Cost Estimation, Behavior, and Prediction

• Cost estimation is the process of determining cost behaviour.
• Cost behaviour is the relationship between costs and activity levels.
• Cost prediction involves using knowledge of cost behaviour to forecast costs at specific activity levels.

Cost Drivers

• A cost driver is an activity or factor that causes a cost to be incurred.
• When selecting cost drivers, the underlying causes of cost need to be considered.
• Volume-based cost drivers are measures of output or activity volume, such as units produced, direct labor hours (DLH), direct labor costs (DL$), or machine hours (MH).
• Non-volume based cost drivers are other factors besides production volume that explain cost behaviour.

Example 1: Spray Painting Business

• The cost of paint increases as more cars are sprayed.
• The number of cars sprayed is the cost driver.
• This is a volume-based cost driver.

Example 2: Large Bank

• Administration costs at the corporate headquarters decreased when senior managers decided to hold fewer face-to-face meetings.
• The number of face-to-face meetings is the cost driver.
• This is a non-volume based cost driver.

Conventional Approach to Cost Drivers

• Volume-based cost drivers are used (e.g., units produced, DLH, DL$, MH).
• Assumes costs are driven by the level of activity such as production or sales volume.
• Appropriate for direct product costs like direct material and labor.

Contemporary Approach to Cost Drivers

• A range of possible cost drivers beyond production volume explain cost behavior.
• Both volume and non-volume based cost drivers are used.

Activity Based Cost Drivers

• Classifies cost drivers into four levels: unit, batch, product, and facility.
• Unit level costs relate to activities performed for each unit produced; uses volume-based cost drivers; example: direct materials.
• Batch level costs relate to activities performed for a group of product units; examples include a batch or delivery load; example: delivery costs.
• Product level costs relate to activities performed for specific products or product groups; also called product sustaining costs; example: research & design costs.
• Facility level costs are costs incurred to run the business, not caused by any particular product; also called facility-sustaining costs; example: premises costs.

Selecting Cost Drivers

• It's important to consider the level of detail needed in the analysis.
• As total costs are split into smaller components with associated cost drivers, the accuracy of the resulting information will increase.
• Cost-benefit criteria are important.
• Cost behaviour and cost drivers can change, therefore time frame is important.
• Choice depends on whether the analysis is for short-term budgeting or long-term strategic decision making.
• For cost estimation, the goal is to understand cost behaviour to estimate cost functions or predict future costs.
• For cost management, the goal is to analyze costs to reduce costs and manage resources effectively - effective cost management requires the identification of root cause cost drivers.
• Root cause cost drivers are the basic factors that cause a cost to be incurred.
• Cost drivers used to predict costs may differ from those used to manage costs.
• A strong correlation means accuracy of cost information increases, while easy to measure means a cost driver is preferred.
• Many organizations select cost drivers for convenience, but not because of their ability to predict costs accurately.
• With more cost drivers, the costs of gathering and analysing information about costs and cost drivers will also increase.

Cost Behavior Patterns

• Cost behaviour is the relationship between a cost and the level of activity (or cost driver).
• Types of cost behavior patterns include variable costs, fixed costs, step-fixed costs, semivariable costs, and curvilinear costs.
• Variable costs change in total, in direct proportion to changes in the level of activity.
• The variable cost per unit remains constant.
• Fixed costs remain unchanged in total despite changes in the level of activity, but fixed cost per unit changes.
• Modern approaches to cost analysis recognize that there are cost drivers for some of these fixed costs and very few costs actually remain fixed.
• Step-fixed costs remain fixed over a wide range of activity levels, but jump to a different amount for levels outside that range.
• Semivariable (or mixed costs) have both fixed and variable components.
• Curvilinear costs have decreasing marginal cost at lower levels of activity and increasing marginal costs at higher levels of activity.
• Marginal cost is the cost of producing one additional unit.
• The relevant range is the range of activity over which a particular cost behaviour pattern is assumed to be valid.

Cost Estimation

• Cost estimation involves identifying the specific cost behaviour pattern for each cost. Approaches to cost estimation include:
• Managerial judgement uses experience and knowledge rather than formal analysis to classify costs behavior.
• Future costs are estimated by examining past costs and identifying other factors that might affect costs in the future.

Reliability is dependent upon manager ability.

• Engineering approach studies processes that result in the incurrence of a cost using time and motion.
• Employees are observed as they work to record the steps for each task and the times taken.
• Useful when there is no reliable past data on which to base cost estimates.
• Most effective when there is a direct relationship between inputs and outputs.
• Quantitative analysis is a formal analysis of past data to identify the relationships between costs and activities.
• Visual fit method - a scatter plot diagram involves plotting the data points to visualise the relationship between cost and level of activity.
• High-low method - involves taking the two observations with the highest and lowest level of activity to calculate the cost function.
• Regression analysis - is a statistical technique that uses a range of data points to estimate the relationship between cost and cost drivers.
• In simple regression, the relationship between the dependent variable (Y) and one independent variable (X) is shown with the formula: Y = a + bX where a represents the fixed cost component, b represents the variable cost per unit, and X is the level of activity.
• Multiple regression estimates a linear relationship between one dependent variable and two or more independent variables Y = a + b₁X₁ + b2X2.
• R^2 measures the proportion of change in the dependent variable that is explained by a change in the independent variable.
• Adjusted R^2 is an R^2 adjusted to compensate for a small sample size.
• Cost estimates are only as good as the data upon which they are based.
• Practical issues in cost estimation include mismatched time periods, outliers, missing data, trade-offs, allocated fixed costs, and inflation.

Data Collection Problems

• These problems include: missing data, outliers, mismatched time periods for dependent and independent variables, allocating fixed costs on a per unit basis, inflation, and trade-offs.

Other Issues in Cost Estimation:

• It's also important that activity-based approaches allow more complex cost behaviour patterns to be considered.
• The accuracy of cost functions, as budgets and cost estimates capture only approximations of cost behaviors.
• All cost functions are based on simplifying assumptions, such as cost behaviors depend on a single or only a few types of activity, and cost behaviors are linear within a relevant range.
• Costs of producing more accurate cost estimates need to be assessed against the likely benefits.