Question

Three methods for cost prediction: Engineering estimates, Account analysis, Statistical methods.

Required: Discuss the advantages and disadvantages of each.

Answer 1

This approach requires that an experienced employee or group of employees review the appropriate accounts and determine whether the costs in each account are fixed or variable. Totaling all costs identified as fixed provides the estimate of total fixed costs. To determine the variable cost per unit, all costs identified as variable are totaled and divided by the measure of activity (units produced is the measure of activity for Bikes Unlimited).

Let’s look at the account analysis approach using Bikes Unlimited as an example. Susan (the cost accountant) asked the financial accounting department to provide cost information for the production department for the month of June (July information is not yet available). Because the financial accounting department tracks information by department, it is able to produce this information.

Advantages and disadvantages of accounts analysis (inspection) methodThe accounts analysis method is easy to use and useful when a quick cost forecast is required. However,it assumes that what occurred in the past will be reflected in the future. This calls for further analysis.The model’s reliability and validity cannot be determined as we cannot measure the size of probableerror in forecasts made i.e. it lacks statistical vigor. The method is highly subjective as different managerswill classify some costs differently.

Engineering method

this method is based on a detailed study of each operation where careful specification is made formaterials, labour and equipment necessary to produce a product. It involves identifying the level ofinput required of an activity in form of raw material and labour while total cost is based on the cost ofeach input. This approach is applicable where no past data exists.

Disadvantage:

The main setback of the approach is that it requires a complex analysis of all theconstituents of an activity and the requirements of an activity in terms of costs detailed into materials,labour, overheads and time.Visual fit (scatter graph method)Cost estimation is based on past data regarding the dependent variable and the cost driver. The past dataon cost levels and the output levels is plotted on a graph (called a scatter graph) and a line of best fit isdrawn as shown in the diagram. A line of best fit is a line drawn so as to cover the most points possibleon a scatter graph. It can also be defined as ‘a straight line used as a best approximation of a summary ofall the points in a scatter-plot’. Its intersection with the vertical axis indicates the fixed cost while thegradient indicates the variable cost per unit. This method takes into account all observations and is easyto apply. However, it cannot be used with two or more independent variables and is subjective to someextent as different lines of best fit may be drawn by