Chapter Five: Cost Estimation: Total Costs

CHAPTER FIVE: COST ESTIMATION
 Total costs= Fixed costs + (Variable cost per unit * Units of output)
 Three general methods are used to estimate the relation between cost behavior and activity levels:
Engineering estimates
 One advantage is that it can detail each step required to perform an operation. This permits comparison with other
centers in which similar operations are performed and enables the company to review its productivity and identify
specific strengths and weaknesses.
 A difficulty is that it can be quite expensive to use because it analyzes each activity involved in the business.
 A consideration is that it is based on optimal conditions.
Account Analysis
 This approach includes the realities of downtime, missed work, machine repair, and other factors that often cause
engineering estimates to be less realistic by looking at existing activities.
 This method calls for a review of each cost account used to record the costs that are of interest, and the
identification of each as fixed or variable, depending on the relation between the cost and some activity.
 Identifying the relationship between the activity and the cost is the key step in account analysis.
 This approach uses the experience and judgment of managers and accountants who are familiar with company
operations and the way costs react to changes in activity levels.
Statistical Method
a. Relevant Range of Activity
- The level of activity for which a cost estimate may be a valid is the relevant range.
- Reliance on past data is relatively inexpensive, and could be the only readily available, cost-effective basis for
estimating costs.
b. Scattergraphs
- Scattergraphs provide a quick indication of the fixed-variable relation of costs and activities and can indicate
whether the relation seems to change at certain activity levels.
- The slope represents the variable cost per unit while the intercept is referred to as the fixed cost.
- Preparing estimates on the basis of a scattergraph is subject to a high level of error especially if the points are
scattered widely.
c. Number of Observations
- The number of observations to include depends on the availability of the data, variability within the data, relative
costs and benefits of obtaining reliable data, and the length of time the current processes has been in operation.
- A common rule of thumb is to use three years of monthly data if the physical processes have not changed
significantly within that time. However, if there are significant changes it would be misleading.
d. High-Low Estimates
Cost at highest activity level−Cost at lowest activity level
- Variable cost per unit =
Highest activity level−Lowest activity level
- Fixed cost = Total cost at highest activity level – (Variable cost * Highest activity level)
- Fixed cost= Total cost lowest activity level – (Variable cost * lowest activity level)
e. Regression Analysis
- The most important step in obtaining regression estimates for cost estimation is to establish the existence of a
logical relation between activities and the cost to be estimated.
- The activities are referred to as predictors, X terms, independent variable, or the right-hand side (RHS) of a
regression equation.
- The cost to be estimated is the dependent variable, Y term, or the left-hand side (LHS) of the regression equation.
- The most commonly used regression technique is the ordinary least squares regression (OLS).
- Total costs=Intercept coefficient + ( b∗labor hours )
e-1. Correlation Coefficient (Multiple R)
- Measures the proximity of the data points to the regression line
- The closer R is to 1.0, the closer the data points are to the regression line. Conversely, the closer R is to 0, the
poorer the fit of the regression line.
e-2. Coefficient of Determination (R Squared)

- Interpreted as the proportion of the variation in Y explained by X predictors
- A higher R2 is considered a good fit of the regression equation to the data.
e-3. Confidence in Coefficients

- T-statistic is used to test the significance of the coefficient. When the estimated coefficient is significantly
different from zero, we may conclude that is not totally fixed.
- T statistic=b/estimated standard error
- As a general rule of thumb, a t-statistic greater than 2.0 is considered significant. The significance level is called
p-value.
Multiple Regression
- The adjusted R2 is the correlation coefficient squared and adjusted for the number of independent variables used
to make the estimate. This recognizes that as the number of independent variable increases, unadjusted R 2 also
increases.
- The additional data requirements can limit their usefulness in many applications.
Common problems with using regression analysis include:

a. Attempting to fit a linear equation to nonlinear data
b. Failing to exclude nonrepresentative observations (outliers)
c. Including predictors with apparent, but spurious, relations to the dependent variable
d. Using data that do not fit the assumptions of the analysis
 Two important assumptions that are often not satisfied in estimating costs are that (1) the process for which costs are
being estimated are constant over time; and (2) the errors in estimating the costs are independent of the cost drivers.
 The learning phenomenon refers to the systematic relationship between the amount of experience in performing a task
and the time required to perform it. Variable costs tend to decrease per unit as the volume of activity increases.
 The two most common cost assumptions are:

a. Cost behavior depends on just one cost driver.
b. Cost behavior patterns are linear within the relevant range.

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CHAPTER FIVE: COST ESTIMATION

e-2. Coefficient of Determination (R Squared)

e-3. Confidence in Coefficients

Common problems with using regression analysis include:

 The two most common cost assumptions are:

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