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Chapter 5 Cost Estimation McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 5-1 Learning Objectives L.O. 1 L.O. 2 L.O. 3 L.O. 4 L.O. 8 L.O. 5 L.O. 6 L.O. 7 Understand the reasons for estimating fixed and variable costs. Estimate costs using engineering estimates. Estimate costs using account analysis. Estimate costs using statistical analysis. Use Microsoft Excel to perform a regression analysis Interpret the results of regression output. Identify potential problems with regression data. Evaluate the advantages and disadvantages of alternative cost estimation methods. . 5-2 Why Estimate Costs? • Managers make decisions and need to compare costs and benefits among alternative actions. Key question: • What adds value to the firm? • Cost estimates can be an important element in helping managers make decisions. 5-3 Basic Cost Behavior Patterns L.O. 1 Understand the reasons for estimating fixed and variable costs. Costs Fixed costs Variable costs Total fixed costs do not change proportionately as activity changes. Total variable costs change proportionately as activity changes. Per unit fixed costs change inversely as activity changes. Per unit variable cost remain constant as activity changes. 5-4 LO1 Methods Used to Estimate Cost Behavior • Charlene, owner of Charlene’s Computer Care (3C), wants to estimate the cost of a new computer repair center. 3 Methods • Engineering estimates • Account analysis • Statistical methods 5-5 Engineering Estimates L.O. 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. 5-6 LO2 Engineering Estimates Advantages: • 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. Disadvantages: • Can be quite expensive to use • Based on optimal conditions 5-7 Account Analysis L.O. 3 Estimate costs using account analysis. • Establish, track & then review each account comprising the total cost being analyzed. • Identify each cost as either fixed or variable. Fixed Variable 5-8 Account Analysis Exhibit 5.1 LO3 John’s cost estimation using account analysis Factory Overhead at 4,519 Machine Hours Rent Utilities Administration Supplies Maintenance Other Totals Total $ 20,784 $ 15,588 Variable $ 9,696 $ 7,272 Fixed $ 11,088 $ 8,316 20,784 10,392 $ 9,696 $ 4,848 $ 11,088 $ 5,544 $ 31,175 $ 5,196 $ 103,918 $ 14,543 $ 2,424 $ 48,478 $ 16,632 $ 2,772 $ 55,440 $ $ 5-9 Demo problem 1 What is the variable cost per machine hour? LO3 Account Analysis Demo 1 Cost estimation using account analysis Fixed costs + (Variable cost/unit × No. of units) = Total cost Determine the cost formula. 5 - 11 LO3 Account Analysis Advantages: • Managers and accountants are familiar with company operations and the way costs react to changes in activity levels. Disadvantages • Cost of data collection may surpass benefit. • Relies heavily on judgment of Managers and accountants who may be biased. • Decisions often have major economic consequences for managers and accountants. 5 - 12 Statistical Cost Estimation L.O. 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 LO4 Hi-Low Cost Estimation Month 1 2 3 4 5 6 7 8 9 10 11 12 Total Machine hours 203 319 425 289 388 471 512 443 262 371 494 342 4,519 Overhead $7,102 8,620 9,120 7,092 7,965 9,641 10,421 8,834 6,935 8,520 10,342 9,326 $103,918 5 - 14 Demo 2 LO4 Hi-Low Cost Estimation • This is a method to estimate cost based on two cost observations, the highest and lowest activity level. Month Overhead costs Repairhours High Low Change 5 - 16 LO4 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 or Total cost at – (Variable cost × Lowest activity level) lowest activity 5 - 17 LO4 Hi-Low Cost Estimation Variable cost = per RH (V) = = $____ per H Fixed costs (F) = = $ Fixed costs (F) = = $ Rounding may produce a slight difference 5 - 18 LO4 Hi-Low Cost Estimation $10,421- 7,102 $3,319 Variable cost = = = per RH (V) 512 – 203 309 Fixed costs (F) = $10,421 – [10.74 x512] Fixed costs (F) = 10.74 $7,102 – [10.74 x203] = 4,922 = 4,922 Rounding may produce a slight difference 5 - 19 LO4 Hi-Low Cost Estimation • How do we estimate manufacturing overhead with 400 hours? TC = F + VX 400 hours: $4,922 + (10.74x400)= $9,218 5 - 20 LO4 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 LO4 Regression Analysis • Hi-low method: Uses two data points • Regression: Uses all of the data points 5 - 22 LO4 Regression Analysis The Regression Equation: Y = a + bX 5 - 23 Microsoft as a Tool L.O. 8 (Appendix A) Use Microsoft Excel to perform a regression analysis. • Demo 3 will serve as our Example. • Interpreting the output is the key to the analysis. 5 - 24 Microsoft as a Tool ♦ The following steps are based Microsoft Office 2007 • Step 1: Ensure you have the Analysis TookPak installed. • Step 2: Enter the data for the Dependent and Independent Variables. • Step 3: Select Regression from the Data Analysis option. • Step 4: Select the data to use in the regression. • Step 5: Run the regression. Scatter graph Highlight cells b1 to c13 Do not include months or totals LO5 Interpreting Regression • The computer output of scatter graph gives the following formula: Total overhead = $4,508 + ($11.025 per MH × No. of MH) • Estimate 3C’s overhead with 400 repair hours. TC = F + VX TC = $6,508 + ($11.02 × 400) = $8,916 5-34 Interpreting Regression L.O. 5 Interpret the results of regression output. • Independent variable: Fixed Costs – Coefficients/Intercept • Dependent variable: Variable costs – Coefficients/X Variable 1 5 - 35 LO5 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. Measures the relationship between cost driver and Changes in the cost pool. 78.8% of the overhead is caused by changes in Machine hours. 5 - 37 LO5 Interpreting Regression • T-statistic: Generally, if it is over 2, then it is considered significant. If significant, the cost is NOT totally fixed. 95% Confidence: Gives a range where you can have 95% confidence that the variable cost coefficient is between the upper & lower levels. 5 - 39 Practical Implementation Problems L.O. 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 - 41 LO6 Practical Implementation Problems The Effect of Outliers on the Computed Regression Computed regression line “Outlier” True regression line 5 - 42 LO6 Practical Implementation Problems • Problem: Outliers move the regression line. • Solution: Prepare a scattergraph, analyze the graph, and eliminate highly unusual observations before running the regression. 5 - 43 Statistical Cost Estimation L.O. 7 Evaluate the advantages and disadvantages of alternative cost estimation methods. Advantages: • Reliance on historical data is relatively inexpensive. • Computational tools allow for more data to be used than for non-statistical methods. Disadvantages: • 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 - 44 LO7 Effect of Different Methods on Cost Estimates • Estimated manufacturing overhead with 400 repair-hours. 5 - 45 LO7 Data Problems • Missing data • Outliers • Allocated and discretionary costs • Inflation • Mismatched time periods 5 - 46