CHAPTER SEVEN

COST ESTIMATION

Cost estimation occurs where one attempts to measure future costs and periodic cost to

achieve the measurement which is necessary to split costs into fixed and variable

elements.

The following techniques may be used:

i. Accounts

classification method

ii. Industrial

engineering method

iii. Forecasting using

analytical techniques

ACCOUNTS CLASSIFICATION METHOD

This method involves examining account records and classifying each on the basis

of the assumed behavior that is fixed and variable elements e.g. rent and rates may

be classified as fixed while material costs may classified as variable. Electricity

standing charge as fixed while the consumption of electricity may be classified as

variables.

Drawbacks of account classification

i. It depends mainly on the initial occasions to classify the costs as fixed or variable

costs.
 ii. It fails to recognize semi-variable and semi-fixed costs that is the method of

dealing with semi-fixed costs is arbitrary.

iii. It assumes that transactions have been correctly charged to one account or the

other. INDUSTRIAL ENGINEERING APPROACH

This approach is to be used where there are no previous records available for example

launching a new product or operation or where the conditions have changed

drastically.

A satisfied analysis is likely to be on the number of uses and industrial engineering

approach uses a determined elemental approach to establish the required level of

output.

The physical inputs are then converted into monetary costs. The

relationship between inputs and outputs is established by the engineer or

technician that is technical experts and the relationship will be used to do

the estimations.

Example:

2 kilograms of materials plus 3 hours of labor plus 4% of overheads will

give a unit of output. The cost can be determined by establishing material

costs and wages cost to produce the physical units needed. The engineering

technique uses the work study and production engineering to establish what

cost should be if a number of units were produced.

It is the approach used to establish standard cost data.

Disadvantages

i. It is expensive.

ii. It involves detailed analysis of physical components of each

task in order to produce one unit of a product.

iii. There are often costs which are incurred in the production

process e.g. maintenance and supervision which may not be associated

with a specific unit of output that is the method is not useful where

there is a less direct link between costs and activity levels of output.

iv. Where a different mix of materials can be used to produce the

same units of output, it may lead to conflicting cost estimation.

FORECASTING USING ANALYTICAL TECHNIQUES

a. High- Low Method

High – Low method is one of the several techniques used to split a mixed

cost into its fixed and variable components. Although easy to understand,

high low method is relatively unreliable. This is because it only takes two

extreme activity levels (i.e. labor hours, machine hours, etc.) from a set of

actual data of various activity levels and their corresponding total cost

figures. These figures are then used to calculate the approximate variable

cost per unit (b), total fixed cost (a) and to obtain a cost volume formula;

y=a+bx
 Variable Cost per unit = y2-y1

x2-x1
Where:

y2 is the total cost at highest level of activity;

y1 is the total cost at lowest level of activity;

x2 are the number of units/ labor hours etc. at highest level

of activity;

x1 are the number of units/labor hours etc. at lowest level

of activity.

The variable cost per unit is equal to the slope of the cost volume line (i.e. change in

total cost/ change in number of units produced).

Total Fixed Cost

Total fixed cost (a) is calculated by subtracting total variable cost from

total cost,

thus: Total Fixed Cost = y2-bx2 =y1-bx1

Example:

Company A wants to determine the cost-volume relationship between its factory

overhead cost and number of units produced. Use the high-low method to split its

factory overhead costs into fixed and variable components and create a cost

volume formula. The volume and the corresponding total cost information of the

factory for the past eight months are given below:

 Sh.

Month Units Factory Overheads

1 1,520 36,375

2 1,250 38,000

3 1,750 41,750

4 1,600 42,360

5 2,350 55,080

6 2,100 48,100

7 3,000 59,000

8 2,750 56,800

Solution:

We have:

At highest activity: x2=3,000; y2=sh. 59,000

At lowest activity: x1=1,250; y1=sh.38, 000

Variable Cost per unit= (sh. 59,000- sh.38, 000) / (3,000-1,250) = sh.12 per unit.

Total fixed cost =sh.59, 000-(sh.12*3000) = sh. 38,000- (sh.12*1,250) =sh.23, 000

Cost Volume Formula: y=sh.23, 000+12x

Due to its unreliability, high low method is rarely used. The other techniques of

variable and fixed cost estimation are scatter-graph method and least squares

regression method.
 b. Linear Regression / Least Squares Method

The use of linear regression (least squares method) is the most accurate method in

segregating total costs into fixed and variable components. The total fixed cost and

variable cost per unit are determined mathematically through a series of

computations.

Like the other methods of cost segregation, the least squares method follows the

same cost function.

y=a+bx

Where:

y=total costs;

a=total fixed costs;

b=variable cost per

level of activity

x=level of activity

The normal equations in differential calculus

∑y=na+b∑x

∑xy=∑xa+b∑x2
Note that through the process of elimination, these equations can be used to

determine the value of a and b. Nonetheless, formulas for total fixed costs (a) and

variable cost per unit (b) can be derived from the above equations.

Variable Cost per unit (b)

Using the normal equations above, a formula for b can be derived. The variable

cost per unit or slope is computed using the following formula: b=n ∑ xy – (∑x)

(∑y)

n∑x2 – (∑x)2

Total fixed costs (a)

Once b has been determined, the total fixed cost or a can be computed using the formula:

a=𝑦̅-b𝑥̅

Where: 𝑦̅= ∑y

and 𝑥̅ = ∑x

Or, it is the same as:

a =∑y-b∑x
n

Example:

The following data was gathered for five production runs of ABC Company. Determine

the cost function using the least squares method.

Batch Units (x) Total Cost (y)

 1 680 sh. 29,800

2 820 sh. 34,000

3 570 sh. 27,500

4 660 sh.29, 000

5 750 sh. 31,900

Solution:

Batch Units (x) Total Cost (y) xy x2

1 680 29, 800 20,264,000 462,400

2 820 34,000 27,880,000 672,400

3 570 27,500 15,675,000 324,900

4 660 29,000 19,140,000 435,600

5 750 31,900 23,925,000 562,500

∑ 3,480 152,200 106,884,000

2,457,800 Substituting the computed values in the formula, we

can compute for b. b=n ∑ xy – (∑x) (∑y)

n∑x2 – (∑x)2
b= (5) (106,884,000) – (3,480) (152,200)

(5) (2,457,800) -

(3,480)2 b=26.6741=

sh.26.67 per unit

Total fixed cost (a) can then be computed by substituting the computed b.

a =∑y-b∑x

n
a =152,200-(26.67) (3,480)
5

a=sh.11, 877.68

The cost function for this particular set using the method of least

squares is y=sh.11, 887.68+sh.26.67x

ASSIGNMENT 1
(a) The following details have been obtained from the records of Mrs. Otieno who owns a
firm that deals in computer repairs and maintenance.

Work Number of components Total cost incurred

1 310 23,200
2 200 19,500
3 480 20,220
4 400 23,600
5 440 18,480
6 600 23,600
7 440 16,200
8 330 20,200

Additional information
 x = 3,200, y = 165,500,  xy = 66,322,800
 x2 = 1,382,600  y2 = 3,453,248,800

Required:
Formulate the cost function in the form of y=a+bx using
(i) High -low method (7 marks )
(ii) Least squares method (7 marks )
(b) Distinguish between:
(i) Allocation and apportionment (2 marks )
(ii) High-Low Method and Least Squares Method (2 marks )
(iii) Abnormal loss and abnormal gain (2 marks )
(iv) Industrial Engineering approach and accounts classification method (2 marks)

ASSIGNMENT 2

a) Outline three factors that influence the choice of the cost estimation method used by a manufacturing

company.

(3 marks)

b) Empire Packages Ltd, a manufacturing company, is in the process of assessing the behavior of its

production costs relative to the quantity of units produced.

The cost accountant of the company has prepared the following schedule of production costs and units

produced over the past thirteen months.

Month Production cost (Sh.000) Units Produced (000)

March 2017 1,540 240

April 2017 1,640

300
 May 2017 1,620

320

June 2017 1,660 280

July 2017 1,920 360

August 2017 1,800 400

September 2017 1,880 400

October 2017 1,900 280

November 2017 2,000 320

December 2017 1,740 360

January 2018 1,600 400

February 2018 1,880 280

March 2018 1,580 300

Required

I. The linear function of the relationship between production costs and the units produced

using both the high-low method and the least squares regression method. (9 marks)

II. Using each of the methods, estimate the production cost for 500,000 units of output.

Comment on the difference in the cost estimates. (2 marks)

c) Highlight six challenges that might arise in the installation of a cost accounting system. (6 marks)