COST ESTIMATION

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 Meaning
• Determining how cost will change with output or other measurable
factors of activity is of vital importance for decision-making, planning
and control.
• The preparation of budgets, for example, depends on reliable
estimates of costs and distinguishing between fixed and variable
costs, at different activity levels.

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Cost estimation methods
Several approaches are used to cost estimation. However, we will cover
only two methods:
1. The High-Low, and
2. The Least-squares methods.

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The High-Low Method
The high-low method compares costs at two different activity levels
to identify the fixed and variable cost components of the total cost.
• Since the fixed element of the total cost is likely to remain unchanged
during different periods, changes in the total costs at two different
levels of activity can be attributed solely to the variable elements.
• Variable cost per unit is calculated as:
1. Select the highest level of activity and the lowest level of activity in the
given series of data.
2. The difference in costs during these periods should be divided by the
changes in output during the same periods.
3. This calculation can be expressed mathematically as follows:
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The High-Low Method…

Fixed Cost = highest cost – (highest units x Variable cost

per unit)
or
Fixed cost = Lowest cost – (lowest units x variable cost per unit)

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Example I
The following data is available for the year 2020 in relation to
supervision costs:
Month Direct labour hours Supervision costs (shs)
January 5.000 720,000
February 5,200 780,000
March 6,000 800,000
April 5,700 790,000
May 7,500 850,000
June 8,000 1,080,000
July 6,300 820,000
August 7,000 830,000
Sept 6,800 810,000

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Example I…
To separate total cost into the fixed and variable elements, apply the
high or low method.

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Example II
A company incurs the following costs at various activity levels:

Activity level (units) Total costs (shs ‘000’)

5,000 250,000
7,500 325,000
10,000 400,000

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Example II…
Using the high-low method, what is the variable cost per unit?
A: Tshs25,000
B: Tshs30,000
C: Tshs35,000
D: Tshs40,000

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Advantages and Disadvantages
of H-L Method
The high-low method has the advantage of simplicity. However, it
suffers from a major flaw that it uses only two points. These points may
not produce accurate results in cost analysis unless they fall such that
they represent a true average of all the points of cost and activity.

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The least-squares method
• This method fits the line by statistical analysis rather than visual
observation on the way the points are scattered on the graph.
• It is based on the assumption that there is a linear relationship
between costs and the level of activity, which can be expressed
mathematically as:
Y = a + bx
where: Y = mixed cost, a = fixed cost component, b = variable cost per
unit, x = level of activity.

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The least-squares method…
• Under this method, the sum of the squared deviations of the plotted
points to the regression line is smaller than would be obtained from
any other line fitted to the data.
• Using the basic equation stated above and a given set of observations,
say n, two equations can be derived that fits the regression line:
∑xy = a∑x + b∑x2
∑y = na + b∑x
Therefore,

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Example III
The following data relates to the consumption of electricity in units and
the related costs.
Using least squares method establish the fixed cost component,
variable cost per unit of power and use these details to estimate
electricity costs when 460 units are consumed.

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Example III…
Period Units of electricity Costs (shs)
1 200 2,050
2 150 1,950
3 260 2,800
4 300 3,100
5 320 3,450
6 400 4,300
7 280 3,000
8 310 3,150
9 280 3,000
10 350 3,850

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