CHAPTER 6 COST ESTIMATION

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CHAPTER 6COST ESTIMATION

• Jinashree Rajendrakumar
• Jisha Nambiar
• Madhuri Chakraborty
• Priyanka Tyagi
• Shalini Singh

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• CASE 6.2

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Case 6.2 The Pump Division

• 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.

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Examples

• (In thousands) Job 1 Job2
• Original Cost Estimate 2,113 1,800
• Costs Incurred to date
• Manufacturing 2,100 -
• Engineering 373 100
• Estimate to complete 367 2,500
• Total current Estimate 2,840 2,600
• Lower-of-cost-or-market Contract sales
  price 2,520 2,000
• Less 10 Allowance for Normal Profit Margin
  (252) (200)
• Inventory Value 2,268 1,800
• Inventory Reserve Adjustment (loss) (572)
  (800)

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Current Problems in the Department

• 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.

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Some unanswered Questions ?

• 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)?

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Inventories

• 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
• Adjusting inventory to physical count Perform
  an annual physical inventory count of inventories
  and reconcile the changes with the inventory
  balance.
• 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.)

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What courses of action appropriate for plant
manager his controller relating to Estimating
Costs

• 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 projects 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.

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Contd..

• 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.
• Cost estimation should build in inflation into
  the cost estimates using Index. Historical data
  can be used to load the estimates for inflation.
• Perform a risk assessment on the entire project
  in order to define and quantify the potential
  risk areas and types.
• Cost estimation methods used should be
  consistent, thorough and traceable.

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Lower of Cost or Market value

• 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 written-off in LCM.
• The loss (market value lt 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.

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What courses of action appropriate for plant
manager his controller relating to the
application of LCM rule

• 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.

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What is the significance of the following methods
on the performance of the operation?

• Progress Payments
• Advance Payments
• Escalation Clauses

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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

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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

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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.

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Benefits of escalation clause

• 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

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• CASE 6.1

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Case 6-1(Background)

• 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 _at_ 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

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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
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High Low Method

• 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
• H the cost driver
• Y dependent variable
• Variable Cost (Y) Change in Cost
• Change in Activity
• Fixed Cost (H) Total Cost Variable Cost

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Simple Regression

• A regression analysis has two types of variables
• 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
  dependentvariable can be predicted by changes in
  the independent variable.
• The t-value is a measure of the reliability of
  each of the independent variables.

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Simple Regression Steps
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Steps..
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Steps
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Scatter Plot steps
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Steps
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Steps
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High Low Method Simple Regression

• 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.

• Most accurate and Most costly
• Complex and involves numerous calculations but
  principle is simple.
• Spreadsheet programs now available to handle the
  complexities.

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High Low Method Simple Regression

• 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 9.74Days5250.32

• 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
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In house food service Health
Food Inc

• Other Staff X
• Food Cost X
• Maintenance X
• Equipment X
• Dietitian X
• 11.50Per meal
• XServices utilized by the respective proposals

• X
• X
• X
• X

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In house service Health
food Inc.

• Other Staff VF
• Food Cost VF
• Maintenance VF
• Equipment VF
• Dietitian F
• 11.50 /Meal
• VVariable FFixed Cost

• F
• F
• F
• V

Figures in italics and underlined are not
considered for comparison because they are common
between the options
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Compare the two options

• Cost of In-house meals
• Equation1.35Days1051.76.94Days69.750.32Days
  0.722Days
• Cost 9.33 Days 1121.45
• Cost of HFI s Proposal
• Cost 11.50 per meal

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Comparing variable component of two options

• In-house meal costs 9.33 per patient day
• HFIs proposal 11.50 per meal
• (1 patient day 2.8 meals )
• HFIs proposal 11.50 2.8 32.20 per patient
  day
• Conclusion In-house meal preparation is cheaper

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Comparison of total cost of the options using two
different occupancy levels
Days In house HFI
X1200 (33 occupancy) 9.3312001121.45 12317.45 32.21200 39640
X600 (16 occupancy) 9.336001121.45 6719.45 32.2600 19320
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• READINGS

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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

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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
• direct labor hours
• machine hours
• number of production setups

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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)
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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

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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

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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

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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 gt 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.

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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)
• t value for machine hours 9.7 (65.44/6.74)
• t value for no of setups 5.49
  (322.21/58.66)

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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.
• Regression analysis is
• practical, effective and objective
• simple when powered by Excel!!!

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What are the steps to perform a simple regression
analysis?

• 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 Toolsdata analysis-regression
• The window will ask to specify X and Y variable
  to perform regression.
• Interpret the regression results
• Use regression equation to estimate

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Table 1 Data for Regression Analysis
  A B C D
Data points  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

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What does Table 4 tell you? there is no table 7

• 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.

R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers
Activities Cost driver 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
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Which cost driver would you pick for each cost
type?

• The cost drivers having higher R squared values
  indicate stronger causal relationship.
• According to this analysis, the cost driver would
  be
• Machine hours Maintenance and Production
  Scheduling
• Pounds of materials Packaging, Materials
  handling, Storage

R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers R squared values for various pairs of Activities and Cost drivers
Activities Cost driver 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