DAR ES SALAAM CPA (T) REVIEWS B5-Performance Management CPA (T) DAVID D KIWIA

COST ESTIMATION AND LEARNING CURVE

I. COST ESTIMATION

Cost Estimation is the process of classifying or separating the cost by behavior (ie variable and
fixed cost) so as to have a cost function that can be used to predict cost at any activity level.
Cost function is the mathematical formular that is used to predict cost at different levels of output.
Cost function is given as
Y = a + bX
Where
Y - Total cost
a - Fixed Cost
b – Variable Cost per Unit (VCu)
X – Activity Level
The following approaches to cost estimation will be examined:
i) engineering methods;
ii) inspection of the accounts method;
iii) graphical or scatter graph method;
iv) high–low method;
v) Least-squares method.
A. Engineering methods
Engineering methods of analyzing cost behaviour are based on the use of engineering analyses of
technological relationships between inputs and output. The approach is appropriate when there is
a physical relationship between costs and the cost driver. The engineering method is useful for
estimating costs of repetitive processes where input–output relationships are clearly defined.

B. Inspection of the accounts method;

The inspection of accounts method requires that the departmental manager and the accountant
inspect each item of expenditure within the accounts for a particular period, and then classify each
item of expense as a wholly fixed, wholly variable or a semi-variable cost. One problem with this
method is that the analysis of costs into their variable and non-variable elements can be very
subjective.

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DAR ES SALAAM CPA (T) REVIEWS B5-Performance Management CPA (T) DAVID D KIWIA

C. Graphical or scatter graph method

This method involves plotting on a graph the total costs for each activity level. The total cost is
represented on the vertical (Y axis) and the activity levels are recorded on the horizontal (X axis).
A straight line is fitted to the scatter of plotted points by visual approximation.

The graphical method is simple to use, and it provides a useful visual indication of any lack of
correlation or erratic behaviour of costs. However, the method suffers from the disadvantage that
the determination of exactly where the straight line should fall is subjective, and different people
will draw different lines with different slopes, giving different cost estimates. To overcome this
difficulty, it is preferable to determine the line of best fit mathematically using the least-squares
method.

D. High–low method

The high–low method consists of selecting the periods of highest and lowest activity levels and
comparing the changes in costs that result from the two levels. The non-variable (fixed) cost can
be estimated at any level of activity (assuming a constant unit variable cost) by subtracting the
variable cost portion from the total cost.

You will see from this illustration that the method ignores all cost observations other than the
observations for the lowest and highest activity levels. The high–low method is not the most
accurate method. To overcome this difficulty, it is preferable to determine the line of best fit
mathematically using the Regression method (least-squares method).

Generate the linear question from the data below,

Volume of production Maintenance costs

(units) (£)
8500 25000
5,000 22,000
9800 29000
10,000 32,000

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DAR ES SALAAM CPA (T) REVIEWS B5-Performance Management CPA (T) DAVID D KIWIA

E. Regression Method (Least-Squares Method)

This is a mathematical method of determining the regression line of best fit. The least squares
method is based on the principle that the sum of the squares of the vertical deviations from the line
that is established using the method is less than the sum of the squares of the vertical deviations
from any other line that might be drawn.

The general equation describing a line is: Y = a + bX

The formula for b =

 (Y  Y )( X  X )
 X  X 
2

And a: a = Y  bX
For example the past observations of maintenance costs is as follows. You are required to prepare
the cost estimation question by using regression method.

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Kiwia, David D. CPA-T, BAF, MFA-OG Email. [email protected] Cell 0716 734 577
DAR ES SALAAM CPA (T) REVIEWS B5-Performance Management CPA (T) DAVID D KIWIA

LEARNING CURVE

A learning curve is a graphical representation of relationship between a learner's performance on

a task and the number of attempts or time required to complete the task.

The learning curve theory proposes that a learner’s efficiency in a task improves over time the
more the learner performs the task. As such a learning curve is a nonlinear function (exponential
function) that shows how labour hours per unit decreases as unit of output increases.

Assumptions of learning curve Theory

 The work is manual
 The work is continuous
 The work is repetitive in nature
 No labour turnover
 No change in technology
 No change in production process
The relevance of learning curve effects in management accounting
(a) Calculate the marginal (incremental) cost of making extra units of a product.
(b) Quote selling prices for a contract, where prices are calculated at cost plus a percentage mark-
up for profit. An awareness of the learning curve can make all the difference between winning
contracts and losing them, or between making profits and selling at a loss-making price.
(c) Prepare realistic production budgets and more efficient production schedules.
(d) Prepare realistic standard costs for cost control purposes.
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DAR ES SALAAM CPA (T) REVIEWS B5-Performance Management CPA (T) DAVID D KIWIA

Example: using the formula

Suppose, a worker at ABC factory usually takes 200hrs to manufacture the first unit and 80%
learning curve applies to production of item ABC.

Required

a) Find the Labour hours to produce 2 units

b) Average time per unit when 8 units are produced
c) Labour hours to produce the second unit
d) Sum of hours to produce the 3rd and 4th units
e) Given that labour charges of Tsh 10 per hour find the labour cost of manufacturing 8 units.
Learning Curve Formular

The formula for the learning curve is Y = aXb, where b, the learning coefficient or learning index,
is defined as (log of the learning rate/log of 2). The learning curve formula can be used to solve all
learning curve scenarios.

The formula for the learning curve is Y = aXb

Where
Y is the cumulative average time per unit to produce x units
X is the cumulative number of units
a is the time taken for the first unit of output
b is the index of learning (logLR/log2)
LR is the learning rate as a decimal

Learning Curve and Production in Terms of Batches

In case production occurs in terms of batches, then the non of batch will be regarded as
“X” in the learning curve formular and hours taken by the first batch will be regarded as
“a”
Recall
Y = aXb
a = Hours taken by the first batch
x – The number of batches
b – The learning index, b = logLR/log2
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Kiwia, David D. CPA-T, BAF, MFA-OG Email. [email protected] Cell 0716 734 577
DAR ES SALAAM CPA (T) REVIEWS B5-Performance Management CPA (T) DAVID D KIWIA

REVIEW QUESTIONS
Question One
BFG Limited is investigating the financial viability of a new product the S-pro. The S-pro is a
short-life product for which a market has been identified at an agreed design specification. The
product will only have a life of 12 months.
The following estimated information is available in respect of S-pro:
1. Sales should be 1,200 units in the year. An average selling price of $1,050 per unit is expected.
All sales are for cash.
2. An 80% learning curve will apply for the first 700 units after which a steady state production
time will apply, with the labour time per unit after the first 700 units being equal to the time
for the 700th unit. The cost of the first unit was measured at $2,500. This was for 500 hours at
$5 per hour.
3. Variable overhead is estimated at $2 per labour hour.
4. Direct material costs will be $514,000 for the year. All purchases are made for cash.
A target net cash flow of $350,000 is required in order for this project to be acceptable.
Required
a. Prepare detailed calculations to show whether product S-pro will provide the target net
cash flow. (9 marks)
b. (b) Calculate what length of time the second unit will take if the actual rate of learning is:
i. 80%;
ii. 90%.
Explain which rate shows the faster learning. (5 marks)
c. (c) Suggest specific actions that BFG could take to improve the net cash flow calculated
above. (6 marks)
(Total = 20 marks)
Question Two
Chair Co has developed a new type of luxury car seat. The estimated labour time for the first unit
is 12 hours but a learning curve of 75% is expected to apply for the first eight units produced. The
cost of labour is $15 per hour. The cost of materials and other variable overheads is expected to
total $230 per unit.
Chair Co plans on pricing the seat by adding a 50% mark-up to the total variable cost per seat,
with the labour cost being based on the incremental time taken to produce the 8th unit.
Required:
(a) Calculate the price which Chair Co expects to charge for the new seat.
Note: The learning index for a 75% learning curve is –0·415. (5 marks)
(b) The first phase of production has now been completed for the new car seat. The first unit
actually took 12·5 hours to make and the total time for the first eight units was 34·3 hours, at
which point the learning effect came to an end. Chair Co are planning on adjusting the price to
reflect the actual time it took to complete the 8th unit.
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Kiwia, David D. CPA-T, BAF, MFA-OG Email. [email protected] Cell 0716 734 577
DAR ES SALAAM CPA (T) REVIEWS B5-Performance Management CPA (T) DAVID D KIWIA

Required:
i) Calculate the actual rate of learning and state whether this means that the labour force
actually learnt more quickly or less quickly than expected. (3 marks)
ii) Briefly explain whether the adjusted price charged by Chair Co will be higher or lower
than the price you calculated in part (a) above. You are NOT required to calculate the
adjusted price. (2 marks)
(10 marks)
Question Three
Henry Company (HC) provides skilled labour to the building trade. They have recently been asked
by a builder to bid for a kitchen fitting contract for a new development of 600 identical apartments.
HC has not worked for this builder before. Cost information for the new contract is as follows:
Labour for the contract is available. HC expects that the first kitchen will take 24 man-hours to fit
but thereafter the time taken will be subject to a 95% learning rate. After 200 kitchens are fitted
the learning rate will stop and the time taken for the 200th kitchen will be the time taken for all the
remaining kitchens. Labour costs $15 per hour.
Overheads are absorbed on a labour hour basis. HC has collected overhead information for the last
four months and this is shown below:
Hours worked Overhead cost $
Month 1 9,300 115,000
Month 2 9,200 113,600
Month 3 9,400 116,000
Month 4 9,600 116,800

HC normally works around 120,000 labour hours in a year.

HC uses the high low method to analyse overheads.
Required
(a) Describe THREE factors, other than the cost of labour and overheads mentioned above, that
HC should take into consideration in calculating its bid. (6 marks)
(b) Calculate the total cost including all overheads for HC that it can use as a basis of the bid for
the new apartment contract. (12 marks)
(c) If the second kitchen alone is expected to take 21·6 man-hours to fit demonstrate how the
learning rate of 95% has been calculated. (2 marks)
(Total = 20 marks)

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Kiwia, David D. CPA-T, BAF, MFA-OG Email. [email protected] Cell 0716 734 577