COST ESTIMATION

Cost estimation involves the use of past costs to predict future costs. It involves breaking
down costs into their fixed and variables elements in order to determine future costs. It also
involves ascertaining the activity. A cost driver can be defined as any factor whose change
causes, a change in the total cost of an activity e.g. direct labour hours, machine hours etc.

Cost estimation methods

Engineering methods
These are methods of the analysis cost behavior which are based on the use of engineering
analysis of technological relationships between inputs and outputs. It is appropriate when
there is a physical relationship between costs and the cost driver.

Accounts inspection method

This approach request that the departmental manager and the accountant inspect each item
of expenditure within the accounts of a particular period, and then clarify each item of
expense as a wholly fixed, wholly variable or semi-variable costs. The costs estimates are
mainly based on arbitrary judgments and may lack the precision necessary when they are
used to make decisions that are sensitive.

High-Low Method
The high-low method uses the highest and lowest activity levels over a period of time to
estimate the portion of a mixed cost that is variable and the portion that is fixed. Like the
account analysis and scatter graph method, the amounts determined for fixed and variable
costs are only estimates. Because it uses only the high and low activity levels to calculate the
variable & fixed costs, it may be misleading if the high and low activity levels are not
representative of the normal activity. For example, if most data points lie in the range of 60
to 90 percent for a particular accounting test, and one student scored a 20, the use of the low
point might distort the actual expectation of costs in the future. The high-low method is
most accurate when the high and low levels of activity are representation of the majority of
the other points. The steps below guide you through the high-low method:
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Step 1: Determine which set of data represents the total cost and which represents the
activity. Find the lowest and highest activity points.
Step 2: Determine variable costs per unit by using the mathematical formula for a slope
where you take divide the change in cost by the change in activity:
Y2 -Y1
= Variable cost per unit
X2 - X1
Where X2 is the high activity level
X1 is the low activity level
Y2 is the total cost at the high activity level selected
Y1 is the total cost at the low activity level selected
Step 3: Plug your answer to steps 2 along with either the high or the low point into the cost
formula by replacing the slope (VC) with variable cost per unit, the high activity total cost
for the y variable, and the high activity for the x variable. Then solve for fixed costs (FC).

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Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope (VC)
with variable cost per unit and the y-intercept (FC) with total fixed costs in the following
format:
y = VC x + FC

Regression analysis
Simple regression analysis is based on the assumption that total cost is determined by one
variable whereas multiple regression considers more than one variable. As far as possible, all
the factors related to cost behavior should be brought into the analysis so that costs can be
predicted and controlled more effectively. The equation for single regression can be
expanded to include more than one independent variable.

In case of simple linear regression:

Y = a + bX

Where:
Y is the cost or variable being estimated
A is the total fixed costs
X is the number of units produced or the independent variable influencing costs
B is the variable cost per unit

In this case:
b = n∑XY - ∑X∑Y
n∑X2 - ∑(X)2

and a= ∑Y -b∑X
n n

If there are two independent variables and the relationship is assumed to be linear, the
regression equation will be:-

Y = a + b 1 X 1 + b2 X 2

Where: a represents the non-variable cost item.

B1 represents the average change resulting from a unit change in X1,
Assuming X2 and all the unidentified items remain constant.
B2 – represents the average change in if resulting from a unit change in
X2 asking that X1 remains constant.

The normal equations for a regression equation with two independent variables are:
∑ y = an + b1 ∑X1 + b 2 ∑ X2
∑Xy = a∑X1 + b1 ∑ X1 2 + b2 ∑X1 X2
∑X2y = a∑X2 + b1 ∑X1 X2 + b2 ∑X12

This can be solved through spreadsheet packages.

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Example of application of multiple regression
Consider a plant that generates its own steam and uses this steam for both heating and
motive power. The cost of steam generation is likely to be determined by both temperature
and machine hours, a multiple regression equation would be:-

Y = a + b1 X1 + b2 X2

Where y – total cost

a – total non-variable cost
y1 - # of machine hours
b1 – regression co-efficient for machine hours
y2 – number of days per month
b2 – required co-efficient for temperature

Multi collinearity
When the independent variable are highly correlated with each other, its is very difficult to
separate the effect of each variable on the dependent variables. This occurs when there is a
simultaneous movement of two or more independent variable in the same direction and at
approximately the same rate. This condition is called multi collinearity.

Factors to consider when using past data to estimate cost functions

1. The cost of data and activity should be related to the same period. Costs used to
estimate costs functions should not be behind the associated activity for accuracy
purpose.
2. The number of observations should be sufficient if acceptable cost estimates are to
be produced.
3. Security policies – data must be examined to ensure that the accounting policies do
not lead to distorted cost functions.
4. Adjustments for past changes – an analysis of past date will yield estimates of future
costs that are based on the cost relationships of previous periods. The approp****
of using past data will depend on the extent to which the future will correspond with
the past. Any change of circumstances in the future will require past data to be
adjusted in line with future data.

Cost estimation when the learning effect is present

Changer in the efficiency of the labour force may render past information unsuitable for
predicting future labour costs. A situation like this may occur when workers become more
familiar with the tasks that they perform, so that the labour time is required for the
production of each unit. The phenomenon is common in manufacturing and is known as
learning curve effect.