Cost Accounting (14th Edition)

in the United Kingdom has a cost-estimating department that develops cost functions for
its retail banking products (checking accounts, VISA cards, mortgages, and so on) based
on the consensus of estimates from personnel of the particular departments. Elegant Rugs
gathers opinions from supervisors and production engineers about how indirect manufacturing
labor costs vary with machine-hours and direct manufacturing labor-hours.
The conference method encourages interdepartmental cooperation. The pooling of
expert knowledge from different business functions of the value chain gives the conference
method credibility. Because the conference method does not require detailed analysis
of data, cost functions and cost estimates can be developed quickly. However, the emphasis
on opinions rather than systematic estimation means that the accuracy of the cost estimates
depends largely on the care and skill of the people providing the inputs.
Account Analysis Method
The account analysis method estimates cost functions by classifying various cost
accounts as variable, fixed, or mixed with respect to the identified level of activity.
Typically, managers use qualitative rather than quantitative analysis when making these
cost-classification decisions. The account analysis approach is widely used because it is
reasonably accurate, cost-effective, and easy to use.
Consider indirect manufacturing labor costs for a small production area (or cell) at
Elegant Rugs. Indirect manufacturing labor costs include wages paid for supervision,
maintenance, quality control, and setups. During the most recent 12-week period, Elegant
Rugs ran the machines in the cell for a total of 862 hours and incurred total indirect manufacturing
labor costs of $12,501. Using qualitative analysis, the manager and the cost
analyst determine that over this 12-week period indirect manufacturing labor costs are
mixed costs with only one cost driver—machine-hours. As machine-hours vary, one component
of the cost (such as supervision cost) is fixed, whereas another component (such as
maintenance cost) is variable. The goal is to use account analysis to estimate a linear cost
function for indirect manufacturing labor costs with number of machine-hours as the cost
driver. The cost analyst uses experience and judgment to separate total indirect manufacturing
labor costs ($12,501) into costs that are fixed ($2,157, based on 950 hours of
machine capacity for the cell over a 12-week period) and costs that are variable ($10,344)
with respect to the number of machine-hours used. Variable cost per machine-hour is
$10,344 ÷ 862 machine-hours = $12 per machine-hour. The linear cost equation, y = a +
bX, in this example is as follows:
Indirect manufacturing labor costs = $2,157 +
($12 per machine-hour * Number of machine-hours)
Management at Elegant Rugs can use the cost function to estimate the indirect manufacturing
labor costs of using, say, 950 machine-hours to produce carpet in the next
12-week period. Estimated costs equal $2,157 + (950 machine-hours * $12 per
machine-hour) = $13,557.
To obtain reliable estimates of the fixed and variable components of cost, organizations
must take care to ensure that individuals thoroughly knowledgeable about the operations
make the cost-classification decisions. Supplementing the account analysis method
with the conference method improves credibility.
COST ESTIMATION METHODS 347
Quantitative Analysis Method
Quantitative analysis uses a formal mathematical method to fit cost functions to past
data observations. Excel is a useful tool for performing quantitative analysis. Columns B
and C of Exhibit 10-3 show the breakdown of Elegant Rugs’ total machine-hours (862)
and total indirect manufacturing labor costs ($12,501) into weekly data for the most
recent 12-week period. Note that the data are paired; for each week, there is data for the
number of machine-hours and corresponding indirect manufacturing labor costs. For
example, week 12 shows 48 machine-hours and indirect manufacturing labor costs of
$963. The next section uses the data in Exhibit 10-3 to illustrate how to estimate a cost
Decision
Point
What are the
different methods
that can be used to
estimate a cost
function?