CHAPTER 10

Cost estimation and cost behaviour

 10.1a
General principles

•A regression equation (or cost function) measures past

relationships between a dependent variable (total cost)and
potential independent variables (i.e. cost drivers/activity
measures).

•Simple regression y = a + bx
Where y = Total cost
a = Total fixed cost for the period
b = Average unit variable cost
x = Volume of activity or cost driver for the period

•Multiple regression y = a + b1 x1 + b2 x2

•Resulting cost functions must make sense and be economically

plausible.
 10.1b

Cost estimation methods

1. Engineering methods

2. Inspection of accounts method

3. Graphical or scattergraph method

4. High-low method

5. Least squares method.

 10.2

Engineering methods
•Analysis based on direct observations of physical quantities required
for an activity and then converted into cost estimates.

•Useful for estimating the costs of repetitive processes where input-

output relationships are clearly defined.

•Appropriate for estimating the costs associated with direct labour,

materials and machine time.

Inspection of accounts
•Departmental manager and accountant inspect each item of
expenditure within the accounts for a particular period and classify
each item as fixed, variable or semi-variable.
 10.3
Graphical or scattergraph method
• Past observations are plotted on a graph and a line of best fit is drawn.

• Unit VC = Difference in cost = £720 – £560 = £2 per hour

Difference in activity 240 hours – 160 hours

Figure 1 Graph of
maintenance costs at
different activity levels

• Y = £240 + £2x
 10.4a

High–low method
•Involves selecting the periods of highest and lowest activity levels
and comparing changes in costs that result from the two levels.

Example
Lowest activity 5 000 units £22 000
Highest activity 10 000 units £32 000
Cost per unit = £10 000/5 000 units = £2 per unit
Fixed costs = £22 000 – (5 000 × £2) = £12,000

•Major limitation = Reliance on two extreme observations

 10.4b

Figure 2 High–low method

 10.5a

The least squares regression formula

Exhibit 1 Past observations of maintenance costs

 10.5b
The simple regression equation y = a + bx can be
found from the following two equations and
solving for a and b:

The above equation can be used to predict costs

at different output levels.
 10.6a

Multiple regression analysis

 10.6b

Multiple regression analysis (cont.)

 10.7
Factors to be considered when using
past data to estimate cost functions
• Identify the potential activity bases (i.e. cost drivers)
1. The objective is to find the cost driver that has the greatest effect on
cost.

• Ensure that the cost data and activity measures relate to the same period.

– Some costs lag behind the associated activity measures (e.g. wages
paid for the output of a previous period).

• Ensure that a sufficient number of observations are obtained.

• Ensure that accounting policies do not lead to distorted cost functions.

• Adjust for past changes so that all data relates to the circumstances of the
planning horizon.

• Adjust for inflation, technological changes and observations based on

abnormal situations.
 10.8
Summary
1. Select the dependent
variable (y) to be predicted.
Figure 3 Effect of
extrapolation costs
2. Select the potential cost
drivers.

3. Plot the observations on a

graph.*

4. Estimate the cost

function.

5.Test the reliability of the

cost function.

*Be aware of the dangers of

predicting costs outside the
relevant range.
 10.9a

Tests of reliability
• Tests of reliability indicate how reliable
potential cost drivers are in predicting the
dependent variable.
• The most simplistic approach is to plot the data
for each potential cost driver and examine the
distances from the straight line derived from the
visual fit.
• A more simplistic approach is to compute the
coefficient of variation (known as r2).
• See slide 9b for the calculation of r2 from the
data shown on sheet 5a.
 10.9b

so that r2 = (0.941)2 = 0.8861

r2 indicates that 88.61% of the variation in total cost is
explained by the variation in the activity base and the
remaining 11.39% by other factors. Therefore the higher the
coefficient of variation the stronger the relationship between
the dependent and independent variable.