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Mixedcostscontainbothafixedcomponentandavariablecomponent.Inordertodetermine
thetwocomponents,managersmustseparatethemixedcostintothetwocostcomponents
fixed costs and variable costs. Breaking mixed costs into fixed and variable portions allows
managers to use the costs to predict and plan for the future given the insight on that cost
behaviorprovides.Theprocessofseparatingmixedcostsintofixedandvariablecomponentsis
referred to as cost estimation. This chapter will present four methods used by managers to
estimatecosts.

CostEstimationMethods
Thefourmethodsofcostestimationtobecoveredinmanagerialaccountingarelistedbelow.
Thefirstthreewillbecoveredinthischapter,withregressioncoveredinthenextchapter.
Accountanalysis
Scattergraphs
Highlowmethod
Linearregression
Costestimationmethodsarenecessaryonlyforcoststhatareidentifiedasmixedcosts.There
isnoneedtoapplyanestimationmethodtobreakacostintofixedandvariableportionsifyou
havealreadydetermineditissolelyfixedorsolelyvariable.Allfourmethodsproduceestimates
ofamountsoffixedandvariablecosts.

TheGoalofCostEstimation
Theultimategoalofcostestimationistodeterminetheamountoffixedandvariablecoststo
createacostformulatobeusedtopredictfuturecosts.Thecostformula,orcostequation,is
the output of the cost estimation process. Because you have only one variable (number of
units),theformulawillbeastraightline,orlinearequation.(Youshouldremembertheconcept
offunctionsfromyourmiddleschoolmathclasses.1)Theformulathatrepresentstheequation
ofalinewillappearintheformatof:

Y=mx+b
whereY=totalcost
m=theslopeoftheline,i.e.,unitvariablecost
X=thenumberofunitsofactivity
b=theyintercept,i.e.,totalfixedcosts
Recall that the Y = VCx + TFC is the equivalent equation used in accounting for estimating
costs.Thetotalcostsideoftheequation(Y)canalsobeexpressedasf(x)sothattheformula
appearsas:
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f(x)=VCx+TFC

Assuch,theequationisoftenreferredtoasafunction.Inaccounting,itisreferredtoasacost
functionbecausethe'Y'equatestototalcost.

Determiningalinearfunctionisusefulinpredictingcostamountsatdifferentlevelsofactivity.
This is useful because managers must be able to predict costs to plan for future operations.
This is often accompanied by whatif analysis that assists with the preparation of budgets,
pricingofproductsorservices,andotherkeymanagementfunctions.

CostEquationComponents
Yourgoalittodeterminethecostequationforaparticularcost,sothatmanagerscanestimate
'total' costs at various activity levels. The cost equation will contain the variable cost per unit
and total fixed costs. These two amounts remain the same at all levels of activity within the
relevantrange.

Thevariable cost component of the cost equation is displayed with two decimals in standard
formbecauseit is a unit cost (and unit costs are always displayed with two decimal places).
Thetotalfixedcostcomponentofthecostequationisdisplayedwithnodecimals.

AccountAnalysisMethod
Theaccountanalysismethodofestimatingfixedandvariablecostsislikelytheapproachyou
have used to identify cost behavior so far in your study of managerial accounting. This
approachinvolvessimplylookingatacostandguessingitsmostlikelytypeofcostbehavior.
This method requires considerable subjective judgment and insight. It is most often used by
accountants or managers who are familiar with the nature of costs within a general ledger
account(oftenmultipleaccounts).Accountanalysisistheonlymethodyoucanusetoestimate
costswhenonlyoneperiodofdataisknown.

The account analysis approach requires that each individual cost is examined, and based on
judgmentiscategorizedasafixedorvariablecost.Thenallvariablecostsaretotaled.Variable
cost per unit is calculated by dividing the total of all variable costs by the number of units
producedandsold.

Totalvariablecosts
=Variablecostperunit
Numberofunitsproducedandsold

Thevariablecostperunitispluggedintothecostformulaasthevariablecost(VC).Thefixed
costsaretotaledseparatelytocalculatetheYintercept(TFC)componentoftheequation.This
resultsinacostequationthatcanbeusedtoestimatecostsforfutureperiods.

Notethatthedeterminationof'costperunit'isliteral.Thecalculationisperformedexactlyhow
itreads:'Cost'isonthenumerator'per'meansdivideand'units'appearonthedenominator.

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WalkThroughProblemAccountAnalysis
HomeShineisestimatingitsfixedandvariablecosts.Thefollowingcostswereincurredduring
themonthofMaybyHomeShinewhen200homeswerecleaned:

Cleaningsupplies
$2,400
Hourlywages
4,850
Depreciationcleaningequipment
650
Managerssalary
1,400
Autocommutingexpenses
1,600
Officerent
850
Totalcosts
$11,750

UsetheaccountanalysismethodtodeterminethetotalcostequationforHomeShine.
Solution
Step 1: Classify each cost as variable or fixed based on judgment. By definition,
variablecostsincreaseintotalwhenmoreactivityoccurs.Bydefinition,fixedcosts
arethesameintotalregardlessoftheactivitylevel.Theactivityforthisproblemis
numberofhomescleaned.
Cleaning supplies = variable cost. The total cost of cleaning supplies
increaseswhenmorehomesarecleaned.
Hourlywages=variablecost.Thetotalcostof hourlywagesincreases
whenmorehomesarecleaned.
Depreciation = fixed cost. The total cost of depreciation is $650
regardlessofthenumberofhomescleaned.
Manager's salary = fixed cost. The manager's salary is the same
regardless of the number of hours worked or the number of homes
cleaned.
Autocommutingexpenses=variablecost.Thetotalcostofcommuting
expenses such as gasoline and maintenance increases when more
homesarecleaned.
Officerent=fixedcost.Themonthlyofficerentisthesameregardlessof
thenumberofhomescleaned.
Step2:Addthecostsyouidentifiedasvariable.

$2,400+$4,850+$1,600=$8,850

Calculate variable cost per unit by dividing the total of the variable costs by the
numberofunits(homes)producedandsold(homescleaned).
$8,850
200

=$44.25

Step3:Addthecostsyouidentifiedasfixedcosts.

$650+$1,400+$850=$2,900

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Step4:Plugyouranswerstosteps2and3intothecostformulabyreplacingthe
slopewiththevariablecostperunitandtheYinterceptwithtotalfixedcosts:
Y=44.25x+2,900
Thecostequationindicatesthatthetotalcostofcleaninghomesis$44.25perhome
plusamonthlycostof$2,900.
ScatterGraphMethod
Creatingascattergraphisanothermethodofestimatingfixedandvariablecosts.Itprovidesa
visualpictureofthetotalcostsatdifferentactivitylevels.However,itisoftenhardtovisualize
thecost equation line through the data points, especially if the data is varied. This approach
requiresmultipledatapointsandrequiresfivesteps:
Step1:Drawagraphwiththetotalcostontheyaxisandtheactivity(units)onthe
xaxis.Plotthetotalcostsforeachactivitypoint.
Step2:Visualizeanddrawastraightlinethroughthedatapoints.

Step 3: Determine variable cost per unit by identifying the slope thorough a
measureofriseoverrun.
Rise
=Variablecostperunit
Run
'Rise'isthedifferenceintotalcostsand'run'isthedifferenceinnumberofhomes
cleaned.

Step 4: Identify where the line crosses the yaxis. This is the total fixed cost
amount.

Step5: Plug your answers to steps 3 and 4 into the cost formula in the following
format:
Y=VCx+TFC

Ifyouhaveforgottenhowtographdatapoints,reviewgraphingconceptshere.1

HighLowMethod
Thehighlowmethodusesthehighestandlowestactivitylevelsof a data set to estimate the
portionofamixedcostthatisvariableandtheportionthatisfixed.Becausethismethoduses
only the high and low activity levels to calculate the variable and fixed costs, it may be
misleadingiftheactivitylevelsarenotrepresentativeofthenormalactivity,i.e.,theymaybe
extremes,oroutliers.Forexample,ifmostdatapointslieintherangeof60to90percentfora
particular accounting test, and one student scored a 20 percent, the use of the low point will
distort the actual expectation of grades in the future. The highlow method is most accurate
whenthecostsincurredatthehighandlowlevelsofactivityarerepresentationofthemajority
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oftheotherdatapoints.Thestepsthatfollowwillguideyouthroughthehighlowmethod:
Step1:Determinewhichdatarepresentsthetotalcost(dependentvariable,Y)and
whichrepresentstheactivity(independentvariable,x).Findthelowestandhighest
activitypointsinthedatarepresentingthexvariable.
Step2:Determinevariablecostsperunitbyusingthemathematicalslopeformula
whichdividesthechangeincostbythechangeinactivity:
Y2Y1
X2X1

=Variablecostperunit

WhereX2isthehighactivitylevel
X1isthelowactivitylevel
Y2isthetotalcostatthehighactivitylevel
Y1isthetotalcostatthelowactivitylevel
Step3:Plugyouranswertostep2andtheamountsfromeitherthehighorthelow
datapointintothecostformulabyreplacingthe'VC'withthevariablecostperunit.
Usingthehighdatapoint,plugthetotalcost(atthehighestactivitypoint)intotheY
variable, and the high activity point for the x variable. Then solve for total fixed
costs,'TFC'.

Step4:Plugyouranswerstosteps2and3intothecostformulabyreplacingthe
slope(VC)withvariablecostperunitandtheyintercept(TFC)withtotalfixedcosts
inthefollowingformat:
Y=VCx+FC

If you have forgotten algebra concepts relating to the slopeintercept form, you can review
thoseconceptshere.2

WalkThroughProblemHighLowMethod
InformationconcerningunitssoldandtotaldeliverycostsforBridges,Inc.forfivemonthsof
2018appearsbelow:

Month
Units
Costs
January
1,200
$74,150
February
1,150
71,000
March
1,190
72,400
April
1,300
80,600
May
1,310
79,040

Usethehighlowmethodtoanswerthefollowing:
A.Howmuchisthevariablecostperunit?
B.Howmucharetotalfixedcosts?
C.Writethecostequationinproperform.

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Solution
Step1:TheUnitscolumncontainstheactivitydata.TheCostscolumncontainsthe
total cost data. Select the high and low data points from the Units column. The
largestactivitywasgeneratedinMaywith1,310units,whilethelowestactivitywas
generatedinFebruarywith1,150units.

Step2:Usetheslopeformulabysubtractingthesmallestfromthelargestactivity
on the denominator. Use the corresponding total costs for May and February and
subtractthesmallestfromthelargestcostonthenumerator:
Y2Y1
Y2Y1

$79,040$71,000
1,3101,150

$50.25perunit

Thevariablecostperunitis$50.25.

Step3:SelecteitherofthetwodatapointsthatyouchoseinStep1toplugintothe
cost equation. Both data points will result in the same answer. Using the low data
point(February),thetotalcostof$71,000issubstitutedforYinthecostequation,
and1,150unitsissubstitutedfor'x'.Substitutetheunitvariablecostfromstep2into
theformulaforVC.Youshouldnowhavethefollowingequation:
Y=VCx+TFC
71,000=(50.25x1,150)+TFC

Solvefortotalfixedcosts(TFC),whichresultsin$13,212.50.
Step4:Writethecostformulainstandardformbyplugginginthevariablecostper
unitandtotalfixedcostsasfollows:
TC=50.25x+13,213

Thestandardformatistoexpressvariablecostperunitusingtwodecimalplacesandtotalfixed
costswithnodecimalplaces.

UsingaCostEquationtoEstimateFutureCosts
Once a cost equation is determined, it can be used to estimate costs at various levels of
activity.Forexample,assumeBridges,Inc.expectstosell1,240unitsofproductinJune.Using
the total cost equation determined in the highlow method walk through problem, the total
estimatedcostwillbe:

Totalcost=(50.25x1,240)+13,213=$75,523

Bridges,Inc.estimatesthatthetotaldeliverycostforJunewillbe$75,523.
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