1. science
2. mathematics
3. statistics

CHAPTER 6
COST ESTIMATION
Jinashree Rajendrakumar
Jisha Nambiar
Madhuri Chakraborty
Priyanka Tyagi
Shalini Singh
CASE 6.2
Case 6.2 – The Pump Division
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The Pump Division has one plant dedicated to the design &
manufacture of pumps.
Typical production cycle of a pump is 1-3 years.
Job is highly technical & customized.
Orders are obtained through bids (based on cost estimate)
and negotiation sessions.
The contracts generally are fixed price.
Sometimes orders accepted as loss leaders.
High risk of job cost overruns.
Examples
(In thousands)
Job 1
Job2
Original Cost Estimate
Costs Incurred to date:
Manufacturing
Engineering
Estimate to complete
Total current Estimate
Lower-of-cost-or-market: Contract sales price
Less 10% Allowance for Normal Profit Margin
Inventory Value
Inventory Reserve Adjustment (loss)
$2,113
$1,800
2,100
373
367
2,840
2,520
(252)
2,268
(572)
100
2,500
2,600
2,000
(200)
1,800
(800)
Current Problems in the Department
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Final job costs significantly varied from original cost
estimates.
Major decline in profitability, combined with several
unfavorable year-end “surprise” inventory adjustments.
As company policy is to record revenue & costs on a
completed contract basis, it is difficult to determine early,
the variances between job costs & estimates.
Some unanswered Questions ?
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It is clear from the table, Job-Order costing is being used as
each job is customized. But is job-order costing being used
within the departments (Engineering, Manufacturing etc) ?
What allocation base/cost driver is being used for applying
overhead costs?
What estimation method (High-Low or Regression Analysis)
is being used for overhead costs?
How is Under or Over applied Overhead Balances being
disposed (Closed out to Cost of goods sold or Allocated
between accounts)?
Inventories
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
Valuation of the Inventory
- FIFO, LIFO or Weighted Average Method
Inventory Adjustments
The accounting procedures include two year-end adjustments to
be made prior to the close of the fiscal year:
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Adjusting inventory to physical count: Perform an annual
physical inventory count of inventories and reconcile the
changes with the inventory balance.
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Adjusting the inventory reserve balance: Departments may
be required to maintain an inventory reserve. Reserves must
be at least equal to and may not exceed the physical
inventory by more than 15%. Therefore, if the reserve
account is less than the physical inventory count or is more
than 15% greater than the physical inventory you will need
to adjust the reserve balance. (NOTE: Departmental
storerooms using a periodic inventory system are not
required to keep a reserve.)
What courses of action appropriate for plant
manager & his controller relating to
Estimating Costs
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Cost estimation team should include Engineering, Design and
Manufacturing representatives. Cost estimation should be
cross-disciplinary for better accuracy and insight.
Sales department should be given the threshold cost of the
project and be trained to negotiate on more favorable
payment terms.
Cost Estimate should be updated to reflect new information,
given a project’s phase of planning and/or execution.
Plant Manager should review the cost estimates and actual
costs more frequently to track variances.
Controller should record costs as a percent of completion
rather than on a completed contract basis.
Contd..
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Since the PLC of the jobs are usually 1-3 yrs, the cost
estimates should incorporate future costs such as risk
contingency costs for major cost elements.
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Cost estimation should build in inflation into the cost estimates
using Index. Historical data can be used to load the estimates
for inflation.
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Perform a risk assessment on the entire project in order to
define and quantify the potential risk areas and types.
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Cost estimation methods used should be consistent, thorough
and traceable.
Lower of Cost or Market value
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LCM requires that inventory be reported in the financial
statements at whichever is lower – its historical cost or its
market value. Also damaged or obsolete inventory is writtenoff in LCM.
The loss (market value < historical cost) must be charged
against revenues of the period. Cost of goods sold will absorb
the inventory write-down.
The replacement cost (market value) must lie between a
ceiling and a floor amount.
The ceiling is the net realizable value(selling price less disposal
cost).
The floor is the net realizable value less a normal profit margin.
If cost is lowest of the four values (cost, replacement cost,
ceiling, floor), use cost. Otherwise use the second lowest
value.
What courses of action appropriate for plant
manager & his controller relating to the
application of LCM rule
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This method applies to the following:
- Goods purchased and on hand
- The basic elements of cost (direct materials, direct labor, and an
allocable share of indirect costs) of goods being manufactured and
finished goods on hand
This method does not apply to the following and must be
inventoried at cost:
- Goods on hand or being manufactured for delivery at a fixed
price on a firm sales contract (that is, not legally subject to
cancellation by either you or the buyer)
- Goods accounted for under the LIFO method (www.irs.gov)
The Pump Division should have an accurate cost estimation
method in place and try to avoid “whatever it takes to get the
order” practice.
What is the significance of the following
methods on the performance of the
operation?
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Progress Payments
Advance Payments
Escalation Clauses
Progress Payments
• Payment on basis of percentage or stage of completion
• Payments are based on costs incurred as work progresses
• Progress payments are currently limited to 80 percent of
incurred costs
• Contractors must have approved accounting systems
• Advantageous from a cash flow perspective
• Improves the working capital of the firm
• Progress payments can decrease interest expense
• Important for long term contracts
• Information is critical for effective contract administration and
for audit and investigative purposes
Advance Payments
• Advance payments are prepayments and cash advances for the
manufacturer to start the job, buy materials and begin
production
• Advance payments if partial payments or progress payments are
not feasible and private financing is not available
• Contractors must have approved accounting systems
Escalation clause
Definition:
A clause in a contract that allows the seller to be offered a
higher price should the buyer or another party make a
higher bid in the market within a certain period. Contracts
can also be indexed for inflation or cost increases.
Benefits of escalation clause
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Effective method of coping with inflation
Hold significance for long term contracts
Price adjustment clauses for long-term contracts
Identifies the item(s) that are subject to the escalation clause
The escalation clause should specify frequency for price
adjustment
Price index for the calculation of price adjustments (PPI)
Transfers the burden of the price hike to the buyer
Corrects the distortion in the cost estimations
CASE 6.1
Case 6-1(Background)
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The Brenham General hospital prepares in-house meals
for its patients
The hospital is facing steady decline in revenues and
wanted to cut costs wherever possible
It is approached by a Health Food Inc . Which offers it
meals @ $11.50
BG Hospital wants to have some idea about the cost of
their in-house meal service
Based on that they wanted to decide whether to accept
the proposal of HFI or not
Data
Patient
Days (X)
Other
staff (Y1)
Maintenance
(Y2)
Patient
Equipment
(Y3)
Dietitian
(Y4)
food cost
(Y5)
Jan
1382
3122
1401
1649
2875
9674
feb
1312
2908
1322
1415
2875
9184
march
1186
2655
1322
1313
2875
8302
april
1012
2600
1288
1105
2875
7084
may
914
2433
1200
1089
2875
6398
june
604
2083
1133
1011
2875
4338
july
516
1809
1093
900
2875
3612
august
896
2322
1122
1112
2875
6275
sept
962
1434
1235
1103
2875
6734
oct
1286
2700
1302
1300
2875
9002
Nov
1208
2789
1300
1442
2875
8456
dec
1114
2600
1322
1396
2875
7798
High Low Method
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The high-low method is based on the rise-over-run
formula for the slope of a straight line. It uses two
points to estimate the general cost equation
Y = a  b H
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H = the cost driver
Y = dependent variable
Variable Cost (Y) = Change in Cost
Change in Activity
Fixed Cost (H) = Total Cost – Variable Cost
Simple Regression
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A regression analysis has two types of variables:
1.
2.
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The dependent variable is the cost to be estimated
The independent variable is the cost driver used to estimate the value of the
dependent variable
Evaluating a regression analysis:
R2, 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.
Simple Regression Steps …
Steps..
Steps…
Scatter Plot: steps…
Steps…
Steps…
High –Low Method
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Very simple to apply
Least expensive
A critical defect – uses
only two data points
Periods in which activity
level is unusually
low/high will produce
inaccurate results.
Simple Regression
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Most accurate and Most
costly
Complex and involves
numerous calculations
but principle is simple.
Spreadsheet programs
now available to handle
the complexities.
High –Low Method
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Other staff =1.52 Days
+1021.36
Food Cost =7.00Days
Maintenance =0.36 Days
+903.48
Equipment = 0.86Days +
460.48
Dietitian = 2875
Total cost= 9.74Days+5250.32
Simple Regression
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Other Staff = 1.35 Days
+1051.7
Food Cost = 6.94 Days +
69.75
Maintenance = 0.32 Days +
915
Equipment = 0.722Days +
490.31
Dietitian = 2875
Total cost = 9.35Days +5401.76
Regression analysis is a better cost estimation method
In house food service
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Other Staff
X
Food Cost
X
Maintenance
X
Equipment
X
Dietitian
X
$11.50Per meal
X=Services utilized by the
respective proposals
Health Food Inc
X
X
X
X
In house service
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Other Staff
Food Cost
Maintenance
Equipment
Dietitian
$11.50 /Meal
Health food Inc.
V+F
V+F
V+F
V+F
F
F
F
F
V
V=Variable & F=Fixed Cost
Figures in italics and underlined are not considered for comparison
because they are common between the options
Compare the two options
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Cost of In-house meals
Equation=1.35Days+1051.7+6.94Days+69.75+0.32Days
+0.722Days
Cost = 9.33 Days +1121.45

Cost of HFI ‘s Proposal
Cost = $11.50 per meal
Comparing variable component of two options
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In-house meal costs = $9.33 per patient day
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HFI’s proposal = $11.50 per meal
(1 patient day =2.8 meals )
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HFI’s proposal = $11.50 *2.8 = $32.20 per patient
day
Conclusion: In-house meal preparation is cheaper
Comparison of total cost of the options using two
different occupancy levels
Days
In house
HFI
X=1200
9.33*1200+1121.45=
12317.45
32.2*1200 =
39640
9.33*600+1121.45 =
6719.45
32.2*600 =
19320
(33% occupancy)
X=600
(16% occupancy)
READINGS
APPLYING OVERHEAD:
HOW TO FIND THE RIGHT BASES AND RATES?
Overview
• Application of “Regression Analysis” to determine the
relationship between the overhead costs and the cost
drivers/ application bases
• Selection of application bases that reflect the causes of
overhead costs
• Using data and an objective tool to understand the relationships
• Using the regression results of rates to ABC models.
• Using regression analysis for construction of multiple
overhead rate
What is Regression analysis used to accomplish in
this article?
•PURPOSE:
Determine the relationship between the overhead costs and
the various cost drivers using regression analysis
Identify the application bases/cost drivers that better reflect
the causes of the overhead costs
Select proper bases that have strong cause-and-effect
relationship with the factory overhead costs using objective
technique
•From a wide selection of application bases three cost
drivers were picked for overhead costs in the article
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direct labor hours
machine hours
number of production setups
What is Regression analysis used to accomplish in
this article?
• Step 1: searching for a proper base
• Simple regressions on collected data
• Three different simple regression analyses were performed
• R squared values ( explain the variability of FOH costs that
can be explained by the independent variable) are as under:
• R squared or coefficient of determination measures the extent
of the relationship between the two variables
(Y) dependent variable
(X) independent variable
R squared values
Factory OH costs (FOH)
Direct labor hours
0.77 (strong)
FOH costs
Machine hours (MH)
0.39 (middle)
FOH costs
No of production setups
0.29 (weak)
What is Regression analysis used to accomplish in
this article?
• Step 2: construction of a single overhead rate
• Constant refers to the estimate of fixed portion of FOH costs
• X coefficient is an estimate of the variable FOH costs
• The regression equation:
Monthly overhead costs (OH) = $72,794+ $74.72 (MH)
fixed
variable
Scatte r plot
250000
y = 74.719x + 72794
FOH costs
200000
1700
1500
1600
13001400
11001200
1080
1060
1090
1080
1100
150000
100000
50000
0
0
200
400
600
800
1000
machine hours
1200
1400
1600
1800
What is Regression analysis used to accomplish in
this article?
• Step 2: contd..
• Assign the fixed portion of the overhead costs to the products
and jobs using a separate base
• Find a separate base that reflects the demands made by the
products and jobs on the fixed resources.
• Use two rates for applying OH costs based on two different
bases
- one for fixed component
- one for variable component
What is Regression analysis used to accomplish in
this article?
• Step 3: Construction of multiple overhead rate
• Variable overhead costs may be driven by several equally
important factors
• Using more than one base for application of overhead costs
will give more accurate cost estimates.
• Perform a multiple regression to construct more than one
overhead rate
- Machine hours (0.77)
- Number of setups (0.39)
• Use FOH costs observations as “Y-Range” and select the range of
observations for both machine hours and no. of setups for “X-Range”
What is Regression analysis used to accomplish in
this article?
• Step 3: Construction of multiple overhead rate
• Regression Equation:
• OH = $19,796.43+ $65.44 MH + $322.21 NS
- monthly total fixed OH costs = $19,796.43
- variable OH costs = $65.44 per Machine hour + $322.21 per setup
• R squared of multiple regression using MH and NS > R-squared
of simple regression for MH. ( 0.95 vs 0.77)
• Variable OH costs based on both machine hours and no of
setups would give more accurate estimates
• Total fixed costs may be applied using a separate base.
What is Regression analysis used to accomplish in
this article?
• Step 3: Construction of multiple overhead rate
• Reliability of the multiple regression
• No of observations used 12
• t value = X coefficients/ Std error of the Coef
• t critical = 2 ( general rule 2 indicates highly reliable estimate)
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t value for machine hours = 9.7 (65.44/6.74)
t value for no of setups = 5.49 (322.21/58.66)
What is Regression analysis used to accomplish in
this article?
• Step 4: Rates for activity based costing
• Regression analysis is used to investigate the strength of the
relationship between the various activities and cost drivers for
selection of proper bases.
• To classify a large no of activities into a few groups (cost
pools) based on common bases/drivers
• Use simple regression to study the relationship between activities
and cost drivers.
• Based on R squared values, group activities into cost pools which
have common bases/cost drivers.
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Regression analysis is
•practical, effective and objective
•simple when powered by Excel!!!
What are the steps to perform a simple regression
analysis?
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Collect actual data on selected variables for several
periods.
Ensure consistency in period: daily, weekly, monthly
Tabulate dependent (Y) and independent (X)
variable on a spreadsheet.
Use the Tools–data analysis-regression
The window will ask to specify X and Y variable to
perform regression.
Interpret the regression results
Use regression equation to estimate
Table 1
Data for Regression Analysis
Data points
A
B
C
D
Factory OH
costs
Direct labor hours
Machine hours
no of setups
(Y)
X1
X2
X3
1
155000
985
1060
200
2
160000
1068
1080
225
3
170000
1095
1100
250
4
165000
1105
1200
202
5
185000
1200
1600
210
6
135000
1160
1100
150
7
145000
1145
1080
165
8
150000
1025
1090
180
9
180000
1115
1300
204
10
175000
1136
1400
206
11
190000
1185
1500
208
12
200000
1220
1700
212
What does Table 4 tell you? … there is no table 7
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Table 4 gives the relationship between the cost type/activities and
the cost drivers.
It gives the strength of the relationship between the cost driver
and the activities. Explains how much of the variability of the cost
type can be explained by the cost driver.
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R squared values for various pairs of Activities and Cost drivers
Maintenance
Packaging
Materials
handling
Storage
Production
scheduling
Machine
hours
0.85
0.46
0.68
0.45
0.82
Pounds of
materials
0.38
0.88
0.90
0.75
0.43
Labor
hours
0.30
0.28
0.38
0.22
0.43
Activities
Cost
driver
Which cost driver would you pick for each cost
type?
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The cost drivers having higher R squared values indicate “stronger”
causal relationship.
According to this analysis, the cost driver would be:
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Machine hours – Maintenance and Production Scheduling
Pounds of materials – Packaging, Materials handling, Storage
R squared values for various pairs of Activities and Cost drivers
Maintenance
Packaging
Materials
handling
Storage
Production
scheduling
Machine
hours
0.85
0.46
0.68
0.45
0.82
Pounds of
materials
0.38
0.88
0.90
0.75
0.43
Labor
hours
0.30
0.28
0.38
0.22
0.43
Activities
Cost
driver