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Cost Estimation

Managerial Accounting

Prepared by Diane TannerUniversity of North Florida

Chapter 5

Cost Estimation Methods

Used by managers to Enable the creation of a cost function so that

costs can be predicted at various activity levels Useful when fixed and variable costs are

grouped together Four common methods

1. Account analysis2. Scattergraph3. High-low4. Linear regression

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The Goal of Cost Estimation

Goal is to create a total cost equationTotal cost = Variable cost/unit * # of units + Total fixed cost

TC = VCx + TFC

Y = mx + bWhere:TC = Y = total costsTFC = b = total fixed costs = y-interceptVC = m = variable cost per unit = slope of function x = units produced/sold

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Both equations serve the same

purpose

Account Analysis Method Used to estimate fixed and variable costs Step 1: Classify costs as variable or fixed

Separate the list of costs into two piles—fixed costs versus variable costs

Requires professional judgment

Step 2: Determine variable costs per unit

Step 3: Determine total fixed costs Add the costs in the fixed cost pile from step 1

Total Variable CostsActivity Level Achieved

Total Variable CostsActivity Level Achieved

Cost function (equation) =TC = VCx + TFC

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Scattergraph Approach

Used to estimate fixed and variable costs to determine how costs and activity levels changeStep 1: Acquire cost information over activity levels Step 2: Graph the data points Step 3 : Eyeball a linear relationship and draw a ‘trend’ line through

the data pointsStep 4: Determine where the line crosses the y-axisi.e., y-intercept = total fixed costsStep 5: Determine the slope (rise over run), i.e., variable cost per unitStep 6: Write the cost equation

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If you have forgotten how to graph data points, this will help. .http://www.studyzone.org/testprep/math4/d/linegraph4l.cfmSource www.studyzone.org Grade 4 Math Lessons

High-Low Method

Used to estimate fixed and variable costs at various levels of activity

Uses two data points, the high and low levels of activity and their related total costs

Results:• Variable cost = Line slope • Total fixed costs = Y-intercept

Results:• Variable cost = Line slope • Total fixed costs = Y-intercept

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High-Low Method

Step 1: Select the high and low data activity pointsStep 2: Subtract the smallest from the largest cost and

the smallest from the largest activity and use the changes in the following formula

= Variable cost per unitChange in Cost

Change in Activity

First select the high and low amounts from the activity column. Then use the costs related to those activity points.

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Step 3: Pick one point—either the high or low:Plug the total cost and the activity of the point you selected in the cost equation: TC = VCx + TFC

High-Low Method Continued

Step 5: Solve for fixed costs “TFC”Step 6: Replace the VC with the variable cost per unit

you calculated and the TFC with the fixed costs you calculated, into the following formula:

TC= VC x + TFC

Only two variables will be displayed in the formula: X and TC. The other components: VC and TFC, should

be replaced by the respective amounts.

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Step 4: Substitute the number of activity units for the data point chosen in step 3 for “x”

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The End