COST ESTIMATION

Introduction: Cost estimation may be defined as a study which attempts to predict the between costs and the activity level or cost driver that causes those costs. In practice, managers frequently encounter such cost drivers (what is a cost 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 cost a represents cost fixed component of the total cost bx represents the variable costs component of the total cost b 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 activities a) It assists in determining the net benefits anticipated in a specific activity based on the relationship between 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 method b) Account Analysis c) Engineering Analysis d) Visual Fit (Scatter graph) method e) Simple linear regression analysis f) Learning curve Theory a) High Low method Here, cost estimation is based on the relationship between past cost and past level of activity. Variable cost 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 cost from which the unit variable cost can be computed by dividing it by the change in output level. This is indicated below: Total Variable Cost = Cost at high activity level Cost at low activity level Therefore, Unit Variable cost = Variable cost Output Units = Cost at high level activity cost at low level activity Units at high activity level units at low activity level

The variable cost per unit so calculated forms the bof the straight line equation mentioned earlier. By substituting 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 for the year ended 31 December 2004 : Labour hours Highest activity level Lowest activity level 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 activity Output Units Units at high activity level units at low activity level Variable Cost Per Unit = Shs.200,000 shs.150,000 800 hrs 300 hrs = Shs.50,000 500 hrs Therefore b = 100 To get the fixed cost a, substitute b into 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 x 200,000 = a + (100) 800 200,000 = a + 80,000 a = 200,000 80,000 a = 120,000 Therefore fixed costs = shs.120,000 NB: Even if we used the 2nd 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) = shs.100/hr 800 300 Service cost (Shs) 200,000 150,000

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 at 1000 labour hours, then the total cost would be Y= 120,000 + 1000(100) =120,000 + 100,000 = Shs.220,000. What are the advantages and disadvantages of the high low method? b) Account Analysis (Inspection of Accounts) Using account analysis, the accountant examines and classifies each ledger account 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 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 500 machine 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 x Where y = total cost x = number of machine hours For 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 total cost. A danger in using this method lies in the fact that many managers may assume a costs behaviour without further 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 for materials, labour and equipment necessary to produce a product. It involves identifying the level of input required of an activity in form of raw material and labour while total cost is based on the cost of each input. This approach is applicable where no past data exists. The main setback of the approach is that it requires a complex analysis of all the constituents of an activity and the requirements of an activity in terms 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 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 . A line of best fit is a line drawn so as to cover the most points possible on a scatter graph. Its intersection with the vertical axis indicates the fixed cost while the gradient indicates the variable cost per unit.

Illustration: Assume a firm has total costs of 8m, 4m and 1m respectively when the output units are 400,000, 200,000 and respectively. Estimate its cost equation using the visual fit method. 10 9 Dependant Variable (Total Cost) 8 7 6 5 4 3 2 1m X X2 0 200,000 X3 400,000 Independent Variable (Output Level)
Fixed Cost X 0 1m Note : Change in Gradient Change in

X X X X X X X X X X X X X X X X X X X X

Y X

Y3 - Y2 X3 X2

Variable Cost Per Unit

= 20

Variable cost = Change in cost = Per unit Change in activity level

8m 4m 400,000 200,000

Total cost equation y = 1m + 20 x

On the basis of the existing data, fixed cost is Shs 1m and the variable cost per unit is 20. On the basis of the developed model, estimates can be made regarding future cost. When the activity level is 600,000 units, total cost will be estimated as: TC = 1M + 20 (600,000) = 1M + 12M = 13 M e) Regression analysis It involves estimating the cost function using past data or the dependent and the independent variables. The cost function is based on the regression of the relevant variables. The cost function will depend on the relationship between the dependant variable and the independent variable. The dependent variable will constitute the relevant cost which may be service, variable cost, 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 Where a is fixed cost, x1,x2,xn are cost drivers x1,x2,x3 upto xn. 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 y is the dependant variable (Total cost) Note that a simple regression produces a cost function of the form y = a + bx so that we only have only one variable cost per unit (b) and only one independent variable (cost driver) x.. However, a multiple regression produces a cost function of the form y = a + b1,x1+ b2, x2 + bn,xn so that we have several variable costs per unit (b1,b2,bn) and several independent variables (x1,x2,xn)