Chapter 5: Cost Estimation productivity and identify specific

strengths and weaknesses

Behaviour/how they behave  does not require data from prior
 most important characteristic of costs for activities in the organization
decision making  can be used to estimate costs for totally
new activities
Cost estimation  can often identify where “slacks” exists
 to estimate the relation between costs in its operations
and the variables affecting costs, the  based on detailed plans and is
cost drivers frequently used for large projects or new
 focus on the relation between costs and products
activity level
Disadvantages
Activities  can be quite expensive to use
 can be measured in volume (units of  based on optimal conditions
output, machine-hours, pages typed,
miles driven), complexity (number of Account Analysis Method
different products, number of
components in a product), or by any Account analysis
cost driver  cost estimation method that calls for a
review of each account making up the
Total Cost total cost being analyzed
 F + VX
Identifying the relation between the activity
Methods Used to Estimate Cost Behavior and the cost
 key step in account analysis
3 General Methods to Estimate the Relation  based on the accountant’s judgment
Between Cost Behavior and Activity Levels and experience

1. Engineering estimates
2. Account analysis
3. Statistical methods (regression analysis)

Engineering Method

Engineering Estimate
 cost estimate based on measurement
and pricing of the work involved in a
task Typical schedule of estimated overhead costs
per month, where the average center operates
Advantages at 720 labor-hours
 can detail each step required to perform
an operation Overhead costs/Total costs
 permits comparison with other centers in  F + VX
which similar operations are performed
and enables the company to review its Account analysis
 useful way to estimate costs
  uses the experience and the judgment
of the managers and accountants
Statistical Cost Estimation
 applying statistical theory which allows
for random events to be separated from
the underlying relation between costs
and activities
Relevant range
 activity levels within which a given total
fixed cost or unit variable cost will be
unchanged
 the level of activity for which a cost
estimated may be valid
 should include only those activity levels
for which the assumed cost relations
used in the estimate are considered to
hold
Past data
 adequate representations of future cost
relations
 reliance is relatively inexpensive
 could be the only readily available, cost-
effective basis for estimating costs
 show the associations that held in prior
periods
 at least can be a meaningful starting
point for estimating costs
Scattergraphs and High-Low Estimates
Scattergraph
 graph that plots costs against activity
level
intercept (vertical) = estimate of fixed cost
slope = variable cost per unit
High-Low Cost Estimation
 method to estimate costs based on two
cost observations, usually at the highest
and lowest activity levels
Variable cost per unit (V)

Fixed cost
 TC at highest act. level – (V x highest
act. level)
 TC at lowest act. level – (V x lowest act.
level)
Statistical Cost Estimation Using
Regression Analysis
Regression
 statistical procedure to determine the
relation between variables
 designed to generate a line that best fits
a set of data points
 resulting estimates have broader base
since it uses all the data points
 permits the inclusion of more than one
predictor, a feature that can be useful
when more than one factor affects cost
Obtaining Regression Estimates
 most important step is to establish the
existence of a logical relation
between activities and the cost to be
estimated
Independent variables
 X term, or predictor, on the right-hand
side (RHS) of a regression equation
Dependent variables
 Y term or the left-hand side (LHS) of a
regression equation
Total costs = Intercept + (b x LH)
Correlation Coefficient (R, referred to as
Multiple R)
 measure of the linear relation between
two or more variables, such as cost and
some measure of activity
 measures the proximity of the data
points to the regression line
  the closer R is to 1.0, the closer the data
points are to the regression line
 the closer R to 0, the poorer the fit of the
regression line
Coefficient of determination (R-squared or
R2)
 square of the correlation coefficient,
interpreted as the proportion of the
variation in the dependent variable
explained by the independent variables
Ordinary Least Squares regression (OLS)
 the regression line is computed so that
the sum of the squares of the vertical
distances from each point is minimized
 seeks to minimize squared differences
Confidence in the Coefficients
T-statistic
 t is the value of the estimated
coefficient, b, divided by its standard
error (SEb)
 used to test the significance of the
coefficient
 t = b / SEb
 t-statistic greater than 2.0 =  easily arise in accounting settings
significant
P-value
 significance level of the t-statistic
b ± t x SEb
Multiple Regressions
Adjusted R-squared (R2)
 correlation coefficient squared and
adjusted for the number of independent
variables used to make the estimate
 this adjustment to R2 recognizes that as
the number of independent variables
increases, R2 (unadjusted) increases
 better measure of association when
more than one X predictor is used
Practical Implementation Problems
Problems using regression estimates
1. attempting to fit a linear equation to
nonlinear data
2. failing to exclude nonrepresentative
observations/ outliers
3. including predictors with apparent, but
spurious, relations to the dependent variable
4. using data that do not fit the assumptions of
regression analysis
Effect of Nonlinear Relations
 effect of attempting to fit a linear model
to nonlinear data is likely to occur when
the firm is operating near its capacity
limits
 to overcome the problem is to define a
relevant range of activity and use the
range for one set of cost-estimating
regression analysis and to model the
nonlinearity explicitly by including
squared value of an independent
variable as the variable itself
Effect of Outliers
 to avoid is to examine the data in
advance and eliminate highly unusual
observations before running the
regression
 prepare a Scattergraph, analyze the
graph, and eliminate highly unusual
observations before running the
regression
Effect of Spurious Relations
 tempting to include many variables in
the regression and let the program “find”
relations among the variables
 carefully analyze each variable and
determine the relationship among all
elements before using the regression
Effect of Using Data that Do Not Fit the
Assumptions of Regression Analysis
2 Important Assumptions that are often not
satisfied in estimating costs
1. the process for which costs are being
estimated remains constant over time
2. the errors in estimating the costs are
independent of the cost drivers
Recommendations
1. fully understand the method and its
limitations
2. specify the model, that is, hypothesized
relation between costs and cost
predictors
3. know the characteristics of the data
being examined
4. examine a plot of the data
 Misplaced sourced documents or
failure to record a transaction can
result in missing data.
2. Outliers
 Extreme observations of cost
activity relations
3. Allocated and discretionary costs
 Fixed costs are often allocated
on volume basis, resulting in
costs that could appear variable
 Discretionary costs also can be
budgeted so that they appear
variable
4. Inflation
5. Mismatched time periods

Learning Phenomenon
 systematic relationship between the
amount of experience in performing a
task and the time required to perform it
 occur when companies introduce new
production methods, make new
products or hire new employees

 Impact: causes the unit price to

decrease as production increases
 this implies a nonlinear model

Cost Estimation Assumptions

1. Cost behaviour depends on just one

cost driver
2. Cost behaviour patterns are linear
within the relevant range

Problems in collecting appropriate data

1. Missing data