Int. Acc. MA LECT 4: CH 9 Cost estimation part 2: (Steps in estimating…
Int. Acc. MA LECT 4: CH 9 Cost estimation part 2:
Linear cost functions and three common ways in which they behave
Cost function is a mathematical expression describing how costs change with changes in the level of an activity.
Direct manufacturing labour-hours
Cost estimation methods
1. Account analysis
Account analysis estimates cost functions by classifying cost accounts in the ledger as variable, fixed or mixed with respect to the identified activity.
The cost analyst uses experience and judgement to separate total costs into fixed and variable.
Why should Nike be careful using historical data for one month (April) to estimate future costs?
April may not be a typical month for outdoor running shoes. Unit costs may be relatively low as the company prepares for increased demand in June, July and August. This might result in a lower materials cost per unit from quantity discounts offered by suppliers. To smooth out these fluctuations, companies often use data from the past quarter or past year to estimate costs.
2.Quantitative analysis methods
Quantitative analysis uses a formal mathematical method to fit linear cost functions to past data observations.
Advantage: Results are objective
Outline six steps in estimating a cost function on the basis of current or past cost relationships (I)
1. Choose the dependent variable:
The cost to be predicted
2. Identify the independent variable cost driver(s):
Cost driver (e.g. level of activity) is the factor used to predict the dependent variable
Two important aspects when identifying a cost driver:
a) It should have an economically plausible relationship
with the dependent variable.
b) It should be accurately measurable.
Steps in estimating a cost function (II)
3. Collect data on the dependent variable and the cost driver(s)
Considers the same entity (organisation, plant, activity area etc.) over a sequence of past time periods.
E.g. Weekly observations of indirect manufacturing labour costs and machine-hours in the Nike factory
Observing many subjects (such as individuals, firms etc.) at the same point of time, or without regard to differences in time
E.g. studies of direct manufacturing labor costs processed at 50 different Nike factories during January 2015
Cost analysts obtain data from company documents, from interviews with managers and through special studies.
4. Plot the data
The general relationship between the cost driver and the dependent variable can readily be observed in a plot of the data.
The plot highlights extreme observations that analysts should check.
5. Estimate the cost function
6. Evaluate the estimated cost function
A key aspect of estimating a cost function is choosing the appropriate cost driver.