Cost estimation: is the

development of well defined

relationship between the cost
object and its cost drivers for
the purpose of predicting the
cost

Predicting
Predicting costs
costs
of
of alternative
alternative .. .. .. ..

Activities,
Activities, processes,
processes,
or
or organizational
organizational
forms.
forms.

Implementation
Implementation
strategies.
strategies.

Strategic management requires accurate cost estimates to facilitate:

1.
1.strategic
strategic positioning
positioning analysis,
analysis, and
and strategy
strategy development
development

and
and analysis:
analysis: Cost
Costestimates
estimatesare
areparticularly
particularlyimportant
importantfor
forfirms
firmscompeting
competing

on
onthe
thebasis
basisof
ofcost
costleadership.
leadership.Cost
Costestimates
estimatesguide
guidemanagement
managementin
in
determining
which
management
techniques,
such
as
business
intelligence,
determining which management techniques, such as business intelligence,
target
targetcosting,
costing,or
ortotal
totalquality
qualitymanagement,
management,the
thefirm
firmshould
shouldemploy
employto
tosucceed
succeed
in
its
chosen
strategy.
in its chosen strategy.
2.
2.value
value chain
chain analysis:
analysis: Cost
Costestimates
estimateshelp
helpthe
thefirm
firmidentify
identifypotential
potential
opportunities
for
cost
reduction
by
reconfiguring
the
value
chain.
For
opportunities for cost reduction by reconfiguring the value chain. Forexample,
example,
cost
estimates
are
useful
in
determining
whether
overall
costs
and
value
cost estimates are useful in determining whether overall costs and valueto
tothe
the
product
can
be
improved
by
manufacturing
one
of
its
components
in-house
or
product can be improved by manufacturing one of its components in-house orby
by
purchasing
it
from
a
supplier
purchasing it from a supplier
3.
3.target
target costing
costing and
and life
life cycle
cycle costing:
costing: Cost
Costestimates
estimatesare
arean
anintegral
integral
part
of
target
costing
and
pricing.
Management
uses
cost
estimates
of
different
part of target costing and pricing. Management uses cost estimates of different
product
productdesigns
designsas
aspart
partof
ofthe
theprocess
processof
ofselecting
selectingthe
theparticular
particulardesign
designthat
that
provides
the
best
value
to
the
customer
while
reducing
manufacturing
and
provides the best value to the customer while reducing manufacturing andother
other
costs.
costs.

4.
4. effective
effective performance
performance measurement,
measurement, evaluation,
evaluation, and
and

compensation:
compensation: Cost
Costestimates
estimatesplay
playaakey
keyrole
rolein
indetermining
determiningcosts
costsin
in

business
businessunits,
units,which
whichaffect
affectdivision
divisionmanagers
managersfinancial
financialperformance
performanceand
and
opportunity
for
promotion
and
compensation
and
the
ability
to
attract
capital
opportunity for promotion and compensation and the ability to attract capital
investment
investmentto
totheir
theirdivision.
division.Accurate
Accuratecost
costestimates
estimatesplay
playaacrucial
crucialrole
rolein
in
performance
measurement
performance measurement


Define
Define the
the cost
cost object
object to
to be
be estimated.
estimated.

Determine
Determine the
the cost
cost drivers.
drivers.

Collect
Collect consistent
consistent and
and accurate
accurate data.
data.

Graph
Graph the
the data.
data.

Select
Select and
and employ
employ the
the estimation
estimation method.
method.

Assess
Assess the
the accuracy
accuracy of
of the
the cost
cost estimate.
estimate.

High-low
High-low
method
method

Work
Work
Measurement
Measurement

Regression
Regression
Analysis
Analysis

Cost Estimation Methods

The
The
management
management accountant
accountant isis interested
interested in
in estimating
estimating
maintenance
maintenance cost.
cost. He
He collected
collected this
this data
data for
for
seven
seven recent
recent years.
years.

Year
Total Operating Hours
Maintenance Costs

1995
3,451
22,843

1996
3,325
22,510

1997
3,383
22,706

1998
3,614
23,030

1999
3,423
22,413

2000
3,410
22,935

2001
3,500
23,175

High-Low Method
The high-low method uses two points to
estimate the general cost equation Y = a bH
Maintenance
Cost

Total Operating Hours

graph
graphthe
thedata
dataand
and
selected
selectedtwo
two
points--the
points--thehigh
high
and
andlow
lowactivities
activities..

High-Low Method
The high-low method uses two points to
estimate the general cost equation Y = a bH
Y = the value of the estimated
maintenance cost
a = a fixed quantity that represents
the value of Y when H = zero
b = the slope of the line, the unit
variable cost for maintenance.
H = the cost driver, the number of
hours of operation for the plant

High-Low Method
High activity level
Low activity level
Change

Hours
3,614
3,325
289

Cost
$ 23,030
22,510
$
520

Ben used these two levels of activity to compute:

the variable cost per unit;
the fixed cost; and then
express the costs in equation form Y = a +
bH.

High-Low Method
High activity level
Low activity level
Change

Hours
3,614
3,325
289

Cost
$ 23,030
22,510
$
520

Unit variable cost = $520 289 hours = $1.80 per hour

High-Low Method
High activity level
Low activity level
Change

Hours
3,614
3,325
289

Cost
$ 23,030
22,510
$
520

Unit variable cost = $520 289 hours = $1.80 per hour

Fixed cost = Total cost Total variable cost
Fixed cost = $23,030 ($1.80 per hour 3,614 hours)
Fixed cost = $23,030 $6,505 = $16,525

High-Low Method
High activity level
Low activity level
Change

Hours
3,614
3,325
289

Cost
$ 23,030
22,510
$
520

Unit variable cost = $520 289 hours = $1.80 per hour

Fixed cost = Total cost Total variable cost
Fixed cost = $23,030 ($1.80 per hour 3,614 hours)
Fixed cost = $23,030 $6,505 = $16,525
Total cost = Fixed cost + Variable cost (Y = a + bH)
Y = $16,525 + $1.80H

High-Low Method
Question 1

If
If sales
sales commissions
commissions are
are $10,000
$10,000 when
when 80,000
80,000
units
units are
are sold
sold and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold,
sold, what
what is
is the
the variable
variable portion
portion of
of
sales
sales commission
commission per
per unit
unit sold?
sold?
a.
a.
b.
b.
c.
c.
d.
d.

$.08
$.08 per
per unit
unit
$.10
$.10 per
per unit
unit
$.12
$.12 per
per unit
unit
$.125
$.125 per
per unit
unit

High-Low Method
Question 1

If
If sales
sales commissions
commissions are
are $10,000
$10,000 when
when 80,000
80,000
units
units are
are sold
sold and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold,
sold, what
what is
is the
the variable
variable portion
portion of
of
sales
sales commission
commission per
per unit
unit sold?
sold?
a.
a.
b.
b.
c.
c.
d.
d.

Units
120,000
80,000
40,000

Cost
$ 14,000
10,000
$ 4,000

$.08
$.08 per
per unit
unitHigh level
Low level
$.10
per
unit
$.10 per unitChange
$.12
$.12 per
per unit
unit
$4,000 40,000 units
$.125
$.125 per
per unit
unit
= $.10 per unit

High-Low Method
Question 2

If
If sales
sales commissions
commissions are
are $10,000
$10,000 when
when 80,000
80,000
units
units are
are sold
sold and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold,
sold, what
what is
is the
the fixed
fixed portion
portion of
of
the
the sales
sales commission?
commission?
a.
a.
b.
b.
c.
c.
d.
d.

$$ 2,000
2,000
$$ 4,000
4,000
$10,000
$10,000
$12,000
$12,000

High-Low Method
Question 2

If
If sales
sales commissions
commissions are
are $10,000
$10,000 when
when 80,000
80,000
units
units are
are sold
sold and
and $14,000
$14,000 when
when 120,000
120,000
units
units are
are sold,
sold, what
what is
is the
the fixed
fixed portion
portion of
of
the
the sales
sales commission?
commission?
a.
a.
b.
b.
c.
c.
d.
d.

$$ 2,000
2,000
$$ 4,000
4,000
$10,000
$10,000
$12,000
$12,000

Total cost = Total fixed cost +

Total variable cost
$14,000 = Total fixed cost +
($.10 120,000 units)
Total fixed cost

= $14,000 - $12,000

Total fixed cost

= $2,000

Work Measurement
A
Acost
cost estimation
estimation
method
method that
that makes
makes aa
detailed
detailed study
study of
of an
an
activity
activity to
to measure
measure the
the
time
time required
required per
per unit
unit
of
of output.
output.
Example

Work Measurement
An insurance company analyzes the time it takes to
process a claim. The mean processing time is 18
minutes, while 95% of the claims require between 10
and 25 minutes.
This
This information
information enables
enables the
the company
company to
to

estimate
estimate cost
cost more
more effectively.
effectively.

evaluate
evaluate the
the processing
processing clerks
clerks more
more
effectively
effectively and
and fairly.
fairly.

Regression Analysis
Regression
Regression analysis
analysis isis aa
statistical
statistical method
method for
for
obtaining
obtaining the
the cost
cost
estimation
estimation unique
unique
equation
equation that
that best
best fits
fits
aa set
set of
of data
data points.
points.

Least
Least squares
squares regression
regression is
is
widely
widely viewed
viewed as
as one
one of
of the
the
most
most effective
effective methods
methods for
for
estimating
estimating costs.
costs.

Regression Analysis
Statistics
Statistics courses
courses and
and
computer
computercourses
courses deal
deal
with
with detailed
detailed
regression
regression
computations
computations using
using
computer
computerspreadsheet
spreadsheet
software.
software.
Accountants
Accountants and
and managers
managers must
must
be
be able
able to
to interpret
interpret and
and use
use
regression
regression estimates.
estimates.

Regression Analysis
The objective of the regression method is still a
linear equation to estimate costs Y = a + bX + e
Y = value of the dependent variable, estimated cost
a = a fixed quantity, the intercept, that
represents the value of Y when X = 0
b = the unit variable cost, the coefficient of
the independent variable measuring the
increase in Y for each unit increase in X
X = value of the independent variable, the cost driver
e = the regression error, the distance from
the regression line to the data point

Regression Analysis
Month
Month Supplies
Supplies Expense
Expense (Y)
(Y) Production
Production Level
Level (X)
(X)
11
$250
50
$250
50 units
units
22
310
100
310
100 units
units
33
325
150
325
150 units
units
44
??
125
125 units
units
Regression
Regression analysis
analysis will
will
enable
enable us
us to
to predict
predict the
the amount
amount of
of supplies
supplies
expense
expense for
for month
month four.
four.

Regression Analysis
400

Supplies Expense

350
300
Regression for the data is
determined by a statistical procedure
that finds the unique line through
the data points that minimizes
the sum of squared error distances.

250
200
50

100
150
Units of Output

Regression Analysis
Month
Month Supplies
Supplies Expense
Expense (Y)
(Y) Production
Production Level
Level (X)
(X)
11
$250
50
$250
50 units
units
22
310
100
310
100 units
units
33
325
150
325
150 units
units
44
??
125
125 units
units
Y
Y == aa ++ bX
bX ++ ee
Y
Y == $220
$220 ++ $.75
$.75 per
per unit
unit 125
125 units
units
Y
Y == $313.75
$313.75

Expense
Expense estimate
estimate for
for month
month 44

Regression Analysis
400

b = the slope of the regression line or the

coefficient of the independent variable
b = $.75 per unit

Supplies Expense

350

e = 15
300

e = 7.5

e = 7.5
250
220
Fixed Cost = $220

200
50

100
150
Units of Output

Regression Analysis
proper line, excluding the outlier
improper line, influenced by outlier

Supplies Expense

400
350
300

Outlier

250
Outliers may be discarded to
obtain a regression that is more
representative of the data.

200
50

100
150
Units of Output

200

Regression Analysis
Evaluating a Regression Analysis
RR22,, the
the coefficient
coefficient of
of determination,
determination,
isis aa measure
measure of
of the
the explanatory
explanatory power
power
of
of the
the regression,
regression, the
the degree
degree that
that
changes
changes in
in the
the dependent
dependent
variable
variable can
can be
be predicted
predicted by
by changes
changes
in
in the
the independent
independent variable.
variable.

The
The t-value
t-value isis aa measure
measure
of
of the
the reliability
reliability of
of each
each of
of
the
the independent
independent variables.
variables.

The
The standard
standard error
error of
of the
the estimate
estimate (SE)
(SE) isis aa measure
measure
of
of the
the accuracy
accuracy of
of the
the regressions
regressionsestimates.
estimates.

Regression Analysis

Dependent Variable

400
350
300

Regression with
high R2 (close to 1.0)

250
200
50

100
150
Independent Variable

200

Regression Analysis

Dependent Variable

400
350
300

Regression with
low R2 (close to 0)

250
200
50

100
150
Independent Variable

200

Regression Analysis

Dependent Variable

400

sta

350

nd
a

rd

er

ro
r

300
Standard error is a range around the
regression estimate in which we
can be reasonably sure that the
unknown value will fall.

250
200
50

100
150
Independent Variable

200

Slide 7-34

Regression Analysis

Dependent Variable

400
350

st

ror
r
e
d
r
a
d
an

300
250

Regression with Wide

(Poor) Standard Error

200
50

100
150
Independent Variable

200

Regression Analysis

Dependent Variable

400
350

d
s t an

ror
r
e
rd

300
250

Regression with Narrow

(Good) Standard Error

200
50

100
150
Independent Variable

200

Regression Analysis
Data
Data and
and Implementation
Implementation Problems
Problems

Data
Data Accuracy
Accuracy

Selecting
Selecting the
the time
time period
period

Mismatched
Mismatched time
time period
period

Length
Length of
of the
the time
time period
period

Length of the time period

Nonlinearity
Nonlinearity problems
problems

Trend
Trend and/or
and/or seasonality
seasonality

Outliers
Outliers

Outliers

Data
Data shift
shift

The End