Cost Estimation

and
Cost Allocation
Chapter
3
Explain the two assumptions
frequently used in
cost-behavior estimation.
Assumptions in Cost-Behavior
Estimation

Changes in total costs can be explained by

changes in the level of a single activity.
Cost behavior can adequately be
approximated by a linear function of the
activity level within the relevant range.
Describe linear cost functions
and three common ways in
which they behave.
 Cost Function

What is a cost function?

It is a mathematical expression
describing how costs change
with changes in the level
of an activity.
 Cost Function

TAJ Hotel offers an airline

three alternative cost structures to
accommodate its crew overnight:
1. Rs600 per night per room usage
y = Rs600x
The slope of the cost function is Rs600.
 Cost Function

2. Rs8,000 per month

y = Rs8,000
Rs8,000 is called a constant or intercept.
The slope of the cost function is zero.
Cost Function
 Cost Function

3. Rs3,000 per month plus Rs24 per room

This is an example of a mixed cost.
y = Rs3,000 + Rs24x
y = a + bx
 Cost Function

$20,000
$15,000
y = Cost

$10,000
$5,000
$0
0 100 200 300
x = Number of rooms
 Cost Classification
and Estimation Function

Choice of cost object

Time span

Relevant range
Choice of Cost Object Example

If the number of taxis owned by a taxi company

is the cost object, annual taxi registration and
license fees would be variable costs.
If miles driven during a year on a particular taxi
is the cost object, registration and license fees
for that taxi are fixed costs.
 Time Span

Whether a cost is variable or fixed with respect

to a particular activity depends on the time span.
More costs are variable with longer time spans.
 Relevant Range

Variable and fixed cost behavior patterns are

valid for linear cost functions only within
the given relevant range.
Costs may behave nonlinear outside the range.
 Cost Estimation

What is cost estimation?

It is the attempt to measure a past
cost relationship between costs
and the level of an activity.
Past cost-behavior functions can help
managers make more accurate
cost predictions.
The Cause-and-Effect Criterion
In Choosing Cost Drivers

Physical relationship

Contractual agreements

Implicitly established by logic

Understand various approaches
to cost estimation.
Cost Estimation Approaches

Industrial engineering method

Conference method

Account analysis method

Quantitative analysis methods

Account Analysis Example

The cost analyst uses experience and

judgment to separate total costs into
fixed and variable.
Avisha & Co. sells software programs.
Total sales = Rs390,000
The company sold 1,000 programs.
Account Analysis Example

Cost of goods sold = Rs130,000

Manager’s salary = Rs60,000
Secretary’s salary = Rs29,000
Commissions = 12% of sales
What is the total fixed cost?
Rs60,000 + Rs29,000 = Rs89,000
What is the fixed cost per unit sold?
 Account Analysis Example

Rs89,000 ÷ 1,000 = Rs89.00

What is the variable cost per unit sold?
Cost of goods sold: Rs130,000
Commissions: Rs390,000 × .12 = Rs46,800
(Rs130,000 + Rs46,800) ÷ 1,000 = Rs176.80
Outline six steps in estimating
a cost function on the basis
of past cost relationships.
 Steps In Estimating
A Cost Function

Step 1:
Choose the dependent variable.
Step 2:
Identify the independent variable cost driver(s).
Step 3:
Collect data on the dependent variable
and the cost driver(s).
Steps In Estimating
A Cost Function

Step 4:
Plot the data.
Step 5:
Estimate the cost function.
Step 6:
Evaluate the estimated cost function.
 High-Low Method Example

High capacity December: 55,000 machine-hours

Cost of electricity: Rs80,450
Low capacity September: 30,000 machine-hours
Cost of electricity: Rs64,200
What is the variable rate?
 High-Low Method Example

(Rs80,450 – Rs64,200) ÷ (55,000 – 30,000)

Rs16,250 ÷ 25,000 = Rs0.65
What is the fixed cost?
 High-Low Method Example

Rs80,450 = Fixed cost + (55,000 × Rs0.65)

Fixed cost = Rs80,450 – Rs35,750 = Rs44,700
Rs64,200 = Fixed cost + (30,000 × Rs0.65)
Fixed cost = Rs64,200 – Rs19,500 = Rs44,700
y = a + bx
y = Rs44,700 + (Rs0.65 × Machine-hours)
 Regression Analysis

It is used to measure the average amount of

change in a dependent variable, such as
electricity, that is associated with unit
increases in the amounts of one or
more independent variables,
such as machine-hours.
Regression analysis uses all available
data to estimate the cost function.
 Regression Analysis

Simple regression analysis estimates the

relationship between the dependent
variable and one independent variable.
Multiple regression analysis estimates the
relationship between the dependent variable
and multiple independent variables.
 Regression Analysis

The regression equation and regression line

are derived using the least-squares technique.
The objective is to find out the values of a and b in
The linear cost function y=a+bX, where y is the
Predicted cost value as distinguished from the
observed cost value, which is denoted by Y.
We wish to find the numerical values of a and b
That minimize (Y-y)2, the sum of the squares to the
Vertical deviations between Y and y.
 Regression Analysis

The objective of least-squares is to develop

estimates of the parameters a and b.
The vertical difference (residual term) measures
the distance between the actual cost and the
estimated cost for each observation.
The regression method is more accurate than
the high-low method.
 Describe three criteria used to
evaluate and choose cost drivers.
 Criteria to Evaluate and
Choose Cost Drivers

Economic plausibility

Goodness of fit

Slope of the regression line

 Economic plausibility

• Chosen cost drivers affect the costs

being analysed.
• Eg: cost of machine maintenance are
likely to be more closely related to
the no. of machine hours used than to
the no. of direct manufacturing
labour- hours.
 Goodness of Fit

The coefficient of determination (r )

2

expresses the extent to which the changes

in (x) explain the variation in (y).
An (r ) of 0.80 indicates that more than
2

80% of the change in the dependent

variable can be explained by the
change in the independent variable.
 Slope of Regression Line

A relatively steep slope indicates a strong

relationship between the cost driver and costs.
A relatively flat regression line indicates a weak
relationship between the cost driver and costs.
 Slope of Regression Line

The closer the value of the correlation

coefficient (r) to ±1, the stronger the
statistical relation between the variables.
As (r) approaches +1, a positive relationship
is implied, meaning the dependent variable (y)
increases as the independent variable (x) increases.
 Slope of Regression Line

As (r) approaches –1, a negative, or inverse,

relationship is implied, meaning the dependent
variable (y) decreases as the independent
variable (x) increases.
Explain and give examples
of nonlinear cost functions.
Nonlinearity and Cost Functions

A nonlinear cost function is a cost function in

which the graph of total costs versus the level
of a single activity is not a straight line within
the relevant range.
Economies of scale
Quantity discounts
Step cost functions
Nonlinearity and Cost Functions

Economies of scale in advertising may enable

an advertising agency to double the number
of advertisements for less than double the cost.
Quantity discounts on direct materials
purchases produce a lower cost per
unit purchased with larger orders.
Nonlinearity and Cost Functions

A step function is a cost function in which the

cost is constant over various ranges of the level
of activity, but the cost increases by discrete
amounts as the level of activity changes
from one range to the next.
 Distinguish the cumulative
average-time learning model
from the incremental
unit-time learning model.
 Learning Curves

A learning curve is a function that shows

how labor-hours per unit decline as units
of output increase.
 Experience Curve

This is a function that shows how the costs

per unit in various value chain areas decline
as units produced and sold increase.
 Cumulative Average-Time
Learning Model

Cumulative average time per unit is reduced by

a constant percentage each time the cumulative
quantity of units produced is doubled.
 Incremental Unit-Time
Learning Model

The time needed to produce the last unit is

reduced by a constant percentage each time
the cumulative quantity of units produced
is doubled.
Be aware of data problems
encountered in estimating
cost functions.
 Data Collection and
Adjustment Issues

The ideal database for cost estimation

has two characteristics:
1. It contains numerous reliably measured
observations of the cost driver(s) and the
cost that is the dependent variable.
2. It considers many values for the cost
driver that span a wide range.
 Data Collection and
Adjustment Issues

Time periods do not match.

Fixed costs are allocated as if they were variable.
Data are either not available or not reliable.
Inflation may play a role.
 Data Collection and
Adjustment Issues

Extreme values of observations occur from

errors in recording costs.
Analysts should adjust or eliminate unusual
observations before estimating a cost relationship.
There is no homogeneous relationship.
The relationship between the cost driver
and the cost is not stationary.
 Data Collection and
Adjustment Issues

The most difficult task in cost estimation

is collecting high-quality, reliably
measured data on the dependent
variable and the cost driver(s).
 Cost Estimation Approaches

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 THANK YOU
AND
HAVE A NICE DAY
Best Wishes for your
Internal