Chapter 4

1. Cost Estimation Chapter 4

2. Understand the reasons for estimating fixed and variable costs. • Estimate costs using engineering estimates. • Estimate costs using account analysis. • Estimate costs using statistical analysis. • Interpret the results of regression output. • Identify potential problems with regression data. • Evaluate the advantages and disadvantages of alternative cost estimation methods. • (Appendix) Use Microsoft Excel to perform analysis. Learning Objectives

3. Managers make decisions and need to compare costs and benefits among alternative actions. What adds value to the firm? Why Estimate Costs? Key Question Good decisions

4. variable cost per unit number of units Total costs = + TC = + V X In Total Per Unit Basic Cost Behavior Patterns L.O. 1 Understand the reasons for estimating fixed and variable costs Cost behavior, how costs vary with activity, is the key distinction for decision making. Costs behave as either fixed or variable. fixed costs F Vary inversely with activity Fixed Fixed Variable Vary Stay the same

5. Methods to Estimate Cost Behavior Charlene, owner of Charlene’s Computer Care (3C), wants to estimate the cost of a new computer repair center. Engineering estimates Account analysis Statistical methods

6. 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.

7. Engineering Estimates Advantages Insurance Details each step required to perform an operation. Rent Labor Permits comparison of other centers with similar operations. Identifies strengths and weaknesses. Disadvantages Can be quite expensive to use. Based on optimal conditions.

8. L.O. 3 Estimate costs using account analysis. Review each account making up the total cost being analyzed. Identify each cost as fixed or variable. Account Analysis Fixed Costs ($) Activity level Variable Cost ($) Activity level

9. Account Total Fixed Cost Variable Cost Office rent $3,375 $2,000 $1,375 Utilities 310 210 100 Administration 3,386 3,200 186 Supplies 2,276 100 2,176 Training 666 350 316 Other ___613 __356 ___257 Total $10,626 $6,216 $4,410 Account Analysis Example 3C Cost Estimation Using Account Analysis Costs at 360 repair-hours

10. Total costs Total costs = = $10,626 = Account Analysis Example Continued 3C Cost Estimation Using Account Analysis variable cost per unit number of units fixed costs + Costs at 360 Repair-Hours a unit is a repair- hour $6,216 + $12.25 360 $4,410 Costs at 520 Repair-Hours $6,216 + $12.25 520 = + $12,586 $6,216 $6,370

11. Account Analysis Advantage Managers and accountants are familiar with company operations and the way costs react to changes in activity levels. Disadvantages Managers and accountants may be biased. Decisions often have major economic consequences for managers and accountants.

12. Statistical Cost Estimation L.O. 4 Estimate costs using statistical analysis. Analyze costs within a relevant range. Relevant range? The limits within which a cost estimate may be valid. Relevant range for a projection is usually between the upper and lower limits of past activity levels for which data is available.

13. Overhead Costs for 3C Month OH Costs Repair-Hours

14. Scattergraph Plot of cost and activity levels A visual representation Does it look like a relationship exists between repair-hours and overhead costs?

15. Scattergraph Continued We use “eyeball judgment” to determine the intercept and slope of the line.

16. 3C Overhead Repair-Hours High-Low Cost Estimation A method to estimate costs based on two cost observations, usually at the highest and lowest activity level. Choose two data points. The highest and lowest activity. Use the two points to determine the line representing the cost-activity relation. Draw a total cost line.

17. Cost at highest activity Cost at lowest activity Highest activity Lowest activity Total cost at highest activity level V Highest activity Total cost at lowest activity level V Lowest activity High-Low Cost Estimation Continued A method to estimate cost based on two cost observations, the highest and lowest activity level. V F or

18. $12,883 $9,054 568 200 $12,883 $10.40 568 $9,054 $10.40 200 High-Low Cost Estimation Continued V $10.40/RH $6,976 F or $6,974 Rounding Difference

19. High-Low Example Estimated manufacturing overhead with 520 repair-hours. TC = F + V X TC = 6,976 + 10.40 520 $12,384 Estimated overhead with 720 repair-hours? Relevant range for a projection is usually between the upper and lower limits of past activity levels for which data is available. Not sure.

20. 3C Overhead Regression Statistical procedure to determine the relationship between variables. High-Low Method Uses two data points. Regression Uses all the data points.

21. Regression Continued The relationship between activities and costs Activities Repair-hours Independent variable The X term, or predictor. Costs Overhead costs Dependent variable The Y term The Regression Equation = + Y a b X + = Slope X Y Intercept = + OH Fixed costs V Repair-hours

22. Interpreting Regression L.O. 5 Interpret the results of regression output. F V + Y = Intercept Slope X = + Y F V X

23. Interpreting Regression Continued Correlation coefficient Measures the linear relationship between variables. Multiple R Coefficient of determination The square of the correlation coefficient. The proportion of the variation in the dependent variable explained by the independent variable(s). R Square

24. Interpreting Regression Continued Correlation Coefficient Coefficient of Determination .91 A linear relationship does exists between repair hours and overhead costs. .828 82.8% of the changes in overhead costs can be explained by changes in repair-hours.

25. Regression Example Estimate 3C’s overhead with 520 repair hours. TC = F + V X 520 + 12.52 TC = 6,472 TC = $12,982

26. Multiple Regression Is repair-hours the only activity that drives overhead costs at 3C? Month OH Costs Repair-Hours Parts

27. Multiple Regression Output Adjusted Correlation Coefficient Adjusted R Square Correlation coefficient squared and adjusted for the number of independent variables used to make the estimate. 89% of the changes in overhead costs can be explained by changes in repair-hours and parts costs. .89

28. Multiple Regression Output Continued Estimate 3C’s overhead for 520 repair-hours and $3,500 parts costs. TC = F + V1 X1 + V2 X2 TC = 6,416 + 8.61 520 + .77 3,500 TC = $13,588

29. Implementation Issues L.O. 6 Identify potential problems with regression data. 1. Curvilinear costs 2. Outliers Curvilinear costs 3. Spurious relations Identify relevant range Relevant Range Analyze relevant range

30. Outliers outlier Regression line with outlier True regression line Outlier moves regression line.

31. Statistical Cost Estimation Advantages Reliance on past data is relatively inexpensive. Computational tools allow for more data to be used than for non-statistical methods. Disadvantages Reliance on past data may be the only readily available, cost-effective basis for estimating costs. Analysts must be alert to cost-activity changes.

32. Choosing an Estimation Method The more sophisticated methods yield more accurate cost estimates than the simple methods. Estimated manufacturing overhead with 520 repair-hours. Account Analysis $12,586 High-Low $12,384 Regression $12,982 Multiple Regression $13,588* * 520 repair-hours and $3,500 parts costs

33. The more sophisticated methods yield more accurate cost estimates than the simple methods. Cost-Benefit

34. Data Problems Missing data Outliers Allocated and discretionary costs Inflation Mismatched time periods

35. Chapter 4 3C The End