COST ESTIMATION

Cost Estimation
Importance, Types, Purpose, Components,
Procedure, Classification of costs, Cost
elements, Cost ladder, Overhead
expenses, Break-even analysis - Concept,
make or buy decision, assumptions, merits
and demerits of break even analysis.
Applications - Linear, multi product break-
even analysis.
Definition

 Cost estimating is the estimation of

the expected cost (probable cost) of
producing a job or executing a
manufacturing order before the
actual production is taken up.

 The expected expenditure on all the items

used to make a product is added to give
the estimated cost of final product.
Costing (or) Cost
accounting
 Costing may be defined as a system of
accounts which systematically and
accurately records every expenditure in
order to determine the cost of a product
after knowing the different expenses
incurred in various department.
 Costing involves classifying, recording and
allocating the appropriate expenditure for
determining the cost of production and
achieved by keeping a continuous record
of all the costs involved in manufacturing.
Factors for calculating the
probable cost of the product
(i) Design time,
(ii) Amount and. cost of materials required,
(iii) Production time required,
(iv) Labour charges,
(v) Cost of machinery, overheads and other
expenses,
(vi) Use of previous estimates of similar parts,
(vii) Effect of volume of production on costing rates,
(viii) Effect of changes in facilities on costing rates,
and
(ix) Probable future changes in unit prices for
materials, labour and expenses when the
proposed product is manufactured at a future
date.
Importance of cost
estimation
 Estimating is of great importance to a
concern because it enables the factory
owner to decide about the manufacturing
and selling policies.
 It is obvious that too high estimates will
not get jobs to the firm by quoting higher
rates according to over estimate.
 whereas under estimating will put the
owner to a loss and will lead the concern
to utter failure.
Purpose of cost estimation
 To establish the selling price of a product for a quotation or
contract, so as to ensure reasonable profit to the company.
 To ascertain whether the proposed product can be,
manufactured and marketed profitably,
 To take make or buy decisions, i.e., to determine Whether
the part or assembly can be manufactured economically, in
the plant elf or to be purchased from outside.
 To determine the most economical process, tooling or
material manufacture the product.
 To establish the standard of performance that may be used
to control costs.
 To prepare production budget.
 To evaluate alternate designs of product.
Functions of cost estimation
 Cost estimates are required to submit accurate
tenders for getting the contracts.
 Cost estimates are required for the manufacturer
to choose from various methods of production the
one which is likely to be most economical.
 Cost estimates are required for fixing the selling
price of a product.
 Cost estimate gives detailed information of all the
operations and their costs, thus setting a
standard to be achieved in actual practice.
 Cost estimate enables the management to plan
for procurement of raw materials, tools, etc., and
to arrange the necessary capital, as it gives
detailed requirement.
Types of estimates
 1. Estimates for fixing the selling price of the
product.
 2. Estimates to help the contractors to
submit accurate tenders for entering into
new contract.
 3. Estimates for setting various standards
for the purpose of comparison.
 4. Estimates to forecast the progress of
production and cost of the order to keep
control of any variation of the material costs.
Elements of Cost
 (A) Material cost,
 (B) Labour cost,
 (C) Other expenses.
Material cost
 Direct material cost : It is the cost of those
materials which are directly used for the
manufacture of the product and become a part
of the finished product.

 Indirect material cost : it is the cost of those

materials which are necessary to help in the
conversion of direct materials into final shape.
 The indirect materials include oils, general tools,
grease, sand papers, coolants, cotton waste etc.
Labour cost
 Direct labour cost : Direct labour is
one who actually works and processes
the materials to convert it into the final
shape. The cost associated with direct
labour is called direct labour cost.
 Examples of the direct labour are the
workers operating lathes, milling
machines or welders, or assemblers in
assembly shop.
 Indirect labour cost: Indirect labour is
one who is not directly employed in the
manufacturing of the product but his
services are used in some indirect
manner. The cost associated with indirect
labour is called indirect labour cost.
 The indirect labour includes supervisors,
inspectors, foreman, storekeeper,
gatekeeper, maintenance staff, crane
driver etc.
Expenses
 Direct expenses: Direct expenses
include all that expenditure which can be
directly allocated and charged to a
particular job.

 The direct expenses include cost of

special jigs or fixtures, patterns, toolings
made for job, or cost of research and
development work done for that specific
job.
 Indirect expenses : Except direct
expenses, all other indirect expenditure
incurred by the manufacturer is called
indirect expenses. The indirect expenses are
also called overhead expenses or on-cost.
 The indirect expenses are further classified
as :
 (i) Factory expenses.
 (ii) Administrative expenses.
 (iii) Selling and distribution expenses.
Factory expenses

 Factory expenses comprise of the indirect

expenses incurred from the receipt of the
order to the completion of production.
 In addition to indirect material and indirect
labour cost it includes
 rent of factory building, licence fee, electricity
and telephone bills of factory, insurance
charges etc.
 Factory expenses are also called “Works
expenses”, or “Factory or Works
overhead”.
Administrative
expenses
 Administrative expenses or office expenses
include the expenditure incurred on control
and administration of the factory.
 It includes the
 salaries of office and administrative staff, rent
of office building, postage and telephone
charges, water and electricity charges for
office, Director’s fee, legal and audit charges
etc.
 Administrative expenses are also known as
‘Administrative overheads’.
Selling and distribution
expenses
 This is the expenditure incurred on Sales
Department for selling the product, i.e.,
 wages
 Salaries
 commission and travelling allowances of
salesmen and officers in Sales Department
 cost of advertisement
 Packing, delivery and distribution expenses
 Rent of warehouses etc.
COST OF PRODUCT (LADDER
OF COSTS)
The components of cost discussed can be
grouped as follows :
1. Prime cost = Direct material cost + Direct
labour cost + Direct expenses
2. Factory cost = Prime cost + Factory
expenses
3. Production cost = Factory cost +
Administrative expenses
4. Total or Ultimate cost = Production cost +
Selling and distribution expenses.
5. Selling price = Ultimate cost + Profit
LADDER OF COSTS
COST ESTIMATION
PROCEDURE
1. Make thorough study of cost estimation request to
understand it fully.
2. Make an analysis of the product and prepare a bill of
materials.
3. Make separate lists of parts to be purchased from the
market and parts to be manufactured in plant.
4. Determine the cost of parts to be purchased from
outside.
5. Estimate the material cost for the parts/components
to be manufactured in plant.
6. Make manufacturing process plan for the parts to be
manufactured in plant.
7. Estimate the machining time for each operation
listed in the manufacturing process plan.
8. Multiply each operation time by the labour wage
rate and add them up to find direct labour cost.
9. Add the estimate of step 4, 5, and 8 to get prime
cost of component.
10. Apply overhead costs to get the total cost of the
component.

The selling price of the component is estimated

by adding profit to the total cost obtained in step 10.
Problem
 Calculate prime cost, factory cost,
production cost, total cost and selling
price per item from the data given below
for the year 2003-04.
Solution
Break Even Analysis
Break even analysis has two forms:
a) CVP (Cost-Volume-Profit): to determine the
volume of sales at which a specific product will
generate zero profit.
Total costs = Sales revenue (or) Sales revenue - Total costs = 0

b)To compare processes (or) options by finding

the volume at which two different processes (or)
options have equal total costs.
Total costs of process (or) option X = Total costs of Process (or)
option Y
Fixed cost
 Fixed costs : The fixed costs are the items of
expenditure which remain more or less constant
irrespective of the volume of production.
 depreciation of plant and machinery and
building,
 interest on capital,
 supervisory charges, cost of lighting, heating
 and cleaning the works,
 operator charges,
 rent of building etc.
Variable costs
 Variable costs : Variable costs are
those items of expenditure which vary
with the volume of production.
 direct material cost,
 cost of power/fuel consumed,
 cost of tools used,
 cost of consumable stores,
 repair and maintenance charges,
storage charges, etc.
Cost volume profit
Analysis
 Break-even point (BEP) represents the
production quantity for which the total cost of
producing the goods equals the total sales price.
 In this point, a business neither earns any profit
nor suffers any loss. Break-even point is therefore
also known as no-profit, no-loss point or zero
profit point.
P – Selling price per unit
V – Variable cost per unit
Break-even chart
 Break-even chart is a graphical
representation of inter-relationship between
quantity produced, cost of producing and sales
return.
 The total cost of production (fixed cost +
variable cost) and total sales return (revenue)
are plotted against quantity produced.
 The intersection of the total cost and total sales
return lines gives the break-even point.

Calculation of break-even point is important for every

business because it tells business owners and
managers how much sales are needed to cover all
fixed as well as variable expenses of the business or
the sales volume after which the business will start
generating profit.
Assumptions of Breakeven
Analysis
 All Fixed and Variable costs can be identified.
 Variable costs are assumed to vary directly with
output.
 Fixed costs will remain constant.
 Selling prices are assumed to remain constant for
all levels of output.
 All units produced are sold (i.e. production is
equal to sales.)
Advantages of break even
analysis
 It helps in deciding profitable level of output, below
which losses will occur.
 It can help in deciding the target.
 It foretells likely profits or losses at various levels
of output.
 It can indicate margin of safety.
 It helps in taking equipment replacement decisions.
 It helps in plant expansion decisions.
Limitations of break even
analysis
 Some costs cannot be identified as precisely Fixed or
Variable
 Semi-variable costs cannot be easily accommodated in
break-even analysis
 Selling cost may not remain constant. (Price reduction may
be necessary to protect sales in the face of increased
competition )
 With Fixed costs the assumption that they are constant over
the whole range of output from zero to maximum capacity is
unrealistic.
 The sales mix may change with changes in tastes and
fashions
 The balance between Fixed and Variable costs may be
altered by new technology.
 The cost revenue – volume relationship is linear. But this is
realistic only over narrow ranges of output.
 Break even analysis is not an effective tool for long range
use and its use should be restricted to the short run only
Applications of break even
analysis
 Four major applications:
1. New product decisions
2. Pricing decisions
3. Modernization or automation decisions.
4. Expansion decisions.
1. New product decisions
 Determine sales volume required for firm
(or individual product) to break even,
given expected sales and expected costs
2. Pricing decisions
 Study the effect of changing price and
volume relationships on total profits
3. Modernization or automation decisions
 Analyze profit implications of a modernization
or automation program
 In this case, firm substitutes fixed costs (i.e. capital
equipment costs) for variable costs (i.e. direct labor)
4. Expansion decisions
 Study aggregate effect of general expansion in
production and sales
 In this case, relationships between total rupees sales for all
products and total rupees costs for all products are
examined in order to indentify potential changes in these
relationships
Margin of safety
 In break even analysis chart, the
distance between B.E.P and the output
being produced is called as Margin of
safety.
 In other words, It is the difference
between actual sales minus break-even
sales.
 i.e. Margin of safety = Estimated
sales – Sales at Break-even point
 As margin of safety is the volume of sales
beyond the break-even sales point, all the
sales above the break-even point give
some profit, which can be calculated as:
Profit = Margin of safety (in units) ×
contribution per unit
(or)
Profit = Margin of safety (in rupees) ×
contribution ratio (PV Ratio)
The size of margin of safety is an important indicator of
the strength of business.
Steps to Improve Margin of Safety:
1. Increasing the level of production and sales.
2. Increasing the selling price.
3. Reducing fixed costs.
4. Reducing the variable cost.
5. Substituting profitable products, with the unprofitable
products
6. Changing the business mix to improve contribution
and dropping unprofitable products.
Angle of Incidence
 The break-even point is indicated where the Total
cost line and Total sales line intersect each other.
The angle that is formed with their intersection is
called ‘Angle of incidence’.
 Larger the angle of incidence, lower is the
break-even point and vice versa.
Break even analysis or CVP (Cost-Volume-
Profit ) Analysis for Single Product

Net Income (NI) = Total Revenue – Total Cost

Total Revenue = Selling Price Per Unit (P) * Number

of Units Sold (X)

Total Cost = Total Variable Cost + Total Fixed Cost (F)

Total Variable Cost = Variable Cost Per Unit (V) *

Number of Units Sold (X)

NI = P X – (V X + F)
(or)
NI = X (P – V) – F
Sample problem

 In a small factory making toys, the fixed

overhead costs are Rs. 5,000 per month
and the variable cost is Rs. 4 per piece.
The selling price is Rs. 6 per piece.
Estimate the minimum monthly
production so that the factory may not
suffer any loss.
Fixed cost (F) = Rs. 5,000
Variable cost (V) = Rs. 4 per piece
Selling price (P) = Rs. 6 per piece
NI = P X – (V X + F)
At break even point, Net income (NI) = 0
Therefore, P X = (V X + F)
(or) PX - VX = F
(or) X(P – V) = F
(or) X = F / (P – V)
X = 5000 / (6 – 4) = 2500.
Therefore, to avoid any loss to the factory, minimum monthly
production should be 2,500 pieces.
 In a small factory making toys, the
fixed cost is Rs. 54,000 per month and
the variable cost is Rs. 15 per piece.
The selling price is Rs. 20 per piece.
Calculate the break-even point and
also find out what should be the
selling price per unit, if the break-even
point should be brought down to 6,000
units?
Fixed cost (F) = Rs. 54,000
Variable cost (V) = Rs. 15 per piece
Selling price (P) = Rs. 20 per piece
NI = P X – (V X + F)
a)At break even point, Net income (NI) = 0
Therefore, P X = (V X + F)
(or) PX - VX = F
(or) X(P – V) = F
(or) X = F / (P – V)
BEP (IN UNITS), X = 54000 / (20 – 15) = 10800.
b)What should be the selling price per
piece, if BEP (in units) is brought down to
6000 units.
X1 = F / (P1 – V)
6000 = 54000 / (p1 – 15)
P1 = Rs.24
Selling price should be Rs. 24 per piece in
order to bring down the BEP (in units) to
6000 units.
Break even analysis (CVP Analysis) for Multi
Product

 The procedure of computing break-even point of

a multi product company (composite break-even
point) is a little more complicated than that of a
single product company.
 For two products, the break even model can be
modified as follows.
Example: Suppose FC = Rs.2,00,000; P1 =
Rs.5; V1 = Rs.2; P2 = Rs.10; V2 = Rs.6.

 NI = (P – V )X + (P – V )X – FC
1 1 1 2 2 2

 0 = (5 - 2)X + (10 - 6)X – 200,000

1 2

 0 = 3X + 4X – 200,000
1 2
(Or)

In the above formula, the weighted average selling price is worked

out as,
(sales price of product A x sales percentage of product A) + (sales
price of product B x sales percentage of product B) .……)/100

Similarly for the weighted average variable expenses,

(Variable expenses of product A x sales percentage of product A) +
(Variable expenses of product B x sales percentage of product B)
.……)/100
Problem.
 The Monster company manufactures three products –
product X, product Y and product Z. The variable expenses
and sales prices of all the products are given below:

Product X Product Y Product Z

Sales price Rs. 200 Rs. 100 Rs. 50
per unit
Variable Rs. 100 Rs. 75 Rs. 25
Thecost
totalper
fixed expenses of the company are Rs.50,000 per
unit
month. For the coming moth. Monster expects the sale of
three products in the following ratio: Product X: 20%;
Product Y: 30%; Product Z: 50%. Compute the BEP in
units and rupees for the coming month.
Solution
Fixed cost (F) = Rs. 50,000
Selling price per unit of Product X (P1) = Rs. 200
Variable cost per unit of Product X (V1) = Rs. 100
Selling price per unit of Product Y (P2) = Rs. 100
Variable cost per unit of Product Y (V2) = Rs. 75
Selling price per unit of Product Z (P3) = Rs. 50
Variable cost per unit of Product Z (V3) = Rs. 25
Product mix
Product X : Product Y : Product Z = 20% : 30% : 50%.
Total fixed expenses (F) = 50,000

Weighted average selling price = [(sales price of

product X x sales percentage of product X) + (sales
price of product Y x sales percentage of product Y)
+ (sales price of product Z x sales percentage of
product Z)]/100

Weighted average selling price = [(200 x 20)+ (100 x 30) +

(50 x 50)]/100
= Rs. 95
Weighted average variable expenses =[ (variable expenses of
product X x sales percentage of product X) + (variable expenses
of product Y x sales percentage of product Y) + (variable
expenses of product Z x sales percentage of product Z)]/100

Weighted average variable expenses = [(100 x 20)+ (75 x 30) + (25 x

50)]/100
= Rs. 55
Composite BEP (in units) = 50000 / (95 – 55)
= 1250
= 250 units of product X + 375 units of
product Y + 625 units of product Z
Composite BEP (in rupees) = [(250 x 200) + (375 x 100)
+ (625 x 50)]
= Rs. 118750
Break Even Point Analysis
Break even point analysis is also used
to make a choice between two different

types of processes to produce a given

component

To make decision on whether to

manufacture a product in house or to buy it
from outside suppliers
( i.e to make decision regarding make or buy)
To determine which of the two processes is most
economical, the total cost of the two processes
(fixed cost + variable cost) is plotted against the
number of units. The point at which the two lines
representing the total costs of the two processes
meet each other, is termed as break even point.
At Break-even point,
Total cost of process 1 = Total cost of process 2
F1 + V1Q = F2 + V2Q
Break even quantity (QE) = (F2 – F1) / (V1 – V2)

 if the quantity to be manufactured ≤ QE

Then use process 1 (which has the minimum fixed cost)
 if the quantity to be manufactured ≥ QE
Then use process 2 (which has the maximum fixed cost)
Example
1. The initial cost for machine A is
Rs.12000 and the unit production cost of
the machine is Rs.6.00 each. For the
other machine B, the initial cost is Rs.
48000 and the unit production cost is
Rs.1.20 each. Which machine will you
select for producing 10000 units.
Example
2. A component can be produced on either a capstan
lathe or an automatic lathe. The different cost factors
for the two machines are given below.
 Machine I
Fixed cost = Rs.500
Variable cost = Rs.3 per piece
 Machine II
Fixed cost = Rs.1500
Variable cost = Rs.1 per piece
Assume that cycle time for production of the component
is same for both the machines. Which machine will
you select for producing (a) 800, (b) 700 components.
Make or buy
Breakeven Analysis in the context of
Production planning addresses the decision
of whether to make or buy a product.
 Making the product involves two cost

elements:
 Fixed costs such as machine renting cost and
operation expenses
 Variable costs such as raw material cost

Buying the product involves only one cost

element, the selling price (Variable cost).
At Break-even point,
Buy cost = Make cost
PQ= F + VQ
Break even quantity (QE) = F / (P - V)
 Problem
A manufacturer of TV buys a TV cabinet at
Rs. 500 each. In case the company makes
it within the factory, the fixed and variable
costs would be Rs. 4,00,000 and Rs. 300
per cabinet respectively. Should the
manufacturer make or buy the cabinet if
the demand is 1,500 TV cabinets?
Solution
Buy cost per TV cabinet (P) = Rs. 500
Fixed cost (F) = Rs. 400000
Variable cost per TV cabinet (V) = Rs. 300
Break even quantity (QE) = F / (P - V)
= 400000/(500 – 300)
= 2000 units
Here, the demand (1,500 units) is less than the
break even quantity (2,000 units). Therefore the
company should buy the cabinets for its TV
production.
 Problem - 2
Assume that Friends Company manufactures a
product which requires a particular type of valves.
The company currently purchases the valves from
a supplier at a price of $5 per unit. The company
can also produce the valves internally. If the
company produces the valve internally, it will
incur the following costs: Direct labor = $1/unit,
Direct material = $2/unit, Variable overhead =
$0.5/unit, Fixed cost = $20,000.
Should Friends Company make or buy the valves
if the demand is 15000 units?
Problem (cost
estimation)
Calculate the selling price per unit from the following
data :
Direct material cost = Rs. 8,000
Direct labour cost = 60 percent of direct material cost
Direct expenses = 5 percent of direct labour cost
Factory expenses = 120 percent of direct labour cost
Administrative expenses = 80 percent direct labour cost
Sales and distribution expenses = 10 percent of direct
labour cost
Profit = 8 percent of total cost
No. of pieces produced = 200