Question

Describe the two assumptions used in cost estimation behavior. Give an example of one of the assumptions.

Answer 1

Two assumptions used in cost estimation behaviour:

Assumption 1: The cost changes with changes in a single activity level

There are various measures for the level of activity like Output quantity, Machine Hours, Direct Labor Hours etc.

The assumption for cost estimation is that total cost changes with single factor of level of activity which may be machine hour, direct labor hour or output quantity.

For example if Budgeted cost of Variable overhead cost is $10,000 for budgeted machine hour of 1000, the assumption is that when the actual machine hour is 800, the Variable overhead cost will be $8000

Assumption 2: The relationship between cost and level of activity is a linear function.

Suppose Fixed cost =$ 10,000

Variable cost =$100 per unit of output.

The cost equation will be Total cost=$10000+$100*N

N=output

Y=a+bX

Y=Cost

a=a and b are constant

X= variable (output)

The total cost at various level of activities will be estimated at:

Level of activity(Output)	Estimated Cost
100	$          20,000
200	$          30,000
300	$          40,000
400	$          50,000
500	$          60,000
600	$          70,000
700	$          80,000
800	$          90,000
900	$        100,000
1000	$        110,000

The equation is linear (Straight line ) as shown in attached graph.