TOPIC 3 INTRODUCTION TO COST ESTIMATION
Cost estimation
Cost estimation may be defined as a study which attempts to predict the relationship between
costs and the activity level or cost driver that causes those costs based on an analysis of historical
costs. In other words, cost estimation occurs when an individual attempts to measure historical
costs in order to predict future costs.
To achieve the measurement, it is necessary to separate cost into their fixed and variable cost
elements. Semi variable costs can be separated into their fixed and variable components using
scatter diagram approach, high-low method or regression analysis.
In this topic, we shall deal with linear cost relationships and equations. A linear equation is an
expression of the relationship between variables, the independent and the dependent variables. The
cost estimating function for linear relationships is
Y = a + bX
Analyzed as
Total cost = Fixed cost + Variable cost
Where
Y – represents the dependent variable or the total cost
a – represents fixed cost component of the total cost (Constant amount)
bX -represents the variable costs component of the total cost b represents the unit variable
cost (this is the gradient of the equation)
x represents independent variable or the output level
This is the usual straight line equation you have been encountering in elementary mathematics.
PURPOSE OF ESTIMATION
It assists in estimating the future expenditure (cost prediction) as the expenditure will depend on
the cost of the respective activities.
It assists in determining the net benefits anticipated in a specific activity based on the relationship
between projected costs and projected revenue (profit prediction).
Cost estimation is useful in the execution of managerial functions: business planning, cost control,
performance evaluation and decision making.
- Budgeting and Planning: Cost estimation is essential for creating budgets and financial plans. By estimating costs accurately, organizations can set realistic financial targets and allocate resources efficiently.
- Product Pricing: Understanding the cost structure of products or services is crucial for setting competitive prices that cover both variable and fixed costs while ensuring profitability.
- Cost Control: Cost estimation helps in monitoring and controlling expenses. By comparing estimated costs with actual costs, management can identify variances and take corrective actions as needed.
- Performance Evaluation: It enables the assessment of the performance of various departments, projects, or activities within the organization. By comparing estimated costs to actual costs, management can evaluate the efficiency and effectiveness of different areas of the business.
- Decision-Making: Cost estimates are vital when making strategic decisions. They provide valuable information for evaluating different options and choosing the most cost-effective courses of action, such as whether to invest in new equipment, expand operations, or outsource a function.
- Inventory Valuation: Cost estimation helps in valuing inventory accurately, which is important for financial reporting and tax purposes. Different methods of inventory valuation (e.g., FIFO, LIFO, weighted average) rely on cost estimates.
- Resource Allocation: It assists in allocating resources, such as labor, materials, and equipment, effectively among various projects or production processes. This allocation can optimize resource utilization and minimize waste.
- Performance Benchmarking: Cost estimation allows organizations to compare their cost structures with industry benchmarks and competitors. This helps in identifying areas where cost reduction or process improvement is needed to stay competitive.
- Cost Reduction Initiatives: By providing a clear picture of where costs are incurred, cost estimation can identify opportunities for cost reduction. This is particularly important in cost-conscious environments and during economic downturns.
- Contract Negotiations: Cost estimates play a crucial role in contract negotiations with suppliers, customers, and partners. Accurate cost information is necessary for ensuring fair and profitable agreements.
- Regulatory Compliance: Many regulatory requirements and financial reporting standards (e.g., GAAP, IFRS) mandate the use of specific cost estimation methods and practices. Compliance with these standards is essential for legal and financial reporting purposes.
