Cost estimation methods and an account analysis example

Organizations need to estimate costs to make pricing decisions, manage expenditures and investments, forecast litigation outcomes, bid for government contracts, and so on. The common methods used to estimate costs include: account analysis, statistical analysis, and engineering analysis. In this article, we will review an example of account analysis.

1. What is an account analysis as a cost estimation method?

Account analysis involves the subjective analysis of all cost accounts with the goal of estimating total fixed costs and variable cost per unit. In the account analysis, we assume a linear cost behavior. Within a relevant range of activity, total fixed costs remain the same and variable cost per unit is constant.

When performing account analysis, all fixed cost accounts are added in one group and all variable cost accounts are added in the second group. Once the total fixed cost and total variable cost are determined, we can develop a mathematical model that shows the relationship between total cost and fixed and variable costs. While fixed costs are constant (within the relevant range of activity), variable costs change in response to some factor, which is called the cost driver.

Total Cost = Total Fixed Cost + Total Variable Cost

Total Cost = Total Fixed Cost + Variable Cost per Cost Driver x Cost Driver

Ideally, total cost and cost driver should have a cause-and-effect relationship. In other words, the chosen cost driver should affect total cost. However, in practice sometimes it is difficult to figure out the cost drivers that actually impact costs. Also, there might be no data or data limitations on the cost driver that causes costs. As such, companies often use simple volume-based cost drivers when modeling cost data relationships. For example, the number of units and other volume-based cost drivers such as direct labor hours, machine hours, and direct labor cost are often used as cost drivers. An example is provided below:

Total Cost = Total Fixed Cost + Variable Cost per DLH x DLH

(*) DHL stands for direct labor hour(s)

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