Chapter Six

Cost Estimation

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 2

Learning Objectives

• Understand the strategic role of cost estimation

• Understand the six steps of cost estimation

• Apply and understand each of three cost estimation

methods: the high-low method, work measurement,
and regression analysis

• Explain the data requirements and implementation

issues associated with each estimation method
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 3

Learning Objectives (continued)

• Use learning curves to estimate a certain class of
non-linear cost function (i.e., to estimate costs when
learning is present)

• Use statistical measures to evaluate a regression

analysis

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 4

Strategic Role of Cost Estimation

• Cost estimation is the development of the functional
relationship between a cost object and its cost drivers
for the purpose of predicting the cost
• Accurate cost estimates facilitate the strategic cost-
management process in two ways:

– Cost estimates based on activity-based, volume-based,

structural, and executional cost drivers facilitate strategic
positioning analysis, value-chain analysis, target costing and
life-cycle costing

– Knowledge of key cost drivers for a cost object, i.e., which

cost drivers are most useful in predicting costs, often plays a
collaborative role to judge and confirm ideas from designers
and engineers
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 5

Cost Function Estimation

There are six steps in the cost estimation process:

Define the cost object to be estimated

Determine the cost driver(s)
– The most important step: specification of underlying causal
factors of a cost

Collect consistent and accurate data

– Consistent means that the data are calculated on the same
accounting basis and all transactions are recorded in the
proper period
– Accuracy refers to the reliability of the data

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 6

Cost Function Estimation (continued)

Graph the data

– To identify unusual patterns, possible nonlinearities, and
any outlier observations

Select and employ a cost-estimation method (e.g.,

linear regression)

Assess the accuracy (descriptive validity) of the

estimated cost function
– One measure of the accuracy of the estimated cost
function is the mean absolute percentage error (MAPE)
produced by that function
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 7

Cost Estimation
Methods
• There are three cost estimation methods discussed
in this chapter:
– The High-Low method
– Work measurement
– Regression analysis (both linear and nonlinear models)

• The methods above are listed in order from least to

most accurate, but the cost and effort in employing
the methods are the reverse of this sequence
• The method chosen by the cost analyst will depend
on the level of accuracy desired and any limitations
on cost, time, and effort
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 8

Cost Estimation: An Example

Bill Garcia, a management accountant, wants to
estimate future maintenance costs for a large
manufacturing company; recent monthly data are as
follows:
January February March April May June July
22,943 22,510 22,706 23,030 22,413 22,935 23,176

24,000

23,500

23,000

22,500

22,000
January February March April May June July

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 9

Cost Estimation: Example

(continued)
Based on above information, Garcia feels that maintenance
costs for August will likely be between $22,500 and $23,500,
but he wants to be more accurate so he considers the use of
a cost estimation method
January February March April May June July
22,943 22,510 22,706 23,030 22,413 22,935 23,176

24,000

23,500

23,000

22,500

22,000
January February March April May June July

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 10

Cost Estimation: Example

(continued)
That is, Garcia would like to estimate an underlying
cost function for maintenance costs. Garcia feels there
is an economic relationship between maintenance cost
and monthly operating hours (a cost driver), so he
collects the following monthly observations:

January February March April May June July

Total operating hours 3,451 3,325 3,383 3,614 3,423 3,410 3,500
Maintenance costs ($) 22,943 22,510 22,706 23,030 22,413 22,935 23,176

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 11

Cost Estimation: Example (continued)

Another graph is created to incorporate the new data:

January February March April May June July
Total operating hours 3,451 3,325 3,383 3,614 3,423 3,410 3,500
Maintenance costs ($) 22,943 22,510 22,706 23,030 22,413 22,935 23,176

23,600
23,400
Maintenance Costs

July
23,200 April
23,000 June

22,800 March January

22,600
22,400 February May
22,200
22,000
3,300 3,350 3,400 3,450 3,500 3,550 3,600 3,650
Total Operating Hours

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 12

The High-Low Method

The high-low method uses algebra to determine a unique
estimation line (cost function) between representative high and
low points in the data
– This method provides a unique cost line rather than a rough
estimate based on a visual fitting of a cost function line through a
set of data points
– The high-low equation is as follows:
Y = a + (bX)

Where Y = the value of the estimated cost

X = the cost driver
a = a fixed quantity that represents Y when X is zero
b = the slope of the line (unit variable cost)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 13

The High-Low Method (continued)

• Using the graph, Garcia picks two data points, one

representative of the lower points and one
representative of the higher points (these points are
often, but not necessarily, the highest and lowest
points in the data set)

• Let us assume that Garcia picks from the data set

February (low point) and April (high point)

• The next step is to calculate the equation of the line

connecting these two points
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 14

The High-Low Method (continued)

Hours Cost
High Point (April) 3,614 $ 23,030
Low Point (February) 3,325 22,510
Change 289 $ 520

 b = Unit variable cost = $520 ÷ 289 hours = $1.80/hour

 a = Fixed cost = Total cost – Estimated variable cost

Fixed cost = $23,030 – ($1.80/hour × 3,614 hours)
Fixed cost = $23,030 – $6,505 = $16,525

 Estimated cost function:

Total cost = Fixed cost + Variable cost
Y = a + (b × X)]
Y = $16,525 + ($1.80 × X)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 15

The High-Low Method (continued)

For values of the cost driver (operating hours) within the

“relevant range,” the preceding equation can be used to
estimate monthly maintenance costs. For example, for the
month of August:

Suppose that 3,600 operating hours are expected

in August:

Y = 16,525 + (1.80 x X)
Y = 16,525 + (1.80 x 3,600)
Y = 16,525 + 6,480
Y = $23,005 in maintenance costs
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 16

The High-Low Method (continued)

Pros:
– Requires less effort and cost than the other two methods
– Provides a unique cost equation from which the
management accountant can estimate future costs –
useful in calculating total cost
Cons:
– Does not provide us with a measure of “goodness-of-fit”
– Relies on only two points, and the selection of those two
points requires judgment (that is, it discards most of the
data)
– The other two methods are more sophisticated and
therefore will likely provide more accurate estimates of
cost
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 17

Work Measurement

The work-measurement method is an engineering-

based estimation method that makes a detailed
study of some production or service activity to
measure the time or input required per unit of output

– This method is applied to manufacturing operations for

direct costs (i.e., where there is a strong “input-out”
relationship)
– This method is also used in non-manufacturing contexts to
measure the time required to complete certain tasks, such
as processing receipts or bills for payment

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 18

Work Measurement (continued)

There are many work-measurement methods

used in practice today, but work sampling is the
most common

– Work sampling is method that makes a series of

measurements about the activity under study, and the
measurements are analyzed statistically to obtain
estimates of the time and/or materials the activity
requires

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 19

Regression Analysis

Regression analysis is a statistical method for

obtaining the unique cost-estimating equation by
minimizing, for a set of data points, the sum of the
squares of the estimation errors:

– An error is the distance measured from the regression

line to one of the data points
– Appropriately, this method of cost-estimation is referred
to as least-squares regression

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 20

Regression Analysis
(continued)

Regression involves two types of variables:

– The dependent variable is the cost to be estimated

– The independent variable is the cost driver(s) used to
estimate cost:

• When one cost driver is used, the regression model is

referred to as a simple regression model
• When two or more cost drivers are used, the regression
model is referred to as a multiple regression model

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 21

Regression Analysis (continued)

A simple (i.e., one-variable), linear regression equation

is as follows:

Y = a + bX + e

Where: Y = the amount of the dependent variable , the cost to be estimated

a = a fixed quantity , also called the intercept or constant term, which
represents the amount of Y when X = 0
X = the value for the independent variable , the cost driver for the cost to be
estimated (note: a multiple-regression model would include two or more
cost drivers)
b = the unit variable cost , also called the coefficient of the independent variable,
that is, the increase in Y (cost) for each unit increase in X (cost driver)
e = the estimation error , which (for each data point) is the distance between
the regression line and the data point
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 22

Regression Analysis (continued)

To illustrate a simple, linear regression cost-estimation
model, the following table contains three months of data
on supplies expense and production levels (normally 12
or more points will be involved):

Month Supplies Expense (Y) Production Level (X)

1 $250 50 units
2 310 100 units
3 325 150 units
4 ? 125 units

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 23

Regression Analysis (continued)

400

350

300
Regression for the data is
determined by a statistical procedure
250 that finds the unique line through
the data points, i.e., the one that minimizes
200 the sum of squared error distances.

50 100 150 Units of Output

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 24

Regression Analysis (continued)

400

350 e = 15
e = 7.5
300
e = 7.5 b = the slope of the regression line = the
coefficient of the independent variable
250 b = $0.75 variable cost per unit of output, X

a = 220
200 Fixed Cost = $220

50 100 150 Units of Output

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 25

Regression Analysis (continued)

Month Supplies Expense (Y) Production Level (X)

1 $250 50 units
2 310 100 units
3 325 150 units
4 ? 125 units

Y = a + bX
Y = $220 + ($0.75 per unit  125 units)
Y = $313.75 = Estimated Cost, Month 4
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 26

Regression Analysis (continued)

Pros:
– Objective, statistically precise method of estimating future costs
– Uses all of the available data
– Dummy variables can be added to the equation to represent the
presence or absence of a condition (e.g., seasonality effects)
– Provides quantitative measures of its precision (“goodness-of-
fit”) and reliability (R-squared, t-values, the standard error of the
estimate (SE), and the p-values)
– Readily available software (such as Excel) to do the
calculations

Cons:
– Can be influenced strongly by unusual data points (called
outliers) resulting in a line that is not representative of most of
the data
– Most expensive and time-consuming method to implement
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 27

Regression Analysis: Measuring

Precision and Reliability

R-squared

– A number between zero and one that describes the

explanatory power of the regression (the degree to which
the change in Y can be explained by changes in X)
– A relative measure of “goodness-of-fit” (i.e., the
percentage change in Y that can be explained by
changes in X)
– The maximum value for R² is 1.00 (i.e., 100%)

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 28

Regression Analysis: Measuring

Precision and Reliability (continued)
T-value

– A measure of the statistical reliability of each independent

variable in the cost function: does the independent variable
have a valid, stable, relationship with dependent variable?
– Variables with a low t-value should be evaluated and
possibly removed to improve cost estimation
– In a multiple-regression model, low t-values signal the
possibility of multicollinearity, meaning two or more
independent variables may be highly correlated with each
other; removal of one or more of these variables may be
desirable
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 29

Regression Analysis: Measuring

Precision and Reliability (continued)
Standard error of the estimate (SE)

– A measure of the accuracy of the regression’s estimate

– An absolute measure of “goodness-of-fit” for the regression
equation (i.e., SE measures the average variability of the data
points around the regression line; an SE of zero means that all
of the data points are on the regression line)
– Related computationally to R2 (an SE of 0 implies an R2 of
100%)
– Can be used to establish Confidence Intervals for cost
estimation (i.e., range estimates for future costs, based on
probability assessments)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 30

Regression Analysis: Measuring

Precision and Reliability (continued)

– SE can be compared to the average size of the dependent

variable
• If the SE value is relatively small compared to the value of the
dependent variable, the regression model can be viewed as
relatively “good”

P-values

– Measures the risk that the true (i.e., population) value of a

given cost coefficient (slope) is zero; lower p-values imply
rejection of the null hypothesis of no relationship between X
and Y
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 31

Regression Analysis (continued)

Continuing on with the Garcia example, regression

software (such Excel) produces the following output:

Y = $15,843 + ($2.02 x 3,600)

Y = $23,115 in maintenance costs

The statistical measures are:

R-squared = 0.461
SE = $221.71
t -value = 2.07
p -value = 0.090
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 32

Regression Analysis (continued)

Garcia reviews the results of his analysis:

– R-squared is less than 0.50, which is a bit lower than desired

– However, the SE is approximately 1% of the mean of the
dependent variable, which is good
– The t-value on the estimated coefficient is slightly more than
2, which implies a low probability that there is no relationship
between monthly maintenance costs and changes in units of
output this
– Associated with a marginally high t-value for the
independent variable, the p-value for the regression
equation is about 10% (typically, we look for a p-value of 5%
or less)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 33

Regression Analysis (continued)

But why is R2 relatively low?

– He notices that May’s maintenance costs are unusually
low compared to the other months and decides to use a
dummy variable to possibly capture seasonal effects
(therefore, he assigns a value of one for May and a value
of zero for the other months)
– After this addition to the formula, the quantitative
measures all improve: apparently, the seasonal
fluctuation was distorting the results

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 34

Regression Analysis (continued)

These are the results after inclusion of the dummy variable:
Y = $16,467 + ($1.856 X) - ($408.638 x D)
Y = $16,467 + ($1.856 x 3,600) - ($408.638 x 0)
Y = $16,467 + $6,682
Y = $23,149 in maintenance costs

The statistical measures are:

R-squared = 0.772
SE = $161.27
t -values:
Hours = 2.60
Dummy variable = -2.33
p -values:
Hours = 0.050
Dummy variable = 0.070
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 35

Data Requirements

To develop a cost estimate using statistical

methods (e.g., High-Low or regression analysis),
management accountants must consider aspects of
data collection that can significantly influence
precision and reliability

Several issues arise....

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 36

Data Requirements (continued)

There are three main issues: data accuracy, time
period choice, and nonlinearity:

– Data accuracy can be improved by strengthening

internal reporting requirements and researching
sources of external data

– Time period choice refers to the importance of

obtaining information from the same time period and for
an adequate length of time

– Nonlinearity can be the result of trends/seasonality,

outliers, or data shifts; these events cause linear
regression to be inaccurate and adjustments must be
made
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 37

Learning Curve Analysis

• A cost whose amount is influenced by learning

is an example of nonlinear cost behavior

• When an activity has a certain labor

component and repetition of the same activity
or operation makes the labor more proficient,
the task over time is completed more quickly
with the same or higher level of quality

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 38

Learning Curve Analysis

(continued)

Learning curve analysis is a systematic method for

estimating costs when learning is present:

– The learning rate, obtained by reviewing historical data, is

the percentage by which average time (or total time) falls
from previous levels as output doubles
– A learning rate range from one (no learning) to 0.5 (best
possible; note, however, that a learning rate of 0.5 is not
achievable in practice—it implies infinite learning!)

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 39

Learning Curve Analysis

(continued)

Below is the general equation used in learning-

curve analysis:

Y = aXb

Where: Y = the average time per unit of output

a = the time required for the first unit of output
X = cumulative output
b = the learning index

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008

 40

Learning Curve Analysis

(continued)
• This cost-estimation model is useful in: life-cycle
planning, cost-volume-profit analysis, budgeting
production levels and labor needs, make-or-buy
decisions, preparing bids for production contracts,
developing standard product costs, managerial
control, and capital budgeting

• Y/a is the “learning rate”; for a learning rate of 80%

and with the common assumption that that learning
rate applies when output doubles, the learning index
is b = -0.3219
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 41

Learning Curve Analysis (continued)

Learning curve analysis has three inherent limitations:
The approach is for labor-intensive contexts that involve
repetitive tasks performed for long production runs, and this
environment is becoming less and less common in the
business world

The learning rate is assumed to be constant

A carefully estimated learning curve might be unreliable

because the observed change in productivity in the data
used to fit the model was actually associated with factors
other than learning
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 42

Chapter Summary

• Accurate cost estimates are a critical starting point for

strategic cost management

• There are six steps in the cost estimation process:

define the cost object to be estimated, determine the
cost driver(s), collect consistent and accurate data,
graph the data, select and employ a cost-estimation
method, and assess the accuracy of the cost estimates

• Three cost-estimation methods are discussed in this

chapter: the high-low method, work measurement, and
regression analysis
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008
 43

Chapter Summary (continued)

• Quantitative measures are available to judge the

precision and reliability of regression analysis; these
measures include: R-squared, SE, t-values, and p-values

• There are three main issues to consider when collecting

data to be used in a statistical cost-estimation model
(such as regression or High-Low): data accuracy, time
period choice, and non-linearity

• Learning curve analysis is a systematic method for

estimating costs when learning is present; learning curve
models represent a particular class of nonlinear cost
functions
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008