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# 11

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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## 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.

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## Increased company value

Better informed decisions about: efficient business processes alternative courses of action performance standards financial forecasts

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Exh. 11-1

## Reasons for Estimating Costs

1. First identify this 3. To reduce these

Costs

## We estimate costs to:

2. Then manage these

Activities

## manage costs make decisions plan and set standards.

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## Basic Cost Behavior Patterns

Summary of variable and fixed cost behavior
Cost Variable In total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per unit Variable cost per unit remains the same over wide ranges of activity. 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). X is the number of cost driver units.

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Learning Objective 2

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Exh. 11-2

## One Cost Driver and Fixed/Variable Cost Behavior

TC = \$190 + (.16 x Miles Driven)
\$600 \$500 \$400

\$.16

Cost

1000 2000 3000

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## Multiple Cost Drivers and Complex Cost Behavior

In cases of complex cost behavior and multiple cost drivers, the cost-benefit test should be considered when developing a cost estimation model.

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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

## 1,000 2,000 3,000 Rented Area (Square Feet)

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## Relevant Range of Activity

Unit variable costs remain unchanged.

The activity limits within which a cost projection may be valid is the relevant range of activity.

## Total fixed costs remain unchanged.

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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

## Minutes per month

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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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## Methods of Estimating Costs

Scattergraph and high-low estimates

## Statistical methods (regression analysis)

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

* * * *

* ** * **

## 0 0 1 2 3 4 Activity: Units produced (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

* * * *

* ** * **

## Estimated fixed cost = \$10,000

0 0 1 2 3 4 Activity: Units produced (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

* * * *

* ** * **

## Horizontal distance is the change in activity.

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

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## 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

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## 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.

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## 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.

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## 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

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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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## 100 150 Independent Variable

200

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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

## F = a fixed quantity, the intercept 50 100 150 Independent Variable 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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50
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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.

## 1 2 3 4 Activity: Units produced (000)

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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

## * * * * The correlation coefficient is near

zero if little or no relationship exists between the variables.

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

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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

## * * * * * * * * * This relationship has a negative

correlation coefficient, approaching a maximum value of 1.0

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

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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 with high R2 (close to 1.0)

100 150 Independent Variable 200

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Regression Analysis
400
350 300 250

## The coefficient of determination, R2, is the correlation coefficient squared.

200
50
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## Regression with low R2 (close to 0)

100 150 Independent Variable 200

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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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## Simple Regression Example

Month January February March April May June July August September October November December January February March April Total Costs \$ 6,720 7,260 7,270 11,060 12,580 8,660 8,580 9,550 13,050 11,060 7,320 7,370 6,790 7,480 6,990 11,400 Units 1,280 1,810 1,620 2,830 3,630 2,610 2,460 2,640 3,620 2,840 1,820 1,650 1,260 1,850 1,710 2,940

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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## Simple Regression Using Excel

We will obtain three pieces of information from our regression analysis: 1. Estimated Variable Cost per Unit (line slope) 2. Estimated Fixed Costs (line intercept) 3. Goodness of fit, 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 \$ 6,720 7,260 7,270 11,060 12,580 8,660 8,580 9,550 13,050 11,060 7,320 7,370 6,790 7,480 6,990 11,400 Units 1,280 1,810 1,620 2,830 3,630 2,610 2,460 2,640 3,620 2,840 1,820 1,650 1,260 1,850 1,710 2,940

## information we will need to

find the following Excel functions: LINEST, INTERCEPT and RSQ.
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## Simple Regression Using Excel

After opening Excel and entering your data, click on Insert and Function

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## Simple Regression Using Excel

When the function box opens, click on Statistical, then on LINEST

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## Simple Regression Using Excel

By clicking on the buttons to the left, you can highlight the desired cells directly from the spreadsheet.

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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## Simple Regression Using Excel

The Slope, or estimated variable cost per unit, is identified here. Click OK to put this value on your spreadsheet.

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## Repeat the procedure using Intercept, to estimate fixed cost.

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## As previously, enter the appropriate cell ranges in their appropriate places.

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## Simple Regression Using Excel

Finally, determine the goodness of fit, or R2, by using the RSQ function.

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## As previously, enter the appropriate cell ranges in their appropriate places.

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## 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 = \$2,618.72 + \$2.768 per unit

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 Analysis

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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## Multiple Regression Analysis

Terms in the equation have the same meaning as in a simple regression. 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.

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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.

## Data points that vary

significantly from the regression line (outliers) draw the regression line away from the majority of data points.

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 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.

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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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## 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

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## Regression Analysis Data Problems

Mismatched Time Periods

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.

## Sum the fixed costs (facility costs).

Sum the variable costs for each cost driver activity. Divide the total variable costs for each cost driver
activity by the total number of cost driver units to obtain variable cost per unit.

## Divide the fixed costs by the number

of time periods in the data.

Objective: TC = F + VX

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## Account Analysis - Example

Overhead Total Cost \$ 450 700 1,000 200 300 400 600 \$ 3,650 Costs for 1,000 Units Variable Fixed Cost Cost \$ 450 700 1,000 200 300 350 50 500 100 \$ 2,000 \$ 1,650

Account Indirect Labor Indirect Material Depreciation Property Taxes Insurance Utilities Maintenance Totals

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## Account Analysis - Example

Estimate the total overhead cost for 1,400 units using the cost relationship from the the preceding example. a. b. c. d. \$3,300 \$4,450 \$3,650 \$5,650

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## Account Analysis - Example

Estimate the total overhead cost for 1,400 units using the cost relationship from the the preceding example. a. b. c. d. \$3,300 \$4,450 \$3,650 \$5,650
TC = F + VX TC = \$1,650 + (\$2 1,400 units) TC = \$1,650 + \$2,800 = \$4,450

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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.

## Assigning a cost to each of the activities.

Past costs are not taken into account.

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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.

## The method is used to estimate costs of new

activities. Data from prior activities are not required.

## A disadvantage of the engineering approach is the high cost of detailed analysis.

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## Choice of an Estimation Method

Each method will likely yield a different estimate. Cost/Benefit must be considered in choosing a method.

Regression and account analysis rely on past data. The engineering method relies on present data.

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## Choice of an Estimation Method

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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## 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; 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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## Issues in Using Regressions

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.

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