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05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 1
Cost Estimation
Unit III Characteristics of Forecasts, Forecasting Horizons, Steps to Forecasting, Forecasting Methods, Seasonal Adjustments, Forecasting Performance Measures, Cost Estimation, Elements of cost, Computation of Material Variances Break Even Analysis‐
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 2
Classification of CostCost According to Elements
Expenses/ OverheadsMaterial Cost Labour Cost
Material cost : Cost of material traceable to one unit of productLabor cost : Cost of human resource involvementExpenses/ overheads : Cost associated with direct /indirect overheads; design, administrative, production, sales/service, distribution
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 3
Classification of Cost
Cost According to Behaviour
Variable CostFixed Cost Semi Variable Cost
Fixed Cost: Fixed in short run and long runVariable Cost: Varies with volume and constant per unitSemi variable Cost: fixed for one level of activity and variable for another
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 4
Classification of Cost
Cost According to Functions
Administration Cost
Production Cost
Selling/ promotion/ Distribution Cost R & D Cost
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 5
Classification of CostCost According to
Management Decisions
Differential Cost
Marginal Cost
Opportunity Cost
Replacement Cost
Imputed Cost
Sunk Cost
Marginal Cost is the cost added by producing one extra unit of a product. Differential cost is the difference between the cost of two alternative decisionsopportunity cost refers to a benefit that could have been, but not received due to choosing other alternative.Sunk cost: is the cost of abandoned plant less salvage value. Not relevant for decision makingImputed Cost or Notional Cost :Actually not incurred (interest on own capital, rent on owned building, etc.) but taken into account in capital budgeting decisions.Replacement Cost : Cost of replacing equipment at current market price.
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 6
Classification of CostCost According to Expenses
Direct Cost Indirect Cost
• Physical assets•Maintenance and operating costs•Materials• Direct labor• Scrapped and reworked product• Direct supervision of personnel
• Utilities• IT systems and networks• Purchasing•Management• Taxes • Legal functions•Warranty and guarantees• Quality assurance•Marketing and publicity
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 7
Cost EstimationCost Estimation : is finding relationship between activities and cost
Cost estimation is done to • Manage cost• Making cost decisions• Plan and set standards
Cost estimation results in reduced costs
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 8
Cost Estimation: simple model• This model ignores other cost behaviours and other cost drivers• This model only takes into account the fixed and variable cost
TC=F+ Q.V
Where TC= Total costF =Fixed costQ =Quantity producedV = Variable cost per unit
Total Cost TC
Fixed Cost FVariable Cost V
Quantity Q
Cost
05/02/2023
Cost Estimation: Unit Method
NHU 501 Dr N R Kidwai, JIT Barabanki15-7
• Unit method is Commonly used for preliminary stage estimates
• Total cost estimate TC is per unit cost (CU) times number of units (N)
TC=Cu × NExample• Cost to operate a car at Rs 5/Km for 500 km: TC = 5 × 500 = Rs 2500/-• Cost to build a 100 m2 house at Rs 3000/m2: TC=3000× 100 = Rs 3 lac
Cost factors must be updated time to time
In case of several cost components, cost estimate components are added to determine total cost estimate
05/02/2023
Cost Estimation: Cost Indexes
NHU 501 Dr N R Kidwai, JIT Barabanki15-8
Cost Index is ratio of cost today to cost in the past• It Indicates cost changes over time & account for inflation• Index is dimensionless• WPI (Wholesale Price Index) is a good exampleCost estimate using index can be made as
00 IICC t
t
, at timeat eindex valu , at timecost t,mepresent tiat eindex valu t,mepresent tiat cost estimated
where
0000 tItCIC tt
05/02/2023
Cost Estimation: Cost-Capacity Equation
NHU 501 Dr N R Kidwai, JIT Barabanki15-12
Cost Capacity equation is also called power law and sizing model
Where C1= Cost at capacity Q1
C2= Cost at capacity Q2
Exponent x defines relation between capacitiesIf x = 1, relationship is linear
x < 1, economies of scale (larger capacity is less costly than linear) x > 1, diseconomies of scale
x
QQCC
1
212
05/02/2023
Cost Estimation: Cost-Capacity Combined with Cost Index
NHU 501 Dr N R Kidwai, JIT Barabanki15-13
Example: A 1 hp water pump cost was Rs 3000 five years ago when the cost index was 120. Estimate the cost of a 2 hp water pump today when the cost index is 250. The exponent for a 1 hp motor pump is 0.9.
Solution: Let C2 represent the cost estimate todayC2 = 3000(2/1)0.9(250/120) = Rs 11,663/-
Cost-capacity equation can be combined cost index (It/I0) to adjust for effect of time (inflation)
000 I
IQQCC t
x
tt
05/02/2023
Cost Estimation: Factor Method
NHU 501 Dr N R Kidwai, JIT Barabanki15-14
• Factor method is especially useful in estimating total plant cost• Both direct and indirect costs can be includedTotal plant cost estimate TC is overall cost factor (h) times total cost of major equipment items (CE) TC = h × CE
The cost factor is commonly the sum of a direct cost componentand an indirect cost component, i.e h = 1 + Σfi , for i components, Example: A packaging machine is expected to cost 2 crore with installation. The cost factor for direct costs of machine in ready to operate condition is 0.45. A cost factor of 0.15 is used to cover indirect cost. What will the cost of the packaging machine ?Solution: h = 1 + 0.45 + 0.15 = 1.6
TC = 1.6*2 crore= 3.2 crore
05/02/2023
Cost Estimation: Indirect Costs
NHU 501 Dr N R Kidwai, JIT Barabanki15-17
Indirect costs (IDC) are incurred in production, processes and service delivery that are not easily tracked and assignable to a specific function. Indirect costs (IDC) are shared by many functions because they are necessary to perform the overall objective of the companyIndirect costs make up a significant percentage of the overall costs in many organizations – 25 to 50%. Few indirect cost examples
• IT services• Quality assurance • Human resources• Management• Safety and security• Purchasing; contracting• Accounting; finance; legal
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 15
Cost Estimation Approach
Equipment and capital Recovery
Direct material
Direct labour
Maintenance and operation
Indirect Cost
Direct Cost
+
+
+
+
+
Total Cost+Desired Profit
Price
Bottom Up ApproachAfter Design stage
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 16
Cost Estimation Approach
Equipment and capital Recovery
Direct material
Direct labour
Maintenance and operation
Indirect Cost
Direct Cost
+
+
+
+
+
Total Cost+Desired Profit
Price
Bottom Up ApproachAfter Design stage
Equipment and capital Recovery
Direct material
Direct labour
Maintenance and operation
Indirect Cost
Direct Cost
+
+
+
+
+
Target Cost+Allowed Profit
Market Price
Top down Approach: Design to costBefore design stage
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 17
Computation of Material Variances•Material Cost Variance(MCV) : Material cost variance is the
difference between actual cost and standard cost.
favourable material variance actual cost < standard cost Unfavourable material variance actual cost > standard cost
direct material cost variance: MCV = (RSQ x SP) - (AQ x AP)
where, revised standard quantity (RSQ) = (SQ/SO x AO) SQ = Standard Quantity, SO = Standard Output , AO = Actual Output
SP = Standard Price, AQ = Actual Quantity, AP = Actual Price
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 18
Computation of Material VariancesExample
- Standard quantity of material Q for 400 units of output is fixed as 700 kg.- Standard price per kg. of material Q is estimated to be Rs 350/-- Actual quantity of material Q was 700 kg.- Actual price of material was Rs 315/kg.- Actual output was 300 units.
Solution,Revised standard quantity (RSQ) = (SQ/SO) x AO
=700/400 x 300 = 550 units.Material Cost Variance(MCV) =(SQxSP)-(AQxAP)
=(550x350)-(700x315)= - 28000/-
Since, the resulting figure is negative the variance is denoted as unfavourable
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 19
Break Even AnalysisA decision maker needs to know which quantity should be sold before entity starts making the profit. Break even analysis determines whether a particular quantity of sales will result in profit or losses
Total Cost TC
Fixed Cost F
Variable Cost V
Quantity
Cost
Revenue
Break even Quantity Q
Steps of break even chart• Draw fixed cost line• Draw variable cost line• Draw Total cost line by adding the two• Draw Revenue line• The point of intersection of revenue line
and total cost line is break even point
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 20
Break Even AnalysisExample: Manufacturing of a engineering product requires fixed cost of Rs 42 lac for 1 lac quantity. Variable cost per product unit is Rs 30/- for material, Rs 15/- for labour, and Rs 5/- for other overheads. Selling price of the product is Rs 120/- Determine the quantity beyond which firm starts making profit (break even quantity)
Fixed Cost = 50 lacVariable cost / unit = 30+15+5= Rs 50/-Total Cost = 4200000 + 50 x QRevenue = 120 x QBreak even quantity B: 120 x B = 4200000 + 50 x B
B = 60000
05/02/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 21
Break Even Analysis: Limitations
Break even analysis make some assumptions• Selling price remains constant• Variable cost is proportional to quantity produced• Fixed cost remains constant• All quantity produced is sold
These assumptions are not realistic mostly, and are limitations of breakeven analysis