Strategic Role of Cost Estimation

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Chapter 8: Cost Estimation

Strategic Role of Cost Estimation
* Cost Estimationthe development of a well-defined relationship b/t a cost object and its cost drivers for the purpose of predicting the cost * Facilitates strategic mgmt is 2 ways
* Helps predict future costs
* Helps identify key cost drivers for a cost object and which driver is most useful * Using Cost Estimation to Predict future costs
* Strategic mgmt requires accurate estimates for the following: * To facilitate strategy development and implementation * To facilitate value-chain analysis
* To facilitate target costing and pricing
* To facilitate effective performance measurement, evaluation, and compensation * Cost Estimation for Different Types of Cost Drivers
* Activity-Based, Volume-Based, Structuralusually long-term impact, Executional * The effect on total cost of experience is nonlinearcosts decrease w/ increase manufacturing experience * Relationship between the structural cost driver, scale, and total cost is nonlinear * Scaleused to describe the manufacture of similar products that differ in size * Using Cost Estimation to Identify Cost Drivers

* Most practical way is to rely on judgment of product designers, engineers, and manufacturing personnelmost knowledgeable

Six Steps of Cost Estimation
* Step 1: Define the Cost Object to be estimated
* Ex. Goal is to estimate product costs to improve pricing, relevant cost object are products manufactured in plant * Ex. Goal is to reward managers for reducing cost, cost object are individual manufacturing depts in plant since they mostly control costs * Step 2: Determine the Cost Drivers

* Most important step
* May be numerous relevant cost drivers
* Step 3: Collect Consistent and Accurate Data
* Data must be consistent and accurate
* Consistenteach prd of data is calculated using same acct basis and all transactions are properly recorded in prd which they occurred * Prd used is too shortchance of mismatch b/t variables increases * Longer prd reduces number of data points available to improve the accuracy of the estimate * Accuracy depends on the source

* Choice of cost drivers requires trade-offs b/t relevance of drivers and consistency and accuracy of data * Step 4: Graph the Data
* ObjectiveIdentify unusual patterns
* Any shift or nonlinearity in data must be given special attention in developing estimate * Step 5: Select and Employ the Estimation Method
* Mgmt accountant chooses the method w/ the best precision/cost trade-off for the estimation objectives * Step 6: Assess the accuracy of the Cost Estimate
* Considering completeness and appropriateness of cost drivers in step 2, consistency and accuracy of data in step 3, the study of graphs in step 4, and the precision of the method in step 5 * Common approachcomparing estimates to actual results over time * Mean Absolute Percentage Error (MAPE)calculated by taking absolute value of each error, and then averaging these errors and converting the result to a percentage of actual values of OH

Cost Estimation Methods
* In choosing best method, mgmt accountants must seek balance b/t level of accuracy desired and any limits on cost, time and efforts * High-Low Methodleast accurate
* Uses algebra to determine a unique estimation line b/t representative high and low points in the data * If either the highest or lowest point is a great distance from the other points around it, a biased estimation can result * Useful for estimating total costs but not the amount of fixed costs aloneonly applies to relevant range of the cost driver * Y=a+b×X

* Y=value of estimated cost
* X=cost driver
* A=fixed quantity...
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