Reasons and methods of cost estimation in accounting
2. What are the common cost estimation methods (tools)?
There are multiple tools (models) that can be used in cost estimation. The decision to use a specific cost estimation tool will likely depend on the information needs and available resources for cost estimation.
Here we will discuss general cost estimation methods that are commonly used by business professionals. In some cases, however, some other cost estimation techniques may be more appropriate.
Cost estimation methods:
- Account analysis
- Statistical analysis
- Engineering data analysis and modeling
Account analysis is a cost estimation method where a subjective assessment of various accounts is used to estimate cost behavior and predict costs. In the account analysis process an accountant or a manager goes through cost accounts and classifies them as fixed or variable in terms of their cost behavior. The accountant can use his or her own experience and knowledge or can also consult with other professionals who have experience in similar activities, tasks, processes, or projects (i.e., estimation by analogy). Once the total fixed and total variable costs are determined, the accountant or manager can develop a simple mathematical model that explains the components of the total cost. Standard office tools such as MS Excel can be used in the account analysis process.
Account analysis is a simple tool but is affected by personal judgment. It is a good starting point in the cost estimation process. However, it should be supplemented with more objective cost estimation tools.
Statistical analysis is a cost estimation method that uses historical data to estimate or predict costs. The analysis of data can be performed in a statistical package. Statistical tools include visual representations of data such as scatter graphs, pie charts, tree maps, and so on. In addition to the visual data analysis, the high-low method and regression analysis are used to predict costs. While the high-low method and linear regression method are based on the linear estimates, managers can develop alternative models that include non-linear cost behavior. For example, if there is a learning phenomenon, the cost estimation model based on the linear estimates will incorrectly predict costs. In the presence of the learning phenomenon, the average product or service cost declines in the non-linear fashion.
In addition to the account and statistical analyses, organizations can also use engineering estimates to predict certain costs. Managers can hire engineers to analyze activities (processes) that impact costs. Using various formulas from physics, calculus, or other sciences, engineers can estimate activities and costs associated with those activities. These estimates, however, are usually based on the optimal conditions (i.e., optimization usually involves either finding a maximum or minimum for a given function). As such, the estimated costs may not be realistic in many scenarios. Nevertheless, engineering estimates can be used as benchmarks and can help organizations determine their strengths and weaknesses and find slack in their operations. Also, engineering estimates are useful in predicting the cost of new activities or products. While engineering estimates can be quite useful in some situations, they are usually expensive to implement.
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