2. An example of account analysis as a cost estimation method

Let’s look at an example of how the account analysis may look like.

Mary Smith, CPA works as a controller for Kledd Corp. She needs to estimate the total manufacturing cost of the company’s new manufacturing facility in Castlebar, Ireland for its second year of operations. Mary has access to accounting information for the manufacturing facility from its first year of operations. Using her experience and judgment, Mary thinks that changes in manufacturing costs are due to the changes in the volume of production. The company relies on advanced manufacturing equipment. Mary decides to use machine hours as a cost driver in her model. She goes through each relevant account and classifies it as variable or fixed depending on whether the account changes in response to the changes in production, proxied with the changes in machine hours. 

In the first year of operations, the company used 3,000 machine hours and incurred the following costs:

Next, Mary decomposes total cost into fixed and variable costs and calculates the totals. To determine the variable cost per machine hour, she divides variable costs by 3,000 machine hours.

In this example, direct materials and direct labor are variable costs (i.e., total cost consists of only variable cost). Factory utilities and factory maintenance are mixed costs: the total cost consists of fixed cost and variable cost. Finally, factory insurance, factory property taxes, factory supervisor salary, and factory depreciation are fixed costs.

The total cost of $11,449,000 consists of $1,429,000 total fixed cost and $10,020,000 total variable cost. To determine the variable cost per unit (of the cost driver), we need to divide the variable costs by the cost driver level at which we incurred those variable costs. In the example, the company incurred the total variable cost of $10,020,000 when the company used 3,000 machine hours. Machine hours are used as a cost driver in the example. Thus, the total variable cost per machine hour is $3,340.

The total cost can be expressed as follows:

Total Cost = $1,429,000 + $3,340 per Machine Hour x Machine Hours

Now, Mary can use the equation above to estimate total cost using machine hours level within the relevant range. For example, if management estimates that the factory will use 3,200 machine hours the following year, the estimated total cost will be determined as follows:

Total Cost = $1,429,000 + $3,340 x 3,200 = $12,117,000

As we can see in this example, the account analysis is a simple tool that can be used to estimate total cost. However, this method is subjective as it relies on the individual judgement when classifying costs into fixed and variable. It might be important to supplement account analysis with the statistical analysis of data.

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