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 Cost Estimation

Chapter 5

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
LO 5-1 Understand the reasons for estimating fixed and variable costs.
LO 5-2 Estimate costs using engineering estimates.
LO 5-3 Estimate costs using account analysis.
LO 5-4 Estimate costs using statistical analysis.
LO 5-5 Interpret the results of regression output.
LO 5-6 Identify potential problems with regression data.
LO 5-7 Evaluate the advantages and disadvantages of alternative
cost estimation methods.
LO 5-8 (Appendix A)
Use Microsoft Excel to perform a regression analysis.
LO 5-9 (Appendix B)
Understand the mathematical relationship describing
the learning phenomenon.

5-3
Why Estimate Costs?
Managers make decisions and need to compare
costs and benefits among alternative actions.

Cost estimates can be an important element

In helping managers make decisions.

5-4
LO
5-1

Basic Cost Behavior Patterns

LO 5-1 Understand the reasons for estimating fixed and variable costs.

Costs

Fixed costs Variable costs

Total fixed costs do not Total variable costs

change proportionately change proportionately
as activity changes. as activity changes.

Per unit fixed costs Per unit variable cost

change inversely as remain constant as
activity changes. activity changes.
5-5
 Methods Used to Estimate
LO
5-1

Cost Behavior

Charlene, owner of Charlene’s Computer Care

(3C), wants to estimate the cost of a
new computer repair center.

1. Engineering estimates
2. Account analysis
3. Statistical methods

5-6
LO
5-2

Engineering Estimates
LO 5-2 Estimate costs using engineering estimates.

Cost estimates are based on measuring and

then pricing the work involved in a task.

Identify the activities involved:

– Labor
– Rent
– Insurance

Estimate the time and cost for each activity.

5-7
LO
5-2

Engineering Estimates

Details each step required to perform an operation

Permits comparison of other centers with similar operations
Costs for totally new activities can be estimated without
prior activity data.

Can be quite expensive to use

Based on optimal conditions

5-8
LO
5-3

Account Analysis
LO 5-3 Estimate costs using account analysis.

Review each account comprising the total

cost being analyzed.

Identify each cost as either fixed or variable.

Fixed Variable

5-9
LO
5-3

Account Analysis

Costs for 360 repair-hours

Variable Fixed
Account Total cost cost
Office rent $ 3,375 $1,375 $2,000
Utilities 310 100 210
Administration 3,386 186 3,200
Supplies 2,276 2,176 100
Training 666 316 350
Other 613 257 356
Total $10,626 $4,410 $6,216
Per repair hour $12.25
5-10
LO
5-3

Account Analysis

Fixed costs + (Variable cost/unit × No. of units) = Total cost

Cost at 360 repair-hours:

$6,216 + ($12.25 × 360) = $10,626

Cost at 480 repair-hours:

$6,216 + ($12.25 × 480) = $12,096

5-11
LO
5-3

Account Analysis

Managers and accountants are familiar with company

operations and the way costs react to changes in
activity levels.

Managers and accountants may be biased.

Decisions often have major economic consequences

for managers and accountants.

5-12
LO
5-4

Statistical Cost Estimation

LO 5-4 Estimate costs using statistical analysis.

Analyze costs within a relevant range, which is

the limits within which a cost estimate may be valid.

Relevant range for a projection is usually between

the upper and lower limits (bounds) of past activity
levels for which data is available.

5-13
 Overhead Cost Estimation
LO
5-4

for 3C
Overhead Repair-
Month costs hours
1 $ 9,891 248
2 $ 9,244 248
3 $13,200 480
4 $10,555 284 These data will be used
5 $ 9,054 200 to estimate costs using
6 $10,662 380
7 $12,883 568
a statistical analysis.
8 $10,345 344
9 $11,217 448
10 $13,269 544
11 $10,830 340
12 $12,607 412
13 $10,871 384
14 $12,816 404
15 $ 8,464 212
5-14
LO
5-4

Scattergraph

Does it look like a relationship exists

between repair-hours and overhead costs?
5-15
LO
5-4

Scattergraph

We use “eyeball judgment” to determine the

intercept and slope of the line.
5-16
LO
5-4

Hi-Low Cost Estimation

This is a method to estimate cost based on two cost

observations, the highest and lowest activity level.

Overhead Repair-
Month costs hours
High $12,883 568
Low $ 9,054 200
Change $ 3,829 368

5-17
LO
5-4

Hi-Low Cost Estimation

Variable cost per unit (V) =

(Cost at highest activity level – Cost at lowest activity level)

(Highest activity level – Lowest activity level)

Fixed cost (F) =

Total cost at
– (Variable cost × Highest activity level)
highest activity

Total cost at
– (Variable cost × Lowest activity level)
lowest activity

5-18
LO
5-4

Hi-Low Cost Estimation

Variable cost ($12,883 – $9,054) $3,829 $10.40

= = =
per RH (V) 568 RH – 200 RH 368 RH per RH

Fixed costs (F) = ($12,883 – ($10.40 × 568 RH) = $6,976

Fixed costs (F) = ($9,054 – ($10.40 × 200 RH) = $6,974

Rounding
difference

5-19
LO
5-4

Hi-Low Cost Estimation

How do we estimate manufacturing

overhead with 480 repair-hours?

TC = F + VX

TC = $6,976 + ($10.40 × 480) = $11,968

5-20
LO
5-4

Regression Analysis

Regression is a statistical procedure to

determine the relation between variables.

It helps managers determine how well the

estimated regression equation describes
the relations between costs and activities.

5-21
LO
5-4

Regression Analysis

Hi-low method:
Uses two data points

Regression:
Uses all of the data points

5-22
LO
5-4

Regression Analysis

Y = a + bX

Y = Intercept + (Slope × X)

For 3C:
OH = Fixed costs + (V × Repair-hours)

5-23
LO
5-5

Interpreting Regression
LO 5-5 Interpret the results of regression output.
Independent variable:
– The X term, or predictor
– The activity that predicts (causes)
the change in costs
Activities:
– Repair-hours

Dependent variable:
– The Y term
– The dependent variable
– The cost to be estimated

Costs:
– Overhead costs
5-24
LO
5-5

Interpreting Regression

The computer output of 3C’s scattergraph

gives the following formula:
Total overhead = $6,472 + ($12.52 per RH × No. of RH)

Estimate 3C’s overhead with 480 repair hours.

TC = F + VX
TC = $6,472 + ($12.52 × 480) = $12,482

5-25
LO
5-5

Interpreting Regression

Correlation coefficient (R):

This measures the linear relationship between
variables. The closer R is to 1.0 the closer the
points are to the regression line. The closer R is
to zero, the poorer the fit of the regression line.

Coefficient of determination (R2):

This is the square of the correlation coefficient.
It is the proportion of the variation in the dependent
variable (Y) explained by the independent variable(s) (X).

5-26
LO
5-5

Interpreting Regression
T-statistic:
This is the value of the estimated coefficient, b, divided
by its estimated standard error (Seb). Generally, if it is
over 2, then it is considered significant. If significant,
the cost is NOT totally fixed.

From the data used in the 3C regression, the t-statistic is:

t = b ÷ Seb
= 12.5230 ÷ 1.5843
= 7.9044

5-27
LO
5-5

Interpreting Regression

An 0.91 correlation coefficient means that a linear

relationship does exists between repair hours
and overhead costs.

An 0.828 coefficient of determination means that

82.8% of the changes in overhead costs can be
explained by changes in repair-hours.

Both have t-statistics that are greater than 2,

so the cost is not totally fixed.

5-28
LO
5-5

Multiple Regression
Multiple regression:
When more than one predictor (x) is in the model

Is repair-hours the only activity that drives

overhead costs at 3C?

Predictors:
X1: Repair-hours
X2: Parts cost

Equation:
TC = VC(X1) + VC(X2) + FC

5-29
LO
5-5

Multiple Regression Output

The adjusted R-squared is the correlation coefficient
squared and adjusted for the number of independent
variables used to make the estimate.

The statistics supplied with the output (rounded off) are:

– Correlation coefficient (R) = 0.953
– R2 = 0.908
– Adjusted R2 = 0.892

5-30
LO
5-5

Multiple Regression Output

TC = F + V1X1 + V2X2

TC = $6,416 + ($8.61 × 480) + (77% × $3,500)

TC = $13,244

5-31
 Practical Implementation
LO
5-6

Problems
LO 5-6 Identify potential problems with regression data.

Effect of:
– Nonlinear relations
– Outliers
– Spurious relations
– Using data that do not fit the assumptions
of regression analysis

5-32
 Practical Implementation
LO
5-6

Problems
The Effect of Nonlinear Relations
$800
Assumed actual cost function
$700
$600
$500
Cost

$400 Regression
estimate
$300
$200 Relevant
range Capacity
$100
$0
0 5 10 15 20 25 30 35 40
Volume

5-33
 Practical Implementation
LO
5-6

Problems
Problem:
• Attempting to fit a linear model to nonlinear data
• Likely to occur near full-capacity

Solution:
• Define a more limited relevant range.
(Example: from 25-75% capacity)
• Design a nonlinear model.

5-34
 Practical Implementation
LO
5-6

Problems
The Effect of Outliers on the Computed Regression

Computed
regression line

“Outlier”
True regression line

5-35
 Practical Implementation
LO
5-6

Problems

Problem:
Outliers move the regression line.

Solution:
Prepare a scattergraph, analyze the graph,
and eliminate highly unusual observations
before running the regression.

5-36
 Practical Implementation
LO
5-6

Problems
The Effect of Spurious Relations
Problem:
Using too many variables in the regression
(i.e., using direct labor to explain materials costs).

Although the association is very high, actually

both are driven by output.

Solution:
Carefully analyze each variable and determine
the relationship among all elements before
using in the regression.
5-37
 Practical Implementation
LO
5-6

Problems
The Effect of Using Data That Do Not
Fit the Assumptions of Regression
Problem:
If the assumptions in the regression are not
satisfied, then the regression is not reliable.

Solution:
There is no clear solution. Limit time to help
assure costs behavior remains constant,
yet this causes the model to be weaker
due to less data.

5-38
LO
5-6

Learning Phenomenon

Learning phenomenon is the systematic relationship

between the amount of experience in performing
a task and the time required to perform it.

5-39
LO
5-7

How an Estimation Method is Chosen

LO 5-7 Evaluate the advantages and disadvantages
of alternative cost estimation methods.

• Reliance on historical data is relatively inexpensive.

• Computational tools allow for more data to be used
than for non-statistical methods.

• Reliance on historical data may be the only readily

available, cost-effective basis for estimating costs.
• Analysts must be alert to cost-activity changes.
5-40
LO
5-7

Data Problems

• Missing data

• Outliers

• Allocated and discretionary costs

• Inflation

• Mismatched time periods

5-41
 Effect of Different Methods
LO
5-7

on Cost Estimates
Estimated manufacturing overhead with 480 repair-hours.

Total Estimated Estimated

estimated fixed variable
Method costs costs costs
Account analysis $12,096 $6,216 $12.25/repair-hour

High-low $11,968 $6,976 $10.40/repair-hour

Simple regression $12,482 $6,472 $12.52/repair-hour

Multiple regression $13,244 $6,416 $8.61/repair-hour

+ 77% of parts cost

5-42
 Appendix A: Regression
LO
5-8

Analysis Using Microsoft Excel

LO 5-8 (Appendix A) Use Microsoft Excel
to perform a regression analysis.

Many software programs exist to aid in performing

regression analysis.

In order to use Microsoft Excel, the Analysis Tool Pak

must be installed.
Data is entered and the user then selects the data and
type of regression analysis to be generated.

The analyst must be well schooled in regression in order

to determine the meaning of the output.

5-43
LO
5-9

Appendix B: Learning Curves

LO 5-9 (Appendix B) Understand the mathematical relationship
describing the learning phenomenon.
This is the systematic relationship between
the amount of experience in performing a task
and the time required to perform it.
Time to Calculation
Unit produce of time
First unit 100.0 hours (assumed)
Second unit 80.0 hours 80% × 100 hours
Fourth unit 64.0 hours 80% × 80 hours
Eighth unit 51.2 hours 80% × 64 hours
• Impact: It causes the unit price to decrease
as production increases.
• This implies a nonlinear model.
5-44
End of Chapter 5

5-45