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12-1 12 Cost Estimation Student Tutorial Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000 12-2 Concept of Cost Estimation 1. Identify ....
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12 Cost Estimation Student Tutorial

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12-2

Concept of Cost Estimation 1. Identify . . .

Relationship Relationship between between activities activities and andcosts costs

2. Manage . . .

Activities Activities

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3. This results in reduced . . .

Costs Costs

We We estimate estimate costs costs to: to: !manage !managecosts costs "make "makedecisions decisions #plan #plan&&set set standards. standards.

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One Cost Driver and Fixed/Variable Cost behaviour

TC = F + VX Where: TC = F = V = X =

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This This model model ignores ignores other other cost cost behaviours behaviours and and other other cost cost drivers. drivers.

Total Costs Fixed Costs Variable Cost Driver Rate # of Cost Driver Units

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One Cost Driver and Fixed/Variable Cost behaviour TC = $190 + (.16 x Miles Driven) 600

510

500

$.16

Cost

400

350

300 200

190

Slope Slope == Cost Cost Driver Driver Rate Rate

Intercept Intercept == Fixed Fixed Cost Cost

100 0 0

1000

2000

3000

Miles driven per month Irwin/McGraw-Hill

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One Cost Driver and Fixed/Variable Cost behaviour

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Snail, Snail, Inc. Inc. makes makes one one model model of of basketball basketball shoe. shoe. The The shoe shoe has has aa sales sales price price of of $125 $125 per per pair. pair. ItIt costs costs $45 $45 per per pair pair to to make make the the shoes. shoes. In In addition, addition, Snail Snail has has $550,000 $550,000 in in fixed fixed costs costs that that must must be be covered covered each each month. month. Irwin/McGraw-Hill

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One Cost Driver and Fixed/Variable Cost behaviour IfIf Snail Snail makes makes 8,000 8,000 pairs pairs in in May, May, what what is is the the total total cost? cost? A. 360,000 A. $$ 360,000 B. B. C. C.

$$ 1,000,000 1,000,000 $$ 550,000 550,000

D. D.

$$ 910,000 910,000 Return to original information.

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One Cost Driver and Fixed/Variable Cost behaviour IfIf Snail Snail makes makes 8,000 8,000 pairs pairs in in May, May, what what is is the the total total cost? cost? A. 360,000 A. $$ 360,000 This is total B. variable cost, but it B. $$ 1,000,000 1,000,000 is not the correct C. $ 550,000 C. $ 550,000 answer. Try again. D. D. $$ 910,000 910,000 Return to original information. Irwin/McGraw-Hill

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One Cost Driver and Fixed/Variable Cost behaviour IfIf Snail Snail makes makes 8,000 8,000 pairs pairs in in May, May, what what is is the the total total cost? cost? A. 360,000 A. $$ 360,000 For some reason, B. you have given me B. $$ 1,000,000 1,000,000 Total Revenue. Try C. $ 550,000 C. $ 550,000 again. D. D. $$ 910,000 910,000 Return to original information. Irwin/McGraw-Hill

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One Cost Driver and Fixed/Variable Cost behaviour IfIf Snail Snail makes makes 8,000 8,000 pairs pairs in in May, May, what what is is the the total total cost? cost? A. 360,000 A. $$ 360,000 This is the fixed B. cost for Snail. I B. $$ 1,000,000 1,000,000 need Total Cost! C. $ 550,000 C. $ 550,000 Try again. D. D. $$ 910,000 910,000 Return to original information. Irwin/McGraw-Hill

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One Cost Driver and Fixed/Variable Cost behaviour IfIf Snail Snail makes makes 8,000 8,000 pairs pairs in in May, May, what what is is the the total total cost? cost? A. 360,000 A. $$ 360,000 B. B. C. C.

$$ 1,000,000 1,000,000 $$ 550,000 550,000

D. D.

$$ 910,000 910,000

Congratulations! You can now proceed.

( $45 × 8,000 ) + $550,000 = Irwin/McGraw-Hill

$910,000

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Multiple Cost Drivers and Complex Cost behaviour In In cases cases of of complex complex cost cost behaviour behaviour and and multiple multiple cost cost drivers, drivers, the the cost-benefit cost-benefit test test should should be be considered considered when when developing developing aa cost cost estimation estimation model. model. Irwin/McGraw-Hill

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Multiple Cost Drivers and Complex Cost behaviour Step Step Cost Cost •A •Acost cost that that increases increasesin insteps steps as asthe theamount amountof of the the cost cost driver drivervolume volume increases. increases. •Also •Also called calledaa “semifixed “semifixedcost” cost”

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Costs Costsstay stayfixed fixedover overaa small smallrange rangeof ofactivity activity called called the the“relevant “relevant range”. range”. As Asactivity activity increases increasesto tothe thenext next “relevant “relevant range,” range,”costs costs step stepup upto tothe thenext next level. level.

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Multiple Cost Drivers and Complex Cost behaviour Exhibit 12-3: Step Costs Example Delivery People Cost

70 60

11person person can can make make50 50 deliveries deliveriesper perday. day. Anything Anything more morethan than50 50 requires requiresan anadditional additional delivery deliveryperson. person.

50 40 30

Relevant Range

20 10 0 0

50

100

Number of meals per job Irwin/McGraw-Hill

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Semivariable Costs A semivariable cost is one that has both a fixed and a variable component.

Exhibit 12-4: Semivariable Costs Example 80

Cost

60

40

20

0 0

20

40

60

Minutes per month

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80

100

For example, a cellular phone plan that charges $40 for the first 60 minutes and a per minute charge thereafter.

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Nonlinear Costs A nonlinear cost is one has a curved component.

Exhibit 12-5: Nonlinear Cost Example

80

Cost

60 40 20 0 0

20

40

60

80

100

For example, the cost of an item may get increasingly cheaper as the quantity purchased increases.

Quantity purchased

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Cost Estimation Methods Alternatives There There are are several several different different methods methods available available for for cost cost estimation: estimation: A Scattergraph plots past costs against cost drivers and creates a visual indicator of cost behaviour.

Regression Irwin/McGraw-Hill

Hi-Lo estimates a cost function by using the costs for the highest and lowest cost driver levels during a period. © The McGraw-Hill Companies, Inc., 2000

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Cost Estimation Methods Regression Analysis AAstatistical statisticalmethod method used usedto to create createan an equation equationrelating relating independent independent(or (orX) variablesto todependent dependent(or (orY) X)variables Y) variables. variables. Past Pastdata datais isused used to toestimate estimaterelationships relationshipsbetween between costs costsand and activities. activities.

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Cost Estimation Methods Regression Analysis AAstatistical statisticalmethod method used usedto to create createan an equation equationrelating relating independent independent(or (orX) variablesto todependent dependent(or (orY) X)variables Y) variables. variables. Past Pastdata datais isused used to toestimate estimaterelationships relationshipsbetween between costs costsand and activities. activities.

Independent variables are the cost drivers that are correlated with the dependent variables. Irwin/McGraw-Hill

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Cost Estimation Methods Regression Analysis AAstatistical statisticalmethod method used usedto to create createan an equation equationrelating relating independent independent(or (orX) variablesto todependent dependent(or (orY) X)variables Y) variables. variables. Past Pastdata datais isused used to toestimate estimaterelationships relationshipsbetween between costs costsand and activities. activities.

Dependent variables are caused by the independent variables. Irwin/McGraw-Hill

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Cost Estimation Methods Regression Analysis The The simple simple cost cost model model is is actually actually aa regression regression model: model: TC TC == FF ++ VX VX This Thismodel modelwill willonly only be beuseful usefulwithin within aa relevant relevant range rangeof of activity. activity.

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Caution: Before doing the analysis, take time to determine if a logical relationship between the variables exists. © The McGraw-Hill Companies, Inc., 2000

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Cost Estimation Methods Regression Analysis A A set set of of data data can can be be regressed regressed using using several several techniques: techniques: •Manual computations •Manual computations •SPSS or SAS SAS Statistical Statistical Software Software •SPSS or •Excel or other other spreadsheet spreadsheet •Excel or The Theresult resultof of the the regression regressionprocess processis isaa regression regressionmodel: model:

Each regression model has an R-square (R2) measure of how good the model is.

TC TC == FF ++ VX VX

Range of R2 = 0 to 1.0

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Cost Estimation Methods Regression Analysis $ The result result of of the the regression regression process process is is aa line line $ The that that best best fits fits the the available available data. data. $ The “line” “line” is is defined defined by by two two numbers: numbers: $ The % thepoint point at at which which the the line line %y-intercept y-intercept -- the crosses crosses the the y-axis. y-axis. In In the theformula, formula, this this is is the the Fixed Fixed Cost Cost number. number. % theamount amountthat that the the independent independentyy%Slope Slope -- the variable variable increases increasesfor for an an increase increase in in the the dependent dependent x-variable. x-variable. This This is is Variable Variable Cost Cost in in the the formula. formula. Irwin/McGraw-Hill

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Cost Estimation Methods Regression Analysis $ $A A model model of: of:

yy == 2.7684x 2.7684x ++ 2618.70 2618.70 $ $Means Means we we have have aa cost cost structure structure with with aa

fixed fixed cost cost of of $2,618.70 $2,618.70 and and variable variable costs costs per per unit unit of of $2.7684. $2.7684.

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Cost Estimation Methods Multiple Regression Analysis Multiple Regression is a regression that has more than one independent (X) variable. Useful Usefulin insituations situationswhere where the thedependent dependent variable variableis is impacted impactedby byseveral several different different independent independent variables. variables.

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For Forexample, example, demand demand may maybe beaffected affectedby by things thingssuch suchas asinflation, inflation, interest interestrates, rates,and and competitors’ competitors’ prices. prices.

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Cost Estimation Methods Account Analysis A A method method that that looks looks at at past past costs costs to to estimate estimate current current cost-driver cost-driver rates. rates.

More expensive than ! Breakcosts costsinto intocategories categories !Break corresponding regression, corresponding to toeach eachcost costdriver. driver. and requires " Sumtotal totalcosts costsfor foreach eachcost cost "Sum driver more detailed drivercategory. category. breakdown of # Dividetotal totalcost cost for foraagiven givencost cost #Divide driver costs. drivercategory categoryby bycost cost driver driver volume. volume. Irwin/McGraw-Hill

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Cost Estimation Methods Peepers, Peepers, Inc. Inc. is is aa small small company company with with one one cost cost driver. driver. Which Which method method would would be be the the most most appropriate appropriate for for estimating estimating aa cost cost function? function? A. Scattergraph A. Scattergraph B. B. C. C.

Multiple Multiple Regression Regression Account Account Analysis Analysis

D. D.

Simple Simple Regression Regression

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Cost Estimation Methods Peepers, Peepers, Inc. Inc. is is aa small small company company with with one one cost cost driver. driver. Which Which method method would would be be the the most most appropriate appropriate for for estimating estimating aa cost cost function? function? Scattergraphs are A. Scattergraph A. Scattergraph very imprecise and B. B. Multiple Multiple Regression Regression inaccurate. Try C. again. C. Account Account Analysis Analysis D. D. Simple Simple Regression Regression

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Cost Estimation Methods Peepers, Peepers, Inc. Inc. is is aa small small company company with with one one cost cost driver. driver. Which Which method method would would be be the the most most appropriate appropriate for for estimating estimating aa cost cost function? function? A. Multiple Regression Scattergraph A. Scattergraph is only used when B. Multiple Regression B. Multiple Regression we have more than C. C. Account Account Analysis Analysis one cost driver. Try again. D. D. Simple Simple Regression Regression

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Cost Estimation Methods Peepers, Peepers, Inc. Inc. is is aa small small company company with with one one cost cost driver. driver. Which Which method method would would be be the the most most appropriate appropriate for for estimating estimating aa cost cost function? function? A. Scattergraph A. Scattergraph Account Analysis is B. B. Multiple Multiple Regression Regression too expensive for a small company. Try C. C. Account Account Analysis Analysis again. D. D. Simple Simple Regression Regression

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Cost Estimation Methods Peepers, Peepers, Inc. Inc. is is aa small small company company with with one one cost cost driver. driver. Which Which method method would would be be the the most most appropriate appropriate for for estimating estimating aa cost cost function? function? A. Scattergraph A. Scattergraph B. B. C. C.

Multiple Multiple Regression Regression Account Account Analysis Analysis

D. D.

Simple Simple Regression Regression

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Congratulations! You can now proceed. © The McGraw-Hill Companies, Inc., 2000

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Cost Estimation Methods Data Problems Mismatched Time Periods Missing Data

Allocated Costs Irwin/McGraw-Hill

Outliers

Inflation

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Cost Estimation Methods Engineering Method Cost Cost estimates estimates are are based based on on measurement measurement and and pricing pricing of of the the work work involved involved in in the the activities activities that that go go into into aa product. product. Not Not based based on on past past costs. costs. Irwin/McGraw-Hill

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Choosing an Estimation Method Things to Consider Regression Regressionand and account account analysis analysisrely relyon on past past data. data. Engineering Engineering relies relieson onpresent present data. data.

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Each Eachmethod method will willlikely likelyyield yield aadifferent different estimate. estimate.

Cost/Benefit Cost/Benefit must must be be considered considered in in choosing choosingaa method. method. © The McGraw-Hill Companies, Inc., 2000

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End of Chapter 12

I wonder if I have regressed TOO far? Irwin/McGraw-Hill

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