Cost Estimation

1
Cost Estimation
Chapter Six
2
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

3
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

4
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

5
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

6
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

7
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