Cost Estimation/Segregation Techniques
Cost estimation is a term used to describe the measurement of historical cost so as to be able to predict future costs for management decision making. That is, historical information is analyzed to provide estimates on which to base future operational To do cost estimation, it is important for the Accountants to be able to ascertain the activity level as well as cost drivers which exert main influence on the company activity. A cost driver is any factor whose change causes a change in the total cost of the operations of an activity. Some examples of cost drivers are: (a) direct labour hours
(b) machine hours
(c) Units of output and
(d) Number of production runs
In some cases, there are mixed costs. That is, such costs have both fixed and variable elements that would need to be segregated.
METHOD OF SEGREGATING MIXED COSTS INTO FIXED COST AND VARIABLE COSTS Mixed costs can be separated into their fixed and variable elements, using a number of methods which include: (i) The accounts classification method
(ii) The high-low method
(iii) The scatter graph
(iv) The linear regression analysis
(v) The multiple regression analysis
Account Classification Method
This is a subjective way of segregating the mixed cost into fixed and variable element. It is usually based on the personal experience of the accountant. This method requires that the the accountant inspect each item of expenditure within the accounts for some output level, and then classify each item of expenses as a wholly fixed, variable or semi- variable cost.
This represents an objective way of segregating the mixed cost into fixed and variable elements. It involves the following procedure- (i) Identify the highest and least activity levels among the observed data.
(ii) Ascertin the difference between the two activity levels (iii) Identify the corresponding cost to both the highest and lowest activity levels.
(iv) Determine the difference between the two corresponding cost. (iv) Divide the difference in cost by the difference in activity level in order to determine variable cost per unit or the level of variability, (vi) Use the variable cost per unit to determine total variable cost. ADVANTAGES
(i) It is capable of providing consistent result from different user (ii) It eliminates subjectivity
(iii) High and low method is simple to calculate.
(i) The method relied solely on the two extreme values, that is highest and lowest. (ii) The fina1 result of the method may not represent the actual cost position of the Company
By this method of cost estimation, historical costs from previous periods are plotted and from the resulting diagram, a ‘line of best fit’ can be drawn by visual estimation
Linear Regression Analysis
This is a statistical method of estimating fixed and variable costs using historical data from previous accounting periods.
Multiple Regression Analysis
Multiple regression recognizes several different factors as affecting levels of activity. For example, total cost may be affected by volume of output, time of the year, size of batch, labour turnover, age of machinery etc. The multiple regression model enable the accountant to estimate the amounts by which the above variables affect total cost.
Illustration: Based on the high-low method
The cost of operating the maintenance department of a computer company ABC Ltd for the last 5 months have been as follows: Month Costs Production volume N (Standards hours) 1100,0007,000