COST ESTIMATION:
MODULE 7
Definition of Cost Behavior
• Cost behavior means how a cost will react as changes takes
place in the level of business activity. Managers who
understand how costs behave are better able to predict what
costs will be under various operating circumstances. An
understanding of cost behavior under varying conditions is
essential to adequate decision making in the planning and
control of firm activity.
Importance of Understanding Cost Behavior
Planning requires that management make decisions based in
part on expectations as to the future.
Control is the process of using feedback information for
comparison with expectation and the implementation of actions
on the basis of that comparison.
Cost analysis is an integral part of the planning and control
function. The key to effective cost production lies in an
understanding of cost behavior patterns.
Types of Cost Behavior Patterns
• Variable Costs
• Fixed Costs
– Committed fixed costs
– Discretionary fixed costs
• Mixed Costs
Types of Cost Behavior Patterns
Variable Cost -Change in total as the level of activity changes in the short run
and within the RELEVANT RANGE
Relevant Range -Range activity within which assumptions relative to variable
and fixed cost behaviour are valid.
*Variable cost PER UNIT is constant in the relevant range
*TOTAL Variable cost changes with respect to the ACTIVITIY BASE
Activity base- Measure of whatever causes the incurrence of variable cost
Types of Cost Behavior Patterns
FIXED COSTS - Costs that remain constant in total regardless of the changes
in the level of activity within the relevant range
*Fixed cost PER UNIT decreases as the level of activity increases.
Committed fixed costs - Long-term in nature and cannot be significantly
reduced even for short periods of time without impairing the profitability or longrun goals of the organization.
Discretionary fixed costs- Usually arise from annual decisions by
management. Management is not locked into a decision regarding such costs.
Types of Cost Behavior Patterns
MIXED COSTS/SEMIVARIABLE COSTS -Contains both variable and fixed
cost elements.
Relationship between mixed cost and level of activity:
Y = a + bX
FIXED PORTION -Basic, minimum cost of just having a service ready and
available for use.
VARIABLE PORTION- Cost incurred for the actual consumption of the service.
The Analysis of Mixed Costs
The fixed portion of mixed cost represents the basic, minimum cost of just
having a service ready and available for use while the variable portion
represents the cost incurred for the actual consumption of the service. The
variable element varies in proportion to the amount of service that is consumed.
METHODS FOR COST ESTIMATION
1. Account analysis method
2. Industrial Engineering method or Work measurement method
3. Conference method
4. Quantitative analysis of current and past costs relationships
a.
b.
High-low method
Regression analysis method
5. Scattergraph or Visual fit method
6. The least-squares regression method
Account Analysis Method
Account analysis is considered a very useful and easier way to estimate costs.
It makes use of the experience and judgment of managers and accounts who
are familiar with company operations and the way costs react to changes in
activity level.
Steps:
Review each cost account and identify as either variable or fixed in relationship
to some activity.
Each major class is itemized and each cost is divided into variable and fixed
component.
*Advantage: involves detailed examination
*Disadvantage: uses subjective, judgmental approach.
Industrial Engineering Method
The industrial engineering method estimates cost functions by analyzing the
relationship between inputs and outputs in physical forms.
STEPS:
Study of physical relation between the quantities of inputs and each unit of
output
Costs are assigned to each of the physical inputs to estimate the cost of the
outputs.
*Advantage: it can detail each step required to perform an operation.
*Disadvantage: quite expensive to use.
Conference Method
Cost functions are estimated based on the analysis and opinions about costs
and drivers obtained from various departments of an organization such as
purchasing, process engineering, manufacturing, employee relation and so on.
This information is used to determine the selling price of the product, optimum
product mix, and evaluate cost improvements overtime.
The High-Low Method
It is based on costs observed at both the high and low levels of activity within
the relevant range.
Steps in Applying the High-Low Cost Estimation
1. Obtain relevant data on past costs and related actual activity levels.
2. Estimate the variable cost per unit or rate using the following equation:
Variable cost rate or per unit = Cost at highest activity – Cost at lowest
activity /Highest activity – Lowest activity
The High-Low Method
3. Compute the fixed cost as follows:
Fixed Cost = Total Cost at highest activity – [Variable cost per unit x
Highest activity stated in units]
Or
Fixed Cost = Total Cost at lowest activity – [Variable cost per unit x
Lowest activity stated in units]
Regression Analysis Method
It uses all available data to estimate the cost function. It is a statistical method
that measures the average amount of change in the dependent variable (costs)
that is associated with a unit change of one or more independent variables.
Sample regression analysis estimates the relationship between the dependent
variable and multiple independent variables. Multiple regressions are used
when the dependent variable is caused by more than one factor. Although
adding more factors or variables make the computation more complex, the
principles involved are the same as in the simple regression analysis.
Simple regression analysis- Estimates the relationship between the
dependent and one independent variable.
Multiple regression analysis- Estimates the relationship between the
dependent variable and multiple independent variables.
Regression Analysis Method
Simple regression analysis uses the following estimated cost function or
equation:
Y=a+bX
While multiple regression analysis uses the following equations:
Y = a + b1 X 1 + b2 X 2……… + o
Where:
Y = costs to be predicted
X1 X 2 X3….. = independent variable on which the prediction is to be based
a = fixed cost
b1b2b3…. = estimated coefficient of the regression model
o = residual term that includes the net effect of other factors not in the model and measurement errors
in the dependent and independent variables.
Least-squares Regression Method
A statistical technique which is often used in separating mixed costs into their
fixed and variable components is least-square regression. Basically, a line of
regression is determined by solving two simultaneous linear equations which
are based on the condition that the sum of deviations above the line equals the
sum of deviation below the line.
The equation for the determination of straight line is:
Y = a + bX
Least-squares Regression Method
The two linear equations that are used to solve for a and b are:
EY = Na + bEx2
Equation (1)
EXY = EXa + bEX2
Equation (2)
Where:
Y = Total cost
a = Fixed cost
b = Variable cost rate
X = measure of activity
N = number of observations
E = Greek letter signifying summation
Scatter graph or Visual Fit
This is a rough guide for cost estimation which plot the cost against past activity
levels. These activities are referred to as predictors or independent variables
(X), or the right-hand-side of a regression equation. The cost to be estimated
may be called the dependent variables (Y), or the left-hand-side of the
regression equation. The line is drawn, insofar as it is possible by visual
judgment, so that the distances of the observation above the line are equal to
the distances of the observations below the line. This line called the line of
regression represents the data as a line of conditional expected values.
Correlation Analysis
In the process of estimating and controlling costs, management must evaluate
whether o not the factor selected for estimating cost behavior in suitable for that
purpose. Costs may or not react with changes in the factor selected for cost
analysis.
r2 = 1 – (Estimated conditional standard deviation measured from line of
regression)2 / (Standard deviation measured from the average of all data)2
The Learning Curve Theory
One assumption in estimating cost behavior is that the cost of each input is a
linear function of the quantity assigned. However, the relationship between
costs and independent variables is not always linear.
Some of the Uses of Curves are as follows:
1. Preparing cost estimates for bidding purposes
2. Setting standards and budget allowances
3. Scheduling labor requirements
4.Evaluating
performance by comparing progress reports with the
accomplishments anticipated under the learning curve
5. Setting incentive wage rates with due consideration for the fact that labor
times will normally be reduced as the workman becomes more experienced
Learning rate formula:
Average input quantity (cost) for the first 2 x units
Average input quantity (cost) for the first x units
END OF MODULE