What is cost estimation ?
What are the purposes of cost estimation ?
Management accounting relies heavily on estimates because of its orientation towards the future.
Estimation helps achieve timeliness and relevance by sacrificing reliability and accuracy.
The purpose of cost estimation is to estimate the value the resources consumed every time
something is done. These estimates are then used as parameters of a cost function allowing
managers to predict either total costs for different volumes of activity or assess the consequences of
managerial decisions.
Cost estimation consists in assessing the parameters of a linear cost function to predict total
costs and its variations
Such cost function and its parameters serve several purposes
- In product costing they are used to compute predetermined overhead rates in normal
costing and standard costing, or in Activity-Based Costing
- In cost-volume-profit analysis they reveal the cost structure of a company and allow an
assessment of operating risks
- In budgeting, they are used to forecast costs for different levels of activity and thus assess
the amount of resources to be secured in various scenarios
- In variance analysis, they serve as benchmarks against which actual performance is
compared to identify and assess the importance of alternative sources of deviations from
budgets.
- In differential analysis, they are used to assess the economic impact of alternative courses of
action which affect activity levels, capacity levels, or the value of any parameter.
What are the different kinds of cost behaviors ?
Costs arise from the use of resources of different natures to make products or provide service.
Product (or service) costing is designed to measure, value, and record the amount of resources
which were consumed for a product or provide a service. It focuses on the resource consumption and
the two cost classifications, cost inventoriability and cost traceability.
Cost estimation is designed to assess the amount of resources which will be consumed because of the
level of activity, the available capacity, or managers’ decisions. The cost classifications cost behavior
matches this focus.
Cost behavior is a description of how a cost changes in relationship to a measure of activity called
cost driver
- Strictly proportional they always increase by the same amount for every additional unit of
activity
- Less than proportional they increase but at a lower pace
- More than proportional they increase at a faster pace
- Not proportional at all
The cost behavior classification relates to two distinct attributes of costs:
- Proportionality: to what extent is resource consumption determined, and thus proportional to, by
the level of activity
, - Flexibility, how easily can the cost be adjusted during the period, can managers adapt it to the
needs of the organization
Costs Proportional Imperfectly proportional Not proportional
Flexible Linear variable Concave variable or convex Discretionary fixed
variable
Imperfectly flexible Step variable or step fixed
Inflexible Capacity fixed
Variable costs are cost proportional to the level of activity. The equation for such cost is typically:
VC dp =Qdp x UC d
d d
Where VC p is the total variable cost of the period resulting from the volume of the cost driver d, Q p
(e.g. the number of bottles juice produced), and UC d the unit variable costs associated with this cost
driver (e.g. the value of the raw materials consumed to make the juice)
A cost is variable relative to a specific cost driver. Therefore, if a cost does not seem to be
proportional to a specific measure of activity, it may have another cost driver. Total costs typically
have multiple costs drivers.
A cost is linear variable when the cost per unit of cost driver is
constant. It is strictly proportional to the level of activity.
UC d is constant and VC p is strictly proportional to the volume of
d
d
activity, Q p
Typical examples of variable costs include the consumption of raw
material or sales commissions which are typically proportional to the
number of units product or the number of units sold respectively.
However, many variable costs are not linear but curvilinear. You can distinguish between concave
variable costs and convex variable costs
A cost is concave variable when the cost per unit of cost driver
decreases as the activity increases. It is less than proportional to
the level of activity
Variable costs are often concave because the more units you produce,
the greater the efficiency in producing each unit. This comes from
economies of scale, learning curves, or volume discounts. All this
contributes to a progressive decrease in unit variable cost, UC d
A cost is convex variable when the cost per unit of cost driver
increases as the activity increases. It is more than proportional to
the level of activity.
Variable costs can be convex when you start exceeding practical capacity
and you incur congestion costs because equipment needs greater
maintenance and may break more hours, people have to be paid extra
hours, and coordination is more complicated. All this can result in a
progressive increase in unit variable cost, UC d
What are the purposes of cost estimation ?
Management accounting relies heavily on estimates because of its orientation towards the future.
Estimation helps achieve timeliness and relevance by sacrificing reliability and accuracy.
The purpose of cost estimation is to estimate the value the resources consumed every time
something is done. These estimates are then used as parameters of a cost function allowing
managers to predict either total costs for different volumes of activity or assess the consequences of
managerial decisions.
Cost estimation consists in assessing the parameters of a linear cost function to predict total
costs and its variations
Such cost function and its parameters serve several purposes
- In product costing they are used to compute predetermined overhead rates in normal
costing and standard costing, or in Activity-Based Costing
- In cost-volume-profit analysis they reveal the cost structure of a company and allow an
assessment of operating risks
- In budgeting, they are used to forecast costs for different levels of activity and thus assess
the amount of resources to be secured in various scenarios
- In variance analysis, they serve as benchmarks against which actual performance is
compared to identify and assess the importance of alternative sources of deviations from
budgets.
- In differential analysis, they are used to assess the economic impact of alternative courses of
action which affect activity levels, capacity levels, or the value of any parameter.
What are the different kinds of cost behaviors ?
Costs arise from the use of resources of different natures to make products or provide service.
Product (or service) costing is designed to measure, value, and record the amount of resources
which were consumed for a product or provide a service. It focuses on the resource consumption and
the two cost classifications, cost inventoriability and cost traceability.
Cost estimation is designed to assess the amount of resources which will be consumed because of the
level of activity, the available capacity, or managers’ decisions. The cost classifications cost behavior
matches this focus.
Cost behavior is a description of how a cost changes in relationship to a measure of activity called
cost driver
- Strictly proportional they always increase by the same amount for every additional unit of
activity
- Less than proportional they increase but at a lower pace
- More than proportional they increase at a faster pace
- Not proportional at all
The cost behavior classification relates to two distinct attributes of costs:
- Proportionality: to what extent is resource consumption determined, and thus proportional to, by
the level of activity
, - Flexibility, how easily can the cost be adjusted during the period, can managers adapt it to the
needs of the organization
Costs Proportional Imperfectly proportional Not proportional
Flexible Linear variable Concave variable or convex Discretionary fixed
variable
Imperfectly flexible Step variable or step fixed
Inflexible Capacity fixed
Variable costs are cost proportional to the level of activity. The equation for such cost is typically:
VC dp =Qdp x UC d
d d
Where VC p is the total variable cost of the period resulting from the volume of the cost driver d, Q p
(e.g. the number of bottles juice produced), and UC d the unit variable costs associated with this cost
driver (e.g. the value of the raw materials consumed to make the juice)
A cost is variable relative to a specific cost driver. Therefore, if a cost does not seem to be
proportional to a specific measure of activity, it may have another cost driver. Total costs typically
have multiple costs drivers.
A cost is linear variable when the cost per unit of cost driver is
constant. It is strictly proportional to the level of activity.
UC d is constant and VC p is strictly proportional to the volume of
d
d
activity, Q p
Typical examples of variable costs include the consumption of raw
material or sales commissions which are typically proportional to the
number of units product or the number of units sold respectively.
However, many variable costs are not linear but curvilinear. You can distinguish between concave
variable costs and convex variable costs
A cost is concave variable when the cost per unit of cost driver
decreases as the activity increases. It is less than proportional to
the level of activity
Variable costs are often concave because the more units you produce,
the greater the efficiency in producing each unit. This comes from
economies of scale, learning curves, or volume discounts. All this
contributes to a progressive decrease in unit variable cost, UC d
A cost is convex variable when the cost per unit of cost driver
increases as the activity increases. It is more than proportional to
the level of activity.
Variable costs can be convex when you start exceeding practical capacity
and you incur congestion costs because equipment needs greater
maintenance and may break more hours, people have to be paid extra
hours, and coordination is more complicated. All this can result in a
progressive increase in unit variable cost, UC d
