Cost Estimation Methods

Mixed costs have both a fixed portion and a variable portion. There are a handful of methods used by managers to break mixed costs in the two manageable components--fixed costs and variable costs. The process of breaking mixed costs into fixed and variable portions allow us to use the costs to predict and plan for the future since we have a good insight on how these costs behave at various activity levels. We often call the process of separating mixed costs into fixed and variable components, cost estimation.

The four methods of cost estimation to be discussed are listed below, with regression covered in chapter 6 and the others in this chapter:

The Goal of Cost Estimation

The ultimate goal of cost estimation is to determine the amount of fixed and variable costs so that a cost equation can be used to predict future costs. You should remember the concept of functions from your business calculus class. The function that represents the equation of a line will appear in the format of:

 y = m x + b

where y = total cost

          m = the slope of the line, i.e., the unit variable cost

          x = the number of units of activity

          b = the y-intercept, i.e., the total fixed costs

Determining a linear function is useful in predicting cost amounts at different levels of activity. Why do managers need to be able to predict costs? They want to plan for future operations often through what-if analysis and budgets. A key concept you must remember is that before you employ any of the estimation methods, you must have already determined the cost is mixed. There is no need to analyze a cost to break it down into fixed and variable portions if you already know whether it is variable or fixed. Your goal it to determine the variable cost per unit and total fixed costs to plug into the cost equation.

Helpful Hint: Note that the determination of 'cost per unit' is literal. When you read this label, write the equation exactly how it reads: Cost is on the numerator' Per means divide; and units appears on the denominator.

One method of estimating fixed and variable costs requires considerable subjective judgment. This is likely the approach you have taken to identify cost behavior so far in your study of managerial accounting by looking at a cost and guessing its most likely type of cost behavior. It is most often used by accountants or managers who are familiar with the costs within an account. Account analysis is the only method you can use to estimate costs when only one data point is known. The account analysis approach requires four steps:

Step 1: Look through the costs that are included in a particular account and classify each amount as variable or fixed based on judgment.

 

Step 2: Total the variable costs. Determine variable costs per unit by dividing the total of all the variable costs you identified by the number of units produced (or sold). This will give you the cost per unit.

Step 3: Total the fixed costs.

 

Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope (m) with variable cost per unit and the y-intercept (b) with total fixed costs in the following format:

                                                            y = m x + b

Creating a scatter graph is another method of estimating fixed and variable costs. It provides a good visual picture of the costs at different activity levels. However, it is often hard to visualize the line through the data points especially if the data is varied. This approach requires multiple data points and requires five steps:

Step 1: Draw a graph with the total cost on the y-axis and the activity (units) on the x-axis. Plot the total cost points for each activity points.

Step 2: Visualize and draw a straight line through the points.

 

Step 3: Determine variable costs per unit by identifying the slope thorough a measure of rise over run.

Step 4: Identify where the line crosses the y-axis. This is the total fixed cost. 

 

Step 5: Plug your answers to steps 3 and 4 into the cost formula by replacing the slope (m) with variable cost per unit and the y-intercept (b) with total fixed costs in the following format:

                            y = m x + b

Note: If you have forgotten how to graph data points, this will help. . http://www.studyzone.org/testprep/math4/d/linegraph4l.cfm

Source www.studyzone.org  Grade 4 Math Lessons