Abstract

Cost estimation is the process of determining how the cost changes in relation to variations in a
particular cost driver. Cost estimation aims at developing a numerical relationship between a cost
and the main factor which causes the cost to be incurred. This numeric relationship is presented
through a cost function. In addition, an understanding of cost behavior is necessary to plan and
control costs. Four models of cost estimation: industrial engineering, account analysis,
conference and quantitative analysis method can be used to estimate the cost. Engineering
analysis method develops cost function using relationships between inputs and outputs. Study of
the accounts in the general ledger is used to determine the fixed and variable cost in account
analysis method. Conference method uses the opinion of different departments. Several
quantitative analysis methods are used to estimate a cost function according to the past data
observations. In scattergraph method, a regression line is developed on the basis of the data
plotted on the graph. The high-low method estimates the cost function by determining the line
that connects the highest and lowest values for the cost driver in the relevant range. Regression
analysis estimates the cost function by using a statistical model that relates the average change in
the dependent variables to a unit change in the cost driver(s).














1.0 Introduction
Cost estimation is the process of developing a well-defined relationship between a cost object
and its cost driver for the purpose of predicting the cost. A manager should consider the cost
behavior before estimating the cost function. Understanding cost behavior patterns is important to
managers as they plan, control, and make decisions in the operation of their organizations. A
manager must understand how costs behave across various levels of activity before approaching
to cost estimation. This report describes the different methods which can be used to analyse and
estimate cost behaviour patterns and thus enable the prediction of future costs. We will also
consider the problems associated with the different cost estimation methods that can be used.
Four models of cost estimation: engineering analysis method, account analysis method,
conference method and quantitative analysis method have been described along with the inherent
limitations of the method. In the next part of the report, several quantitative analysis method like
Scattergraph method, high-low techniques and least square regression method have been
described with appropriate illustrations. A company can use a combination of these methods to
develop its cost function. A particular method can provide the best estimation for a particular
situation. On the other hand, another method may be best suited to another situation.











2.0 Cost Behavior Analysis
Cost behavior is the manner in which a cost changes as some related activity changes. Thus, cost
behavior analysis is associated with the determination of how costs behave when business activity such as
production volume, sales volume changes. This section describes some common patterns of cost behavior.
This analysis is important because knowledge of them can enable predictions of future cost
amounts and also the use of decision-making techniques. There are three main types of costs
according to their behavior:
Fixed cost
Variable cost
Mixed cost
They have been described below:
i) Fixed costs
Fixed costs are those costs which do not change with the level of activity within the relevant
range. These costs will incur even if no units are produced. For example rent expense, straight-
line depreciation expense, etc. The wages paid to a production supervisor or a factory manager
would also be a fixed amount per annum provided that they are not paid extra for working
overtime. These costs are all based on time and not on some measure of activity or output. Fixed
cost per unit decreases with increase in production. In addition, they are costs that do not change
in response to changes in activity levels. Because the total amount of a fixed cost remains
constant, it means that as production volume increases fixed cost per unit decreases.


ii) Variable costs
Variable costs change in direct proportion to the level of production. This means that total
variable cost increase when more units are produced and decreases when less units are produced.
Thus, if activity increases by 10 percent, variable costs are assumed to increase by 10 percent.
Some common variable costs are direct and indirect materials, direct labor, energy, and sales
commissions. Variable cost behavior pattern specifies that variable costs have a linear
relationship to the level of activity; that is, when the level of activity increases, total variable
costs rise at a directly proportional rate. Although variable in total, these costs are constant per
unit. On a per unit basis, however, a variable cost remains constant while the activity level is
within the relevant range. If activity increases or decreases significantly, cost relationships will
probably change.


iii) Mixed costs
Mixed costs are costs that contain both a variable cost element and a fixed cost element. These
costs are sometimes referred to as semi variable costs. For example, a salesperson may be paid
Tk 80,000 per year (fixed amount) plus commissions equal to 1 percent of sales (variable
amount). In this case, the salespersons total compensation is a mixed cost. Note especially that
total production cost is also a mixed cost since it is composed of material, labor, and both fixed
and variable overhead cost items. Another example may be electricity bill. An electricity bill will
usually include a fixed supply charge for a certain time period as well as a charge for the total
amount of electricity consumed during that period. Even if production lines had been completely
shut down for the whole of the billing period, and no electricity had been used, the fixed supply
charge must be paid. This is the minimum cost of keeping electric power available for the
factory. It represents the fixed component of total electricity cost.

Mixed costs or semi-variable costs have properties of both fixed and variable costs due to
presence of both variable and fixed components in them. Since mixed cost figures are not useful
in their raw form, therefore they are split into their fixed and variable components by using cost
behavior analysis techniques.








3.0 Some Issues regarding Cost Estimation
This is the process of determining how the cost changes in relation to variations in a particular
cost driver or, in some cases, with variations in multiple cost drivers. In many cases, an
examination of past cost behaviour can enable accurate predictions of future costs. The process
of using data on past costs, and the corresponding levels of activity; to construct meaningful
relationships between them is called cost estimation. The aim of this process is to establish a
numerical relationship between a cost and the main factor which causes the cost to be incurred.
Such a factor is called the cost driver. For example, an assembly labour cost for a given time
period may vary with the number of units assembled during that period. Likewise, for a bakery
the cost of electricity consumed may vary with the number of batches of bread baked. The
number of units assembled and the number of batches baked are cost drivers which are output
measures. To be able to predict future costs accurately there should be a strong correlation
between a cost and the chosen cost driver, but we also need to be able to predict future changes
in the cost driver easily. When there are semi-variable or mixed costs we need to be able to
determine how much of each one is fixed and how much is variable. We also need to know how
the variable component of such a cost will change in response to changes in the principal cost
driver. Some important issues regarding cost estimation have been discussed below:



Cost Function
Cost behavior is identified by estimating cost functions. Cost function is mathematical
relationship between cost and the level of an activity. Examples of activities used in cost
accounting to develop cost functions are units of output, direct manufacturing labor hours,
machine hours etc. Most costs are assumed to behave in a linear (straight line) manner. The
assumption that most costs are linear means that it is easy to calculate the relevant cost function.
This is a mathematical description of how a cost changes with changes in the level of its cost
driver.



The general form of a linear cost function is simply the formula for a straight line:
y = a + bx
where: y = the estimated total cost amount (y is called the dependent variable)
a = constant which represents the component of total cost that does not change as the
level of activity changes
b = the slope coefficient i.e. the amount by which the total cost amount increases for a
one unit increase in the level of activity.
x = the actual (or expected future) level of activity (x is called the independent variable)

There are two basic assumptions regarding the function:
i. Variations in the cost under consideration are explained by variations in the level of a
single activity. Thus, single activity is sufficient to capture the variation in the cost.
ii. Cost behavior is adequately approximated by a linear function within the relevant
range. Even though the function is shown on the graph from zero to infinity, the
decision maker knows that the graph is valid only between some range and not from
zero to infinity.
It should be noted that assumptions about cost behaviour are usually valid only within a
restricted range of activity called the relevant range. If the planned level of activity falls outside
the relevant or normal range, caution is needed if past cost data is used to predict future costs.











Relevant Range
The relevant range is the range of activity for which estimates and predictions are expected to be
accurate. Outside the relevant range, the estimates of fixed and variable costs may not be very
useful. Beyond the relevant range the cost estimation may not give good result. In order to design
a cost function, it is assumed that there is linear relationship of costs. Outside the relevant range,
the cost behavior becomes nonlinear. When companies produce unusually large quantities, for
example, production may not be efficient, resulting in costs increasing more rapidly than the rate
implied by a straight line. This may not be a serious limitation for a straight-line approach as
long as the predictions and estimates are restricted to the relevant range.



Time horizon
Time horizon is also an important issue to determine whether a particular cost is variable or
fixed. The cost behavior patterns identified are true only over a specified period of time. Beyond
this, the cost may show a different cost behavior pattern. A final, but important, point:
determining whether a cost is fixed or variable depends on the time horizon. The longer the time
period, the more likely it is that a cost will be variable. The so-called short run is a period of
time for which at least one cost remains fixed. In the long run, all costs are variable.










4.0 Cost Estimation Approaches
There are four approaches which can be used to estimate the cost. These methods use different
approaches to estimate the cost function. Before choosing a method, the managers should
consider the expenses, technical expertise required for each method. They are not mutually
exclusive and thus, a company can choose a cost model by combining these methods. The four
cost estimation approaches have been discussed below:

4.1 Industrial Engineering Method
The aim of this method is to identify the relationships which should exist between inputs and
outputs. This method is also termed as the work-measurement method. Industrial engineers could
conduct time and motion studies or task analyses which involve observing employees as they
undertake work tasks and establish a normal time for each type of task. These times are then
costed using the wage rates for the various types of worker. By analysing the sequence of tasks
or activities needed to make a particular product or to provide a certain type of service, a normal
or standard labour cost can be estimated. The engineers can then determine from design
specifications the types and quantities of material required for each unit of the product or service
and how much these materials should cost. An estimated amount of overhead cost will be added
to the material and labour costs and this gives a standard unit cost which can then be used to
predict future costs based on planned levels of activity. The industrial engineering method relies
for its accuracy on the skills and experience of trained engineers. It is time-consuming and
expensive, but it has to be used when estimating costs for a completely new product because
there is no historical data to rely upon. This method is most useful for estimating the costs of
repetitive processes where input-output relationships for material and labour are clearly defined.

The major limitation of this method is that it requires a through and detailed way to determine
the cost functions. Moreover, it is time consuming to use this method. On the other hand, this
method can be used to determine the direct manufacturing cost but it is difficult to determine the
indirect manufacturing cost using this method. For example, it is difficult to determine research
and development cost by this method.

4.2 Account Analysis Method
In this method, each account is classified as either fixed or variable based on experience and
judgment of accounting and other qualified personnel in the organization. The account
classification method requires a study of an account in the general ledger. The experienced
analysts use the account information as well as their own judgment to determine how costs will
behave in the future. Using this method requires the management accountant to review past cost
behaviour patterns as shown in the organizations ledger accounts and other accounting records.
Then management use judgment and knowledge of operations to classify each cost as either
fixed, variable or semi-variable.

This method requires that the manager use professional judgment to classify costs as either fixed
or variable. The total of the costs classified as variable can then be divided by a measure of
activity to calculate the variable cost per unit of activity. The total of the costs classified as fixed
provides the estimate of fixed cost. We can use an illustration to show how the costs are
allocated under this method. Let, ABC Co. is a manufacturing company. The activities of ABC
Co. during the month August, 2013 are shown below:

Production in units 5,000
Production Cost
Component cost
Assembly labour cost
Utilities
Office Rent
Depreciation of equipment
Total production cost

TK 1,50,000
30,000
40,000
1,30,000
80,000
TK 4,30,000

Using professional judgment and analysis of the accounts, management of ABC Co. has decided
that component cost, assembly labour cost and 50% of utilities are variable costs and all other
items are fixed costs.


So, the fixed and variable cost can be estimated as follows:

Variable Cost Estimate
Component cost
Assembly labour cost
50% of Utilities
Total variable cost
Production in units
Variable cost per unit
TK 1,50,000
30,000
20,000
TK 200,000
5,000
TK 40
Fixed Cost estimate
50% of utilities
Office Rent
Depreciation of equipment
Total fixed cost

TK 20,000
1,30,000
80,000
TK 2,30,000

So, here the fixed cost is TK 2,30,000 and variable cost is TK 40 per unit produced. So, we can
write the cost function as:
Total production cost = TK 2,30,000 + TK 40 Production in units

Thus, if the production is 10,000 units, the total cost of production is
Total production cost for 10,000 units = TK 2,30,000 + TK 40 10,000
= TK 6,30,000

The account analysis method is subjective in that different managers viewing the same set of
facts may reach different conclusions regarding which costs are fixed and which costs are
variable. Despite this limitation, most managers consider it an important tool for estimating fixed
and variable costs.


4.3 Conference Method
Under this approach, costs are classified based on opinions from various company departments
such as purchasing, process engineering, manufacturing, employee relations and so on. Here,
cost function is developed on the opinion given by the departments. Here opinions are gathered
from the supervisors and managers of several departments to determine the cost drivers and
variable-fixed cost classification. Thus, efficiency of the cost function depends on the skills and
expertise of the department managers and supervisors. The main features of this method can be
stated as:
This method doesnt require so much analysis of the data and investigation like
engineering method. So, the cost function can be determined quickly. It is not time
consuming like industrial engineering method. Thus, this can help to reduce the time
needed to develop the cost classification and cost function.
This method can increase the cooperation among different departments. The opinions
from different departments are required to determine the cost behavior. Thus, this can
increase the responsiveness of the employees.
As this method develops cost function based on the inputs and opinions given by several
departments. So, the efficiency and accuracy of cost estimation depends on the skills and
expertise of the persons providing the inputs.













4.4 Quantitative Analysis Method
This methods develops a mathematical model to estimate a cost function according to the past
data observations. There are six steps of developing the cost function under this method. They
are described below:
i. Defining the cost to be estimated: At first, the dependent variable is determined. Here
dependent variable means the cost that is to be predicted. The example of dependent
variable is the total production cost during a particular period.
ii. Determining the cost drivers: Here cost driver or dependent variable is used to predict the
dependent variable. Cost driver is variable that causally affects the costs over a given
time span. There should be an economically plausible relationship between the cost
driver and dependent variable. For example, the direct labour hour can be the cost driver
for determining the total manufacturing labour cost.
iii. Collection of consistent and accurate data: Here data of both dependent and independent
variable should be collected. Several sources like company documents, opinions of the
managers, special studies may be used to collect relevant data.
iv. Plotting the data: Then the data of dependent and independent variable can be plotted.
This can show the graphical relationship between the cost driver and dependent variable.
This can help in determining the extreme observations. This can also help in determining
the relevant range of the data.
v. Selection and use of the appropriate estimation method: In this step, several methods are
used to develop the cost function. In this case, computer programme like Microsoft Excel
can be used to plot the data and perform necessary calculation.
vi. Assessment of the accuracy of the cost estimate: At this step the accuracy of the
prediction can be judged. Moreover, the criteria for evaluating the cost driver of the
estimated cost function can also be described in this step.
The above mentioned steps are followed in quantitative analysis method to develop a cost
function.




Three commonly used quantitative analysis methods are:
Scattergraph/ Visual fit method
High-low method
Regression analysis

In Scattergraph Method, all observed costs at various activity levels are plotted on a graph.
Based on sound judgment, a regression line is then fitted to the plotted points to represent the
line function. The high-low method of approximating cost behavior considers only two points of
data, the highest and lowest, for activity within the relevant range. Least-squares regression
method is a statistical technique that investigates the association between dependent and
independent variables. This method determines the line of best fit for a set of observations by
minimizing the sum of the squares of the vertical deviations between actual points and the
regression line. Cost estimation procedures using these three methods will be described with
appropriate illustration in the next section.














5.0 Cost estimation using different quantitative methods

5.1 Scattergraph/ Visual Fit Method
Scatter Graph Approach
Creating a scatter graph is another method of estimating fixed and variable costs. It provides a
good visual picture of the costs at different activity levels. Many organizations prefer to use
the scatter graph method to estimate costs. Accountants who use this approach are looking for an
approach that does not simply use the highest and lowest data points. However, it is often hard to
visualize the line through the data points especially if the data is varied. This approach requires
multiple data points and requires five steps:
Step 1: Plot the data points for each period on a graph.
Step 2: Visually fit a line to the data points and be sure the line touches one data point.
Step 3: Estimate the total fixed costs (A).
Step 4: Calculate the variable cost per unit (B).
Step 5: State the results in equation form Y = A + BX.

Step 1: Plot the data points for each period on a graph
This step requires that each data point be plotted on a graph. The x-axis (horizontal axis) reflects
the level of activity (units produced in this example), and the y-axis (vertical axis) reflects the
total production cost.

Step 2: Visually fit a line to the data points and be sure the line touches one data point
Once the data points are plotted as described in step 1, it is required to draw a line through the
points touching one data point and extending to the y-axis. The goal here is to minimize the
distance from the data points to the line (i.e., to make the line as close to the data points as
possible).

Step 3: Estimate the total fixed costs (A)
The total fixed costs are simply the point at which the line drawn in step 2 meets the y-axis. This
is often called the y-intercept. The line meets the y-axis when the activity level (units produced
in this example) is zero. Fixed costs remain the same in total regardless of level of production,
and variable costs change in total with changes in levels of production. Since variable costs are
zero when no units are produced, the costs reflected on the graph at the y-intercept must
represent total fixed costs.

Step 4: Calculate the variable cost per unit (B)
After completing step 3, the equation to describe the line is partially complete and stated as Y =
A + BX. The goal of step 4 is to calculate a value for variable cost per unit (B). Simply use the
data point the line intersects, and fill in the data to solve for v.

Step 5: State the results in equation form Y = A + BX.
We know from step 3 that the total fixed costs are A, and from step 4 that the variable cost per
unit is B. Thus the equation used to estimate total costs looks like this:
Y
C
= A + BX
Now it is possible to estimate total production costs given a certain level of production (X).



Alta Production Inc. reported the following production costs for the 12 months January through
December.
Reporting Period
(Month)
Total Production
Costs
Level of Activity
(Units Produced)
January Tk. 460,000 300
February 300,000 220
March 480,000 330
April 550,000 390
May 570,000 410
June 310,000 240
July 440,000 290
August 455,000 320
September 530,000 380
October 250,000 150
November 700,000 450
December 490,000 350

1. Using the information, we can perform the five steps of the scatter graph method to
estimate costs and state your results in cost equation form Y
C
= A + BX.
2. Assume Alta Production, Inc. will produce 400 units next month. We can calculate total
production costs for the month.



Step 1: Plot the data points for each period on a graph



Step 2: Visually fit a line to the data points and be sure the line touches on the data


BDT 0.00
BDT 100,000.00
BDT 200,000.00
BDT 300,000.00
BDT 400,000.00
BDT 500,000.00
BDT 600,000.00
BDT 700,000.00
BDT 800,000.00
0 50 100 150 200 250 300 350 400 450 500
Total Production Costs
BDT 0.00
BDT 100,000.00
BDT 200,000.00
BDT 300,000.00
BDT 400,000.00
BDT 500,000.00
BDT 600,000.00
BDT 700,000.00
BDT 800,000.00
0 50 100 150 200 250 300 350 400 450 500
T
o
t
a
l

C
o
s
t

Unit Produced
Total Production Costs


Step 3: Estimate the total fixed costs (A)
The y-intercept represents total fixed costs. This is where the line meets the y-axis. Total fixed
costs in the graph appear to be approximately $5,000. You will likely get a different answer
because the answer depends on the line that you visually fit to the data points. Remember you
must draw the line through one data point. The line intersects the data point for March ($480,000
production costs; 330 units produced). This will be used in step 4.

Step 4: Calculate the variable cost per unit (B)
After completing step 3, the equation to describe the line is partially complete and stated as Y =
$5,000 + BX. The goal of this step is to calculate a value for variable cost per unit (v). Use the
data point the line intersects (for March, 330 units produced and $480,000 total costs), and fill in
the data to solve for v (variable cost per unit):

Step 5: State the results in equation form Y = A + BX
We know from step 3 that the total fixed costs are $5,000, and from step 4 that variable cost per
unit is $1,439.39. Thus the equation used to estimate total production costs is stated as:
It is evident from this information that this company has very little in fixed costs and relatively
high variable costs. This is indicative of a company that uses a high level of labor and materials
(both variable costs) and a low level of machinery (typically a fixed cost through depreciation or
lease costs).





Advantage of Scatter Graph Method
The key weakness of the high-low method is that it considers only two data points in estimating
fixed and variable costs. The scatter graph method mitigates this weakness by considering all
data points in estimating fixed and variable costs. The scatter graph method gives us an
opportunity to review all data points in the data set when we plot these data points in a graph in
step 1. If certain data points seem unusual, we can exclude them from the data set when drawing
the best-fitting line. In fact, many organizations use a scatter graph to identify outliers and then
use regression analysis to estimate the cost equation Y
C
= A + BX.
Although the scatter graph method tends to yield more accurate results than the high-low
method, the final cost equation is still based on estimates. The line is drawn using our best
judgment and a bit of guesswork, and the resulting y-intercept (fixed cost estimate) is based on
this line. This approach is not an exact science.












5.2 High-Low Method

Scatter Graph Approach
Creating a scatter graph is another method of estimating fixed and variable costs. It provides a
good visual picture of the costs at different activity levels. Many organizations prefer to use
the scatter graph method to estimate costs. Accountants who use this approach are looking for an
approach that does not simply use the highest and lowest data points. However, it is often hard to
visualize the line through the data points especially if the data is varied. This approach requires
multiple data points and requires five steps:
Step 1: Plot the data points for each period on a graph.
Step 2: Visually fit a line to the data points and be sure the line touches one data point.
Step 3: Estimate the total fixed costs (A).
Step 4: Calculate the variable cost per unit (B).
Step 5: State the results in equation form Y = A + BX.

Step 1: Plot the data points for each period on a graph
This step requires that each data point be plotted on a graph. The x-axis (horizontal axis) reflects
the level of activity (units produced in this example), and the y-axis (vertical axis) reflects the
total production cost.

Step 2: Visually fit a line to the data points and be sure the line touches one data point
Once the data points are plotted as described in step 1, it is required to draw a line through the
points touching one data point and extending to the y-axis. The goal here is to minimize the
distance from the data points to the line (i.e., to make the line as close to the data points as
possible).

Step 3: Estimate the total fixed costs (A)
The total fixed costs are simply the point at which the line drawn in step 2 meets the y-axis. This
is often called the y-intercept. The line meets the y-axis when the activity level (units produced
in this example) is zero. Fixed costs remain the same in total regardless of level of production,
and variable costs change in total with changes in levels of production. Since variable costs are
zero when no units are produced, the costs reflected on the graph at the y-intercept must
represent total fixed costs.

Step 4: Calculate the variable cost per unit (B)
After completing step 3, the equation to describe the line is partially complete and stated as Y =
A + BX. The goal of step 4 is to calculate a value for variable cost per unit (B). Simply use the
data point the line intersects, and fill in the data to solve for v.

Step 5: State the results in equation form Y = A + BX.
We know from step 3 that the total fixed costs are A, and from step 4 that the variable cost per
unit is B. Thus the equation used to estimate total costs looks like this:
Y
C
= A + BX
Now it is possible to estimate total production costs given a certain level of production (X).



Alta Production Inc. reported the following production costs for the 12 months January through
December.
Reporting Period
(Month)
Total Production
Costs
Level of Activity
(Units Produced)
January Tk. 460,000 300
February 300,000 220
March 480,000 330
April 550,000 390
May 570,000 410
June 310,000 240
July 440,000 290
August 455,000 320
September 530,000 380
October 250,000 150
November 700,000 450
December 490,000 350

1. Using the information, we can perform the five steps of the scatter graph method to
estimate costs and state your results in cost equation form Y
C
= A + BX.
2. Assume Alta Production, Inc. will produce 400 units next month. We can calculate total
production costs for the month.



Step 1: Plot the data points for each period on a graph



Step 2: Visually fit a line to the data points and be sure the line touches on the data


BDT 0.00
BDT 100,000.00
BDT 200,000.00
BDT 300,000.00
BDT 400,000.00
BDT 500,000.00
BDT 600,000.00
BDT 700,000.00
BDT 800,000.00
0 50 100 150 200 250 300 350 400 450 500
Total Production Costs
BDT 0.00
BDT 100,000.00
BDT 200,000.00
BDT 300,000.00
BDT 400,000.00
BDT 500,000.00
BDT 600,000.00
BDT 700,000.00
BDT 800,000.00
0 50 100 150 200 250 300 350 400 450 500
T
o
t
a
l

C
o
s
t

Unit Produced
Total Production Costs


Step 3: Estimate the total fixed costs (A)
The y-intercept represents total fixed costs. This is where the line meets the y-axis. Total fixed
costs in the graph appear to be approximately $5,000. You will likely get a different answer
because the answer depends on the line that you visually fit to the data points. Remember you
must draw the line through one data point. The line intersects the data point for March ($480,000
production costs; 330 units produced). This will be used in step 4.

Step 4: Calculate the variable cost per unit (B)
After completing step 3, the equation to describe the line is partially complete and stated as Y =
$5,000 + BX. The goal of this step is to calculate a value for variable cost per unit (v). Use the
data point the line intersects (for March, 330 units produced and $480,000 total costs), and fill in
the data to solve for v (variable cost per unit):

Step 5: State the results in equation form Y = A + BX
We know from step 3 that the total fixed costs are $5,000, and from step 4 that variable cost per
unit is $1,439.39. Thus the equation used to estimate total production costs is stated as:
It is evident from this information that this company has very little in fixed costs and relatively
high variable costs. This is indicative of a company that uses a high level of labor and materials
(both variable costs) and a low level of machinery (typically a fixed cost through depreciation or
lease costs).





Advantage of Scatter Graph Method
The key weakness of the high-low method is that it considers only two data points in estimating
fixed and variable costs. The scatter graph method mitigates this weakness by considering all
data points in estimating fixed and variable costs. The scatter graph method gives us an
opportunity to review all data points in the data set when we plot these data points in a graph in
step 1. If certain data points seem unusual, we can exclude them from the data set when drawing
the best-fitting line. In fact, many organizations use a scatter graph to identify outliers and then
use regression analysis to estimate the cost equation Y
C
= A + BX.
Although the scatter graph method tends to yield more accurate results than the high-low
method, the final cost equation is still based on estimates. The line is drawn using our best
judgment and a bit of guesswork, and the resulting y-intercept (fixed cost estimate) is based on
this line. This approach is not an exact science.


5.3 Regression Analysis
A parametric cost-estimating model consists of one or more functions or relationships between
the cost as the dependent variable and the cost governing factors as the independent variables.
Regression analysis (RA) represents one of the most widely used methods for parametric cost
estimation during early project stages. Traditionally, cost-estimating relationships are developed
by applying RA to historical project information. Linear regression is a process which fits the
equation of a line in the form Y
C
= A + BX, where B is the slope of the line and A is the Y
C

intercept, to a given set of data. Linear regression calculates the equation for this line by
minimizing the sum of the squared residuals between the actual data points and the predicted
data points using the estimated lines slope and intercept. Once the slope and intercept have been
calculated, it is fairly easy to substitute other values for X and predict a corresponding value for
Y
C
, or to substitute a value for Y
C
and predict a value for X. Linear regression is often used to
estimate the fixed and variable components from a companys or departments total costs. In
these circumstances, the values for X are usually the cost driver for the organization or
department. Examples might include units produced, hours worked, hours of machine time, and
others. The values for Y
C
are the total cost for that level of X input. The computed slope of the
linear regression line will indicate the variable cost per unit of X, while the computed Y
C
-
intercept will indicate the fixed cost. In many or most circumstances, this type of cost analysis
will generate slopes and Y
C
-intercepts that make sense in the real world. It is sometimes
possible, though, that the fixed cost component in particular may not make any sense. The
generated Y
C
-intercept (fixed cost) might be negative, for example, to make the linear regression
line fit the observed cost data as closely as possible. Be aware, as well, that it is rarely a good
idea to use such an equation to predict too far into the future from the actual data used, since
circumstances can change rather quickly. In other words, if you fit a line using cost data for units
produced from 500 to 1500 a month, making cost predictions using forecasted production levels
of 5000 units a month may generate unreliable results. Also, since time is not a variable in these
calculations, the order in which the costs are input as data points does not matter you may enter
the data points in any order desired




Assumptions of the Regression Model
The assumptions listed below enable us to calculate unbiased estimators of the population) and to
use these in predicting values and regression function coefficients (of Y given X). You should be
aware of the fact that violation of one or more of these assumptions reduces the efficiency of the
model, but a detailed discussion of this topic is beyond the purview of this text. Assume that all
these assumptions have been met.
For each value of X there is an array of possible Y values which is normally distributed
about the regression line.
The mean of the distribution of possible Y values is on the regression line. That is, the
expected value of the error term is zero.
The standard deviation of the distribution of possible Y values is constant regardless of
the value of X.
The error terms are statistically independent of each other. That is, there is no serial
correlation.
The error term is statistically independent of X.

Developing and Using a Simple Regression Equation
Simple Regression Model: The simple regression model is based on the equation for a straight
line: Y
C
= A + BX
Where,
Y
C
= the calculated or estimated value for the dependent (response) variable
A = the Y intercept, the theoretical value of Y when X = 0
X = the independent (explanatory) variable
B = the slope of the line, the change in Y divided by the change in X, the value by
which Y changes when X changes by one.
For a given data set, A and B are constants. They do not change as the value of the
independent variable changes. Y
C
is a function of X. Specifically, the functional
relationship between Y
C
and X is that Y
C
is equal to A plus the product of B times X.

The following figure graphically depicts the regression line:





Steps for Developing a 2-Variable Linear Regression Equation
To develop a regression equation for a particular set of data, use the following 5-step least-
squares-best-fit (LSBF) process:

Step 1: Collect the historical data required for analysis
Identify the X and Y values for each observation.
X = Independent variable
Y = Dependent variable
Step 2: Put the data in tabular form
Step 3: Compute X bar and Y bar
X =

Y =

Where,
X bar = sample mean for the observations the independent variables
Y bar = sample mean for the observations the dependent variables
= Summation of all the variables that follow the symbol (e.g., X represents
the sum of all X values)
X = Observation value for the independent variable
Y = Observation value for the dependent variable
n = Total number of observations in the sample

Step 4: Compute the slope (B) and the Y intercept (A)

A = Y - BX

Step 5: Formulate the Estimating Equation
Y
C
= A + BX



2-Variable Linear Regression Equation Development Example
Assume a relationship between a firm's direct labor hours and manufacturing overhead cost
based on the use of direct labor hours as the allocation base for manufacturing overhead.
Develop an estimating equation using direct labor hours as the independent variable and
manufacturing overhead cost as the dependent variable. Estimate the indirect cost pool assuming
that 2,100 manufacturing direct labor hours will be needed to meet 2008 production
requirements.

Step 1: Collect the Historical Data Required for Analysis
Historical Data
Year
Manufacturing
Direct Labor Hours
Manufacturing
Overhead
2002 1200 73,000
2003 1500 97,000
2004 2300 128,000
2005 2700 155,000
2006 3300 175,000
2007 3400 218,000
2008 2100 (est)


Step 2: Put the Data in Tabular Form
X = Manufacturing direct labor hours in hundreds of hours (00s) Y = Manufacturing overhead in
thousands of dollars ($000s)
Tabular Presentation
X Y XY X
2
Y
2

12 73 876 122 5329
15 97 1455 225 9409
23 128 2944 529 16384
27 155 4185 729 24025
33 175 5775 189 30625
34 218 7412 1156 47524
Column Totals X = 144 Y = 846 XY = 22647 X
2
= 3872 Y
2
= 133296


Step 3: Compute X and Y
X =

= 24

Y =

= 141


Step 4: Compute the slope (B) and the Intercept (A)

=
()()
()

= 5.6322
A = Y - BX
= 141 - 5.6322(24)
= 141 - 135.1728
= 5.8272


Step 5: Formulate the Estimating Equation
Substitute the calculated values for A and B into the equation:
Y
C
= A + BX
Y
C
= 5.8272 + 5.6322X
Where,
Y
C
= Manufacturing Overhead
X = Manufacturing Direct labor Hours

Estimate manufacturing overhead given an estimate for manufacturing direct labor hours of
2100.
Y
C
= 5.8272 + 5.6322X
= 5.8272 + 5.6322 21
= 5.8272 + 118.2762
= 124.1034 thousand taka
Rounded to the nearest taka, the estimate would be Tk. 124,103


The Contrast between Regression Analysis and High-Low Analysis
Regression analysis estimates the cost function by using a statistical model that relates
the average change in the dependent variables to a unit change in the cost driver(s).
The high-low method estimates the cost function by determining the line that connects
the highest and lowest values for the cost driver in the relevant range.

The Advantages of Using Regression Analysis
Provides an estimation model with best fit (least squared error) to the data
Provides measures of goodness of fit and of the reliability of the model which can be
used to assess the usefulness of the specific model, in contrast to the other estimation
methods which provide no means of self-evaluation
Can incorporate multiple independent variables
Can be adapted to handle non-linear relationships in the data, including trends, shifts and
other discontinuities, seasonality, etc.
Results in a model that is unique for a given set of data.













6.0 Conclusion
Cost estimation can help managers to make more accurate forecast about future costs. Better
forecast can assist managers to make more informed planning and decision making. So, it is
essential to use a model for developing a cost function that can help in estimating future costs.
There are several methods of cost estimation. A company should consider the expertise and
technology necessary for a particular cost estimation method. There are certain limitations of a
particular method. So, an organization should consider them before choosing a particular
method. For example, engineering analysis method can provide good estimation but it requires
huge analysis and involves time consuming process. As account analysis method is based on the
judgment of the account in the general ledger, this may be subjective because of the judgment of
the managers. Conference method may increase cooperation among different departments and
develop a cost function quickly. But efficiency and accuracy of cost estimation depends on the
skills and expertise of the person providing the inputs. In scattergraph method, user fits the
regression line through the data points is entirely subjective. The high-low method estimates the
cost function by highest and lowest values for the cost driver in the relevant range. These two
points may not be truly representative of the general relation between cost and activity. Though
regression analysis requires complex calculation, this method provides quantitative and objective
measures of the precision and reliability. Thus, it can provide better estimation in contrast to the
other estimation methods which provide no means of self-evaluation.










References
Garrison, RH, Noreen, EW & Brewer, PC 2008, Managerial Accouting, 12th edn, McGraw-Hill companies
Inc.
Horngren, CT, Datar, SM, Foster, G, Rajan, M & Ittner, C 2013, Cost Accounting- A Manegerial Emphais,
13th edn, Prentice-Hall Inc.
Horngren, CT, Sundem, GL, Stratton, WQ, Burgstahler, D & Schatzberg, J 2009, Introduction to
Management Accounting, 14th edn, Perason Education Inc.