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Cost Estimation
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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.
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Learning Objective 1
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Management needs to know the costs that are likely to be incurred for each alternative.
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Better informed decisions about: efficient business processes alternative courses of action performance standards financial forecasts
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Exh. 11-1
Costs
Activities
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Fixed
Total Costs = Fixed costs + Variable costs TC = F + VX V is the variable cost per cost driver unit (cost driver rate). X is the number of cost driver units.
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Learning Objective 2
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Exh. 11-2
Cost
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Step Costs
Step Cost
A cost that increases in steps as the amount of the cost driver volume increases. Also called a semifixed cost Activity Total cost remains unchanged over a narrow range of activity. As activity increases to the next range, total cost steps up to the next level.
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Cost
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Step Costs
Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost.
Continue
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Step Costs
$90,000
Total cost remains unchanged for a range of activity, then jumps to a higher cost for the next range of activity.
$60,000
$30,000
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The activity limits within which a cost projection may be valid is the relevant range of activity.
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Mixed Costs
Exhibit 11-4: Mixed Cost Example
80
A mixed cost is one that has both a fixed and a variable component. For example, a cellular phone plan that charges $40 for the first 600 minutes and $0.10 per minute thereafter.
60
Cost
40
20
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Nonlinear Costs
Curvilinear Cost Function
Total Cost
Relevant Range
A nonlinear cost pattern (e.g. changes in unit variable cost) may often approximate a straight line (when the unit variable cost is constant) within the relevant range.
Activity
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Account analysis
Engineering method
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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. It can reveal outlier data points and suggest possible relationships between the variables.
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The Scattergraph
Plot the data points on a graph (total cost vs. activity). $20,000
$10,000
* * * *
* ** * **
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The Scattergraph
Draw a line through the plotted data points so that about an equal amount of points falls above and below the line.
$20,000
$10,000
* * * *
* ** * **
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The Scattergraph
The slope of this line is the unit variable cost. (Slope is the change in total cost for a one-unit change in activity).
Total Cost
$20,000
$10,000
* * * *
* ** * **
0
0 1 2 3 4 Activity: Units produced (000)
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$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.
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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.
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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
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Learning Objective 3
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Regression Analysis
A statistical method used to create an equation relating dependent (or Y) variables to independent (or X) variables. Data from the past are used to estimate relationships between costs and activities.
Independent variables are the cost drivers that drive the variation in dependent variables.
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Before doing the analysis, take time to determine if a logical relationship between the variables exists.
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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, the intercept, 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, the cost driver
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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
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Regression Analysis
400
350 300 250
V = the slope of the regression line or the coefficient of the independent variable. Here it represents the increase in TC for each unit increase in X.
200
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Regression Analysis
400
350 300 250
proper line, excluding the outlier improper line, influenced by outlier
Outlier
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Outliers may be discarded to obtain a regression that is more representative of the data.
100 150 Independent Variable 200
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Regression Analysis
The correlation coefficient (r) is a measure of the linear relationship between variables such as cost and activity.
Total Cost
$20,000
$10,000
* * * *
0
* ** * **
The correlation coefficient is highly positive (close to 1.0) if the data points are close to the regression line.
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Regression Analysis
The correlation coefficient (r) is a measure of the linear relationship between variables such as cost and activity.
Total Cost
$20,000
* *
$10,000
0 0
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Regression Analysis
The correlation coefficient (r) is a measure of the linear relationship between variables such as cost and activity.
$20,000
$10,000
0 0
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Regression Analysis
400
350 300 250 R2, the coefficient of determination, 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.
200
50
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Regression Analysis
400
350 300 250
200
50
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Regression Analysis
Includes all data points,
resulting in more thorough study of the relationship between the variables. Generates statistical information that describes the relationship between variables. Permits the use of more than one cost driver activity to explain cost behavior.
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Regression Analysis
Statistics courses deal with detailed regression computations using computer spreadsheet software.
Accountants and managers must be able to interpret and use regression estimates. Lets look at an example using Excel.
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Eagle Enterprises wants to analyze the relationship between units produced and total costs.
Using the data to the right, lets see how to do a regression using Excel.
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After opening Excel and entering your data, click on Insert and Function
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1. Enter the cell range for the cost amounts in the Known_ys box. 2. Enter the cell range for the quantity amounts in the Known_xs box.
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The Slope, or estimated variable cost per unit, is identified here. Click OK to put this value on your spreadsheet.
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The high value for R2 tells us that approximately 93.26 percent of the variation in total cost is explained by the variation in the number of units produced.
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Multiple Regression is a regression that has more than one independent (X) variable.
Can be very useful in situations where the dependent variable is impacted by several different independent variables.
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For example, demand for a product may be affected by factors such as inflation, interest rates and competitors prices.
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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.
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Regression Analysis
Let me give you some pointers on regression analysis.
A logical relationship
must be established between the variables.
Entering data into the analysis that have no logical relationship will result in meaningless estimates.
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Regression Analysis
Let me give you some pointers on regression analysis.
The least squares procedure minimizes the sum of squares of the distances from the data points to the line.
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Regression Analysis
Let me give you some pointers on regression analysis.
The intercept is likely to be outside the relevant range of observations as it occurs at an activity level of zero.
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Regression Analysis
Let me give you some pointers on regression analysis.
A regression equation
may be a poor predictor of future costs if . . . .
Cost-activity relationships have changed. Costs themselves have changed independently of changes in activity.
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Failing to exclude
outliers
Including variables
that have apparent but spurious relationships
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Missing Data
Inflation
Allocated Costs
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Learning Objective 4
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Account Analysis
Cost estimates are based on a review of each activity account making up the total cost being analyzed.
Objective: Relate costs and activity in the form of the general cost equation: TC = F + VX
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Account Analysis
Identify cost drivers and the costs associated with each
driver.
Objective: TC = F + VX
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Account Indirect Labor Indirect Material Depreciation Property Taxes Insurance Utilities Maintenance Totals
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Learning Objective 5
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Engineering Method
Engineering estimates of cost are made, based on:
Measurement of work
involved in the activities that go into a product.
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Engineering Method
Direct Labor Direct Material
Analyze the kind of work performed. Estimate the time required for each labor skill for each unit. Use local wage rates to obtain labor cost per unit.
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Material required for each unit is obtained from engineering drawings and specification sheets. Material prices are determined from vendor bids.
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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.
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Regression and account analysis rely on past data. The engineering method relies on present data.
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No single method is best for all situations. Better results are often obtained by use of several of the methods. For example:
Engineering estimates and account analysis may lead to the establishment of logical, causal relationships between variables. A scattergraph plot will lead to a better understanding of the relationship and may reveal outlier data points. Regression provides a cost equation for the data points with statistical measures of fit.
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Levels of demand under different prices Success of new products/services Adequacy of present production and office facilities; feasibility of outsourcing Overall profitability under many cost and price scenarios
Just keep in mind the limitations of these estimation techniques!
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Learning Objective 6
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This technique does not provide exact measurements. It yields good approximations of the actual relationships between cost drivers and costs. There is seldom 100% confidence about a relationship between dependent and independent variables. It cannot be always assumed that the cost estimation errors are normally distributed, independent and with constant variation. So-called independent variables may be in fact closely correlated.
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Learning Objective 7
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Learning Curve
Time
The learning phenomenon: as we gain in experience, we take less time to perform a task.
Repeated tasks
For cost estimation: as cost driver activity increases, the learning phenomenon leads to lower costs per unit and greater profitability.
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Minimum profit
Incremental profit
Output
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End of Chapter 11
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