Accounting for Operational Activities: Illustrative Transactions and Financial Statements Answers

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CHAPTER FIVE: COST ESTIMATION

Introduction

When managers make decisions they need to compare the costs (and benefits) among alternative actions. In this chapter, we discuss how to estimate the costs required for decision making (Lanen, 2008).

Learning Objectives:

According to Lanen (2008), after completing Chapter 5 you should:

1. Understand the reasons for estimating fixed and variable costs.

2. Estimate costs using engineering estimates.

3. Estimate costs using account analysis.

4. Estimate costs using statistical analysis.

5. Interpret the results of regression output.

6. Identify potential problems with regression data.

7. Evaluate the advantages and disadvantages of alternative cost estimates.

8. (Appendix A) Use Microsoft Excel to perform a regression analysis.

9. (Appendix B) Understand the mathematical relationship describing the learning phenomenon.

Why Estimate Costs?

Managers make decisions and need to compare costs and benefits among alternative actions. Good decision requires good information about costs, the better these estimates, the better the decision managers will make (Lanen, 2008)..

Key Question

What adds value to the firm? Good decisions.

You saw in Chapters 3 and 4 that good decisions require good information about costs. Cost estimates are important elements in helping managers make decisions that add value to the company (Lanen, 2008).

Learning Objective One: Understand the reasons for estimating fixed and variable costs

The reasons for estimating fixed and variable costs

The basic idea in cost estimation is to estimate the relation between costs and the variables affecting costs, the cost drivers. We focus on the relation between costs and one important variable that affect them: activity (Lanen, 2008).

Basic Cost Behavior Patterns

By now you understand the importance of cost behavior. Cost behavior is the key distinction for decision making. Costs behave as either fixed or variable (Lanen, 2008).

Fixed costs are fixed in total, variable costs vary in total. On a per-unit basis, fixed costs vary inversely with activity and variable costs stay the same. Are you getting the idea? Cost behavior is critical for decision making.

The formula that we use to estimate costs is similar cost equation:

Total costs = fixed costs + {variable cost per unit} number of units

T c = f + {v} x

|With a change in Activity |In Total |Per Unit | |Fixed Cost |Fixed |Vary | |Variable |Vary |Fixed |

What Methods are used to Estimate Cost Behavior?

Three general methods used to estimate the relationship between cost behavior and activity levels that are commonly used in practice: Engineering estimates, Account analysis & Statistical methods (Such as regression analysis) (Lanen, 2008).

Results are likely to differ from method to method. Consequently, it’s a good idea to use more than one method so that results can be compared. These methods, therefore, should be seen as ways to help management arrive at the best estimates possible. Their weakness and strengths require attention.

Learning Objective Two: Estimate costs using engineering estimates.

Engineering Estimates

Cost estimates are based on measuring and then pricing the work involved in a task. This method based on detailed plans and is frequently used for large projects or new products. This method often omits inefficiencies, such as downtime for unscheduled maintenance, absenteeism and other miscellaneous random events that affect the entire firm...
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