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7 Cost Estimation

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The Strategic Role 7-2

of Cost Estimation

Predicting costs
of alternative . . . .

Activities, processes,
Implementation
or organizational
strategies.
forms.

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Using Cost Estimation to 7-3

Predict Future Costs

Strategic management requires
accurate cost estimates to facilitate:

 strategic positioning
analysis.
 value chain analysis.
 target costing and life
cycle costing.

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The Six Steps of Cost Estimation

 Define the cost object to be estimated.

 Determine the cost drivers.
 Collect consistent and accurate data.
 Graph the data.
 Select and employ the estimation method.
 Assess the accuracy of the cost estimate.

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Cost Estimation Methods

High-low Work
method Measurement

Regression
Analysis

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Cost Estimation Methods

Ben Garcia, the

management accountant,
is interested in estimating
maintenance cost. Ben
collected this data for
seven recent years.

Year 1995 1996 1997 1998 1999 2000 2001

Total Operating Hours 3,451 3,325 3,383 3,614 3,423 3,410 3,500
Maintenance Costs 22,843 22,510 22,706 23,030 22,413 22,935 23,175

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High-Low Method
The high-low method uses two points to
estimate the general cost equation Y = a  bH

Maintenance
Cost
23,200
23,000
22,800
22,600
22,400 Ben graphed the
22,200 data and selected
x
22,000
3325 3383 3410 3423 3451 3501 3614
two points--the
high and low
Total Operating Hours
activities.
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High-Low Method
The high-low method uses two points to
estimate the general cost equation Y = a  bH

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
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High-Low Method

Hours Cost
High activity level 3,614 $ 23,030
Low activity level 3,325 22,510
Change 289 $ 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 + bH.
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High-Low Method

Hours Cost
High activity level 3,614 $ 23,030
Low activity level 3,325 22,510
Change 289 $ 520

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

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High-Low Method

Hours Cost
High activity level 3,614 $ 23,030
Low activity level 3,325 22,510
Change 289 $ 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

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High-Low Method

Hours Cost
High activity level 3,614 $ 23,030
Low activity level 3,325 22,510
Change 289 $ 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 + bH)
Y = $16,525 + $1.80H
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High-Low Method Question 1
If sales commissions are $10,000 when 80,000
units are sold and $14,000 when 120,000 units
are sold, what is the variable portion of sales
commission per unit sold?

a. $.08 per unit

b. $.10 per unit
c. $.12 per unit
d. $.125 per unit

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High-Low Method Question 1
If sales commissions are $10,000 when 80,000
units are sold and $14,000 when 120,000 units
are sold, what is the variable portion of sales
commission per unit sold?
Units Cost
a. $.08 per unit High level 120,000 $ 14,000
b. $.10 per unit Low level 80,000 10,000
Change 40,000 $ 4,000
c. $.12 per unit
d. $.125 per unit $4,000 ÷ 40,000 units
= $.10 per unit
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High-Low Method Question 2
If sales commissions are $10,000 when 80,000
units are sold and $14,000 when 120,000 units
are sold, what is the fixed portion of the sales
commission?

a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000

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High-Low Method Question 2
If sales commissions are $10,000 when 80,000
units are sold and $14,000 when 120,000 units
are sold, what is the fixed portion of the sales
commission?

Total cost = Total fixed cost +

a. $ 2,000 Total variable cost

b. $ 4,000 $14,000 = Total fixed cost +

($.10 × 120,000 units)
c. $10,000
Total fixed cost = $14,000 - $12,000
d. $12,000
Total fixed cost = $2,000

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Work Measurement

A cost estimation
method that makes a
detailed study of an
activity to measure the
time required per unit
of output.

Example

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Work Measurement
Kupper 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 information enables Kupper to

 estimate cost more effectively.

 evaluate the processing clerks

more effectively and fairly.

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Regression Analysis

Regression analysis is a
statistical method for
obtaining the cost
estimation unique
equation that best fits
a set of data points.
Lease squares regression is
widely viewed as one of the
most effective methods for
estimating costs.
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Regression Analysis
Statistics courses and
computer courses deal
with detailed
regression
computations using
computer spreadsheet
software.
Accountants and managers
must be able to interpret
and use regression
estimates.
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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
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Regression Analysis
Month Supplies Expense (Y) Production Level (X)
1 $250 50 units
2 310 100 units
3 325 150 units
4 ? 125 units

Regression analysis will

enable us to predict the amount of supplies
expense for month four.
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Regression Analysis
400

350

300
Regression for the data is
determined by a statistical procedure
250
that finds the unique line through
the data points that minimizes
200 the sum of squared error distances.

50 100 150
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Regression Analysis
Month Supplies Expense (Y) Production Level (X)
1 $250 50 units
2 310 100 units
3 325 150 units
4 ? 125 units

Y = a + bX + e
Y = $220 + $.75 per unit  125 units
Y = $313.75 Expense estimate for month 4
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Regression Analysis
400 b = the slope of the regression line or the
coefficient of the independent variable
b = $.75 per unit
350

e = 15 e = 7.5
300
e = 7.5
250
220
200 Fixed Cost = $220

50 100 150
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Regression Analysis
proper line, excluding the outlier
400 improper line, influenced by outlier

350

300

250 Outlier
Outliers may be discarded to
200 obtain a regression that is more
representative of the data.
50 100 150 200
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Regression Analysis

Evaluating a Regression Analysis

R2, the coefficient of determination,

is a measure of the explanatory power
of the regression, the degree that
changes in the dependent
variable can be predicted by changes
in the independent variable.
The t-value is a measure
of the reliability of each of
the independent variables.

The standard error of the estimate (SE) is a measure

of the accuracy of the regression’s estimates.
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Regression Analysis
400

350

300

250 Regression with

high R2 (close to 1.0)
200

50 100 150 200

Independent Variable
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Regression Analysis
400

350

300

250 Regression with

low R2 (close to 0)
200

50 100 150 200

Independent Variable
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Regression Analysis
400

350

300

Standard error is a range around the

250 regression estimate in which we
can be reasonably sure that the
200 unknown value will fall.

50 100 150 200

Independent Variable
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Regression Analysis
400

350

300

250
Regression with Wide
(Poor) Standard Error
200

50 100 150 200

Independent Variable
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Regression Analysis
400

350

300

250
Regression with Narrow
(Good) Standard Error
200

50 100 150 200

Independent Variable
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Regression Analysis

Data and Implementation Problems

Data Accuracy
Selecting the time period
 Mismatched time period
 Length of the time period
Nonlinearity problems
 Trend and/or seasonality
 Outliers
 Data shift
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The End

This is a tough
cost to estimate!

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