1. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-1 7 Cost Estimation

2. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-2 7 The Strategic Role of Cost Estimation Predicting costs of alternative.... Activities, processes, or organizational forms. Implementation strategies.

3. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-3 7  strategic positioning analysis.  value chain analysis.  target costing and life cycle costing.  strategic positioning analysis.  value chain analysis.  target costing and life cycle costing. Using Cost Estimation to Predict Future Costs Strategic management requires accurate cost estimates to facilitate:

4. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-4 7 The Six Steps of Cost Estimation  Define the cost object to be estimated.  Determine the cost drivers.  Collect consistent and accurate data.  Graph the data.  Select and employ the estimation method.  Assess the accuracy of the cost estimate.  Define the cost object to be estimated.  Determine the cost drivers.  Collect consistent and accurate data.  Graph the data.  Select and employ the estimation method.  Assess the accuracy of the cost estimate.

5. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-5 7 Cost Estimation Methods High-low method Work Measurement Regression Analysis

6. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-6 7 Ben Garcia, the management accountant, is interested in estimating maintenance cost. Ben collected this data for seven recent years. Ben Garcia, the management accountant, is interested in estimating maintenance cost. Ben collected this data for seven recent years. Cost Estimation Methods

7. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-7 7 Total Operating Hours Maintenance Cost Ben graphed the data and selected two points--the high and low activities. High-Low Method The high-low method uses two points to estimate the general cost equation Y = a  b  H

8. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-8 7 High-Low Method The high-low method uses two points to estimate the general cost equation Y = a  b  H Y = the value of the estimated maintenance cost a = a fixed quantity that represents the value of Y when H = zero b = the slope of the line, the unit variable cost for maintenance. H = the cost driver, the number of hours of operation for the plant

9. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-9 7 Ben used these two levels of activity to compute:  the variable cost per unit;  the fixed cost; and then  express the costs in equation form Y = a + b  H. High-Low Method

10. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-10 7  Unit variable cost = $520 ÷ 289 hours = $1.80 per hour High-Low Method

11. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-11 7  Unit variable cost = $520 ÷ 289 hours = $1.80 per hour  Fixed cost = Total cost – Total variable cost Fixed cost = $23,030 – ($1.80 per hour × 3,614 hours) Fixed cost = $23,030 – $6,505 = $16,525 High-Low Method

12. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-12 7  Unit variable cost = $520 ÷ 289 hours = $1.80 per hour  Fixed cost = Total cost – Total variable cost Fixed cost = $23,030 – ($1.80 per hour × 3,614 hours) Fixed cost = $23,030 – $6,505 = $16,525  Total cost = Fixed cost + Variable cost (Y = a + b  H) Y = $16,525 + $1.80  H High-Low Method

13. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-13 7 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit High-Low Method Question 1

14. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-14 7 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. $.08 per unit b. $.10 per unit c. $.12 per unit d. $.125 per unit $4,000 ÷ 40,000 units = $.10 per unit High-Low Method Question 1

15. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-15 7 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 High-Low Method Question 2

16. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-16 7 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 High-Low Method Question 2

17. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-17 7 A cost estimation method that makes a detailed study of an activity to measure the time required per unit of output. Work Measurement Example

18. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-18 7 Kupper Insurance Company analyzes the time it takes to process a claim. The mean processing time is 18 minutes, while 95% of the claims require between 10 and 25 minutes. Work Measurement This information enables Kupper to estimate cost more effectively. evaluate the processing clerks more effectively and fairly. This information enables Kupper to estimate cost more effectively. evaluate the processing clerks more effectively and fairly.

19. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-19 7 Regression analysis is a statistical method for obtaining the cost estimation unique equation that best fits a set of data points. Regression Analysis Lease squares regression is widely viewed as one of the most effective methods for estimating costs.

20. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-20 7 Statistics courses and computer courses deal with detailed regression computations using computer spreadsheet software. Accountants and managers must be able to interpret and use regression estimates. Regression Analysis

21. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-21 7 The objective of the regression method is still a linear equation to estimate costs Y = a + bX + e Y = value of the dependent variable, estimated cost a = a fixed quantity, the intercept, that represents the value of Y when X = 0 b = the unit variable cost, the coefficient of the independent variable measuring the increase in Y for each unit increase in X X = value of the independent variable, the cost driver Regression Analysis e = the regression error, the distance from the regression line to the data point

22. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-22 7 Month Supplies Expense (Y) Production Level (X) 1$25050 units 2310100 units 3325150 units 4 ? 125 units Month Supplies Expense (Y) Production Level (X) 1$25050 units 2310100 units 3325150 units 4 ? 125 units Regression Analysis Regression analysis will enable us to predict the amount of supplies expense for month four.

23. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-23 7 Supplies Expense 400 350 300 250 200 50 100 150 Regression Analysis Regression for the data is determined by a statistical procedure that finds the unique line through the data points that minimizes the sum of squared error distances. Units of Output

24. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-24 7 Regression Analysis Month Supplies Expense (Y) Production Level (X) 1$25050 units 2310100 units 3325150 units 4 ? 125 units Month Supplies Expense (Y) Production Level (X) 1$25050 units 2310100 units 3325150 units 4 ? 125 units Y = a + bX + e Y = $220 + $.75 per unit  125 units Y = $313.75 Expense estimate for month 4 Y = a + bX + e Y = $220 + $.75 per unit  125 units Y = $313.75 Expense estimate for month 4

25. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-25 7 Supplies Expense Units of Output 50 100 150 400 350 300 250 200 e = 7.5 e = 15 e = 7.5 220 Fixed Cost = $220 Regression Analysis b = the slope of the regression line or the coefficient of the independent variable b = $.75 per unit

26. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-26 7 50 100 150 200 400 350 300 250 200 Outlier proper line, excluding the outlier improper line, influenced by outlier Regression Analysis Supplies Expense Units of Output Outliers may be discarded to obtain a regression that is more representative of the data.

27. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-27 7 Regression Analysis Evaluating a Regression Analysis R 2, the coefficient of determination, is a measure of the explanatory power of the regression, the degree that changes in the dependent variable can be predicted by changes in the independent variable. The t-value is a measure of the reliability of each of the independent variables. The standard error of the estimate (SE) is a measure of the accuracy of the regression’s estimates.

28. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-28 7 50 100 150 200 400 350 300 250 200 Regression with high R 2 (close to 1.0) Regression Analysis Dependent Variable Independent Variable

29. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-29 7 Regression Analysis 50 100 150 200 400 350 300 250 200 Regression with low R 2 (close to 0) Dependent Variable Independent Variable

30. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-30 7 standard error Regression Analysis 50 100 150 200 400 350 300 250 200 Dependent Variable Independent Variable Standard error is a range around the regression estimate in which we can be reasonably sure that the unknown value will fall.

31. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-31 7 standard error Regression with Wide (Poor) Standard Error Slide 7-34 Regression Analysis 50 100 150 200 400 350 300 250 200 Dependent Variable Independent Variable

32. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-32 7 standard error Regression Analysis 50 100 150 200 400 350 300 250 200 Dependent Variable Independent Variable Regression with Narrow (Good) Standard Error

33. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-33 7 Data and Implementation Problems  Data Accuracy  Selecting the time period  Mismatched time period  Length of the time period  Nonlinearity problems  Trend and/or seasonality  Outliers  Data shift Data and Implementation Problems  Data Accuracy  Selecting the time period  Mismatched time period  Length of the time period  Nonlinearity problems  Trend and/or seasonality  Outliers  Data shift Regression Analysis

34. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Slide 7-34 7 The End This is a tough cost to estimate!