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Lesson 2 Cost Estimation

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COST ESTIMATION
Introduction:
Cost estimation may be defined as ‘a study which attempts to predict the between costs and the activity level
or cost driver that causes those costs. In practice, managers frequently encounter such cost drivers (what is a
cost driver?) as machine hours, number of transaction, work cells, labour hours, and units of output e.t.c.
The cost estimating function is
y = a + bx,
Where
Y represents Total cost
a represents cost fixed component of the total cost
bx represents the variable costs component of the total cost
b represents the unit variable cost (this is the gradient of the equation)
x represents output level
This is the usual straight line equation you have been encountering in elementary mathematics.
2.4.1 Purpose of Estimation
It assists in estimating the future expenditure (cost prediction) as the expenditure will depend on the cost of
the respective activities
a) It assists in determining the net benefits anticipated in a specific activity based on the relationship
between projected costs and projected revenue.
Cost estimation is useful in business planning, cost control, performance evaluation and decision making.
2.4.2 Methods of cost estimation
We will consider following cost estimation methods commonly utilized, namely:
a) High Low Activity method
b) Account Analysis
c) Engineering Analysis
d) Visual Fit (Scatter graph) method
e) Simple linear regression analysis
f) Learning curve Theory
a) High Low method
Here, cost estimation is based on the relationship between past cost and past level of activity. Variable
cost is based on the relationship between costs at the highest level of activity and the lowest level of
activity. The difference in cost between high and low activity level is taken to be the total variable cost
from which the unit variable cost can be computed by dividing it by the change in output level. This is
indicated below:
Total Variable Cost = Cost at high activity level Cost at low activity level
Therefore,
Unit Variable cost = Variable cost = Cost at high level activity cost at low level activity
Output Units Units at high activity level units at low activity level
The variable cost per unit so calculated forms the ‘b’of the straight line equation mentioned earlier. By
substituting ‘ b’ into the equation, we can obtain ‘a’, the fixed cost.
Illustration
Based on performance, you have been provided with the following information regarding ABC Ltd for
the year ended 31 December 2004 :
Labour hours Service cost (Shs)
Highest activity level 800 200,000
Lowest activity level 300 150,000
Required
Develop a total cost function based on the above data using the high-low method.
Solution
Unit Variable cost = Variable cost = Cost at high level activity cost at low level activity
Output Units Units at high activity level units at low activity level

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Variable Cost Per Unit = Shs.200,000 shs.150,000
800 hrs 300 hrs
= Shs.50,000 = shs.100/hr
500 hrs
Therefore b = 100
To get the fixed cost a, substitute ‘b’ into the straight line equation as follows:
When labour hours (x) = 800, service cost (total cost, y) = shs.200,000
Therefore from the Straight Line equation, y = a + b x
200,000 = a + (100) 800
200,000 = a + 80,000
a = 200,000 80,000
a = 120,000
Therefore fixed costs = shs.120,000
NB: Even if we used the 2
nd
set of labour hours and service costs, were would still get he same answer i.e.
When labour hours (x) = 300, service cost (total cost, y) = Shs.150,000.
Therefore 150,000 = a + 100(300)
a =150,000 30,000 = Shs.120,000
Therefore the cost equation is:
y = 120,000 + 100x
This equation can be used to estimate or predict the total costs : for example, when the activity level is say at
1000 labour hours, then the total cost would be
Y= 120,000 + 1000(100)
=120,000 + 100,000
= Shs.220,000.
What are the advantages and disadvantages of the high low method?
b) Account Analysis (Inspection of Accounts)
Using account analysis, the accountant examines and classifies each ledger account as variable, fixed or
mixed. Mixed accounts are broken down into their variable and fixed components. They base these
classifications on experience, inspection of cost behaviour for several past periods or intuitive feelings of
the manager.
Example
Management has estimated Shs.1,090 variable costs, Shs.1,430 fixed costs to make 100 units using 500
machine hours. Since machine hours drives variable costs in our example, the variable cost stated as
Then we get the total cost equation as
Y = ,1430 +2.18 x (1090/500=2.18)
Where y = total cost
x = number of machine hours
For 550 machine hours
Total cost = Shs.1,430 + Shs. 2.18 (550) = 1,430 + 1,999 = Shs.2,629
This analysis should determine whether any factors apart from output machine hours are influencing total
cost.
A danger in using this method lies in the fact that many managers may assume a cost’s behaviour without
further analysis. This is because the method is highly subjective.
Marginal Costing and Absorption Costing
Marginal Costing is an alternative method of costing to absorption costing
In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated which is
sales revenue minus the variable cost of sales. Closing stocks of work in progress or finished goods are
valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full
to the profit and loss account of the accounting period in which they are incurred.
Marginal Cost is the cost of a unit of a product or service which would be avoided if that unit were not
produced or provided.

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COST ESTIMATION Introduction: Cost estimation may be defined as ‘a study which attempts to predict the between costs and the activity level or cost driver that causes those costs. In practice, managers frequently encounter such cost drivers (what is a cost driver?) as machine hours, number of transaction, work cells, labour hours, and units of output e.t.c. The cost estimating function is y = a + bx, Where Y represents Total cost a represents cost fixed component of the total cost bx represents the variable costs component of the total cost b represents the unit variable cost (this is the gradient of the equation) x represents output level This is the usual straight line equation you have been encountering in elementary mathematics. 2.4.1 Purpose of Estimation It assists in estimating the future expenditure (cost prediction) as the expenditure will depend on the cos t of the respective activities a) It assists in determining the net benefits anticipated in a specific activity based on the relations hip between projected costs and projected revenue. Cost estimation is useful in business planning, cost control, performance evaluation and decision making. 2.4.2 Methods of cost estimation We will consider following cost estimation methods commonly utilized, namely: a) High Low Activity method b) Account Analysis c) Engineering Analysis d) Visual Fit (Scatter graph) method e) Simple linear regression analysis f) Learning curve Theory a) High – Low method Here, cost estimation ...
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