ACY 106 I COST ACCOUNTING & CONTROL

COST
ESTIMATION
CHAPTER 2

GROUP II • BUENAVISTA • CADIZ • CALIBOD

LEARNING OBJECTIVES
EXPLAIN THE STRATEGIC ROLE OF COST
01 ESTIMATION

02 APPLY THE SIX STEPS OF COST ESTIMATION

USE THE HIGH - LOW AND REGRESSION
03 ANALYSIS METHOD OF COST ESTIMATION

04 EXPLAIN THE IMPLEMENTATION ISSUES OF

THE COST ESTIMATION METHODS
05 USE LEARNING CURVES IN COST ESTIMATION
WHEN LEARNING IS PRESENT
"You can’t connect the dots looking forward;
you can only connect them looking backward.
So you have to trust that the dots will
somehow connect in your future."
- Steve Jobs
 COST ESTIMATION
Cost estimation
The development of well-defined relationship
between cost object and its cost drivers for the
purpose of predicting the cost.
This is critical in cost planning and decision
making.

Cost object Cost drivers

It is any item for which costs are being
Are the activities that drive up cost.
separately measured. It is a key concept used
Types of cost drivers:
in managing the costs of a business.
a) Activity-based
Types of cost objects:
a) Output-Related Cost Objects
b) Volume-based
b) Operational Cost Objects c) Structural
c) Business Relationship Cost Objects d) Executional
"We first survey the plot, then draw the
model; and when we see the figure of the
house, then must rate the cause of the
erection; which, if we find outweighs ability,
what do we do then but draw anew the
model."
- William Shakespeare
 STRATEGIC ROLE OF
COST ESTIMATION
facilitates strategic management
helps predict future cost using identified
activity-based, volume-based, structural, or
executional cost drivers.
helps identify the key cost drivers for a cost
object & which are most useful in predicting
cost.

USING COST ESTIMATION TO PREDICT FUTURE COSTS

To facilitate strategy development and
implementation.
To facilitate planning and decision making
To facilitate target costing and pricing
To facilitate effective performance measurement,
evaluation, and compensation
 STRATEGIC ROLE OF
COST ESTIMATION
COST ESTIMATION FOR DIFFERENT TYPES OF COST DRIVERS
activity-based, volume based, structural, executional
relationship between costs & activity-based or
volume-based
often fit best by linear cost estimation methods
structural cost drivers involve plans & decisions that
have long-term & strategic impact on firm
experience & scale often require nonlinear methods
experience represents reduction in unit cost due to
learning
relationship between structural cost driver is
nonlinear
scale describes manufacture of similar products that
differ in size
common effect of scale is total manufacturing cost
increases more rapidly than increase in size of
product
 STRATEGIC ROLE OF
COST ESTIMATION
USING COST ESTIMATION TO IDENTIFY COST DRIVERS

identify cost drivers relies on judgment of product

designers, engineers, and manufacturing personnel.
plays a discovery role and at other times a collaborate
role to validate and confirm judgments.
 DIFFERENT TYPES OF COST
FIXED COSTS VARIABLE COSTS
Costs that remain constant in Those that change in total as the
total regardless of changes in the level of activity changes in the
level of activity within the short run and within relevant
relevant range range
Decreases per unit as the activity Constant per unit because each
level rises and increased per unit unit costs the same amount
as the activity level fall Example: Any direct material,
Example: factory rent direct labor, factory overhead

STRATEGY N°3
 DIFFERENT TYPES OF COST
STEP FIXED COSTS MIXED COSTS
Costs that are fixed within Costs that contains both variable
certain activity levels, however and fixed cost elements.
once the specified activity level
exceeds, there will be a need to
incur a step increase.
Example: Renting for another
factory to increase units of
production

STRATEGY N°3
 SIX STEPS OF COST
ESTIMATION
Collect
Define the cost Determine the
consistent and
object cost drivers
accurate data
STEP 1 STEP 2
STEP 3

Assess the
Select and employ
Accuracy of the Graph the data
the estimation
cost estimate
method

STEP 6 STEP 5 STEP 4

 SIX STEPS OF COST ESTIMATION
Define the cost object

1 -Defining cost to be estimated requires care

Determine the Cost Drivers

2 -cost drivers are causal factors used in estimation of cost

-identifying cost drivers is most important step in developing cost estimate

Collect Consistent & Accurate Data

3 -must be consistent & accurate

-consistent means each period of data is calculated using the same accounting basis &
all transactions are properly recorded in period in which they occurred
-management accountants must determine which time period best satisfies the
objective of accurate estimation
-accuracy of data depends on source
 SIX STEPS OF COST ESTIMATION
Graph the Data

4 -identify unusual patterns

-any shift or nonlinearity in data must be given special attention in developing the
estimate

Select & Employ the Estimation Method

5 -two estimation methods differ in ability to provide superior accuracy in cost

estimation relative to cost of expertise & resources required

Assess the Accuracy of the Cost Estimate

6 -consider potential for error when estimate is prepared

-consider completeness & appropriateness of cost drivers, consistency & accuracy of
data selected, study of graphs, precision of method selected
-Mean absolute percentage error (MAPE): calculated by taking the absolute value of
each error, & then averaging these errors & converting the result to a percentage of
the actual values
COST ESTIMATION METHOD
A cost estimate is an evaluation
and analysis of future costs
generally derived by relating
historical cost, performance,
schedule and technical data of
similar items or services.
HIGH-LOW METHOD
The high-low method is an
accounting technique used to
separate out fixed and variable
costs in a limited set of data. It
involves taking the highest level of
activity and the lowest level of
activity and comparing the total
costs at each level.
 HIGH-LOW METHOD
What are the formulas for the high-low method?

1.Variable cost per unit = (Highest activity cost - Lowest

activity cost) / (Number of highest activity units - Number
of lowest activity units)

2.Total fixed cost = Highest activity cost - (Variable cost x

Number of highest activity units)

3.Total cost per unit = Total fixed cost + Total variable

cost
 EXAMPLE

The data a company is analyzing only applies to one quarter of a

year, so it only has three entries in its data set. The table below
represents the first quarter for the company, which produces
boots, and the steps it takes to calculate the high-low method:

Month Cost per Month Units (Pairs of Boots)

January ₱ 30,000 10,000
February ₱ 40,000 15,000
March ₱ 35,000 14,000
April Unknown Cost (Calculation Needed) 16,000 (Goal)
 EXAMPLE
Solution:

The highest units produced are in February, with 15,000 pairs of

boots produced at ₱40,000, while the lowest is in January, with
10,000 pairs of boots produced at ₱30,000.

Variable cost per unit = (Highest activity cost - Lowest activity

cost) / (Number of highest activity units - Number of lowest activity
units)
Variable Cost per Unit = (₱40,000 - ₱30,000) / (15,000 - 10,000)
Variable Cost per Unit = (₱10,000) / (5,000)
Variable Cost per Unit = ₱2.00
 EXAMPLE
Solution:

Total fixed cost = Highest activity cost - (Variable cost x

Number of highest activity units)
Total Fixed Cost = ₱40,000 - (₱2.00 x 15,000)
Total Fixed Cost = ₱40,000 - ₱30,000
Total Fixed Cost = ₱10,000

Total Variable Cost = Variable cost x Goal (Number of units)

Total Variable Cost = ₱2.00 x 16,000
Total Variable Cost = ₱32,000
 EXAMPLE
Solution:

Total Cost = Total Fixed Cost + Total Variable Cost

Total Cost = ₱10,000 + ₱32,000
Total Cost = ₱42,000 for the predicted month of
April
 REGRESSION ANALYSIS
A statistical method for obtaining the unique cost-estimating equation that best fits a
set of data points.
Each error is the distance measured from the regression line to one of the data points
This is more accurate than the high-low method, but has the greatest computational
complexity and requires more expertise to properly interpret the results.
Least squares regression: minimizes the sum of the squares of the estimation errors, is
widely viewed as one of the most effective methods for estimating costs
Can be influenced strongly by outliers which are unusual data points.

Advantages Disadvantages
Objective measures of the reliability and Can be difficult to calculate
precision of the regression estimate. Underlying assumptions need to be met
Quantitative
 REGRESSION ANALYSIS

Dots= Actual data points

Straight line = Line of best fit
Vertical deviation: The difference between the actual dot and the estimated point
where that point should be on the line.
REGRESSION ANALYSIS

Prepare graph of data prior to using regression & each outlier is

reviewed to either remove or correct

Choosing the Dependent Choosing the

Variable Independent Variable(s)
This is the cost to be estimated This is a cost driver used to estimate
the value of the dependent variable
choice of cost objective
might be very aggregate level or at consider all financial, operating, &
a detail level other economic data that might
choice of aggregation level be relevant for estimating
depends on objectives for cost dependent variable
estimation, data availability, choose variables that (1) are
reliability relevant & (2) don’t duplicate
other independent variables
REGRESSION ANALYSIS
TYPES OF
LINEAR REGRESSION
Simple Linear Multiple Linear
Regression Regression
Used to describe regression Used to describe regression
applications having a single applications having two or more
independent variable. independent variables.

BASIC FORMULA OF REGRESSION

VARIABLE
Y = a + bX + e
Y = is amount of dependent variable
a = is fixed quantity
b = is unit variable cost
X = is independent variable
e = is estimation error
REGRESSION ANALYSIS

EVALUATING REGRESSION ANALYSIS

-provides quantitative measures of precision & reliability that aid management

accountants in assessing the usefulness of the regression
Precision: Reliability:
The accuracy of estimates from Whether regression reflects actual
the regression relationships among the variables

FOUR KEY AND RELATED

MEASURES
1) R-squared aka coefficient of determination
2) T-value
3) The standard error of the estimate (SE) aka the standard error of the regression
4) P-value
 FOUR KEY AND RELATED MEASURES

R-SQUARED T-VALUE
a number between zero & 1 & often is measure of the reliability of each
described as a measure of the independent variable; that is, the
explanatory power of the regression; degree to which an independent
that is, the degree to which changes variable has a valid, stable, long-
in the dependent variable can be term relationship with the
predicted by changes in the dependent variable
independent variable(s)
the higher the R-squared, the more small t-value indicates little/no
reliable (if equal 1, SE = 0) statistical relationship between
high R-squared shows data points independent & dependent variables
lying near regression line (more
scattered with low R-squared)

-Two or more independent variables are highly correlated with each other -not supposed to
be correlated
Multicollinearity
- A given variable tends to change predictably in the same (or opposite) direction for a
given change in the other, correlated variable -effect of multicollinearity is estimates of
Correlat ion
coefficients for independent variables are unreliable
 FOUR KEY AND RELATED MEASURES

STANDARD ERROR OF P-VALUE

THE ESTIMATE (SE) measures the risk that a particular
independent variable has only a
a measure of the dispersion of the actual
chance relationship to the
observations around the regression line,
dependent variable
& as such provides a measure of the
small p-value is desirable (.05 or
accuracy of the regression’s estimates
less)
useful for management accountants to
t-values greater than 2 have low p-
describe degree of precision obtained
values
from regression prediction
SE must be interpreted by relationship to
average size of dependent variable
if SE is small to dependent variable,
precision is good

- a range around the regression line within which the management accountant can be
Confidence confident the actual value of the predicted cost will fall
interval -67% confidence interval identifies that 1 standard-error distance on either side of line;
95% confidence interval determined from 2 standard-error distances
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 ANSWERS
IDENTIFICATION
1. Cost estimation
2. -4. -To facilitate strategy development and implementation.
-To facilitate planning and decision making
- To facilitate target costing and pricing
- To facilitate effective performance measurement, evaluation, and compensation
5. Cost drivers
6. Step fixed cost
7. Step 4
8. Regression Analysis Method
9 . High-Low method
10. T-value
TRUE OR FALSE
1. TRUE 2. TRUE 3. TRUE 4. FALSE 5. TRUE
6. FALSE 7. FALSE 8. TRUE 9. TRUE 10. TRUE