CHAPTER V: Cost Estimation

Estimated Cost
- the overall expected future expenses incurred by a project or manufacturer.

Why Estimate Costs?

- managers need to estimate the costs associated with each alternative as they need to compare
the costs (and benefit) among alternative actions when they make decisions.
- good decisions require good information about costs; the better these estimates, the better the
decision managers will make.
- Cost estimates can be an important element in helping managers make decisions that add value to
the company.

Basic Cost Behavior Patterns

- the most important characteristic of costs for decision making is how they behave— how they vary
with activity is the key distinction for decision making.

Basic idea in cost estimation

- estimate the relation between costs and the variables affecting costs, the cost drivers.

Activity Level
- important variable that affects the relation between costs.
- Activities can be measured by volume (for example, units of output, machine-hours, pages typed,
miles driven), by complexity (for example, number of different products, number of components in a
product), or by any other cost driver.

Key terms of Cost behavior: variable costs and fixed costs.

Variable costs change proportionately with activity levels but fixed costs do not.

formula to use to estimate costs is the familiar cost equation

Total Cost = Fixed costs + (Variable costs per unit of activity) Volume of the activity

We usually
have data
about the
total costs
Methods Used to Estimate Cost Behavior
3 General Methods
1. Engineering estimates
o Cost estimate based on measurement and pricing of the work involved in a task
o An engineering estimate is based on detailed plans and is frequently used for large projects
or new products.
o can be quite expensive to use because it analyzes each activity involved in the business
o often based on optimal conditions, therefore it is important to recognize that the actual work
conditions will be less than optimal.
o often omit inefficiencies, such as downtime for unscheduled maintenance, absenteeism, and
other miscellaneous random events that affect all firms
Examples
might be
renting the
office where
the repairs
will take
place, using
lights and
other utilities,

2. Account analysis
o Cost estimation method that calls for a review of each account making up the total cost
being analyzed.
o Account analysis is a useful way to estimate costs. It uses the experience and judgment of
managers and accountants who are familiar with company operations and the way costs
react to changes in activity levels.
o relies heavily on personal judgment, however. This may be an advantage or
disadvantage, depending on the bias of the person making the estimate.
(Decisions based on cost estimates often have major economic consequences for the people
making them.)
(Objective results are often used in conjunction with account analysis to obtain the
advantages of multiple methods.)
o approach to estimating costs that includes the realities of downtime, missed work,
machine repair, and the other factors that often cause engineering estimates to be less
than realistic is to look at results from existing activities.
o Identifying the relation between the activity and the cost is the key step in account
analysis
o often based on last period’s costs alone and is subject to managers focusing on specific
issues of the previous period even though these might be unusual and infrequent.

For example,
accountants
often use the
account
analysis
approach to
estimate
costs. This
method calls
for a review
Cost Estimation Using Account Analysis

3. Statistical methods, such as regression analysis

o allows for random events to be separated from the underlying relation between costs
and activities.
o Deals with both random and unusual events is to use several periods of operation or
several locations as the basis for estimating cost relations.
o centers on practical applications rather than underlying statistical theory
Relevant Range of Activity
- Limits within which a cost estimate may be valid
- When using statistical approaches to cost estimation, we need to ensure that the activity
levels of the past are relevant for the activity levels estimated.
- It should include only those activity levels for which the assumed cost relations used in the
estimate are considered to hold.
Past data
- the relevant range for the projection is usually between the upper and lower limits of past
activity levels for which data are available. Although the use of past data for future cost
estimation has limitations, past data are adequate representations of future cost relations, even
if the forecasted level of activity is somewhat outside the relevant range.
- reliance on past data is relatively inexpensive; it could be the only readily available, cost-
effective basis for estimating costs.
- Past data do show the associations that held in prior periods and at least can be a meaningful
starting point for estimating costs as long as their limitations are recognized.
Scatter graphs and High-Low Estimates
- When you begin a statistical analysis of costs and activities, it is helpful to begin by graphing
the costs against activities using a scatter graph.
- visual representation of the data provides a quick indication of the fixed-variable relation of
costs and activities and can indicate whether the relation seems to change at certain activity
levels.
- To prepare the graph, we first obtain the relevant data.
- The scatte rgraph can be used graphically to illustrate cost-activity relations based on past
experience and provides a useful visual display of the cost-volume relation. However,
because it offers only a rough approximation of the relation, we recommend using the scatter
graph in conjunction with other cost estimation methods, especially those that rely on
statistical approaches
Number of Observations
- The number of observations to include depends on the availability of the data, the variability
within the data, the relative costs and benefits of obtaining reliable data, and the length of
time the current process has been in operation.
High-Low Cost Estimation
- Method to estimate costs based on two cost observations, usually at the highest and lowest
activity levels.
- A simple approach to estimating the relation between cost and activity is to choose two points
on the scatter graph and use these two points to determine the line representing the cost-
activity relation
- Activity can be defined in terms of units of production, hours of work, or any other measure
that makes sense for the problem at hand.
- Although the high-low method is easy to apply, use it carefully to ensure that the two points
chosen to prepare the estimates represent cost and activity relations over the range of activity
for which the prediction is made.
- The highest and lowest points could represent unusual circumstances. When this happens,
you should choose the highest and lowest points that appear representative.
- Although the high-low method allows computation of estimates of the fixed and variable
costs, it ignores most of the information available to the analyst.
The slope of the total cost line, which estimates the increase in variable costs associated with
an increase of one unit of activity, can be estimated using the following equation:

The intercept is estimated by taking the total cost at either activity level and subtracting the
estimated variable cost:

Statistical Cost Estimation Using Regression Analysis

Regression
- Statistical procedure to determine the relation between variables.
- techniques are designed to generate a line that best fits a set of data points.
- regression procedure uses all the data points, the resulting estimates have a broader base than
those based on a few select points (such as the highest and lowest activity levels).
- In addition, regression techniques generate information that helps a manager determine how
well the estimated regression equation describes the relations between costs and activities.
- Regression analysis also permits the inclusion of more than one predictor, a feature that can
be useful when more than one factor affects costs.
Obtaining Regression Estimates
- The most important step in obtaining regression estimates for cost estimation is to establish
the existence of a logical relation between activities and the cost to be estimated.
independent variable
- X term, or predictor, on the right-hand side of a regression equation.
dependent variable
- Y term or the left-hand side of a regression equation.
Correlation Coefficients
- Measure of the linear relation between two or more variables, such as cost and some measure
of activity.
coefficient of determination
- Square of the correlation coefficient, interpreted as the proportion of the variation in the
dependent variable explained by the independent variable(s).
t -statistic t is the value of the estimated coefficient, b , divided by its standard error.

Multiple Regression
- a statistical technique that can be used to analyze the relationship between a single dependent
variable and several independent variables
adjusted R -squared (R2) Correlation coefficient squared and adjusted for the number of
independent variables used to make the estimate.

Practical Implementation Problems

(1) attempting to fit a linear equation to nonlinear data
(2) failing to exclude outliers
(3) including predictors with apparent, but spurious, relations to the dependent variable, and (4) using data
that do not fi t the assumptions of regression analysis.

Effect of Nonlinear Relations

- The effect of attempting to fi t a linear model to nonlinear data is likely to occur when the fi
rm is operating near its capacity limits.
- Close to maximum capacity, costs increase more rapidly than activity because of overtime
premiums paid to employees, increased maintenance and repair costs for equipment, and
similar factors.
- The linear cost estimate understates the slope of the cost line in the ranges close to capacity.
Effect of Outliers
- Because regression minimizes the sum of the squared deviations from the regression line,
observations that lie a significant distance away from the line could have an overwhelming
effect on the regression estimates
- This type of problem can easily arise in accounting settings
- An inspection of the scatter graph can often reveal this problem.
- When an extreme outlier appears in the data set, scrutiny of the output from the regression
analysis will rarely identify it. Instead, a plot of the regression line on the data points is
usually needed.
- If multiple predictors are used, an outlier will be even more difficult to find.
- The best way to avoid this problem is to examine the data in advance and eliminate highly
unusual observations before running the regression.

Effect of Spurious Relations

- It is sometimes tempting to include many variables in the regression and let the program
“find” relations among the variables.
- This can lead, however, to spurious relations

Effect of Using Data that Do Not Fit the Assumptions of Regression Analysis
- Regression analysis is a powerful tool for analyzing and estimating costs, but it relies on
several important assumptions. If the assumptions are not satisfied, the results of the
regression will not be reliable.
Two important assumptions that are often not satisfied in estimating costs are that
(1) the process for which costs are being estimated remains constant over time and
(2) the errors in estimating the costs are independent of the cost drivers.

Regression Must Be Used with Caution

- A regression estimate is only an estimate. Computerized statistical techniques sometimes
have an aura of truth about them.
- a regression estimate can be little better than an informal estimate based on plotted data.
- Regression has advantages, however, It is objective, provides a number of statistics not
available from other methods, and could be the only feasible method when more than one
predictor is used.
that user of regression;
(1) fully understand the method and its limitations;
(2) specify the model, that is, the hypothesized relation between costs and cost predictors;
(3) know the characteristics of the data being used; and
(4) examine a plot of the data.

learning phenomenon
- the systematic relationship between the amount of experience in performing a task and the
time required to perform it.
Decision Making
Performance Evaluation

How Is an Estimation Method Chosen?

The two most common assumptions;
1. Cost behavior depends on just one cost driver. (Multiple regression is an exception.) In
reality, however, costs can be affected by a host of factors, including the weather and the
mood of the employees.
2. Cost behavior patterns are linear within the relevant range. We know that costs actually,
follow curvilinear, step, semi variable, and other patterns.
Data Problems
- If a company’s operations have followed a particular pattern in the past and that pattern is
expected to continue in the future, using the relation between past costs and activity to
estimate future costs can be useful.
- If the relation changes, it could be necessary to adjust the estimated costs accordingly or
explicitly consider the changes when developing the estimates.
Collecting appropriate data is complicated by the following problems:
• Missing data. Misplaced source documents or failure to record a transaction can result in missing
data.
• Outliers. Extreme observations of cost-activity relations can unduly affect cost estimates. For
example, a tornado recently affected operations in Oklahoma businesses, resulting in unusually low
volume.
• Allocated and discretionary costs. Fixed costs are often allocated on a volume basis, resulting in
costs that could appear variable. Discretionary costs also can be budgeted so that they appear
variable (e.g., advertising expense budgeted as a percentage of revenue).
• Inflation. During periods of inflation, historical cost data do not accurately reflect future cost
estimates. Even if inflation remains low in one country, fi rms with international operations must
consider the effects of subsidiary operations when making cost estimates.
• Mismatched time periods. The time period for the dependent and independent variables may not
match (e.g., running a machine in February and receiving [ recording] the energy bill in March).
Effect of Different Methods on Cost Estimates
- Each cost estimation method can yield a different estimate of the costs that are likely to result
from a particular management decision. This underscores the advantages of using two or
more methods to arrive at a final estimate. The different manufacturing overhead estimates
that resulted from the use of four different estimation methods
NOTE!
- Results are likely to differ from method to method
- It is a good idea to use more than one method so that results can be compared.
- Large differences in cost estimates suggest it is worthwhile to conduct additional analysis.
- If the estimates are similar, you may have more confidence in them.
Operating managers
- frequently apply their own best judgment as a final step in the estimation process.
- They often modify the estimate submitted by the controller’s staff because
- they have more knowledge of the process and, more important, they bear ultimate
responsibility for all cost estimates.

SUMMARIZATION
- The behavior of costs, not the accounting classification, is the important distinction for
decision making.
- Cost estimation focuses on identifying (estimating) the fixed and variable components of
costs.
- Estimate costs using engineering estimates.
- Cost estimates can be developed by identifying all activities and resources required to make a
product or provide a service.
- An engineering cost estimate applies unit costs to the estimate of the physical resources
required to accomplish a task.
- Estimate costs using account analysis.
- Reviewing historical accounting data to determine the behavior of costs requires analyzing
the accounts. Because these estimates are based on actual results, they include factors such as
downtime for maintenance and absenteeism that could be missed by an engineering estimate.
- Estimate costs using statistical analysis. Statistical analysis of data allows estimates of costs
to be based on many periods of operation. Statistical estimates average out fluctuations in the
relation between costs and activities. Scatter graphs provide a visual representation of the
relation and are useful to see how closely costs and activities are related. High-low analysis
uses two observations to estimate the slope of the line (an estimate of the unit variable cost)
and the intercept (an estimate of the fixed costs). Regression analysis uses all data and can be
accomplished easily with a spreadsheet program. Using regression analysis avoids the
problem of selecting observations in the high-low method that might not be representative.
- Interpret the results of regression output. Using regression analysis requires care because the
estimates depend on certain assumptions. At a minimum, you should look at a scatter graph to
determine whether the relation appears to be representative for your data. You should also
check the coefficient of determination (R2) to determine how closely the estimates fi t the
observed data.
- Identify potential problems with regression data. Regression methods rely on certain
assumptions. The relation between cost and activity is assumed to be linear, but this might not
be the case, especially outside the relevant range. In using data from actual operations, it is
important to ensure that each observation is representative and that there have been no special
circumstances (strikes, weather disasters, etc.) for the period. Also, it is important to guard
against spurious relations that are masked by a good statistical fit.
- Evaluate the advantages and disadvantages of alternative cost estimation methods. Each
method has its advantages and disadvantages. Using two, three, or four of the methods
together can indicate whether you should be confident of the estimates (if all the methods
give similar results) or invest in more analysis.
- Use Microsoft Excel to perform a regression analysis. Microsoft Excel or many other
statistical software programs can be used to perform a regression analysis.
- Understand the mathematical relationship describing the learning phenomenon.