Question

' Information Systems Analysis & Design

Q. It requires to explain the three approaches to cost estimation and give examples of each.

Answer 1

The approaches to cost estimation to be covered are listed below:

• Account analysis
• Scatter graphs
• High-low method

Cost estimation approaches are necessary only for costs that are identified as mixed costs. There is no need to apply an estimation method to break a cost into fixed and variable portions if it had already determined it is solely fixed or solely variable.

The Goal of Cost Estimation

The ultimate goal of cost estimation is to determine the amount of fixed and variable costs to create a cost formula to be used to predict future costs. The cost formula, or cost equation, is the output of the cost estimation process. Because it have only one variable (number of units), the formula will be a straight line, or linear equation. The formula that represents the equation of a line will appear in the format of:

Y = mx + b

where Y = total cost

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

          X = the number of units of activity

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

Y = VCx + TFC is the equivalent equation used in accounting for estimating costs. The total cost side of the equation (Y) can also be expressed as f(x) so that the formula appears as:

f(x) = VCx + TFC

As such, the equation is often referred to as a function. In accounting, it is referred to as a cost function because the 'Y' equates to total cost.

Account Analysis Method :

The account analysis method of estimating fixed and variable costs is likely the approach you have used to identify cost behavior so far in your study of managerial accounting. This approach involves simply looking at a cost and guessing its most likely type of cost behavior. This method requires considerable subjective judgment and insight. It is most often used by accountants or managers who are familiar with the nature of costs within a general ledger account (often multiple accounts). Account analysis is the only method you can use to estimate costs when only one period of data is known.

The account analysis approach requires that each individual cost is examined, and based on judgment is categorized as a fixed or variable cost. Then all variable costs are totaled. Variable cost per unit is calculated by dividing the total of all variable costs by the number of units produced and sold.

Total variable costs/Number of units produced and sold=Variable cost per unit

The variable cost per unit is plugged into the cost formula as the variable cost (VC). The fixed costs are totaled separately to calculate the Y-intercept (TFC) component of the equation. This results in a cost equation that can be used to estimate costs for future periods.

Example:

Home Shine is estimating its fixed and variable costs. The following costs were incurred during the month of May by Home Shine when 200 homes were cleaned:

Cleaning supplies	$ 2,400
Hourly wages	4,850
Depreciation - cleaning equipment	650
Manager’s salary	1,400
Auto commuting expenses	1,600
Office rent	850
Total costs	$11,750

Use the account analysis method to determine the total cost equation for Home Shine.

Step 1: Classify each cost as variable or fixed based on judgment. By definition, variable costs increase in total when more activity occurs. By definition, fixed costs are the same in total regardless of the activity level. The activity for this problem is number of homes cleaned.

Cleaning supplies = variable cost. The total cost of cleaning supplies increases when more homes are cleaned.

Hourly wages = variable cost. The total cost of hourly wages increases when more homes are cleaned.

Depreciation = fixed cost. The total cost of depreciation is $650 regardless of the number of homes cleaned.

Manager's salary = fixed cost. The manager's salary is the same regardless of the number of hours worked or the number of homes cleaned.

Auto commuting expenses = variable cost. The total cost of commuting expenses such as gasoline and maintenance increases when more homes are cleaned.

Office rent = fixed cost. The monthly office rent is the same regardless of the number of homes cleaned.

Step 2: Add the costs you identified as variable.

$2,400 + $4,850 + $1,600 = $8,850

Calculate variable cost per unit by dividing the total of the variable costs by the number of units (homes) produced and sold (homes cleaned).

$8,850	= $44.25
200

Step 3: Add the costs you identified as fixed costs.

$650 + $1,400 + $850 = $2,900

Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope with the variable cost per unit and the Y-intercept with total fixed costs:

Y = 44.25x + 2,900

The cost equation indicates that the total cost of cleaning homes is $44.25 per home plus a monthly cost of $2,900

Scatter Graph Method:

Creating a scatter graph is another method of estimating fixed and variable costs. It provides a visual picture of the total costs at different activity levels. However, it is often hard to visualize the cost equation 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 costs for each activity point.

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

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

Rise/Run=Variable cost per unit

'Rise' is the difference in total costs and 'run' is the difference in number of homes cleaned.

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

Step 5: Plug your answers to steps 3 and 4 into the cost formula in the following format:

Y = VCx + TFC.

High-Low Method:

The high-low method uses the highest and lowest activity levels of a data set to estimate the portion of a mixed cost that is variable and the portion that is fixed. Because this method uses only the high and low activity levels to calculate the variable and fixed costs, it may be misleading if the activity levels are not representative of the normal activity, i. e., they may be extremes, or outliers. For example, if most data points lie in the range of 60 to 90 percent for a particular accounting test, and one student scored a 20 percent, the use of the low point will distort the actual expectation of grades in the future. The high-low method is most accurate when the costs incurred at the high and low levels of activity are representation of the majority of the other data points. The steps that follow will guide you through the high-low method:

Step 1: Determine which data represents the total cost (dependent variable, Y) and which represents the activity (independent variable, x). Find the lowest and highest activity points in the data representing the x variable.

Step 2: Determine variable costs per unit by using the mathematical slope formula which divides the change in cost by the change in activity:

Y2 - Y1/X2 - X1 =Variable cost per unit

Where X2 is the high activity level

            X1 is the low activity level

            Y2 is the total cost at the high activity level

            Y1 is the total cost at the low activity level

Step 3: Plug your answer to step 2 and the amounts from either the high or the low data point into the cost formula by replacing the 'VC' with the variable cost per unit. Using the high data point, plug the total cost (at the highest activity point) into the Y variable, and the high activity point for the x variable. Then solve for total fixed costs, 'TFC'.

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

Y = VC x + FC.

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