05/03/2023 NHU 501 Dr N R Kidwai, JIT Barabanki 1

Cost Estimation

Unit III Characteristics of Forecasts, Forecasting Horizons, Steps to Forecasting, Forecasting Methods, Seasonal Adjustments, Forecasting Performance Measures, Cost Estimation, Elements of cost, Computation of Material Variances Break Even Analysis‐

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Classification of CostCost According to Elements

Expenses/ OverheadsMaterial Cost Labour Cost

Material cost : Cost of material traceable to one unit of productLabor cost : Cost of human resource involvementExpenses/ overheads : Cost associated with direct /indirect overheads; design, administrative, production, sales/service, distribution

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Classification of Cost

Cost According to Behaviour

Variable CostFixed Cost Semi Variable Cost

Fixed Cost: Fixed in short run and long runVariable Cost: Varies with volume and constant per unitSemi variable Cost: fixed for one level of activity and variable for another

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Classification of Cost

Cost According to Functions

Administration Cost

Production Cost

Selling/ promotion/ Distribution Cost R & D Cost

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Classification of CostCost According to

Management Decisions

Differential Cost

Marginal Cost

Opportunity Cost

Replacement Cost

Imputed Cost

Sunk Cost

Marginal Cost is the cost added by producing one extra unit of a product. Differential cost is the difference between the cost of two alternative decisionsopportunity cost refers to a benefit that could have been, but not received due to choosing other alternative.Sunk cost: is the cost of abandoned plant less salvage value. Not relevant for decision makingImputed Cost or Notional Cost :Actually not incurred (interest on own capital, rent on owned building, etc.) but taken into account in capital budgeting decisions.Replacement Cost : Cost of replacing equipment at current market price.

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Classification of CostCost According to Expenses

Direct Cost Indirect Cost

• Physical assets•Maintenance and operating costs•Materials• Direct labor• Scrapped and reworked product• Direct supervision of personnel

• Utilities• IT systems and networks• Purchasing•Management• Taxes • Legal functions•Warranty and guarantees• Quality assurance•Marketing and publicity

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Cost EstimationCost Estimation : is finding relationship between activities and cost

Cost estimation is done to • Manage cost• Making cost decisions• Plan and set standards

Cost estimation results in reduced costs

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Cost Estimation: simple model• This model ignores other cost behaviours and other cost drivers• This model only takes into account the fixed and variable cost

TC=F+ Q.V

Where TC= Total costF =Fixed costQ =Quantity producedV = Variable cost per unit

Total Cost TC

Fixed Cost FVariable Cost V

Quantity Q

Cost

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Cost Estimation: Unit Method

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• Unit method is Commonly used for preliminary stage estimates

• Total cost estimate TC is per unit cost (CU) times number of units (N)

TC=Cu × NExample• Cost to operate a car at Rs 5/Km for 500 km: TC = 5 × 500 = Rs 2500/-• Cost to build a 100 m2 house at Rs 3000/m2: TC=3000× 100 = Rs 3 lac

Cost factors must be updated time to time

In case of several cost components, cost estimate components are added to determine total cost estimate

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Cost Estimation: Cost Indexes

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Cost Index is ratio of cost today to cost in the past• It Indicates cost changes over time & account for inflation• Index is dimensionless• WPI (Wholesale Price Index) is a good exampleCost estimate using index can be made as

00 IICC t

t

, at timeat eindex valu , at timecost t,mepresent tiat eindex valu t,mepresent tiat cost estimated

where

0000 tItCIC tt

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Cost Estimation: Cost-Capacity Equation

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Cost Capacity equation is also called power law and sizing model

Where C1= Cost at capacity Q1

C2= Cost at capacity Q2

Exponent x defines relation between capacitiesIf x = 1, relationship is linear

x < 1, economies of scale (larger capacity is less costly than linear) x > 1, diseconomies of scale

x

QQCC

1

212

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Cost Estimation: Cost-Capacity Combined with Cost Index

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Example: A 1 hp water pump cost was Rs 3000 five years ago when the cost index was 120. Estimate the cost of a 2 hp water pump today when the cost index is 250. The exponent for a 1 hp motor pump is 0.9.

Solution: Let C2 represent the cost estimate todayC2 = 3000(2/1)0.9(250/120) = Rs 11,663/-

Cost-capacity equation can be combined cost index (It/I0) to adjust for effect of time (inflation)

000 I

IQQCC t

x

tt

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Cost Estimation: Factor Method

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• Factor method is especially useful in estimating total plant cost• Both direct and indirect costs can be includedTotal plant cost estimate TC is overall cost factor (h) times total cost of major equipment items (CE) TC = h × CE

The cost factor is commonly the sum of a direct cost componentand an indirect cost component, i.e h = 1 + Σfi , for i components, Example: A packaging machine is expected to cost 2 crore with installation. The cost factor for direct costs of machine in ready to operate condition is 0.45. A cost factor of 0.15 is used to cover indirect cost. What will the cost of the packaging machine ?Solution: h = 1 + 0.45 + 0.15 = 1.6

TC = 1.6*2 crore= 3.2 crore

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Cost Estimation: Indirect Costs

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Indirect costs (IDC) are incurred in production, processes and service delivery that are not easily tracked and assignable to a specific function. Indirect costs (IDC) are shared by many functions because they are necessary to perform the overall objective of the companyIndirect costs make up a significant percentage of the overall costs in many organizations – 25 to 50%. Few indirect cost examples

• IT services• Quality assurance • Human resources• Management• Safety and security• Purchasing; contracting• Accounting; finance; legal

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Cost Estimation Approach

Equipment and capital Recovery

Direct material

Direct labour

Maintenance and operation

Indirect Cost

Direct Cost

+

+

+

+

+

Total Cost+Desired Profit

Price

Bottom Up ApproachAfter Design stage

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Cost Estimation Approach

Equipment and capital Recovery

Direct material

Direct labour

Maintenance and operation

Indirect Cost

Direct Cost

+

+

+

+

+

Total Cost+Desired Profit

Price

Bottom Up ApproachAfter Design stage

Equipment and capital Recovery

Direct material

Direct labour

Maintenance and operation

Indirect Cost

Direct Cost

+

+

+

+

+

Target Cost+Allowed Profit

Market Price

Top down Approach: Design to costBefore design stage

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Computation of Material Variances•Material Cost Variance(MCV) : Material cost variance is the

difference between actual cost and standard cost.

favourable material variance actual cost < standard cost Unfavourable material variance actual cost > standard cost

direct material cost variance: MCV = (RSQ x SP) - (AQ x AP)

where, revised standard quantity (RSQ) = (SQ/SO x AO) SQ = Standard Quantity, SO = Standard Output , AO = Actual Output

SP = Standard Price, AQ = Actual Quantity, AP = Actual Price

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Computation of Material VariancesExample

- Standard quantity of material Q for 400 units of output is fixed as 700 kg.- Standard price per kg. of material Q is estimated to be Rs 350/-- Actual quantity of material Q was 700 kg.- Actual price of material was Rs 315/kg.- Actual output was 300 units.

Solution,Revised standard quantity (RSQ) = (SQ/SO) x AO

=700/400 x 300 = 550 units.Material Cost Variance(MCV) =(SQxSP)-(AQxAP)

=(550x350)-(700x315)= - 28000/-

Since, the resulting figure is negative the variance is denoted as unfavourable

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Break Even AnalysisA decision maker needs to know which quantity should be sold before entity starts making the profit. Break even analysis determines whether a particular quantity of sales will result in profit or losses

Total Cost TC

Fixed Cost F

Variable Cost V

Quantity

Cost

Revenue

Break even Quantity Q

Steps of break even chart• Draw fixed cost line• Draw variable cost line• Draw Total cost line by adding the two• Draw Revenue line• The point of intersection of revenue line

and total cost line is break even point

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Break Even AnalysisExample: Manufacturing of a engineering product requires fixed cost of Rs 42 lac for 1 lac quantity. Variable cost per product unit is Rs 30/- for material, Rs 15/- for labour, and Rs 5/- for other overheads. Selling price of the product is Rs 120/- Determine the quantity beyond which firm starts making profit (break even quantity)

Fixed Cost = 50 lacVariable cost / unit = 30+15+5= Rs 50/-Total Cost = 4200000 + 50 x QRevenue = 120 x QBreak even quantity B: 120 x B = 4200000 + 50 x B

B = 60000

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Break Even Analysis: Limitations

Break even analysis make some assumptions• Selling price remains constant• Variable cost is proportional to quantity produced• Fixed cost remains constant• All quantity produced is sold

These assumptions are not realistic mostly, and are limitations of breakeven analysis