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,
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.
Purpose of Estimation
It assists in estimating the future expenditure (cost prediction) as the expenditure will depend on the cost of the respective activities
- 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.
Methods of cost estimation
We will consider following cost estimation methods commonly utilized, namely:
- High Low Activity method
- Account Analysis
- Engineering Analysis
- Visual Fit (Scatter graph) method
- Simple linear regression analysis
- Learning curve Theory
- 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
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.
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