25 Less0n Tw0

In decisi0n making, 0nly c0ntr0llable c0sts are c0nsidered because they can be changed by
the decisi0n maker. There is little 0r n0thing that the decisi0n maker can d0 ab0ut the n0n-
c0ntr0llable c0sts thus they are irrelevant in decisi0n making. H0wever, the facilities
pr0vided by the nun-c0ntr0llable c0sts sh0uld be efficiently used.

2.3.3 Functi0nal Classificati0n 0f c0sts:

Under this classificati0n, c0sts are classified acc0rding t0 the functi0n they perf0rm in an
0rganizati0n. C0sts can functi0nally be classified as:

a) Pr0ducti0n c0sts: Are all the c0sts incurred in pr0ducti0n 0f units during a time peri0d e.g.
raw material c0sts, direct lab0ur c0sts and pr0ducti0n 0verheads.
b) Administrati0n c0sts: These are all c0sts incurred in ensuring the sm00th running 0f the
0rganizati0n s0 as t0 facilitate the pr0ducti0n and sale 0f g00ds and services. These
include: salaries f0r the managers, salaries f0r supp0rt empl0yees (such as acc0untants,
clerks and secretaries) etc
c) Selling and distributi0n c0sts: These are c0sts that are incurred t0 enable the delivery 0f
pr0ducts and services t0 the actual markets and pr0m0te 0r c0mplete a sale. These c0sts
include: salesmen c0mmissi0n, salesw0man salaries, advertising c0sts, depreciati0n 0n
m0t0r vehicles used by salesmen, the c0st 0f fuel used by vehicles used f0r distributi0n
purp0ses etc.
d) 0ther functi0nal classificati0ns

2.4 C0ST ESTIMATI0N

Intr0ducti0n:
C0st estimati0n may be defined as ‘a study which attempts t0 predict the between c0sts and the
activity level 0r c0st driver that causes th0se c0sts. In practice, managers frequently enc0unter such
c0st drivers (what is a c0st driver?) as machine h0urs, number 0f transacti0n, w0rk cells, lab0ur
h0urs, and units 0f 0utput e.t.c.
The c0st estimating functi0n is
y = a + bx,
Where
Y represents T0tal c0st
a represents c0st fixed c0mp0nent 0f the t0tal c0st
bx represents the variable c0sts c0mp0nent 0f the t0tal c0st
b represents the unit variable c0st (this is the gradient 0f the equati0n)
x represents 0utput level
This is the usual straight line equati0n y0u have been enc0untering in elementary mathematics.

C0ST ACC0UNTING
C0st Classificati0n and Estimati0n 26

2.4.1 Purp0se 0f Estimati0n

It assists in estimating the future expenditure (c0st predicti0n) as the expenditure will depend 0n the
c0st 0f the respective activities
a) It assists in determining the net benefits anticipated in a specific activity based 0n the
relati0nship between pr0jected c0sts and pr0jected revenue.
C0st estimati0n is useful in business planning, c0st c0ntr0l, perf0rmance evaluati0n and decisi0n
making.
2.4.2 Meth0ds 0f c0st estimati0n
We will c0nsider f0ll0wing c0st estimati0n meth0ds c0mm0nly utilized, namely:
a) High L0w Activity meth0d
b) Acc0unt Analysis
c) Engineering Analysis
d) Visual Fit (Scatter graph) meth0d
e) Simple linear regressi0n analysis
f) Learning curve The0ry

a) High – L0w meth0d

Here, c0st estimati0n is based 0n the relati0nship between past c0st and past level 0f activity.
Variable c0st is based 0n the relati0nship between c0sts at the highest level 0f activity and the
l0west level 0f activity. The difference in c0st between high and l0w activity level is taken t0 be
the t0tal variable c0st fr0m which the unit variable c0st can be c0mputed by dividing it by the
change in 0utput level. This is indicated bel0w:
T0tal Variable C0st = C0st at high activity level – C0st at l0w activity level
Theref0re,
Unit Variable c0st = Variable c0st = C0st at high level activity – c0st at l0w level activity
0utput Units Units at high activity level – units at l0w activity level

The variable c0st per unit s0 calculated f0rms the ‘b’0f the straight line equati0n menti0ned
earlier. By substituting ‘ b’ int0 the equati0n, we can 0btain ‘a’, the fixed c0st.

Illustrati0n
Based 0n perf0rmance, y0u have been pr0vided with the f0ll0wing inf0rmati0n regarding ABC
Ltd f0r the year ended 31 December 2004 :
Lab0ur h0urs Service c0st (Shs)

Highest activity level 800 200,000

L0west activity level 300 150,000

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27 Less0n Tw0

Required
Devel0p a t0tal c0st functi0n based 0n the ab0ve data using the high-l0w meth0d.
S0luti0n
Unit Variable c0st = Variable c0st = C0st at high level activity – c0st at l0w level activity
0utput Units Units at high activity level – units at l0w activity level

Variable C0st Per Unit = Shs.200,000 – shs.150,000

800 hrs – 300 hrs

= Shs.50,000 = shs.100/hr
500 hrs
Theref0re b = 100
T0 get the fixed c0st a, substitute ‘b’ int0 the straight line equati0n as f0ll0ws:

When lab0ur h0urs (x) = 800, service c0st (t0tal c0st, y) = shs.200,000
Theref0re fr0m the Straight Line equati0n, y = a + b x
200,000 = a + (100) 800
200,000 = a + 80,000
a = 200,000 – 80,000
a = 120,000
Theref0re fixed c0sts = shs.120,000

NB: Even if we used the 2nd set 0f lab0ur h0urs and service c0sts, were w0uld still get he same
answer i.e.

When lab0ur h0urs (x) = 300, service c0st (t0tal c0st, y) = Shs.150,000.
Theref0re 150,000 = a + 100(300)
a =150,000 – 30,000 = Shs.120,000
Theref0re the c0st equati0n is:
y = 120,000 + 100x
This equati0n can be used t0 estimate 0r predict the t0tal c0sts : f0r example, when the activity level
is say at 1000 lab0ur h0urs, then the t0tal c0st w0uld be
Y= 120,000 + 1000(100)
=120,000 + 100,000
= Shs.220,000.

C0ST ACC0UNTING