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Slide 7-1

7 Cost Estimation

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7 The Strategic Roleof Cost Estimation

Predicting costsof alternative . . . .Predicting costs

of alternative . . . .

Activities, processes, or organizational

forms.

Activities, processes, or organizational

forms.

Implementationstrategies.

Implementationstrategies.

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7

strategic positioninganalysis.

value chain analysis.

target costing and life cycle costing.

strategic positioninganalysis.

value chain analysis.

target costing and life cycle costing.

Using Cost Estimation toPredict Future Costs

Strategic management requiresaccurate cost estimates to facilitate:

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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7 The Six Steps of Cost Estimation

Define the cost object to be estimated. Determine the cost drivers. Collect consistent and accurate data. Graph the data. Select and employ the estimation method. Assess the accuracy of the cost estimate.

Define the cost object to be estimated. Determine the cost drivers. Collect consistent and accurate data. Graph the data. Select and employ the estimation method. Assess the accuracy of the cost estimate.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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7 Cost Estimation Methods

High-lowmethod

High-lowmethod

WorkMeasurement

WorkMeasurement

RegressionAnalysis

RegressionAnalysis

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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7

Ben Garcia, the management accountant,is interested in estimating

maintenance cost. Bencollected this data for

seven recent years.

Ben Garcia, the management accountant,is interested in estimating

maintenance cost. Bencollected this data for

seven recent years.

Cost Estimation Methods

Year 1995 1996 1997 1998 1999 2000 2001Total Operating Hours 3,451 3,325 3,383 3,614 3,423 3,410 3,500 Maintenance Costs 22,843 22,510 22,706 23,030 22,413 22,935 23,175

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7

Total Operating Hours

Maintenance Cost

22,000

22,200

22,400

22,600

22,800

23,000

23,200

3325 3383 3410 3423 3451 3501 3614

x

Ben graphed the Ben graphed the data and selected data and selected two points--the two points--the high and low high and low

activities.activities.

Ben graphed the Ben graphed the data and selected data and selected two points--the two points--the high and low high and low

activities.activities.

High-Low Method

The high-low method uses two points to estimate the general cost equation Y = a bH

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7 High-Low Method

The high-low method uses two points to estimate the general cost equation Y = a bH

Y = the value of the estimated maintenance cost

a = a fixed quantity that represents the value of Y when H = zero

b = the slope of the line, the unit variable cost for maintenance.

H = the cost driver, the number of hours of operation for the plant

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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7

Ben used these two levels of activity to compute: the variable cost per unit; the fixed cost; and then express the costs in equation form Y = a + bH.

Hours Cost

High activity level 3,614 23,030$ Low activity level 3,325 22,510 Change 289 520$

High-Low Method

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7

Unit variable cost = $520 ÷ 289 hours = $1.80 per hour

Hours Cost

High activity level 3,614 23,030$ Low activity level 3,325 22,510 Change 289 520$

High-Low Method

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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Hours Cost

High activity level 3,614 23,030$ Low activity level 3,325 22,510 Change 289 520$

Unit variable cost = $520 ÷ 289 hours = $1.80 per hour Fixed cost = Total cost – Total variable cost Fixed cost = $23,030 – ($1.80 per hour × 3,614 hours)

Fixed cost = $23,030 – $6,505 = $16,525

High-Low Method

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7

Unit variable cost = $520 ÷ 289 hours = $1.80 per hour Fixed cost = Total cost – Total variable cost

Fixed cost = $23,030 – ($1.80 per hour × 3,614 hours)

Fixed cost = $23,030 – $6,505 = $16,525 Total cost = Fixed cost + Variable cost (Y = a + bH) Y = $16,525 + $1.80H

High-Low Method

Hours Cost

High activity level 3,614 23,030$ Low activity level 3,325 22,510 Change 289 520$

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7

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales

commission per unit sold?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales

commission per unit sold?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit

High-Low Method Question 1

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7

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales

commission per unit sold?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales

commission per unit sold?

a. $.08 per unit

b. $.10 per unit

c. $.12 per unit

d. $.125 per unit $4,000 ÷ 40,000 units = $.10 per unit

Units Cost

High level 120,000 14,000$Low level 80,000 10,000 Change 40,000 4,000$

High-Low Method Question 1

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7

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales

commission?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales

commission?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

High-Low Method Question 2

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7

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales

commission?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales

commission?

a. $ 2,000

b. $ 4,000

c. $10,000

d. $12,000

Total cost = Total fixed cost + Total variable cost

$14,000 = Total fixed cost +($.10 × 120,000 units)

Total fixed cost = $14,000 - $12,000

Total fixed cost = $2,000

High-Low Method Question 2

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7

A cost estimation A cost estimation method that makes a method that makes a detailed study of an detailed study of an

activity to measure the activity to measure the time required per unit time required per unit

of output. of output.

A cost estimation A cost estimation method that makes a method that makes a detailed study of an detailed study of an

activity to measure the activity to measure the time required per unit time required per unit

of output. of output.

Work Measurement

ExampleExample

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7

Kupper Insurance Company analyzes the time it takes to process a claim. The mean processing time

is 18 minutes, while 95% of the claims require between 10 and 25 minutes.

Work Measurement

This information enables Kupper toestimate cost more effectively.evaluate the processing clerks

more effectively and fairly.

This information enables Kupper toestimate cost more effectively.evaluate the processing clerks

more effectively and fairly.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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7

Regression analysis is a statistical method for

obtaining the cost estimation unique

equation that best fits a set of data points.

Regression analysis is a statistical method for

obtaining the cost estimation unique

equation that best fits a set of data points.

Regression Analysis

Lease squares regression is Lease squares regression is widely viewed as one of the widely viewed as one of the most effective methods for most effective methods for

estimating costs.estimating costs.

Lease squares regression is Lease squares regression is widely viewed as one of the widely viewed as one of the most effective methods for most effective methods for

estimating costs.estimating costs.

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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7

Statistics courses and computer courses deal

with detailed regression

computations using computer spreadsheet

software.

Statistics courses and computer courses deal

with detailed regression

computations using computer spreadsheet

software.Accountants and managers

must be able to interpret and use regression

estimates.

Accountants and managers must be able to interpret

and use regression estimates.

Regression Analysis

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7

The objective of the regression method is still a linear equation to estimate costs Y = a + bX + e

Y = value of the dependent variable, estimated cost

a = a fixed quantity, the intercept, that represents the value of Y when X = 0

b = the unit variable cost, the coefficient of the independent variable measuring the increase in Y for each unit increase in X

X = value of the independent variable, the cost driver

Regression Analysis

e = the regression error, the distance from the regression line to the data point

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7

Month Supplies Expense (Y) Production Level (X)

1 $250 50 units

2 310 100 units

3 325 150 units

4 ? 125 units

Month Supplies Expense (Y) Production Level (X)

1 $250 50 units

2 310 100 units

3 325 150 units

4 ? 125 units

Regression Analysis

Regression analysis willenable us to predict the amount of supplies

expense for month four.

Regression analysis willenable us to predict the amount of supplies

expense for month four.

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Slide 7-23

7S

up

plie

s E

xpen

se

400

350

300

250

200

50 100 150

Regression Analysis

Regression for the data isdetermined by a statistical procedure

that finds the unique line throughthe data points that minimizes

the sum of squared error distances.

Units of Output

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7 Regression Analysis

Month Supplies Expense (Y) Production Level (X)

1 $250 50 units

2 310 100 units

3 325 150 units

4 ? 125 units

Month Supplies Expense (Y) Production Level (X)

1 $250 50 units

2 310 100 units

3 325 150 units

4 ? 125 units

Y = a + bX + e

Y = $220 + $.75 per unit 125 units

Y = $313.75 Expense estimate for month 4

Y = a + bX + e

Y = $220 + $.75 per unit 125 units

Y = $313.75 Expense estimate for month 4

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Slide 7-25

7S

up

plie

s E

xpen

se

Units of Output

50 100 150

400

350

300

250

200

e = 7.5

e = 15 e = 7.5

220Fixed Cost = $220Fixed Cost = $220

Regression Analysis

b = the slope of the regression line or the coefficient of the independent variableb = $.75 per unit

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7

50 100 150 200

400

350

300

250

200

Outlier

proper line, excluding the outlierimproper line, influenced by outlier

Regression AnalysisS

up

plie

s E

xpen

se

Units of Output

Outliers may be discarded toobtain a regression that is more

representative of the data.

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7 Regression Analysis

Evaluating a Regression Analysis

R2, the coefficient of determination, is a measure of the explanatory power

of the regression, the degree thatchanges in the dependent

variable can be predicted by changesin the independent variable.

R2, the coefficient of determination, is a measure of the explanatory power

of the regression, the degree thatchanges in the dependent

variable can be predicted by changesin the independent variable.

The t-value is a measureof the reliability of each ofthe independent variables.

The t-value is a measureof the reliability of each ofthe independent variables.

The standard error of the estimate (SE) is a measureof the accuracy of the regression’s estimates.

The standard error of the estimate (SE) is a measureof the accuracy of the regression’s estimates.

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7

50 100 150 200

400

350

300

250

200

Regression withhigh R2 (close to 1.0)

Regression AnalysisD

epen

den

t V

aria

ble

Independent Variable

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7 Regression Analysis

50 100 150 200

400

350

300

250

200

Regression withlow R2 (close to 0)

Dep

end

ent

Var

iab

le

Independent Variable

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standard error

Regression Analysis

50 100 150 200

400

350

300

250

200

Dep

end

ent

Var

iab

le

Independent Variable

Standard error is a range around the regression estimate in which we can be reasonably sure that the

unknown value will fall.

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7

standard error

Regression with Wide(Poor) Standard Error

Slide 7-34

Regression Analysis

50 100 150 200

400

350

300

250

200

Dep

end

ent

Var

iab

le

Independent Variable

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standard error

Regression Analysis

50 100 150 200

400

350

300

250

200

Dep

end

ent

Var

iab

le

Independent Variable

Regression with Narrow(Good) Standard Error

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7

Data and Implementation ProblemsData and Implementation Problems Data AccuracyData Accuracy Selecting the time periodSelecting the time period

Mismatched time periodMismatched time periodLength of the time periodLength of the time period

Nonlinearity problemsNonlinearity problemsTrend and/or seasonalityTrend and/or seasonalityOutliersOutliersData shiftData shift

Data and Implementation ProblemsData and Implementation Problems Data AccuracyData Accuracy Selecting the time periodSelecting the time period

Mismatched time periodMismatched time periodLength of the time periodLength of the time period

Nonlinearity problemsNonlinearity problemsTrend and/or seasonalityTrend and/or seasonalityOutliersOutliersData shiftData shift

Regression Analysis

© The McGraw-Hill Companies, Inc., 2002McGraw-Hill/Irwin

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7 The End

This is a toughcost to estimate!