B313F Management and Cost Accounting

Lecture 6

Cost Estimation

By Charles Chiu, PhD, CFA

Introduction
Cost estimation
Process of determining cost behavior, often focusing on historical data.

Cost behavior
Relationship between cost and activity.

Cost prediction
Using knowledge of cost behavior to forecast level of cost at a particular 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 Variable In Total Total variable cost is proportional to the activity level within the relevant range. 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.

Fixed

Unit Variable Cost

Total Variable Cost

Total Fixed Cost

Unit Fixed Cost

Examples of variable costs

Merchandisers
Cost of Goods Sold

Service Organizations
Supplies and travel

Manufacturers
Direct Material, Direct Labor, and Variable Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Examples of fixed costs

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

Committed
Long-term, cannot be reduced in the short term.

Discretionary
May be altered in the short-term by current managerial decisions

Examples
Depreciation on Buildings and Equipment

Examples
Advertising and Research and 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)

Identifying Cost Drivers

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

1.

Economic Plausibility

Economic significance

2. 3.

Goodness of Fit Significance of the Independent Variable

Statistical significance

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The Linear Cost Function

y = a + bX
The Dependent Variable: The cost that is being predicted
The Intercept: Fixed costs The Independent Variable: The cost driver The Slope of the Line: Variable cost per unit
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The total cost line can be expressed as an equation: Y = a + bX Where:

Y
Cost

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

X
Number of Units Produced

Fixed Cost
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The Linearity Assumption and the Relevant Range

1.

2.

Variations in the level of a single activity (the cost driver) explain the variations in the related total costs 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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A straight line Economists closely Curvilinear Cost approximates a Function curvilinear

Total Cost

Relevant Range

variable cost line within the relevant range.

Accountants Straight-Line Approximation (constant unit variable cost) Activity

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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 cost.

Continue
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Rent Cost in Thousands of Dollars

90 Relevant
Range
Total cost doesnt change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

60

30

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.

2.

3.

Choice of Cost Object different objects may result in different classification of the same cost Time Horizon the longer the period, the more likely the cost will be variable 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.
2. 3. 4.

Industrial Engineering Method Conference Method Account Analysis Method Quantitative Analysis Methods
1. 2.

High-Low Method 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 Labor

Direct Material

Analyze the kind of work performed.

Estimate the time required for each labor skill for each unit. Use local wage rates to obtain labor cost per unit.

Material required for each unit is obtained from engineering drawings and specification sheets. Material prices are determined from vendor bids.

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Nonlinear Cost Functions

1.
2. 3. 4.

5.

Economies of Scale Quantity Discounts Step Cost Functions resources increase in lot-sizes, not individual units Learning Curves labor hours consumed decrease as workers learn their jobs and become better at them 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

Number of Units 1 2 4 8 16 Average Labor Time per Unit 1 10 = 10 .80 10 = 8 .80 8 = 6.4 .80 6.4 = 5.12 .80 5.12 = 4.096 Total Time: Average x Units 1 10 = 10 2 8 = 16 4 6.4 = 25.6 8 5.12 = 40.96 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 produceunit 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
What is the cumulative average time to produce 5 units? What is the total time to produce 5 units? What is the time it took to produce the 5th unit?
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1.

2.
3.

Incremental Unit-Time Learning Model

Using the example of Berry Co. and using the incremental unit-time learning model
Number of Units 1 2 3 4 5 Individual Unit Time for X-th Unit 1 10 = 10 0.80 10 = 8 7.02 0.80 8 = 6.40 5.96 Cum. Cumulative Ave. Time Total Time Per Unit 10 10 10 + 8 = 18 9 18 + 7.02 = 25.02 8.34 25.02 + 6.40 = 31.42 7.86 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 Total Cost $ 450 700 1,000 200 300 400 600 $ 3,650 Costs for 1,000 Units Variable Fixed Cost Cost $ 450 700 1,000 200 300 350 50 500 100 $ 2,000 $ 1,650
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Account Indirect Labor Indirect Material Depreciation Property Taxes Insurance Utilities Maintenance Totals

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. 2. 3.

4.
5. 6.

Choose the dependent variable (the cost to be predicted) Identify the independent variable or cost driver Collect data on the dependent variable and the cost driver Plot the data Estimate the cost function using the HighLow Method or Regression Analysis 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:
High activity level Low activity level Change Units 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 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 8,000 5,000 3,000 Cost $ 9,800 7,400 $ 2,400

High activity level Low activity level Change

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

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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

This model will only be useful within a relevant range of activity. Caution: Before doing the analysis, take time to determine if a logical relationship between the variables 47 exists.

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

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* * * * R2 for this relationship is near

100% since the data points are very close to the regression line. 0 1 2 3 Activity 4 X
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* ** * **

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.

2.

The database should contain numerous reliably measured observations of the cost driver and the costs In relation to the cost driver, the database should consider many values spanning a wide range
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