raw
material and purchase part requirements. The remaining elements of
cost (such as quality control or various overhead charges) may be
factored from the direct labor and material costs.
• The use of engineering estimates requires extensive knowledge of a
system’s (and its components’) characteristics, and lots of detailed data.
Section I |
Part I

Conti…
The several advantages to the Engineering Cost estimating method
include:
• The estimator’s ability to determine exactly what the estimate includes
and whether anything was overlooked,
• Its unique application to the specific program and manufacturer,
• That it gives good insight into major cost contributors, and
• Easy transfer of results to other programs.
• Some disadvantages of the Engineering Cost estimating method
include:
• It can be expensive to implement and it is time consuming
• It is not flexible enough to answer what-if questions
• New estimates must be built for each alternative
• The product specification must be well known and stable
• All product and process changes must be reflected in the estimate
Section I |
Part I

2) Account Analysis

• Under account analysis method, the accountant

examines and classifies each cost as variable, fixed
or mixed.
• Mixed accounts are broken down into their variable
and fixed components. They base these
classifications on experience, inspection of cost
behavior for several past periods or intuitive
feelings of the manager.
• This is with a view to develop a cost function in the
form y = a + bx
Section I |
Part I

Cont…
• This approach involves looking at a cost and analyzing its most
likely type of cost behavior. This method requires considerable
subjective judgment and insight.
• It is most often used by accountants or managers who are familiar
with the nature of costs within a general ledger account (often
multiple accounts). Account analysis is the only method you can
use to estimate costs when only one period of data is known.
• The account analysis approach requires that each individual cost
is examined and based on judgment is categorized as a fixed or
variable cost.
• Then all variable costs are totaled. Variable cost per unit is
calculated by dividing the total of all variable costs by the number
of units produced and sold.
 Section I |
Part I
Conti…

Total variable costs

= Variable cost per unit

Number of units produced and sold

The variable cost per unit is plugged into the cost formula as the variable cost
(VC). The fixed costs are totaled separately. This results in a cost equation that
can be used to estimate costs for future periods.

TC=FC+VQ
V Variable cot per unit
Y=a +bx

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 Section I |
Part I

Illustration one
Management has estimated Shs.1,090 variable costs,
Shs.1,430 fixed costs to make product X using 500
machine hours.
TC=FC+VQ
Since machine hours drives variable costs in our example,
the variable cost is stated as 2.18(1090/500).
Then we get the total cost equation as
Y = 1,430 + 2.18X

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 Section I |
Part I
Illustration two

• Home Shine is estimating its fixed and variable costs. The following costs were
incurred during the month of May,2020 by Home Shine when 200 homes were
cleaned:
Cleaning supplies VC 2,400

Hourly wages -VC 4,850

Depreciation (straight-line) - cleaning equipment - FC 650

Manager’s salary-FC 1,400

Auto commuting expenses-Vc 1,600

Office rent-Fc 850

Total costs 11,750

Use the account analysis method to determine the total cost equation for Home
Shine

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 Section I |
Part I
Solution

Step 2: Add the costs you identified as variable.

• 2,400 + 4,850 + 1,600 = 8,850
Calculate variable cost per unit by dividing the total of the variable costs by the number of
units (homes) produced and sold (homes cleaned).
8,850
= 44.25
200

Step 3: Add the costs you identified as fixed costs

650 + 1,400 + 850 = 2,900
Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope with
the variable cost per unit and the Y-intercept with total fixed costs:
• Y = 2,900+ 44.25x
• The cost equation indicates that the total cost of cleaning homes is 44.25 per home plus
a monthly cost of 2,900.
• X=300

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Section I |
Part I
Illustration three
Section I |
Part I

Illustration four
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Part I
Advantages and disadvantages of accounts analysis

The accounts analysis method is easy to use and useful when

a quick cost forecast is required.
The model’s reliability and validity cannot be determined as
we cannot measure the size of probable error in forecasts
made i.e. it lacks statistical vigor.
The method is highly subjective

MIS Notes
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 Section I |
Part I
3) High-low method/Two-point method/Range
• High/low analysis compares the costs at two different activity levels
so as to identify the fixed and variable costs components of the total
costs.
• The difference in cost between high and low activity level is taken
to be the total variable cost from which the unit variable cost can be
computed by dividing it by the change in output level.
This is indicated below:
Unit Variable cost = Cost at high level activity – cost at low level activity
Units at high activity level – units at low activity level
 Section I |
Part I
Conti….
It is used where there is:
• Insufficient data
• Straight line relationship between dependent and independent
variables exist.
• The limitations of the high-low method are as follows:
• Its reliance on historical data, assuming that (i) activity is the only
factor affecting cost and (ii) historical costs reliably predict future costs.
• The use of only two values, the highest and the lowest, means that the
results may be distorted because of random variations in these values.
 Section I |
Partunder
Steps I high-low method
• Step 1: Determine which data represents the total cost (dependent variable, Y)
and which represents the activity (independent variable, x). Find the lowest and
highest activity points in the data representing the x variable.
• Step 2: Determine variable costs per unit by using the mathematical slope
formula which divides 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
• Y1 is the total cost at the low activity level
Section I |
Part I

Illustration one
 Section I |
Part I
Illustration two
Information concerning units sold and total delivery costs for Bridges, Inc. for five
months of 2015 appears below:
Month Units Costs
January 1,200 74,150
February 1,150 71,000
March 1,190 72,400
April 1,300 80,600
May 1,310 79,040

• Use the high-low method to answer the following:

• A. How much is the variable cost per unit?
• B. How much are total fixed costs?
• C. Write the cost equation in proper form.
 Section I |
Part I
Solution
Y2 - Y1 79,040 - 71,000

=
= 50.25 per unit
Y2 - Y1 1,310 - 1,150

The variable cost per

.
unit is 50.25
71,000 = (50.25 x 1,150) + TFC
Solve for total fixed costs (TFC), which results in 13,212.50.
TC = 50.25x + 13,213
Y= 13,215.50 + 50.25X
 Section I |
Part I
4) Visual fit (scatter graph method)

For this method a scatter diagram is constructed

which is used to visually i.e. by inspection deduce a
relationship from observed pattern if there is any. By
obtaining any two points on
Cost estimation is based on past data regarding the
dependent variable and the cost driver.
The past data on cost levels and the output levels is
plotted on a graph (called a scatter graph) and a line
of best fit is drawn as shown in the diagram.

MIS Notes
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 Section I |
Part I

A line of best fit is a line drawn so as to cover the

most points possible on a scatter graph.
 It can also be defined as ‘a straight line used as a
best approximation of a summary of all the points
in a scatter-plot’.
Its intersection with the vertical axis indicates the
fixed cost while the gradient indicates the variable
cost per unit.

MIS Notes
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Section I |
Part I

Illustration
Assume a firm has total costs of 8m, 4m and 1m
respectively when the output units are 400,000,
200,000 and respectively.
• Required:
• Using scatter graph estimate its cost equation using
the visual fit method.
• Compute the total cost if the activity level is
600,000 units.
Section I |
Illustration
Part I
 Section I |
Part I
• Advantages of visual fit method
• It takes into account all the observations unlike the high low
method.
• It is easy to apply.
• Disadvantages of visual –fit method
• It cannot be used for two or more independent variables
• We cannot measure the size of probable error.
• It is subjective to some extent.

costing
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Section I |
Part I
5) Ordinary least squares regression method

• Regression analysis is a technique that uses a statistical model to

measure the amount of change in one variable (dependent variable) that
is associated with changes in amounts of one or more variables.
• It involves estimating the cost function using past data on the dependent
and the independent variables. The cost function will depend on the
relationship between the dependent variable and the independent
variable.
• The dependent variable will constitute the relevant cost which may be
service, variable cost, and overhead cost e.t.c. The independent variable
will be the cost drivers where the cost drivers will be labour hours, units
of labour or raw materials, units of output e.t.c.
• In regression analysis, a regression model of the form y= a + bx for a
simple regression is obtained. For a multiple regression, a regression
model of the form Y = a + b1x1 +b2x2 + bnxn is obtained
Section I |
Part I
Conti…

• y = a + bx
• where y is total cost – the dependent variable
• a is fixed cost, x1,x2,xn are cost drivers
• b1,b2 bn are changes in cost with the change in value of
cost driver i.e. variable cost per unit of change in x1,x2,xn
• The values of a and b are determined after substituting
data.
Section I |
Part I

Conti…
Section I |
Test of reliability
Part I
Various tests of reliability can be applied to see how
reliable potential cost drivers are in predicting the
dependent variable.
The most simplistic approach is to plot the data for
each potential cost driver and examine the distances
from the straight line derived from the visual fit (using
graphical method) or the least squares regression
equation.
A more sophisticated approach is to compute the
coefficient of variation ( known as R²). Also known as
coefficient of determination.

35
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Part I

Conti…
• If the regression line calculated by the least square method
were to fit the actual observations
perfectly, then all observed points would lie on the
regression line.

• The coefficient of determination, r2, explains the amount of

variation in Y which is explained by the introduction of X in
the model.
•
A perfect linear relationship between X and Y would result in
r2 being equal to 1
Section I |
Part I

coefficient of variation
Section I |
Part I

Thank you

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