Lecture – Rashid Hussain

Cost Estimation
 Introduction

Cost Cost Cost

estimation behavior prediction

Process of Relationship Using knowledge

determining between of cost behavior
cost behavior, cost and to forecast
often focusing activity. level of cost at
on historical a particular
data. activity. Focus
is on the future.

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Cost Terminology
◼ Variable Costs – costs that change in
total in relation to some chosen activity
or output
◼ Fixed Costs – costs that do not
change in total in relation to some
chosen activity or output
◼ Mixed Costs – costs that have both
fixed and variable components; also
called semivariable costs
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 Cost Behavior Patterns
Summary of Variable and Fixed Cost Behavior
Cost In Total
Variable Total variable cost is
proportional to the activity
level within the relevant range.
Fixed Total fixed cost remains the
same even when the activity
level changes within the
relevant range.
Per Unit
Variable cost per unit remains
the same over wide ranges
of activity.
Fixed cost per unit goes
down as activity level goes up.
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 Unit Variable Cost
Total Variable Cost

Unit Fixed Cost

Total Fixed Cost

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 Examples of variable costs
Merchandisers Service Organizations
Cost of Goods Sold Supplies and travel

Manufacturers Merchandisers and

Direct Material, Direct Manufacturers
Labor, and Variable Sales commissions and
Manufacturing Overhead shipping costs

Examples of fixed costs

Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising 6
 Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
reduced in the short short-term by current
term. managerial decisions

Examples Examples
Depreciation on Advertising and
Buildings and Research and
Equipment Development
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 Trends in Cost Structure
A trend toward more fixed costs because of
• Increased automation.
• Stable workforce.
Implications
Managers are more “locked-in” with fewer decision
alternatives.
Planning becomes more crucial: fixed costs are difficult to
change with current operating decisions.
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Cost Functions
◼ A cost function is a mathematical
representation of how a cost changes
with changes in the level of an activity
relating to that cost (cost driver)

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 Identifying Cost Drivers

Cost Driver Examples

Activity Cost Driver
Machining operations Machine hours
Setup Setup hours
Production scheduling Manufacturing orders
Inspection Pieces inspected
Purchasing Purchase orders
Shop order handling Shop orders
Valve assembly support Customer requisitions
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 Criteria for Evaluating
Alternative Cost Drivers

1. Economic Plausibility
◼ Economic significance
2. Goodness of Fit
3. Significance of the Independent
Variable
◼ Statistical significance

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 The Linear Cost Function
y = a + bX
The Dependent
Variable: The Independent
The cost that is Variable:
being predicted The cost driver

The Slope of
The Intercept: the Line:
Fixed costs Variable cost
per unit
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 The total cost line can be expressed
as an equation: Y = a + bX

Where: Y = the total mixed cost

a = the total fixed cost (the
Y vertical intercept of the line)
b = the variable cost per unit of
Cost activity (the slope of the line)
X = the level of activity

Variable Cost

X Fixed Cost
Number of Units Produced
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 The Linearity Assumption and
the Relevant Range
1. Variations in the level of a single
activity (the cost driver) explain the
variations in the related total costs
2. Cost behavior is approximated by a
linear cost function within the
relevant range
◼ Graphically, the total cost versus the level
of a single activity related to that cost is a
straight line within the relevant rage
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 Economist’s A straight line
closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
line within the
Relevant
Total Cost

relevant range.
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)

Activity 15
Fixed Costs and Relevant
Range
Example: Office space
is available at a rental
rate of $30,000 per
year in increments of
1,000 square feet. As
the business grows
more space is rented,
increasing the total Continue
cost. 16
 90
Thousands of Dollars

Total cost doesn’t

Rent Cost in

Relevant change for a wide

60 range of activity,
Range and then jumps to a
new higher cost for
the next higher
30 range of activity.

00 1,000 2,000 3,000

Rented Area (Square Feet)
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 Criteria for Classifying Variable
and Fixed Components of a Cost

1. Choice of Cost Object – different objects

may result in different classification of the
same cost
2. Time Horizon – the longer the period, the
more likely the cost will be variable
3. Relevant Range – behavior is predictable
only within this band of activity

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Cause-and-Effect Relationship
for Cost Drivers
◼ The most important issue in estimating a cost
function is determining whether a cause-and-effect
relationship exists between the level of an activity
and the costs related to that level of activity.
◼ A cause-and-effect relationship might arise as a result
of:
◼ A physical relationship between the level of activity and
costs
◼ A contractual agreement
◼ Knowledge of operations
◼ Note: a high correlation (connection) between
activities and costs does not necessarily mean
causality
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Question for Discussion 1 
Which of the following statements about cost
behavior are true?
a Fixed costs per unit vary with the level of
activity.
b Variable costs per unit are constant within
the relevant range.
c Total fixed costs are constant within the
relevant range.
d Total variable costs are constant within the
relevant range.
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 Cost Estimation Methods
1. Industrial Engineering Method
2. Conference Method
3. Account Analysis Method
4. Quantitative Analysis Methods
1. High-Low Method
2. Regression Analysis

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Industrial Engineering
Method
◼ Estimates cost functions by analyzing the
relationship between inputs and outputs in
physical terms
◼ Includes time-and-motion studies
◼ Very thorough and detailed, but also costly
and time consuming
◼ Also called the Work-Measurement Method

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 Direct Costs
Direct Labor Direct Material

•Analyze the kind •Material required

of work performed. for each unit is
•Estimate the time obtained from
required for each labor engineering drawings
skill for each unit. and specification sheets.
•Use local wage rates to •Material prices are
obtain labor cost determined from
per unit. vendor bids.
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Nonlinear Cost Functions
1. Economies of Scale
2. Quantity Discounts
3. Step Cost Functions – resources increase
in “lot-sizes,” not individual units
4. Learning Curves – labor hours consumed
decrease as workers learn their jobs and
become better at them
5. Experience Curve – broader application of
learning curve that includes downstream
activities including marketing and
distribution
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Learning Curves
There is often a systematic
relationship between experience
in performing a task and the time
required to do it.

The average time per task declines

by a constant percentage each time
the quantity of tasks done doubles.
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Types of Learning Curves
◼ Cumulative Average-Time Learning
Model – cumulative average time per unit
declines by a constant percentage each time
the cumulative quantity of units produced
doubles
◼ Incremental Unit-Time Learning Model –
incremental time needed to produce the last
unit declines by a constant percentage each
time the cumulative quantity of units
produced doubles 26
 Effect of Learning on Cost
Behavior
Berry Co. makes products requiring labor
that follows an 80 percent learning rate.
If the first unit of such a product requires
10 hours, what is the average time for 16
units of this product?
An 80 percent learning rate:
the average time required to make 2 units is 80 percent
of the time for 1 unit and the average time for 4 units is
80 percent of the time for 2 units, etc.
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 Cumulative Average-Time
Learning Model

Average
Number Labor Time Total Time:
of Units per Unit Average x Units
1 1 × 10 = 10 1 × 10 = 10
2 .80 × 10 = 8 2 × 8 = 16
4 .80 × 8 = 6.4 4 × 6.4 = 25.6
8 .80 × 6.4 = 5.12 8 × 5.12 = 40.96
16 .80 × 5.12 = 4.096 16 × 4.096 = 65.536

The graphic presentation of the learning

phenomenon is called the learning curve.
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 Learning Curve

Learning effects
are large initially.
Average Labor
Time per Unit

Learning effects
become smaller, eventually
reaching expected final time.

Cumulative Production Output

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 This is used to help
determine investment required.
Average Labor
Time per Unit

This is used to estimate

ongoing results.

Cumulative Production Output

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 Learning Curve Formula
Cumulative average labor time per unit
= DLH to produce unit 1
 (Cumulative no. of units produced)
learning factor

ln (learning rate % in decimal form)

Learning factor =
ln 2

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 Question for Discussion 2 
◼ Time to produce the first unit = 100
minutes
◼ Learning factor = ln(0.80)/ln2 = -0.32193

1. What is the cumulative average time to

produce 5 units?
2. What is the total time to produce 5 units?
3. What is the time it took to produce the 5th
unit?
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 Incremental Unit-Time
Learning Model

Using the example of Berry Co. and using

the incremental unit-time learning model

Cum.
Number Individual Unit Time Cumulative Ave. Time
of Units for X-th Unit Total Time Per Unit
1 1 × 10 = 10 10 10
2 0.80 × 10 = 8 10 + 8 = 18 9
3 7.02 18 + 7.02 = 25.02 8.34
4 0.80 × 8 = 6.40 25.02 + 6.40 = 31.42 7.86
5 5.96 31.42 + 5.96 = 37.38 7.48
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Conference Method
◼ Estimates cost functions on the basis of
analysis and opinions about costs and
their drivers gathered from various
departments of a company
◼ Pools expert knowledge
◼ Reliance on opinions still makes this
method subjective

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Account Analysis Method

◼ Estimates cost functions by classifying

various cost accounts as variable, fixed,
or mixed with respect to the identified
level of activity
◼ Is reasonably accurate, cost-effective,
and easy to use, but is subjective

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 Example
Overhead Costs for 1,000 Units
Total Variable Fixed
Account Cost Cost Cost
Indirect Labor $ 450 $ 450
Indirect Material 700 700
Depreciation 1,000 1,000
Property Taxes 200 200
Insurance 300 300
Utilities 400 350 50
Maintenance 600 500 100
Totals $ 3,650 $ 2,000 $ 1,650

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Total Cost = $2 per unit + $1,650
◼ Problems
◼ what is the proper cost driver
◼ what is truly fixed

◼ changes in price

◼ is a history available

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Quantitative Analysis
◼ Uses a formal mathematical method to
fit cost functions to past data
observations
◼ Advantage: results are objective

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Steps in Estimating a Cost Function
Using Quantitative Analysis

1. Choose the dependent variable (the cost to

be predicted)
2. Identify the independent variable or cost
driver
3. Collect data on the dependent variable and
the cost driver
4. Plot the data
5. Estimate the cost function using the High-
Low Method or Regression Analysis
6. Evaluate the cost driver of the estimated
cost function
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 The High-Low Method

WiseCo recorded the following production activity

and maintenance costs for two months:
Units Cost
High activity level 8,000 $ 9,800
Low activity level 5,000 7,400
Change 3,000 $ 2,400

Using these two levels of activity, compute:

the variable cost per unit;
the fixed cost; and then
express the costs in equation form Y = a + bX. 40
 The High-Low Method

Units Cost
High activity level 8,000 $ 9,800
Low activity level 5,000 7,400
Change 3,000 $ 2,400

 Variable cost = $2,400 ÷ 3,000 units = $0.80 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,800 – ($0.80 per unit × 8,000 units)
Fixed cost = $9,800 – $6,400 = $3,400
 Total cost = Fixed cost + Variable cost (Y = a + bX)
Y = $3,400 + $0.80X 41
 Question for Discussion 3

Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, what is the variable portion of sales
salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
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 Question for Discussion 4 
Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000 when
120,000 units are sold. Using the high-low
method, what is the fixed portion of sales
salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
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 Regression Analysis
◼ Regression analysis is a statistical method
that measures the average amount of change
in the dependent variable associated with a
unit change in one or more independent
variables
◼ Is more accurate than the High-Low
method because the regression equation
estimates costs using information from all
observations; the High-Low method uses only
two observations 44
 Types of Regression
◼ Simple – estimates the relationship between
the dependent variable and one independent
variable
◼ Multiple – estimates the relationship
between the dependent variable and two or
more independent variables

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 Terminology
◼ Goodness of Fit – indicates the
strength of the relationship between the
cost driver and costs
◼ Residual Term – measures the
distance between actual cost and
estimated cost for each observation

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 The simple cost model is actually a
regression model:
TC = F + VX

Caution: Before doing

This model will only the analysis, take time
be useful within a to determine if a
relevant range of logical relationship
activity. between the variables
exists. 47
 Simple Regression Method
◼ Software can be used to
fit a regression line
through the data points.
◼ The cost analysis
objective is the same:
Y = a + bX
Least-squares regression also provides a statistic,
called the R2, that is a measure of the goodness
of fit of the regression line to the data points.
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R2 is the percentage of the variation in total cost
explained by the activity.
Y
20
* ** *
Total Cost

* * **
10 * * R2 for this relationship is near
100% since the data points are
very close to the regression line.
0 X
0 1 2 3 4 49
Activity
Multiple Regression

Multiple regression includes two or

more independent variables:

TC = FC + V1X1 + V2X2

Terms in the equation have the same

meaning as in simple regression with
only one independent variable.

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Data Problems
◼ The time period for measuring the
dependent variable does not match the
period for measuring the cost driver
◼ Fixed costs are allocated as if they are
variable
◼ Some data may be missing or are not
uniformly reliable
◼ Extreme values of observations occur from
errors in recording costs
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◼ There is no homogeneous relationship
between the cost driver and the individual
cost items in the dependent variable-cost
pool.
◼ The relationship between the cost driver and
the cost is not stationary (not stable)
◼ Inflation has affected costs, the driver, or
both

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 Data Adjustment
◼ Corresponding numbers should be causally
related (i.e., if relating supplies to production
units, the figures should be usage of supplies
per some number of units of production NOT
supplies purchased in the same period).
◼ Consider outliers carefully: the object is to
find the relationship that will hold in the
future.
◼ Remember that cost relationships can change
over time (a “nonstationary” relationship). 53
 The Ideal Database
1. The database should contain
numerous reliably measured
observations of the cost driver and the
costs
2. In relation to the cost driver, the
database should consider many values
spanning a wide range

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